1st Quarter 2014
It was a benign quarter for stocks with most of the major U.S. averages posting modestly positive returns, including the broad market S&P 500 Index (1.81%) and tech-oriented Nasdaq (0.54%) exchange. The only exception was the Dow Jones Industrial Average, which had a slightly negative return. Fourth quarter company earnings were generally in line with (reduced) expectations and, while severe winter weather negatively affected first quarter growth, there were relatively few macroeconomic surprises during the period.
The modest returns masked an increase in volatility, however, as a number of interesting cross currents and potential trend shifts emerged. Although indicators like the Chicago Board Options Exchange (CBOE) Market Volatility Index (“the VIX”) ended the quarter well below their historical average, most volatility measures trended higher during the quarter. The increase was largely associated with a nearly 6% drop in stocks (as measured by the S&P 500) between mid-January and early February—the largest correction since April-June 2012. The correction was triggered by weak data out of China, coupled with growing political and fiscal concerns in a number of developing nations. While the retreat was not particularly large or unexpected, the higher trend in volatility suggests that investors may be more reactive to negative data going forward.
Small-cap stocks lagged large-caps for the second consecutive quarter, with the small-cap oriented Russell 2000 Index gaining only 1.12% versus 2.05% for the Russell 1000 Index. Mid-cap stocks were the top performer, with the Russell Midcap Index up 3.53%. The relative underperformance of small-cap stocks has historically been a reliable late-cycle market indicator. Although recent underperformance is not enough to conclude that a significant reallocation is underway, according to analysis by the well-regarded Leuthold Group, “If the S&P 500 is making new highs two months from now and the Russell  isn’t, bigger trouble will be afoot.”
Market leadership also shifted late during the quarter. In mid-March, concerns about the economy and tension in the Ukraine weighed on stocks. During her first press conference, new Federal Reserve Chair Janet Yellen spooked investors by indicating the central bank may hike rates sooner rather than later. This triggered a sharp correction among the high-flying momentum stocks that have led the market over much of the past two years, including the soaring biotechnology industry. Growth and high-beta (a stock’s volatility relative to the Fund’s benchmark) leadership also retreated in March, affecting quarter-end style and factor performance. The shift in leadership generally favored our fundamentals-based Absolute Value investment approach.
From a sector perspective, eight of the 10 economic sectors in the Fund’s Russell 2000 Value Index benchmark posted positive returns. Sectors with the highest total returns included Energy and Utilities, while the sectors with the lowest included Consumer Discretionary and Industrials.
The Fund outperformed its benchmark during the quarter while maintaining its exceptionally low volatility profile (as measured by both the portfolio’s relative standard deviation and beta of returns). A number of factors, including strong stock selection, merger and acquisition (M&A) activity, and increased market volatility aided portfolio performance.
Strong stock selection helped overcome the negative affect of the portfolio’s underweight allocation to Utilities and overweight to Consumer Discretionary. Our investment style does not favor the highly regulated and capital-intensive Utilities sector, thus the portfolio tends to have little to no exposure to that area. Conversely, our style does favor consumer companies. The portfolio’s “off-the-beaten-path” consumer holdings historically have only a moderate correlation to the broader index-weighted consumer groups.
Heightened M&A activity has historically been a positive catalyst for the Fund’s performance. Extending a major theme from 2013, the portfolio experienced four M&A events during the period, affecting five positions (Hilltop Holdings agreed to acquire another portfolio holding, SWS Group). Although all of the transactions occurred slightly below our assessed valuations (indicating that acquirers remain very value-conscious), each was well above our cost and a premium to where the stock was trading prior to the announcement.
Most investors rightfully view market volatility as a negative influence on investment returns, but low volatility in an overpriced market actually creates challenges for fundamental stock pickers like ourselves. Stock price volatility creates discounts in valuation that allow us to establish new positions to replace those we are trimming and eliminating. Volatility has been low for several years while stock prices have moved sharply higher. As a result, the portfolio has become increasingly concentrated. Fortunately, the volatility experienced during the first quarter, particularly in January and March, allowed the Fund to establish a position in a number of attractive new investments.
Holdings in Healthcare and Materials were among the biggest contributors to relative performance during the quarter, with Myriad Genetics and Nordion boosting returns within Healthcare. Genetic testing firm Myriad reported strong quarterly results with minimal market share loss from its BRCA test and published data demonstrating its new prostate cancer test, Prolaris, is an accurate predictor of disease progression. This strengthened our belief that the company’s pipeline contains several tests that could become significant future contributors, though we trimmed the position as the discount to our assessed Absolute Value narrowed. Nordion reported in-line results for the quarter but gave strong guidance for 2014. The company expects strong revenue growth in its Medical Isotopes segment due to competitor reactor outages while its Sterilization Technologies segment is projected to deliver solid revenue growth as well. Very late in the quarter, the company announced an agreement to be acquired by a private equity firm at 90% of our calculated Absolute Value.
Innophos, a global producer of specialty phosphates, was the standout in Materials after delivering a solid quarter as the ill effects of an equipment failure at the company’s Mexican plant earlier in the year dissipated and product mix improved. Management also boosted investor confidence by reaffirming its 2014 outlook. We trimmed the position as it approached our Absolute Value target.
The sectors with the lowest contribution to relative return during the quarter were Technology and Consumer Staples. Both sectors underperformed owing to poor stock selection, led by Neustar. The company is the exclusive provider of telephone number portability in the U.S. This contract represents 50% of total revenues and expires on June 30, 2015. The contract is undergoing a new bidding process that has been marked with significant delays and lack of transparency. The winning bidder was to be announced January 20, but the announcement was delayed, not for the first time, to May 6. Investors now fear that NeuStar will lose the contract in its entirety to rival bidder Telcordia. Our research suggests that NeuStar will at least retain a large portion of the contract, but have to make pricing concessions. We maintained the portfolio’s position during the quarter.
Consumer Discretionary stocks Ascena Retail Group and Rent-A-Center were also among the biggest individual detractors during the period. Ascena is the operator of the dressbarn, maurices, Justice, Lane Bryant, and Catherines specialty apparel stores. In a heightened competitive retail environment, it posted flat comparable same-store sales despite strong e-commerce growth. Margins compressed from new store growth and other investments. The company believes increasing cash flow from operations in fiscal 2014 will allow the company to pay down the majority of its remaining debt from its Charming Shoppes acquisition and fund transformational initiatives that should enhance future profitability.
Rent-to-own (RTO) operator Rent-A-Center reported disappointing results and initiated 2014 guidance well below expectations, causing a sharp decline in its stock. Core same-store sales were down due to increased promotions and continued product deflation in electronics, while the company continues to face significant headwinds in its core customer base. Due to the declining core results and a loss of conviction, we trimmed the position.
Finally, the end of the quarter saw performance for the first quarter of 2009 roll off the Fund’s five-year record. Investors will recall that this period represented the bottom for markets during the financial crisis and was a period when our low-beta style shined. Given the sharp rise in equities since that time, the loss of that period makes the portfolio’s relative five-year performance appear particularly negative. We think this snapshot of the Fund’s performance will improve somewhat later this year when the third quarter of 2009 also rolls off, a classic early cycle period during which the Russell 2000 Value led by high-beta/low-quality stocks soared. The portfolio’s performance during both the first and third quarters of 2009 reflect how our Absolute Value style can significantly dampen the volatility of the broader market without accumulating significant cash or overweighting fundamentally unattractive, but highly defensive sectors such as Utilities.
An increase in market volatility created greater value opportunities during the quarter, which allowed us to modestly expand the number of holdings in the Fund. Eight new holdings were purchased and five sold. Among the new positions added, two were in the energy & equipment services industry (Nuverra Environmental Solutions. and PHI), while the others represented a highly diverse group of industries. The market-cap of the new purchases ranged from $215 million to $3 billion, with an average of $1.2 billion.
Among the five companies sold, four had achieved their Absolute Value price targets (including one takeover—CEC Entertainment, operator of Chuck E. Cheese restaurants). Just one holding (hair salon operator Regis Corp.) was sold due to a negative fundamental change in our outlook.
We strategically increased the positions in 18 firms, the largest of which were in Murphy USA and American Vanguard. We strategically reduced 12 positions, most of which were related to price appreciation. The two largest reductions included Big Lots and DST Systems.
The largest changes to the portfolio’s sector positioning were a decline in Consumer Discretionary and an increase in Industrials. It is worth noting that the Fund’s Consumer Staples exposure remains near its lowest absolute and relative level since inception. In addition, from a relative perspective, the Financials sector also remains near an all-time low while Technology remains near an all-time high. This does not represent a change in strategy, but rather our pursuing the most attractive valuation opportunities among companies possessing the required fundamental characteristics we look for—a challenging task in the current environment.
The largest new position added during the quarter was Rovi, provider of interactive program guides (IPGs or TV Guides) built into set-top boxes to cable/satellite TV operators. Rovi is strictly business-to-business (B2B) and is primarily focused on content discovery, which includes search, recommendations, cloud data services, and access to its extensive database.
Essentially all major North American cable and satellite TV providers (approximately 97%) are Rovi customers. As a result, recurring revenue accounts for more than 85% of total revenues and gross margins are greater than 80%.
Technological innovation has changed TV viewing habits as more customers are cutting their cable services in favor of over-the-top (OTT) services like Netflix or Hulu, and we believe this transition represents a great opportunity for Rovi. Traditional cable providers are upgrading their interactive TV offerings to compete better with the OTT market, while Rovi has had recent success with the OTT market in signing new licensing deals with Apple, Google, Vudu, Hulu, etc. The stock was trading at a 20% discount to our Absolute Value at the time of initial purchase.
Outlook: When Will Valuations Matter?
It’s a Wall Street adage that valuation alone is a poor indicator of near-term market performance. That would certainly be true of the last 12 months. We first sounded the alarm on small-cap valuations about a year ago when our discount-to-Absolute Value indicator, which tracks the weighted discount to value for the portfolio’s top-20 holdings, reached a new, all-time high, entering a range historically associated with market corrections. In the 12 months that followed, small-cap stocks soared 25%, experiencing only a couple of minor, mid-single digit corrections. This past quarter, the most richly valued stocks in the market did experience a “mini-crash.” However, the damage was well contained. Indeed, as of March 31, the S&P 500 Index had gone 626 days without a 10% correction—the seventh longest rally since 1930. As a recent Bloomberg article noted, “Small-cap shares tracked by the Russell 2000 Index have rallied for seven straight quarters, the longest stretch ever, sending valuations 26 percent above levels at the height of the 1990s rally.”
The lesson we learned in 2013 was that it is difficult to translate a fundamental forecast into a price expectation in a world where historical fundamental relationships have been rendered irrelevant by unprecedented monetary stimulus. We suspect that valuations may not matter, at least in their historical sense, until investors believe the Fed has exhausted its ability or willingness to stimulate the economy through higher asset prices. Given the weather-related soft patch in the economy and recent comments by Fed Chair Yellen, that day may not arrive anytime soon.
In our fourth quarter commentary, we stated that earnings expectations for 2014 were too high and would likely decline in the months ahead. Although we did not consult the Farmer’s Almanac in making that forecast, earnings expectations have fallen largely due to one of the worst winters in recent history. According to Bank of America/Merrill Lynch Small Cap analyst Steven DeSanctis, first quarter earnings expectations have fallen from north of 20% to just 7%. While expectations for the remainder of the year remain high, we think those numbers will also moderate as we move closer to mid-year.
We also highlighted a number of “wildcard” themes that we expected to play out in 2014, including value over growth, low beta over high, and high quality over low. Although these themes may appear self-serving (as each would support our style of investing), the expectation for each was driven by a belief that high valuations, declining growth expectations, and an aging equity cycle would lead to at least a moderate increase in volatility and investor risk aversion. While it is too early to speculate if or just how these themes will unfold, each was present during the first quarter.
As we’ve stated before, it is philosophically difficult for us to anticipate positive returns in the face of historically high valuations and declining growth expectations. Our year-end analysis and experience with the first quarter, however, continue to support a modestly positive outlook for the year. Although our conviction in this year’s outlook is unusually low, the Fed’s unwavering commitment to supporting asset prices under Chair Yellen, combined with the relatively tame inflation outlook, lead us to look beyond valuation concerns. While small cap valuations are high, certain areas of the market (such as mega cap) are less extended.
This is not a time for investors to be complacent—just the opposite. Many of the trend shifts we saw during the first quarter correspond to late cycle themes. If volatility increases, as we expect, we believe value and quality will become dominant trends, investors will become more risk averse, and the broader small-cap market will come under pressure. It is too early to tell if the recent soft patch was largely, or just partly, weather-related. We will hopefully gain more insight during the upcoming earnings reporting season and calls with management teams.
River Road Asset Management
As of March 31, 2014, Hilltop Holdings comprised 1.48% of the portfolio’s assets, SWS Group – 0.60%, Myriad Genetics – 1.21%, Nordion – 2.97%, Innophos Holdings – 1.75%, Neustar – 1.82%, Ascena Retail Group – 1.87%, Rent-A-Center – 0.94%, Nuverra Environmental Solutions – 0.76%, PHI – 0.37%, Murphy USA – 1.38%, American Vanguard – 1.26%, Big Lots – 1.62%, DST Systems – 0.78%, and Rovi – 1.87%.
Note: Small-cap stocks are considered riskier than large-cap stocks due to greater potential volatility and less liquidity. Value investing often involves buying the stocks of companies that are currently out of favor that may decline further.
Before investing, consider the Fund’s investment objectives, risks, charges, and expenses. Contact 800 992-8151 for a prospectus or summary prospectus containing this and other information. Please, read it carefully. Aston Funds are distributed by Foreside Funds Distributors LLC.