2nd Quarter 2010 Commentary
Flight to Safety
Deteriorating economic trends and renewed concerns about sovereign debt in the Euro region led to a global plunge in equities during the second quarter. In the U.S., stocks rose modestly throughout much of April as companies reported strong first quarter earnings. By late April, however, investors began to confront a deepening crisis in Europe and a stream of progressively weaker US economic data. As confidence in the global recovery eroded, so did equity prices. A general flight to safety led to a rally in bond markets as well as investors seeking the protection of gold. Interestingly, US equities underperformed other developed regions in June by several percentage points (as measured by the S&P 500 Index versus the MSCI EAFE index). Normally in a flight to quality, US equities would outperform global markets. This unusual occurrence may signal that global investors are becoming less patient with the United States' deteriorating fiscal condition and diminished growth prospects.
Investor confidence was dealt a further blow on May 6 when markets experienced one of the largest intra-day price swings on record. In a matter of minutes, some of the largest, most liquid securities on the New York Stock Exchange inexplicably dropped 25% or more. A few stocks briefly traded near zero. Later, investors would learn the extraordinary price action was not the result of a massive program trading error, as many believed, but rather actions related to the largely unregulated world of "high frequency" trading. In the wake of the financial crisis, the Madoff scandal, and other similar events, the Flash Crash was just another striking example of regulators' questionable grasp on rapidly developing technologies and strategies on Wall Street.
Investor preference for lower risk assets had a significant impact on fundamental performance during the quarter, with low-beta (volatility), high-quality stocks assuming leadership. Within the Fund's Russell 2500 Value Index benchmark, the lowest beta stocks (first quintile) declined 5%, while the highest beta (fifth quintile) lost 15%. According to figures from Lipper Analytics and BoA/Merrill Lynch, 63% of active small-cap value managers outperformed the index during the period, and only 53% for the year-to-date through the end of June. Small-value managers typically perform well in a declining market environment. We believe a clue to the disappointing results lies in the recent high correlation of U.S. stocks, as the correlation of individual stock returns is near its all-time high. High levels of correlation (low levels of dispersion) make it extremely difficult for managers that focus on fundamental characteristics to outperform. In effect, winning or losing becomes more about positioning your portfolio on the right side of market volatility.
The Fund outperformed the benchmark for the quarter and the year-to-date through the end of June. The sectors with the highest contribution to relative performance during the quarter were Consumer Discretionary and Consumer Staples. Despite a significant overweight in both consumer sectors, the portfolio benefited the most from merger and acquisition activity and from investments in companies with the ability to grow in a period of modest economic growth. The latter include companies such as restaurant operator Cracker Barrel Old Country Stores and discount retailer Dollar Tree.
The most significant impact on performance came from merger & acquisition activity, with three of the portfolio's top contributors having received a tender offer! In early April, North America’s second largest independent convenience operator Alimentation Couche-Tard (which operates the Circle K chain) made an unsolicited cash offer for Casey's General Stores. The bid was just $1 below our $37 assessed Absolute Value. Couche-Tard privately approached Casey’s Board of Directors in October 2009, but they were strongly rebuffed. Once Couche-Tard took their offer public, Casey's shares immediately began trading at a premium to the bid. Given our reluctance to be merger arbitrageurs, the Fund liquidated its position at prices well above the bid.
In late May, hospice provider Odyssey HealthCare agreed to be acquired for $27 a share in cash in a strategic deal by home health care provider Gentiva Health Services. This deal validated our investment thesis that hospice will be a solution for reducing U.S. health care given the country's aging demographic trends. The recently enacted health care reform provided the hospice industry with an unusually high degree of reimbursement visibility, and was largely spared the reimbursement cuts faced by other areas of healthcare. The portfolio also holds an investment in Chemed, which owns the largest U.S. hospice provider—VITAS. The transaction multiple on Odyssey supports the multiple we are applying to Chemed, the industry leader. After the announcement, we fully exited the portfolio's position in Odyssey.
Other top individual contributors to performance were beverage company Compania Cervecerias Unidas and Bank of Hawaii. CCU is Chile's largest brewer, its second largest wine producer, and its third largest soft drink producer. The firm controls 85% of the beer market in Chile thanks to its flagship brand Cristal, and is the go-to producer for foreign brands. The firm reported a modest increase in sales and operating margin despite adverse affects on production related to the February earthquake in Chile. By April, beer volume growth resumed and the water and soft drinks division led all categories. In a reversal from the first quarter, Bank of Hawaii reported strong earnings driven by an increase in earning assets, lower non-interest expense, and an improvement in net interest margin that drove the stock higher. The Fund sold the position when its shares traded above our assessed Absolute Value.
An underweight stake in Utilities and stock selection within Industrials were the main detractors from relative returns. Operating margins compressed unexpectedly at global security firm Brink's Company within the Industrials sector due to declines in the U.S., poor pricing in Europe, and weak demand for diamond and jewelry-related services. Management provided optimistic guidance for 2010, but we are concerned about the poor economic outlook in Europe (which generates 40% of the company's revenues) and currency headwinds facing the Euro. The firm's strong balance sheet and growth strategy in Emerging Markets warrant a continued position, but we have lowered our 2011 outlook for the company and our assessed Absolute Value in addition to trimming the holding.
Other disappointing holdings during the quarter were Equifax, Kindred Healthcare, and Genoptix. Equifax, the largest credit bureau in the United States, announced first quarter results that disappointed both River Road and Wall Street, as overall revenue increased slightly but was offset by weakness in their Consumer Information Solutions segment. Still, Equifax is the only industry player that can offer credit, employment, income, and wealth verification services on a single platform, and the company is gaining market share during a period of weak volumes. Given significant cost cutting efforts in 2009, we think the company is poised to post impressive results when volume growth resumes. Thus, despite the disappointing quarter, we increased our Absolute Value on the stock from $39 to $41 and continue to maintain our position.
In the final weeks of quarter, the Centers for Medicare and Medicaid Services (CMS) proposed reducing 2011 reimbursements for certain physical and occupational therapy services covered under Medicare Part B. If approved, the reimbursement cuts will negatively impact the profitability of Kindred Healthcare. We analyzed multiple valuation scenarios incorporating this new risk, and though the magnitude of the impact is uncertain, we subsequently lowered our Absolute Value target and trimmed the position. Oncology diagnostics provider Genoptix missed first quarter estimates due to what we believed were long-term investments in its sales force. We were initially content with that story, but decided to trim the position when the management team also unexpectedly cancelled their presentation at an investor conference in Boston. A month later management revealed more serious issues, including a decline in gross margins, declining market share, and a weaker outlook. The news, combined with inconsistent explanations from management, caused the stock to sell off sharply. We sold the remainder of the Fund's position shortly after quarter-end.
Russell Rebalancing Non-event
Unlike in previous years, there were few material changes to the benchmark following the annual Russell Index rebalancing that occurred in late June. The largest changes in sector weightings were in Consumer Discretionary and Industrials, as both decreased roughly two percentage points.
As stated in our previous two quarterly commentaries, we remain focused on high quality companies that we believe are well-positioned for a period of modest economic growth. We like dividend-payers in this environment, as well as companies that are showing clear operating momentum. As economic growth moderates, we like firms that can continue to generate top-line growth and we continue to search for opportunities in the attractively priced Healthcare space. Finally, we continue to look for attractively priced energy-related names to replace those exiting the portfolio.
The largest new position added during the quarter was BJ's Wholesale Club. The benefits of the warehouse club business model are well known. Warehouse clubs eliminate the handling costs of traditional distribution channels by purchasing full truckloads of merchandise directly from manufacturers and storing the goods on the club floor, not in a central warehouse. Combined with no-frills retail facilities, warehouse clubs generate lower cost structures than traditional retailers and create a competitive advantage based on price. Warehouse clubs also require paid membership, which reinforces customer loyalty. To differentiate itself from its largest competitors (Sam's Club and Costco), BJ's tries to offer a better shopping experience, broader product assortment, more express self-checkout lanes, and longer store hours. The stock traded at a 28% discount to our assessed Absolute Value at the time of the Fund's initial purchase.
For several quarters, we have stated our belief that the economic recovery would be both fragile and modest in magnitude. From our perspective, there are too many secular imbalances to reasonably believe otherwise. Our market outlook for 2010, however, had been decidedly more positive based upon four near-term drivers: A pick-up in merger & acquisition activity, improving credit conditions, rising earnings, and positive fund flows. We also considered that small-cap stocks rarely post a negative return in the second year of a recovery.
On April 23, the Russell 2000 Value peaked with a year-to-date return of nearly 22%. From that point forward, both economic trends and stock prices deteriorated rapidly. From May through June, retail and auto sales decelerated, transports and industrials weakened, mortgage applications plunged, and employment growth disappeared. These were surprising developments and are abnormal for a recovery.
At this stage, only the merger & activity driver remains fully intact. Unfortunately, the other drivers deteriorated along with the economy. Credit spreads have widened and, despite historically low interest rates, lending standards remain restrictive. Earnings momentum has decelerated and positive revisions have diminished sooner than we expected. Fund flows have also turned sharply negative and analysts are now slashing Gross Domestic Product estimates, though most remain behind the curve.
The good news is that the market correction has resulted in more attractive valuations. Even discounting for lower earnings estimates and multiples in 2011, our portfolio discount-to-absolute value indicator remains attractively positioned slightly below the midpoint of its historical range. Thus, we believe the market has already discounted lower growth for the second half of this year. Both inflation and interest rates remain low and, as long as China stays healthy, deflation remains a minor risk.
The real wildcard is the upcoming elections. While we believe there is no panacea for what ails this country, a fiscally conservative, pro-growth agenda in Washington could have a big impact on investor confidence. From our perspective, a cut in the corporate income tax rate, which remains among the highest in the developed world, and tax credits targeted at meaningful job creation would go a long way to boost both confidence and spur economic activity. Thus, IF (note this is a big if) we see positive sentiment after the elections, we believe the market could rally through the end of the year. If we do not see positive sentiment following the elections, given our reduced expectations for 2011, we could experience negative returns.
Fortunately, we believe the portfolio is well positioned for the current environment and either outcome in November. The high-beta (volatility), low-quality trend appears to have faded and we remain focused on stocks with stable growth, attractive valuations, and healthy balance sheets. We are also continuing to focus on identifying companies that we believe will make attractive acquisition targets in the months ahead.
River Road Asset Management
July 13, 2010
As of June 30, 2010, Cracker Barrel Old Country Store comprised 2.00% of the portfolio's assets, Dollar Tree – 2.58%, Chemed – 0.69%, Compania Cervecerias Unidas – 1.10%, Bank of Hawaii – 0.00%, Brink's Company – 1.62%, Equifax – 2.25%, Kindred Healthcare – 1.33%, Genoptix – 0.28%, and BJ's Wholesale Club – 1.07%.
Note: Small-cap stocks are considered riskier than large-cap stocks due to greater potential volatility and less liquidity.
Past performance does not guarantee future results. Investment return and principal value of mutual funds will vary with market conditions, so that shares, when redeemed, may be worth more or less than their original cost.
Before investing, carefully consider the fund’s investment objectives, risks, charges and expenses. Contact 800 992-8151 for a prospectus containing this and other information. Read it carefully. Aston Funds are distributed by BNY Mellon Distributors Inc.