4th Quarter 2010 Commentary
An Outstanding Year for Small-Caps
While 2010 was a good year for equity investors, it was an outstanding year for investors in small-cap stocks. Thanks to a spectacular fourth quarter rally, the Russell 2000 Index gained nearly 27% in 2010. This compares to a return of 14.1% for the Dow Jones Industrial Average and 15.1% for the S&P 500 Index. It was the second consecutive year that the Russell 2000 gained greater than 20% (which has previously occurred only twice since 1979), and marked the best performance by small-caps relative to large-caps since 2000. Through December 31, 2010, the Russell 2000 was up a remarkable 129% (price appreciation) from the market bottom on March 9, 2009. This compares to a 91% gain for the S&P 500 which, according to Ned Davis Research, is the largest gain for that index over a comparable period since 1955.
The top performing equity style in 2010 was growth, which outperformed value across the market-cap spectrum for the second consecutive year. Among small-cap stocks, this was the first back-to-back outperformance for small-cap growth since 1998-99. The biggest driver behind growth's performance in 2010 was the Technology sector, while the largest relative drag in value was, once again, Financials. For some time, we have observed that small-growth stocks were cheap relative to value. Despite outperforming for three of the past four years, this still appears to be true.
All 10 economic sectors within the Fund's Russell 2000 Value Index benchmark posted a positive return for both the fourth quarter and full year. Cyclical and more inflation-sensitive sectors such as Energy and Materials had the strongest performance during the quarter, while Utilities and Consumer Staples had the lowest returns. The dominant performance factor during the quarter, and much of 2010, was statistical volatility (beta). Stocks in the highest quintile for beta within the benchmark rose a stunning 26% during the quarter versus just 9% for stocks in the lowest quintile. For the full year, stocks with the highest beta nearly doubled the gain by the lowest beta stocks. In addition, the high-quality theme that had emerged during the second quarter of 2010, and continued throughout much of the third quarter, faded during the last quarter.
High Risk and High Correlations
The Fund had a good year in absolute terms, but fell short of the benchmark. Five years ago, we authored a paper titled How We Beat the Index that described how our low-volatility style of investing tends to underperform the market during periods when investors are aggressively accumulating risk. From this perspective, 2010 was much like 2003—a period also characterized by high-beta leadership. Following 2003, the market entered the mid-cycle stage of the recovery and investors became a bit more risk averse. Although we initially believed that a mid-cycle transition was beginning to occur in mid-2010, the Fed's actions in August reignited the risk rally. We now believe that transition will begin to occur by mid-2011.
The other stylistic headwind in 2010 was the extremely high correlation among equities. In a sharply rising market this is a headwind for our style of investing. Company-specific fundamentals receive less investor interest and the "off the beaten path” types of stocks that we tend to favor often get left behind. The good news is that the beta trend is becoming very long in the tooth and the level of equity correlation has begun to fall significantly.
Lagging in Materials and Energy
Not surprisingly, much of the Fund's underperformance for the year came during the fourth quarter as holdings in the Materials and Energy sectors delivered the lowest contribution to relative returns. Within Materials, the Fund typically underperforms the broader sector when commodities are surging in price (as they did this past quarter). This is a result of not owning raw material producers which, from our perspective, are capital intensive businesses that typically lack the predictable and sustainable business models we seek. In other words, we think investors are rarely compensated for the risk they must assume by investing in these industries. We were disappointed, however, with the performance in Energy. Unlike most raw materials, oil is a rapidly diminishing resource that is being consumed at an increasing rate and Energy has historically been a source of rich returns for the Fund. Unfortunately, we have sold many of the portfolio's oil and gas holdings in the past 12 months as they achieved our Absolute Value price targets, and have struggled to find replacements that meet our investment criteria.
In terms of individual names, consumer-related holdings Regis and Big Lots were among the biggest negative contributors to performance. We initiated a position in hair salon operator Regis in August after the company hired the Peter J. Solomon Co. to explore strategic alternatives, including the potential sale of the company. In December, the company announced the completion of its strategic review, concluding that it would remain an independent public company. Although the review did not result in a transaction, it did spur several operational changes designed to improve long-term shareholder value, and we continue to maintain a position in this market-leading company.
Big Lots is the nation's largest closeout retailer. The firm reported third quarter earnings and fourth quarter guidance that were in-line with our expectations, but disappointed Wall Street due to soft same-store sales comparisons. In addition, new store openings led to increased costs and margin compression. The firm's Board of Directors opportunistically repurchased its shares during the quarter, as part of 11% of the shares outstanding repurchased on the year. We used the share price weakness to incrementally increase the Fund's position in this winning, high-conviction position.
Two names in Financials, Oppenheimer Holdings and DST Systems, dragged on performance as well. Oppenheimer is a full service broker-dealer and middle market investment bank that underperformed after its earnings release disclosed that poor market sentiment in July and August negatively affected commissions and principal transactions led to a dramatic year-over-year decline in earnings per share. We did not take any strategic action on this position as we believed the strong performance of equity markets during the fourth quarter would drive improvements in commissions and advisory fees. DST, the largest third-party provider of mutual fund accounting services, reported third quarter results that included a small revenue decline caused by the loss of a large client within its Output Solutions segment. Total accounts serviced fell and management's overall tone on this metric was less optimistic than in previous comments—a risk to which we are devoting significant attention. Despite the top-line pressure, DST was able to expand margins due to a restructuring program implemented last year and announced a new customer that will bring a large number of accounts to the firm in 2011-13.
Looking back on the Fund's largest negative contributors for the full year, we made two notable mistakes. The first was the failure to trim the investment in Telecommunications Systems more aggressively following a poor strategic acquisition by the company. The experience led us to improve our process for monitoring losing positions in the portfolio. The second mistake was an investment in for-profit educators Lincoln Educational Services and Corinthian Colleges. These stocks plummeted when Congress and regulators pursued a "Gainful Employment" proposal that tied financial aid to expected post-graduation income. This was an unexpected development during a period of such high unemployment. Despite relatively small positions, the proposed restrictions on government funding and unfavorable repayment rates for both companies caused their share prices to gap down, making it difficult to control losses.
The sectors with the highest contribution to relative performance during the quarter were Healthcare and Utilities. For several quarters we have highlighted our focus on finding compelling value in the beaten down Healthcare sector. Many of those investments began to pay off in the fourth quarter as the portfolio's healthcare-related companies significantly outperformed the broader sector. Of the 12 healthcare companies held in the portfolio, five appreciated 25% or more during the quarter and only one, ICU Medical, posted a negative return. With regard to Utilities, the portfolio benefited from both positive stock selection and being underweight the benchmark.
The top-three individual contributors to performance during the quarter were Rent-A-Center, Martek Biosciences, and Unifirst. Rent-A-Center is the largest consumer focused rent-to-own operator in the United States. Its stores make brand-name merchandise available to customers who cannot afford to pay cash and for whom traditional financing is not an option. Management has delivered positive earnings surprises in each of the last six quarters and the stock has responded in-kind. The company is finding new growth opportunities (with minimal capital expenditure requirements) in its new RAC Acceptance business, which provides consumer lease-purchase financing through kiosks in furniture and electronics retailers. The company also continues to use its ample free cash flow to both pay down debt and repurchase shares.
Martek produces and sells proprietary algal DHA oils (life’s DHA™) that are used as additives for infant formula and other consumer and wellness products. In late December, the company announced it would be acquired by DSM, a primary supplier to the firm, in a strategic, all-cash deal that valued the company at $31.50 per share—a 35% premium to the previous closing price. At the time of the deal announcement, our Absolute Value on Martek was $31 per share. Following the announcement, we sold most of the Fund's position just as the year closed.
Lastly, Unifirst is the third largest provider and servicer of workplace uniforms in North America. When the company reported its fiscal fourth quarter results, management announced a core laundry organic growth rate of 2.2%, its first positive reading in the past six quarters. Improved customer retention levels and new business wins contributed to the gain and led to better than expected operating performance, plus strong free cash flow generation has allowed Unifirst to reduce net debt the past two fiscal years. This high conviction investment remains a top-10 position in the portfolio.
Reflecting on 2010, the Fund's top-two contributors were also the portfolio's largest holdings, AptarGroup and Ruddick. Specialty dispensing systems manufacturer AptarGroup delivered strong organic growth throughout the year as demand sharply rebounded and its customers restocked their thin inventory levels from 2009. We began to trim the position late in the year as the stock approached our Absolute Value. Ruddick delivered solid performance in its Harris Teeter grocery stores despite the headwinds caused by food deflation, customers trading down, and higher promotional activity within the industry. Its American & Efird industrial thread subsidiary also posted significant operating improvements after its management team completed a well-executed restructuring program.
As of December 31, the portfolio held 86 positions—a decrease from the 91 held at the end of the third quarter and a substantial reduction from the 100 names held in early 2010. Seven new companies were purchased and 12 companies sold during the quarter. Among the companies sold, 10 either achieved our Absolute Value price targets or agreed to be acquired. Just two companies were sold due to accumulated losses and/or declining fundamentals.
The seven new positions added were broadly diversified among the Consumer, Energy, Telecom, Technology, and Healthcare sectors. For the second consecutive quarter, we also increased the concentration in the top-20 holdings of the portfolio. This action reflects both our increased conviction in these names, as well as their attractive valuations. Concentration also increasingly reflects the scarcity of value in the broader small-cap universe. We believe these actions increased the quality of the portfolio, which is important in a period of modest economic growth. Finally, we continue to search for new opportunities in Healthcare and Energy, having recently sold many of our holdings in these sectors after they achieved their assessed Absolute Values.
The largest new position added during the quarter was ManTech International, which provides information technology systems, architecture, cyber security, and support for customers such as the U.S. Departments of Defense, State, and Homeland Security. The shares of many defense contractors, including ManTech, have been weak due to concerns about cutbacks in federal spending. While we believe there is a strong probability of reductions in the federal defense budget, the majority of cutbacks are likely to be on large weapons system procurements. The federal government has increased IT spending (including cyber security) every year since 1980, and we expect that trend to continue. Another factor in our investment thesis was The Weapon Systems Acquisition Reform Act of 2009, which includes guidelines to avoid conflicts of interest when the same company works on both advisory and production in the same procurement program. This new law favors non-conflicted providers like ManTech, as conflicted competitors are restricted from bidding on advisory work. The stock was trading at a 26% discount to our assessed Absolute Value at the time of initial purchase.
While most fundamental value managers cringe when asked about their outlook for stocks or the economy, we believe a manager’s outlook can be an important factor driving portfolio positioning. From our perspective, it would be difficult to create a valuation without some opinion regarding the broader business and investment environment, especially in a macro dominated market like the one experienced in 2010. As outlined in our third quarter commentary, our market outlook is typically based upon an assessment of five factors: 1) valuations; 2) monetary policy/credit trends; 3) fiscal policy; 4) CEO and investor sentiment; and 5) a "wildcard" which typically includes a few key trends that we believe may drive stock performance, or impact our valuations, over the next six to 18 months.
Our outlook emphasizes valuations above all else. When stocks are cheap, we get excited. When stocks are expensive, we get worried. Currently, we think small-caps are fully valued. Rising forward estimates and opportunistic positioning offset the rise in equity prices as the discount to value in the portfolio improvedi fourth quarter% of AV in the had diminished the chases in the portfolio. eers. from 83% of Absolute Value in mid-November to 80% of by the end of the year. Although this move may appear modest, and still reflects that stocks are fully valued, it shows that (at least by our internal indicator) the market is not grossly overvalued. When fourth quarter results are reported in a few weeks however, any reduction in expectations could negatively impact first half market performance, especially for small-s. In addition, the valuation gap between large- and small-caps is particularly wide by historical standards and would lead us to favor the large-cap asset class over small in the near-term.
In his landmark book Winning on Wall Street the legendary Marty Zweig said that, "The major direction of the market is dominated by monetary considerations, primarily Federal Reserve policy and the movement of interest rates." That was true when Marty published the book in 1986 and has never been truer than the past decade, but the Fed's influence may be diminishing. The Fed's mandate is to "promote maximum employment, stable prices, and moderate long-term interest rates." Therefore, as long as prices are stable, the Fed is going to pursue full employment, which most commentators would equate to an unemployment rate of 6%. This means QE1, QE2 and so on, if necessary. Unfortunately for the Fed, neither commodity prices nor bond yields are cooperating. This means the Fed's tools are becoming less effective and perhaps even dangerous. For now, the Fed is fueling the rally, but investors and even the Fed may consider alternative strategies if this trend continues.
From our perspective, the most important development for markets during the fourth quarter was the election and subsequent extension of the Bush tax cuts. Along with the additional tax incentives signed into law by President Obama, investors have finally received the much needed clarity and stimulus required to sustain a recovery. While the cuts do nothing to address the longer-term deficit issue, which will hang over the incoming Congress, it was a big part of the year-end rally.
Over the past few months, we have seen signs of improving sentiment among the firms and CEOs that we follow as well. Unfortunately, investor sentiment is flashing a warning sign, as evidenced by the study of the American Association of Individual Investors indicating excessive optimism. We see the same among mutual fund managers, with studies showing very low cash levels.
In the wildcard category, our biggest concern—and what we consider the number one threat to a sustained market recovery in 2011—is rising commodity prices, particularly oil. Many of the Fund's holdings are seeing input prices spike higher, which foretells lower margins for non-branded goods and services. On a positive note, companies are flush with cash and access to capital is easing, which should continue to support robust merger and acquisition activity.
In 2010, we were positive in our outlook, initially expecting a 10% to 20% increase in the Russell 2000 Value Index benchmark for the year. At mid-year, as markets were in steep decline, we said that a positive election would still deliver the low end of that range. In hindsight, we underestimated the impact of the Fed.
For 2011, we think the broader market will deliver a low double-digit return, but small-cap stocks will lag large-caps and may only deliver a low single-digit gain. If oil prices experience a sustained spike, a negative return for small-caps is possible. As previously mentioned, the small-cap market has experienced back-to-back 20% annual returns twice before—and the subsequent third year returns in those two cases were -7% and +2%.
Regardless of what happens we are pleased with the quality and positioning of the Fund and, thus, the opportunity we believe lies ahead. We think investors should be intently focused on quality, stock selection, and risk management. We remain steadfastly focused on stocks with stable growth, attractive valuations, and healthy balance sheets. We continue to focus on identifying companies that we believe will make attractive acquisition targets. Despite the market advance, we have also been successful in finding value and enhancing the overall portfolio through active positioning. Last year was a period of high equity correlations and high beta performance. We believe that trend will fade in 2011, creating excellent opportunities for our Absolute Value style of investing.
River Road Asset Management
14 January 2011
As of December 31, 2010, Regis Corporation comprised 1.27% of the portfolio's assets, Big Lots – 2.29%, Oppenheimer Holdings – 0.84%, DST Systems – 1.94%, Telecommunications Systems – 0.00%, Lincoln Educational Services – 0.00%, Corinthian Colleges – 0.00%, ICU Medical – 1.69%, Rent-A-Center – 2.83%, Martek Biosciences – 0.10%, Unifirst – 2.12%, AptarGroup – 3.74%, Ruddick – 4.06%,and ManTech International – 1.33%.
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, 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.