1st Quarter 2011 Commentary
Equity markets showed remarkable resilience during the first quarter of 2011, rallying in the face of sharply rising oil prices and a devastating earthquake and tsunami in Japan. Even the release of weak economic data in early March failed to have a lasting impact on stocks. Small-cap stocks performed especially well during the quarter, with the Russell 2000 Index gaining nearly 8% versus a little more than 6% for the larger-cap Russell 1000 Index. At the end of the first quarter, the Russell 2000 was more than 40% above its August 2010 low and about 1% below its all-time high set on July 13, 2007.
Small-cap stocks benefited from a number of trends during the quarter, including tight credit spreads, healthy merger & acquisition activity, and strong fund flows. Access to capital was also easy, with high-yield issuance at its highest level since 1993. Small-caps further benefited from low overall market volatility, which spiked briefly following the events in Japan but promptly returned to the prior level.
The dominant performance theme for stocks throughout 2010 and into 2011 was volatility (as measured by beta). Although the outperformance of high-beta stocks is common in the early stages of a market recovery, the current trend is unusually elongated. As discussed in last quarter’s commentary, we believe the primary factor driving this trend is the extraordinary liquidity being provided to markets by the Federal Reserve. As the market looks ahead to the end of the Fed’s latest round of quantitative easing (QE2) in June, however, there are signs that the beta theme is beginning to fade. Within the S&P 500 Index, for example, beta was the third worst performing quantitative factor during the first quarter (out of 34 factors tracked by BofA/Merrill Lynch strategist Savita Subramanian). Within the small-cap universe, the highest beta stocks (fifth quintile) continued to outperform the lowest (first quintile). The margin of outperformance, however, narrowed substantially as the quarter progressed. During March, the lowest beta stocks in the Russell 2000 Index actually outperformed the highest beta stocks by more than a percentage point.
The Fund underperformed its Russell 2000 Value Index benchmark during the period due largely to the first two weeks of the quarter, when the high beta trend remained intact. As that trend faded, performance improved. During late February, when violence erupted in Libya and oil prices began to rise sharply, the broader risk trade diminished and the portfolio began to outperform—eventually outgaining the benchmark in March. As investors celebrated the two-year anniversary of the recovery at the end of February, we analyzed our strategy’s performance during the last beta-driven recovery in 2003. Our objective was to determine if the relative performance trends were similar during the two periods. As we discovered, they were virtually identical. The frustrating part is that the prior beta-trend lasted just a year, while the current trend has lasted twice as long.
Although Energy was the top performing sector within the benchmark, boosted by a 24% increase in the price of Brent crude oil during the period, it was one of the sectors with the lowest contribution to returns for the Fund. The portfolio suffered primarily from an underweight allocation relative to the index. Although we continue to favor energy-related investments longer-term, we find that valuations in the Energy sector are generally not attractive. Thus, the Fund’s recent energy investments have only been special situation opportunities. Poor performances from Village Super Market and Harbinger Group resulted in lagging returns within the Consumer Staples sector as well.
Village Super Market operates 26 ShopRite supermarkets located primarily in New Jersey. The company announced strong second quarter same-store sales results, but a drop in gross margin led to slightly lower profitability year-over-year. In our view, these results did not warrant significant concern as management raised their same-store sales guidance for fiscal 2011 and the company paid a special dividend back in December.
Harbinger is a holding company with a 54% ownership in Spectrum Brands and 100% ownership of U.S. Life (a former life insurance subsidiary of Old Mutual). The firm, in turn, is 93% owned by Harbinger Capital Partners, a New York City-based private hedge fund led by Philip Falcone, which specializes in distressed equity and debt. Harbinger’s strategy is to provide a legal and capital structure suited for complex investments with long time horizons. Although this complexity makes it difficult for the market to understand the underlying value of the portfolio, we see opportunity. Spectrum Brands is a consumer products company that recently emerged from bankruptcy and reported quarterly results in line with our optimistic expectations in addition to trading at a compelling discount. Harbinger negotiated the purchase of U.S. Life during the summer of 2010, when market conditions were less certain and Old Mutual was motivated to sell due to a restructuring from the financial crisis. We are awaiting further disclosure on U.S. Life while the transaction gains final regulatory approval, but our initial assessment is the company’s equity could be worth well beyond what Harbinger is paying for the company. To remain conservative, we currently ascribe no incremental upside to our assessed Absolute Value from the U.S. Life transaction.
Other individual detractors from performance during the first quarters were OfficeMax, Volt Information Sciences, and PetMed Express. OfficeMax’s new CEO Ravi Saligram disappointed Wall Street with lower guidance for fiscal 2011, after the firm reported good fourth quarter results. He expects gross margin gains to be more than offset by higher compensation costs (which had been held back for the previous two years) and increased spending to launch new sales initiatives. We view these investments as prudent and necessary for the long-term health of the business. Given the guidance, we lowered our Absolute Value and slightly trimmed the portfolio’s position.
Staffing and consulting firm Volt delayed filing their financial statements back in late 2009 after a review of their revenue recognition practices. Initially, we took comfort that Volt used Ernst & Young as their auditor. The amount of revenues in question subsequently increased four-fold, however, and the scope of the review was expanded into other business segments, with the restatement period extended back into fiscal 2007. After multiple filing extensions from the NYSE and the launch of an SEC investigation, it became apparent that the company would not file restated financials prior to the NYSE initiating the delisting process. Upon this news, the Fund exited the position at a loss after several trims previously triggered by our sell discipline. Online pet medication seller PetMed Express reported disappointing third quarter results for fiscal 2011. Competition from specialty pet stores clearly affected PetMed’s greatest asset: repeat customers. This marked the first quarterly decline in reorders in the company’s history. Since repeat customers were a cornerstone to our investment thesis and the position in the Fund had accumulated unrealized losses, we eliminated it from the portfolio.
Strong stock selection within Consumer Discretionary and a large underweight position in struggling Financials aided returns during the quarter. The portfolio’s particular emphasis on value-oriented retailers, notably Big Lots and Ascena Retail Group, was the driving force behind the strong performance within Consumer Discretionary. Big Lots is the largest closeout retailer in the United States. The big news came on February 7 when Bloomberg reported that the firm had hired Goldman Sachs to explore strategic alternatives, including a possible sale of the company. The stock moved significantly higher after the announcement, triggering a reduction in the position as the share price approached our assessed Absolute Value. Ascena (formerly Dress Barn), which operates specialty-apparel concept stores throughout the United States, reported a sizeable jump in second quarter sales. The company continues to benefit from its well-timed and well-executed acquisition of Justice, which accounted for more than two-thirds of the sales increase. In addition, Ascena repurchased a million shares during the period and still has a significant cash position on its balance sheet.
Other top contributors to performance during the quarter included Brink’s and ICU Medical. Global security services provider Brink’s reported excellent fourth quarter results, with double-digit revenue growth driven by improvements in the Latin America and Asia-Pacific regions. Since 2008, Brink’s has used its strong balance sheet and cash flow generation to repurchase shares, acquire businesses for future growth, and improve the funded status of its pension fund. While the market has started to give credit to the exceptional capital allocation decisions made by CEO Michael Dan, we believe additional upside remains. ICU Medical reported fourth quarter results that were above market expectations on higher organic revenue growth in its CLAVE and Custom product lines. With the company’s investment in a new manufacturing facility in Slovakia and the integration of its acquisition of Hospira’s Critical Care division both near completion, free cash flow should improve in 2011—further bolstering net cash on its balance sheet that we expect to be used for additional stock repurchases. Recurring revenues from ICU’s disposable product offerings and sensible capital allocation decisions by management give us confidence in the company’s long-term value.
Each year, Russell rebalances its indices according to market-cap and style. In a few past instances this rebalancing has had a major impact on the composition of the benchmark. For 2011, the rebalancing will take effect on June 24 and the changes are expected to be relatively significant.
One of the more important changes this year involves the methodology surrounding the style factors. In an effort to reduce turnover among the style indices, Russell is implementing a band on its overall composite value scores. This will effectively reduce the number of names that switch between the Russell 2000 Value and Growth Indices on an annual basis. Russell introduced banding a few years ago for its market-cap indices, which substantially reduced turnover. Based on analysis from BofA/Merrill Lynch Analyst Steven DeSanctis, this year’s rebalancing of the Russell 2000 Value index will make the benchmark more growth-oriented and a bit less cyclical. The greatest expected weighting increases will be to the Consumer Discretionary (+3.3%), Information Technology (+1.5%), and Health Care (+1.2%) sectors. The biggest decreases are expected within Energy (-2.9%), Financials (-2.0%), and Materials (-1.4%). Interestingly, these changes reflect our own observations about the valuation of these groups.
As of March 31, 2011, the portfolio held 81 positions—a decrease from the 86 held at the end of last year and a substantial reduction from the 100 names held in early 2010. For the third consecutive quarter, we also increased the concentration in the top-20 holdings of the portfolio. This action reflects both our increased conviction in the Fund’s current holdings, their attractive valuations, as well as the scarcity of value in the broader small-cap universe. Eight new holdings were purchased, including three Energy-related investments, and 13 companies were sold from the portfolio. Among the companies sold, seven achieved our Absolute Value price targets and six were sold due to either accumulated losses and/or a negative change in our fundamental outlook for the firm. These actions increased both the value and quality of the portfolio, which we believe is particularly important in a period of modest economic growth.
During the first quarter of 2011, equity markets continued to advance even in the face of sharply higher oil prices and a devastating natural disaster. We have seen the operating environment for many of the portfolio’s companies continue to improve over the past six months. Thanks to healthy balance sheets, easy credit, and a host of fresh tax incentives, there has been a rebound in capital spending, especially in areas focused on improving productivity and reducing labor costs.
There has also been a developing trend of improved business results among consumer companies that cater specifically to higher and lower end consumers. Businesses that sell to higher end consumers, such as denim apparel manufacturer True Religion Apparel, have benefited from a rebound in consumer spending and their ability to pass along higher raw material costs. Businesses that deal in lower end customers, such as closeout retailer Big Lots are feeling more margin pressure, but are seeing demand increase as consumers trade down. Firms that transact business in overseas markets, especially developing markets, are also seeing a strong rebound compared to 2009’s depressed levels. Security services provider Brink’s is just one holding that is benefiting from this trend.
But risks are increasing and momentum is fading. During the past six weeks, the trend in markets, economic data, and management commentary has become more uneven. In March, more Wall Street analyst estimates were revised down than up. Company management teams are increasingly focusing their comments on inflationary pressures, margin compression and, in some cases, weakening sales as a result of higher energy costs. Many are also clearly concerned about the strength of the recovery—the second weakest economic expansion in the post-war period thus far.
Conversely, the recovery in stocks has been one of the strongest on record, which points to one of the greatest risks investors currently face—extrapolating recent corporate and market performance into the future. Not only have margins likely peaked for this stage of the cycle, valuations among small-cap stocks are stretched. Additionally, the stimulus that has fueled the market rally during the past seven months is winding down. Unemployment remains high and housing has yet to show any signs of a material rebound. In other words, we are likely transitioning into a period of modest earnings growth and heightened market volatility.
As stated in our last letter, at this stage of the recovery we believe investors should be intently focused on quality, stock selection, and risk management. In this context, we are pleased with the quality and positioning of the portfolio, which we think looks highly attractive in terms of value, growth, and quality relative to the benchmark. The Fund has also become appropriately more concentrated, reflecting both an emphasis on quality as well as the scarcity of value in the broader market. Overall, we believe the market is finally transitioning to a period of lower-beta performance, which is supportive for our low volatility, Absolute Value style of investing.
River Road Asset Management
18 April 2011
As of March 31, 2011, Village Super Market comprised 1.40% of the portfolio’s assets, Harbinger Group – 0.64%, OfficeMax – 1.22%, Volt Information Sciences – 0.00%, PetMed Express – 0.00%, Big Lots – 2.81%, Ascena Retail Group – 2.74%, The Brink’s Company – 2.72%, ICU Medical – 2.11%, and True Religion Apparel – 0.81%.
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.