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-to-mid cap stocks performed especially well during the quarter, with the Russell 2500 Index gaining more than 8.5% versus a little more than 6% for the larger-cap Russell 1000 Index. At the end of the first quarter, the Russell 2500 was more than 40% above its August 2010 low and about 1% below its all-time high set in June 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-to-mid 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 2500 Index actually outperformed the highest beta stocks.
The Fund underperformed its Russell 2500 Value Index benchmark during the period due largely to the first two weeks of January, 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 both February and March.
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. Healthcare was the benchmark’s second best performing sector, and the Fund’s second lowest contributor. The underperformance in Healthcare owed largely to the overall poor relative performance of services stocks and the portfolio’s lack of exposure to the life sciences and pharmaceutical industries.
Among the more notable individual detractors from performance during the first quarter were OfficeMax, Cracker Barrel Old Country Store, and two bank stocks. 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. Restaurant operator Cracker Barrel reported soft second quarter revenues as snow storms in the Southeast negatively affected store traffic. Sentiment from Wall Street turned negative as higher gas and food prices raised concerns over the financial health of consumers. Anticipating this reaction, we had significantly reduced the position during the fourth quarter of 2010.
UMB Financial and People’s United Financial both lost ground during the quarter. UMB reported fourth quarter results that were below sell-side analyst estimates. The largest earning asset on the balance sheet is the investment portfolio, which experienced falling earning asset yields due to lower reinvestment rates. This contraction in net interest margin continues to pressure earnings. Although UMB remains extremely well-capitalized and continues to deploy capital in shareholder friendly ways, we have significantly trimmed the position due to slight investment losses and lower conviction. Although People’s United reported in-line fourth quarter results, the focus was on its agreement to acquire Danvers Bancorp. We think the firm paid a large premium for the Massachusetts bank with 28 branches. Our initial investment thesis was based on excess capital being deployed in large, accretive acquisitions when bank valuations were low and capital was scarce. To date, the company has completed several transactions, but they have not been of significant size. Bank valuations are less attractive today than a year or two ago and capital is abundant. In our view these combined forces greatly increase the risk that People’s United overpays for future acquisitions. We eliminated the position.
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 individual contributors to performance during the quarter were DST Systems and Energen. DST is the largest third-party provider of mutual fund accounting services. It also provides statement and billing services to the financial, telecommunication, and healthcare industries. The company reported in-line fourth quarter results due to an acquisition and higher software sales. As expected, total accounts serviced and total registered accounts fell slightly quarter-over-quarter. DST retired some convertible debt, repurchased $4 million in stock, and raised its dividend substantially. Despite the stock price appreciation, we believe DST shares are still attractively valued and expect that free cash flow will continue to be used for the benefit of shareholders. Energen has two segments: an onshore oil & gas exploration and production company and a natural gas utility in the state of Alabama. Recent actions highlight the company’s sensible corporate strategy. First, it purchased an attractive stake in the Permian Basin, continuing the firm’s targeted shift to more lucrative oil prospects. Second, the company protected cash flow by entering into oil hedges at $89 per barrel in 2014. Energen capped off January with a strong earnings report and dividend increase, marking its 29th consecutive year of dividend growth.
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 2500 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 2500 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 (+2.9%) and Information Technology (+1.7%). The biggest decreases are expected within Energy (-4.9%) and Materials (-1.1%). Interestingly, these changes (particularly with Energy) reflect our own observations about the valuation of these groups.
Eight new positions were added during the quarter, including two Energy-related investments. The new investments tended to be smaller in market-cap, reflecting the scarcity of value among larger, higher profile securities. Ten companies were sold, six having achieved out Absolute Value price targets and four owing to accumulated losses and/or a decline in fundamentals. The net result was a decrease in the weighting to Financials and Materials, where the negative fundamental changes were mostly found.
The largest new purchase during the quarter was Neustar, a neutral third-party administrator that manages all telephone area codes, phone numbers, and number portability in the U.S. and Canada. The thousands of carriers that offer telecom services to the public must use Neustar’s clearinghouse to properly route all of their customers’ calls and its number portability services. It has no competition for call routing, phone number portability, managing area codes, or the inventory of unused phone numbers. In addition, the firm provides domain name services that help direct and manage Internet traffic, including the directories for the .us and .biz Internet domains. The largest risk to this story is the looming expiration of its contract for number portability administration center (NPAC) services in June 2015. The contract will be up for re-bid, but we believe Neustar is in a strong position to retain it with minimal price concessions. The company has high levels of customer satisfaction, the barriers to entry are significant due to the large amount of required upfront capital, and switching costs are high given the threat of a service disruption in a highly technical transition. The stock was trading at a 23% discount to our assessed Absolute Value at the time of initial purchase.
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 Company 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, OfficeMax comprised 1.22% of the portfolio’s assets, Cracker Barrel Old Country Store – 0.88%, UMB Financial – 0.69%, People’s United Financial – 0.00%, Big Lots – 2.81%, Ascena Retail Group – 2.77%, DST Systems – 2.42%, Energen – 1.48%, Neustar – 1.58%, True Religion Apparel – 0.77%, and Brink’s Company – 2.64%.
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.