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. In addition, higher-quality stocks outperformed lower quality during the quarter. Within the Fund’s Russell 2000 Value Index benchmark, stocks with the highest quintile for return-on-equity (ROE) outgained the stocks in the lowest quintile by more than three percentage points. Stocks with the lowest price/earnings (P/E) ratios delivered a similar advantage over stocks with the highest P/E ratios and those with negative earnings.
Despite a large cash position held throughout the quarter, the Fund generated strong absolute returns that also bested the benchmark. The positive performance was the result of stock selection, as the return of just the portfolio’s equity holdings was more than 13%. Stock performance was driven by several holdings that approached or exceeded our calculated valuations, and the limited number of holdings with negative returns. Of the 41 stocks that were held during the quarter, only six posted a negative contribution to return.
The top contributor to performance was rent-to-own retailer Aaron’s. During the past few years, the company shifted from an aggressive growth strategy to a more moderate expansion plan. This slowdown has increased the company’s free cash-flow generation and improved its balance sheet through a net decline in debt. Aaron’s has also used this cash to buy back its own stock. Strong fourth quarter operating results were the main contributor to stock performance, as same-store sales increased and earnings grew. We expect these positive trends to continue in 2011 from increased customer traffic.
Other big winners during the quarter were closeout retailer Big Lots and Total System Services (TSS). Big Lots reported in-line fourth quarter results and provided solid guidance for 2011, but 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, causing us to sell the position from the portfolio as its share price exceeded our assessed valuation. Third-party credit card processor TSS announced strong fourth quarter results fueled by increased transactions. We think the firm’s healthy balance sheet and steady cash-flow generation should allow management to capitalize on emerging international growth opportunities and seek attractive acquisition targets. In early January, TSS acquired the remaining 49% of First National Merchant, the tenth largest merchant servicer in the United States.
What Didn't Work
Tellabs, Arden Group, and Central Garden & Pet were the three biggest detractors from performance during the quarter, with telecomm equipment manufacturer Tellabs by far the worst performer. Tellabs is exposed to the cyclical risk of the capital expenditures of telecom providers as well as technology risk as industry standards shift from circuit-based switches to an IP-based protocol. In January, Tellabs announced both fourth quarter earnings and a first quarter 2011 outlook that were below expectations, elevating concerns that the company will lose market share as the industry shifts to new technology standards. The firm has been through many industry cycles since its founding in 1975, and with plenty of cash on its balance sheet we think it has the ability to continue to invest during the current cycle. Tellabs spent heavily on new products during the fourth quarter with research and development costs reaching 20% of revenues. We believe Tellabs has limited financial risk due to its strong balance sheet and continues to trade at a discount to our valuation. We recognize the above-average operating risk at the firm however, thus it remains a small position in the portfolio.
High-end, Los Angeles County, CA grocer Arden caters to mostly affluent customers by focusing on cleanliness, customer service, and specialty goods in charging premium prices and earning industry-leading margins. This premium strategy also causes results to be more cyclical than a typical grocer. The firm’s top-line has struggled for the last several years due to the bursting real estate bubble and high unemployment rate in Los Angeles, but has recently shown signs of stabilization. Uncertainty associated with labor costs is another issue, as the collective bargaining agreement with its labor force is renegotiated every few years. Despite this inherent uncertainty and cyclicality, Arden has a very strong balance sheet that allows it to weather these developments with very little financial risk. With a large cash position on its balance sheet and the ability to generate significant free cash-flow in a normalized environment, we believe that Arden continues to trade at an attractive discount.
Although sales at Central Garden & Pet improved during the last quarter, higher costs pressured gross margins. Price increases have been implemented, but uncertainty remains around the lag of the price increases and whether they can offset the continued surge in raw material costs. The company’s strong free cash-flow generation has allowed it to cut its net debt almost in half the past three years while repurchasing a significant amount of its own stock. We believe Central Garden & Pet is well positioned to effectively operate in a rising price environment and the current operating risks are priced into the stock.
The portfolio remains defensively positioned. Cash and turnover increased during the quarter as sales of fairly valued positions outnumbered new ideas able to meet our absolute return criteria. Our focus on higher-quality, small-cap stocks persisted with a continued focus on businesses with limited operating and financial risk. Given current small-cap valuation levels, we believe investors are not being adequately compensated to assume the risks inherent in many of these businesses. Therefore, the Fund continues to hold a large percentage of its assets in cash as we search for opportunities that meet our objective of positive absolute returns.
The largest new position added during the quarter was energy exploration and production (E&P) firm Bill Barrett Corporation. Although is a relatively new E&P company (it went public in 2004), its founders have a long history of generating strong reserves and production growth in the Rocky Mountain region. When we invest in commodity businesses, we demand low-cost producers with strong balance sheets. These attributes improve the odds of surviving and thriving throughout each industry cycle. A recent industry breakeven analysis report published by Bank of America on April 4, 2011 ranked Bill Barrett as having the second lowest breakeven price out of 46 E&P companies. Although most of our valuations are calculated by discounting free cash-flow, in certain cases we use an asset valuation for a business with an asset heavy balance sheet. We value Bill Barrett in this manner, with an emphasis on replacement value supported by recent private market transactions. Along with trading at an appealing discount, we believe Bill Barrett is positioned well in the industry given its low-cost structure, relatively strong balance sheet, growing exposure to oil and natural gas liquids, and potential upside in reserves.
The high-quality companies we follow saw their operating environments improve, on average, during the past several months. Business and economic themes that began to form in 2010 developed further during the first quarter of 2011. 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- or lower-income consumers. Businesses that sell to higher-end consumers have benefited from asset inflation. Meanwhile, with unemployment high and rising costs for many products and services, businesses that help consumers trade down, such as discount retailers, also reported improved operating results. Businesses that sell to overseas end markets, especially in developing economies, have seen a strong rebound in demand from 2009’s depressed levels as well. As a whole, margins have improved, balance sheets are stronger, and business outlooks appear much more stable than a year ago.
Despite the improved business environment, the portfolio remains defensively positioned with above-average levels of cash. We believe many of the small-cap businesses we have analyzed for possible purchase are currently generating margins and cash flows that are above normalized levels. A recent Bloomberg article noted profit margins were at an 18-year high. We believe it is important to remain focused on each business’s normalized free cash-flow, not short-term trends in margins and profit growth or what a business earns at the peak of its cash flow cycle. This, we think, provides more accurate valuations.
Accurate valuation, or a high degree of confidence in what we believe a business is worth, is essential to our absolute return and opportunistic investment approach. For example, many small-cap stocks valued at peak cash flows in 2007 were ultimately valued too generously and investors suffered the consequences as cash flows declined and eventually troughed in 2009. In contrast, cash flows and margins were below normalized levels in 2009 and valuations based on these trough cash flows were too pessimistic. By using normalized free cash-flows we think a more accurate valuation can be made by combating the common mistake of extrapolating short-term trends too far into the future. In essence, we value businesses based on cash flows that represent what we believe a business can sustain long-term under normal operating conditions.
Current valuations are unlikely, in our opinion, to provide an adequate absolute return. Prices in the small-cap market have continued to increase in 2011, making buying high-quality businesses at a discount even more challenging. We remain committed to only taking risk when being adequately compensated for that risk. Although the operating environment for many of our businesses has improved considerably during the past two years, much of that improvement has been reflected in the price of their stock. As has been the case in past small-cap cycles when valuations appeared elevated, we believe patience and flexibility are required. We believe the Fund is appropriately positioned given the current environment, and look forward to future volatility and the opportunity it brings with it.
River Road Asset Management
22 April 2011
As of March 31, 2011, Aaron’s comprised 3.77% of the portfolio's assets, Big Lots – 0.00%, Total Systems Services – 3.20%, Tellabs – 0.89%, Arden Group – 3.29%, Central Garden & Pet – 1.51%, and Bill Barrett – 3.65%.
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.