2nd Quarter 2011 Commentary
2nd Quarter 2011 Commentary
Stocks Flat Following a Volatile Quarter
It was a volatile quarter for equity markets with stocks gyrating on robust earnings early in the period followed by weak economic data. Although management comments provided advance warning of a contraction in growth, the pivot point occurred on April 29 when the slowdown officially appeared in the U.S. Gross Domestic Product (GDP) numbers. A stream of disappointing economic news continued through May, particularly in housing and labor, which weighed on equities. In June, the fiscal crisis in Greece added to the turbulence, with investors initially fearing a broader debt contagion and later celebrating the passage of austerity measures. Toss into the mix the end of the second round of quantitative easing (QE2), more economic braking in China, and the deficit stalemate in Congress and investors were given considerable reason to reduce risk exposure during the period.
Despite the macroeconomic uncertainty, the broader equity market (as represented by the S&P 500 Index) eked out positive gains. The performance of small-cap stocks, however, reflected the market’s heightened volatility and investor risk aversion. After rallying to an all-time high in late April, the Russell 2000 Index plunged 10% through mid-June before rebounding in the final week of trading to end the quarter with a 1.61% loss. Growth outperformed value across all market-caps, with small-cap value trailing primarily due to smaller weightings in the Healthcare and Consumer Discretionary sectors and a larger relative weighting to lagging Financials.
The high-beta (volatility) theme that has dominated equity performance since the start of the recovery (and was refreshed by the launch of QE2) continued to subside during the second quarter, as investors flocked to higher-quality stocks. Investors tended to favor stocks with a high return-on-equity (ROE) and a high dividend yield, with high-beta stocks among the worst performers. This was especially true within the Fund's Russell 2000 Value Index benchmark, where stocks with the highest ROE (first quintile) outperformed stocks with the lowest ROE by an average of more than seven percentage points. Stocks with the lowest price-to-earnings (P/E) ratios also significantly outperformed stocks with the highest P/Es. The performance in beta was even more pronounced, with the lowest beta stocks outpacing the highest by nearly 10 percentage points.
M&A Activity Increases
Over the years, merger and acquisition activity has been a powerful driver of performance in the Fund. We believe this is because our Absolute Value style of investing centers on many of the same characteristics that private equity and strategic investors find attractive—discounted valuations, strong free cash flow, talented management teams with high insider ownership, etc. Earlier in the year, we were surprised more transactions were not occurring given the easy access to credit, healthy corporate balance sheets, limited organic growth opportunities in many industries, and large cash balances at many private equity firms. We were also surprised when several companies reportedly being shopped (Big Lots, Regis) were unable to complete a transaction. In most cases, it appeared buyer and seller could not agree on price.
More recently, M&A activity has improved as five transactions have occurred in the Fund in the past 60 days. This is a highly unusual (and very encouraging) level of activity in such a short period of time. We are seeing increased activity in industries such as Healthcare and Insurance, but relatively few deals in the consumer space. This is a different trend than what we observed during the 2006-2007 M&A boom, when consumer stocks were more expensive but the consumer was much healthier. We are very excited about this developing M&A theme and believe it could continue to have a positive impact on the portfolio’s absolute and relative performance.
Elsewhere, Russell conducted the annual rebalancing of its indices on June 24. As noted in our commentary last quarter, one of the more important changes this year involved the methodology surrounding the style factors. In an effort to reduce turnover among the style indices, Russell implemented a band on its overall composite value scores. Russell believes 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-capitalization indices, which substantially reduced turnover.
This year’s rebalancing of the Russell 2000 Value Index resulted in a lower overall market-cap and more growth in the benchmark. The largest holding declined from $4.6 billion in market-cap to just $3.1 billion. Similarly, the weighted average market cap for the index fell as well. The largest sector weight increases as a result of the rebalancing were in Technology (+2.8%) and Consumer Discretionary (+2.4%). The largest weight decreases were in Financials (-2.7%) and Energy (-2.6%). Interestingly, these changes largely reflect our own observations about the valuation of these sector groups.
The Fund slightly outperformed the benchmark during the second quarter in posting a loss of a couple of percentage points. Since late February, performance has benefited from the market trend favoring lower risk stocks. Although not readily apparent from the full quarter's results, the portfolio has posted a nearly four percentage point improvement in relative performance during the past two months. The Consumer Staples and Materials sectors delivered the highest contribution to relative performance during the full period. A significant overweight position and positive stock selection in Consumer Staples helped returns, while the portfolio’s Materials holdings benefited primarily from positive stock-picking driven by limited exposure to falling commodity prices.
Top individual contributors included supermarket-related holdings in Ruddick and Winn-Dixie Stores. Ruddick operates the Harris Teeter supermarket chain in the eastern U.S., which was able to pass most of its food inflation costs on to customers. The company’s wholly-owned subsidiary American & Efird, the world’s second largest manufacturer of industrial threads, also reported solid sales growth and improved profitability. Given the firm’s solid operating results, capable management team, and strong balance sheet, Ruddick continues to be the largest holding in the Fund. Pure supermarket play Winn-Dixie reported results that were ahead of both Wall Street and River Road expectations and noted that Florida (where roughly 70% of its store base is located) was showing signs of improvement with tourism rebounding, more new construction starts, and higher personal income levels.
Another notable contributor, property and casualty insurer White Mountains Insurance Group, was one of the beneficiaries of the previously noted M&A activity. The company signed a deal to sell its car insurance subsidiary Esurance to Allstate for a price in excess of our own valuation for that part of the business. Our assessed Absolute Value and conviction increased following the transaction, and we subsequently added to the Fund’s position at an attractive discount.
Consumer Discretionary and Healthcare turned in the lowest contributions to relative returns during the quarter. Big Lots within Consumer Discretionary was the worst performer. Shares of the closeout retailer rallied sharply during the first quarter on rumors that it had hired Goldman Sachs to pursue a possible sale of the company. In May, it was reported that Big Lots terminated the auction process when bids from several private equity firms did not meet internal expectations. The company also reported disappointing earnings results and gave a weaker than expected 2011 outlook.
After the reported termination of the auction process and decline in share price, the Board of Directors authorized a sizeable increase in its share repurchase program that if fully exercised at today’s prices would represent 18% of the company’s outstanding shares. In addition, Big Lots announced the acquisition of distressed Canadian closeout retailer Liquidation World, a potentially attractive international growth opportunity. Since we had trimmed roughly 20% of the Fund’s investment on the deal rumors, we seized the opportunity to increase the position after the decline.
Another poor performer was OfficeMax. The office supply retailer reported disappointing results as heightened promotional activity in its Retail Segment and the loss of key government customers in its Contract Segment led to lower sales and profitability. New CEO Ravi Saligram introduced a business plan designed to improve traffic and reverse the secular declines facing the Retail Segment. Negative industry sentiment and skepticism surrounding the changes in strategic direction led to Wall Street analysts slashing their revenue and earnings estimates. We lowered our estimates and cash flow multiple and, given its accumulated losses and revised risk/reward, eliminated the remaining shares from the portfolio.
Finally, Rent-A-Center, the largest retail chain in the U.S. that offers branded rent-to-own merchandise fell when the company announced revenue and earnings results below Wall Street expectations. Fewer tax-refund anticipation loans for consumers appeared to have a larger negative impact on Rent-A-Center than on main competitor Aaron’s. After nine consecutive quarters of exceeding estimates the shortfall was a surprise, but the modest earnings miss was not large enough to cause management to adjust their full year guidance. We viewed the quarter as a temporary setback that did not impact our level of conviction. In May, the firm increased its annual dividend, demonstrating strong free cash flow generation and a shareholder-friendly orientation.
During the quarter, the Fund purchased seven new holdings and sold eight stocks. Among the companies sold, four achieved our Absolute Value price targets and four were sold due to either accumulated losses and/or a negative change in our fundamental outlook for the firm. Among the new positions added, three were Financials-related investments, while the others represented a diversified group among the Energy, Industrial, and Consumer Staples sectors. All of the new investments were also smaller in size, a trend that has been evident with our purchases during the past several quarters.
The largest new position added during the quarter was Wyoming coal producer, and former Rio Tinto subsidiary, Cloud Peak Energy. Due to federal regulations that limit sulfur emissions, the coal produced in the Powder River Basin where the firm operates is desirable because of its low sulfur content. Cloud Peak supplies coal mostly to the Midwestern U.S., but recently started exporting coal to Asia through Canadian ports at prices well above the US market (though transportation costs are also significantly higher). Due to limited port capacity, exports are still less than 5% of the firm’s sales, but as port capacity expands it will improve pricing for Powder River Basin coal. The largest risk to the company is its relatively short reserve life of 10 years. The entire reserve acquisition process can take four to 10 years and requires significant capital investment before production can begin. Cloud Peak, however, recently won bids for two federal leases that will add roughly five years to its reserve life.
We think the market is entering the mid-cycle stage of the recovery. Since the beginning of 2011, we anticipated that as the end of QE2 approached the following two events would occur: 1) investors would begin to de-risk their portfolios and, thus, low beta/high quality stocks would begin to outperform; and 2) given stretched valuations, the small-cap market would experience at least a modest correction. We further believed the correction would signal the market’s entry into the mid-stage of the recovery, where earnings (and stock price gains) moderate. Finally, we stated that a sustained rise in oil prices would pose the greatest threat to what we continue to believe is a very fragile recovery.
Looking back at the first half of 2011, investors have been de-risking their portfolios since late February and the small-cap market experienced a -10% correction between late April and mid-June. Earnings growth began to moderate and higher oil prices contributed to a slowdown. The end of QE2, however, appears to have been more coincident than a major catalyst to these events.
We further anticipated that large-cap stocks would begin to outperform small-caps when the transition to lower risk occurred. In reality, small-cap stocks underperformed large-caps by a modest amount during the correction and rallied back to near parity by the end of the quarter. This was surprising to us and suggests that investors are not yet as risk averse as relative small-cap valuations suggest they should be. Of course, many aspects of the current environment are favorable for small-caps—credit spreads remain relatively tight, credit is available for publicly traded companies, and M&A is picking up. Investors may also be expecting another round of quantitative easing, which would likely boost small-cap relative performance. Either way, as fundamental investors we would be surprised if large-cap stocks did not begin to outperform as the market moves further into the mid-cycle stage of this recovery.
Specific to the portfolio, the recent uptick in market volatility was a positive event. It both enhanced the Fund’s relative performance and increased its opportunity set. Our discount-to-value indicator declined from a peak of about 85% in April to 75% in mid-June. This is only slightly above where the indicator troughed in the August 2010 correction. Barring a second recession, we believe this 75% figure is an excellent indicator of value in the portfolio in both absolute and relative terms. If recent volatility is indicating a more dramatic slowdown ahead and the economy falls back into recession, we believe the portfolio is well positioned.
Looking out over the next two or three years, we are also modestly positive on equities. Although “tail risk” will remain elevated, the economy appears poised to continue growing (albeit at a sluggish pace) and should continue to look favorable relative to most other developed nations. The Federal Reserve indicated it will remain supportive, broad inflation appears subdued, and companies are well capitalized. Corporate margins will likely compress, but thanks to low wage inflation they should remain reasonably attractive. The White House is likely to do whatever it can to keep oil prices low and boost employment prior to the 2012 election. If the Republicans win, we can expect a favorable reaction from Wall Street on the assumption of greater tax relief. While austerity measures will ultimately need to be adopted in the U.S. public sector, the really tough choices are likely to be addressed well after the 2012 election—even if Republicans win the White House. Finally, the fixed-income market looks like a crowded trade, especially in the public and high-yield sectors.
In summary, we believe that while there are clear structural issues that will weigh on U.S. equities longer-term and a sustained rise in oil prices remains a huge risk, in the intermediate-term the U.S. is one of the more attractive equity markets in the developed world.
River Road Asset Management
12 July 2011
As of June 30, 2011, Big Lots comprised 2.86% of the portfolio’s assets, Regis – 0.00%, Ruddick – 5.01%, Winn-Dixie Stores – 1.20%, White Mountain Insurance Group – 2.95%, OfficeMax – 0.00%, Rent-A-Center – 2.60%, Aaron's – 0.00%, and Cloud Peak Energy – 1.13%.
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.