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.
The Fund substantially outperformed its Russell 2000 Value Index benchmark during the quarter, posting a modest gain versus an absolute loss of more than two percentage points by the index. The positive absolute performance achieved during the quarter resulted from strong stock selection and, more specifically, a favorable mix of winners and losers. Of the 40 stocks the portfolio held, only 12 posted a negative contribution to return. We believe that our strict buy discipline and willingness to hold cash to avoid overpaying for any stock contributed to that ratio. The Fund held an average cash position of 49% during the quarter.
The top contributing holding during the quarter was energy exploration and production (E&P) company Bill Barrett. Focused in the Rockies region, Bill Barrett has reinvested much of its significant cash flows into the exploration and development of existing properties, with the firm expecting to continue to increase production growth by double-digits annually through 2012. Its first quarter results supported these expectations and the stock responded positively as a result.
High-end grocer Arden Group switched from a bottom contributor last quarter to a top contributor during the second quarter on the heels of several developments. Collective bargaining negotiations between competitor grocery stores in the Los Angeles area and their union labor deteriorated, a scenario similar to 2003 when Arden gained market share. In April, the company directly repurchased 2.8% of outstanding shares from an institutional investor at an attractive price. Finally, Arden’s CFO made a significant insider purchase, the first by a minority owner/executive officer in more than 10 years.
Avista, a natural gas and electric utility with six hydroelectric projects generating more than 50% of its production, benefitted from a cold and wet first quarter that led to increased power consumption. In addition, an increase in hydroelectric generation reduced power supply costs and Advantage IQ, a non-regulated subsidiary that provides utility expense management services, continues to perform well. As a result, earnings improved and management now believes 2011 earnings will be at the high end of their original expectations.
Money Fund Woes
The largest negative contributor during the quarter was asset manager Federated Investors. A significant part of the firm’s assets under management come from money market funds, which currently face challenges stemming from record low short-term interest rates. In fact, fee waivers that allow Federated to maintain a positive or zero net yield in its funds reduced operating income by 20% during the first quarter. Fee waivers are expected to continue as long as short-term interest rates remain near 0% and should increase in the second quarter of 2011, causing earnings to drop below 2010 levels. There is also concern regarding the money market fund industry’s exposure to European banks and the European debt crisis. Still, we believe we have appropriately adjusted for these well-known risks. We are well aware of the possibility of an extended 0% interest rate environment and will continue to monitor these risks and adjust our valuation assumptions as necessary.
Billing and customer relationship software provider CSG Systems International also declined during the quarter. CSG has historically maintained a concentrated customer base within the satellite and cable industry, with 64% of revenues coming from its top-four customers in 2010. The firm’s recent acquisition of Intec, whose focus is on telecommunication providers, lowered the concentration of its four largest customers to 45% of total revenues. The firm faces other integration risks plus the impact of price concessions on a recently renegotiated contract with DISH Network. We believe we have accounted for the uncertainty by using an above average discount rate of 14% in our valuation model, and remain attracted to the company’s high revenue visibility (80% of revenue under contract) and strong free cash flow attributes.
Ambassadors Group, the market leader in providing international travel programs for students, was another poor performer. Ambassadors has a long history of more than 44 years operating the People to People travel program. Although the business remains highly profitable, operating results have suffered during the past two years due to declining enrollment and we expect cash flows to remain near trough levels in 2011. We have taken this environment into consideration when determining the normalized free cash flow assumption in our valuation model. Despite the headwinds, Ambassadors’ balance sheet remains strong with no debt outstanding and plenty of deployable cash. Although the firm has limited financial risk, the cyclical nature of its free cash flows makes it an investment with above-average risk for the portfolio. Thus, we expect it to remain a relatively small position.
Although the small-cap market declined slightly overall during the quarter, the pullback did not affect prices sufficiently to provide us with enough opportunities to reduce the Fund’s cash position. In fact, cash levels increased during the quarter as we sold several holdings, including large positions in Aaron’s and Ducommun, which had reached our valuation targets. Our focus on higher quality small-cap stocks remains unchanged and we think served investors well during the quarter. Until volatility increases and valuations allow for adequate absolute returns, we expect the portfolio to remain defensively positioned.
The largest new position added during the quarter was UniFirst Corporation, the third largest provider of workplace uniforms and protective clothing in North America. The company weathered the most recent recession well by implementing a “back-to-basics” strategy that emphasized fiscal discipline and customer service. These steps, along with lower energy and merchandise costs, helped propel earnings to record levels in 2009—one of the most difficult operating environments in its history—giving us confidence in its ability to navigate a full economic cycle. With an average customer relationship of 12 years and a 92% retention rate, the company has historically generated consistent operating results and recurring revenue allowing us to estimate free cash flows with a high degree of conviction. Although the company is exposed to fluctuating commodity costs and remains economically sensitive, with net debt less than annual free cash flow generation we believe it has limited financial risk. UniFirst is a solid example of a business that we think has limited operating and financial risk—the ideal traits of a core Independent Value holding.
We noticed several common themes among the approximately 300 small-cap businesses on our focus list throughout second quarter. Similar to the first quarter, many businesses continued to benefit from pent-up demand, stronger business spending, spending on productivity enhancements, and improved balance sheets. The economy appeared to be on a slightly upward trend even though the economic expansion appears uneven and there are increasing concerns about inflation and the sustainability of government spending. Most companies remain cautious about hiring and remain more committed to improving productivity and defending the margins of existing businesses.
Operating margins generally remained healthy, but broad cost pressures increased relative to the previous quarter. Management teams commented frequently on the need and ability to pass on price increases originating from higher commodities, labor, and transportation costs. Toward the end of the second quarter, there was a slight shift in tone, as concern grew that recent price increases may impact demand. As gasoline approached $4/gallon in May, the negative impact on discretionary spending was noted by several businesses, especially those that cater to low-income consumers. With rising costs and the possibility of demand destruction, we continue to believe it is important to stay disciplined regarding our normalized margins and cash flow estimates. Although we believe rising costs and margin pressures have been well communicated by management, the valuations of many small-cap businesses do not yet reflect this risk. In summary, in a period where operating margins may be near peak levels, it is extremely important to minimize valuation error by avoiding extrapolating results that may be unsustainable.
We are often asked why we hold cash given that the portfolio’s equity-only performance has outperformed the broader portfolio. Our use of cash is not an attempt to time the market, but is a direct result of the number of opportunities within our focused universe of mature, high-quality small-cap businesses. While cash, currently yielding 0%, does have short-term opportunity costs, as absolute investors we are more concerned about the risk of permanent loss of capital than the risk of underperforming a benchmark. Holding cash may reduce relative performance in the short-term, but it can also enhance long-term absolute and relative performance by allowing the Fund to act opportunistically without the need to sell existing holdings. In essence, cash allows the portfolio to invest decisively when it is being appropriately compensated to take risk and to limit mistakes when small-cap prices are extended and risks are elevated. Without these benefits, we do not believe the equity returns in the Fund would have been achievable.
River Road Asset Management
15 July 2011
As of June 30, 2011, Bill Barrett comprised 2.40% of the portfolio's assets, Arden Group – 0.72%, Avista – 2.54%, Federated Investors – 2.52%, CSG Systems International – 2.66%, Ambassadors Group – 0.71%, Aaron’s – 0.00%, Ducommun – 0.00%, and UniFirst – 2.66%.
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.