2nd Quarter 2011 Commentary
Flat Quarter Masks Substantial Volatility
Global equity markets faced the proverbial wall of worry during the second quarter. The fiscal crisis in Greece caused fear of a possible liquidity crisis, while rising oil and commodity prices stunted the economic recovery in the U.S.—leading to increased inflation within Emerging Markets. U.S. unemployment remained stubbornly high as the Federal Reserve’s second round of quantitative easing (QE2) came to an end. Despite these concerns, equity markets showed resilience, with the Fund’s Russell 3000 Index benchmark losing only a fraction of a percentage point during the quarter. Although the U.S. consumer continued to struggle, U.S. businesses reported historically high profit margins and solid balance sheets. The flat return, however, masked substantial volatility. From its peak on April 29, the Russell 3000 declined 7.5% to its quarterly low on June 15, erasing a 2.9% gain to start the quarter, before regaining its footing in mid-June to rally back to near its starting point.
Overall, higher-quality stocks led lower-quality stocks across the market-cap spectrum. Stocks in in the highest quintile of the S&P 500 Index in terms of return-on-equity (ROE) outperformed those in the lowest quintile by more than six percentage points. The volatile second quarter also rewarded lower-beta (volatility) stocks, as stocks in the lowest quintile for beta substantially outperformed the highest beta quintile. Conversely, price and earnings momentum strategies lagged during the quarter.
Net Equity Exposure
Performance of both the long and short portfolios contributed positively to results since the Fund’s May 4, 2011 inception. The short portfolio performance was especially gratifying since the lower price and earnings momentum stocks outperformed high momentum stocks during the period. We maintain a proprietary price and earnings momentum ranking on all of the stocks in our investment universe, and select short positions only from the bottom half.
We took advantage of the market correction during the period to increase long equity exposure to 80% by the end of June. Short exposure during the period since the Fund’s launch fluctuated modestly between -14% and -17% as periods of rising prices created new shorting opportunities. The Fund’s expected range of net long equity exposure is 50% to 70%, and all net market exposure movements were driven by market opportunity.
If market valuations become extreme, we will move net long market exposure outside that expected 50% to 70% range. Valuations remained reasonable throughout the period, however. Under our Drawdown Plan, we will also move the net long market exposure below the normal range if the portfolio declines significantly from its high water mark. By seeking to reduce net long market exposure quickly during market declines, we hope to preserve capital during bear markets.
A top holding for the long portfolio since inception through the end of the second quarter was property and casualty insurer White Mountains Insurance Group. The company announced that it had signed a deal to sell its car insurance subsidiary Esurance to Allstate for a price in excess of our own valuation. Our overall assessed Absolute Value and conviction increased following the Esurance transaction and we added to the Fund’s position at what we think was an attractive discount during the period.
Another contributor on the long side of the portfolio was Allegiant Travel, a niche airline providing non-stop flights from smaller cities to large vacation destinations such as Las Vegas and Orlando. Unlike most air carriers with their massive debt and underfunded pension obligations, Allegiant has demonstrated both financial and operating discipline. The company relies on a common sense business model of concentrating on leisure customers in small markets with little or no concentration, using cheaper planes, and only flying where it is profitable. Further, we believe Founder, Chairman, and CEO Maurice Gallagher is a proven operator, and we appreciate his 22% stake in the company.
Following the bankruptcy of several major carriers, Wall Street turned positive on airlines as they returned to profitability, driven by higher utilization of reduced capacity. The industry reported a profit in 2010 for only the third time in a decade, however, and the irrational behavior that led to prior industry instability seems to be returning. The Fund is short two of the large airlines because historically they have squandered the benefits of emerging from bankruptcy by taking on more debt and increasing capacity. Ironically, it is Allegiant’s stock that is heavily sold short by the market while the bigger, legacy carriers have largely been ignored by short-sellers.
Ruddick, which operates the Harris Teeter supermarket chain in the eastern United States, also contributed positively to returns. The company reported second quarter results reflecting positive traffic trends and same-store sales gains, as Harris Teeter was able to pass through 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. We reduced the Fund’s position in Ruddick as it approached our calculated Absolute Value.
Big Lots, Artio Global Investors, and Canadian Oil Sands detracted from performance on the long side. Disappointing first quarter results, a weaker 2011 outlook, and the termination of an auction process to possibly sell the company sparked a sell-off in closeout retailer Big Lots. In May, it was speculated that management terminated the auction process when the bids from several private equity players did not meet internal expectations. With the subsequent decline in share price, the Board of Directors authorized a large stock repurchase program. In addition, it announced the acquisition of distressed closeout retailer Liquidation World in Canada, which presents an attractive international growth opportunity. We took the opportunity to add to the portfolio’s holding after the reported termination of the auction process caused the stock to decline.
We owned Artio in the Fund even though we were aware that this asset manager was experiencing outflows in its two flagship funds—International Equity Fund I and International Equity Fund II. We were optimistic that improved performance and newer equity and fixed-income strategies would result in an improvement in its business prospects and stock valuation. Although the stock was trading at a significant discount to its Absolute Value, it quickly developed into one of the portfolio’s largest unrealized losers. Although we continue to believe this is more likely a value opportunity than a value trap, we trimmed and ultimately eliminated the position in favor of ideas in which we had higher conviction.
Another poor performer was Canadian Oil Sands. The company owns a 37% stake in Syncrude, a joint venture in northern Alberta, which is located in one of the few politically stable areas with sizable oil reserves. The Fund established a position at a significant discount to our assessed Absolute Value, but our timing for the long position was relatively poor as oil prices peaked during the first quarter. To partially hedge the portfolio’s exposure to oil, we simultaneously established a short position in the exchange-traded fund United States Oil (USO). Fortunately, that short position had the highest contribution to relative return among the short positions and partially offset the losses in Canadian Oil Sands.
Shorting USO provided a good hedge because it has structural flaws when the futures market for oil is in contango (the price for near-term delivery of oil is less than the price for longer-term delivery). We think USO tracks declines in oil prices better than it tracks increases in such a situation, thus working well when shorted amid falling oil prices.
USG and Pitney Bowes were two other short positions that worked well for the Fund from inception through the end of the second quarter. Building materials company USG has a strong brand and is a market leader in wallboard, but demand for wallboard diminished in the wake of the housing crisis. USG also carries substantial debt which could put them at risk if the housing market does not recover in the near-term. Indeed, Wall Street analysts have revised down their estimates for most building materials. We covered a portion of the Fund’s position as the stock traded near our calculated Absolute Value. Mail-related product firm Pitney Bowes reported a weak first quarter with continuing declines in its core, high-margin business. We expect these trends to persist. The company pays a generous dividend that we think its cash flows cannot support. Dividend increases have slowed and we believe a dividend cut is a very real possibility, which would serve as a catalyst for another decline in the stock price. Although we have covered a portion of the position as the stock price has fallen, it remains among the Fund’s largest short positions.
Printing company R.R. Donnelley & Sons is an example of a short position that did not work out during the period. Our thesis was that more than half of Donnelley’s sales are attributable to magazines, catalogs, retail inserts, books, direct mail, and forms/labels, with digital alternatives not only replacing many of these printed materials but also competing for the same advertising dollars. Management has acknowledged they expect pricing to decline at a 1% annual rate. The firm recently announced a share repurchase authorization, however, that helped to prop up the stock. We don't think the firm generates sufficient cash flow to carry that authorization out without having to increase debt, which could negatively affect their credit. Given its short-term and long-term operational risks, we believe the increased financial risk will jeopardize the dividend and that the near-term boost of the buyback program will fade quickly.
Market Outlook & Portfolio Positioning
Although there are a number of macroeconomic risks that could alter the outcome, we believe that US equity markets look relatively attractive. Emerging Markets (EM) equities are relatively expensive and several EM central banks, including China and Brazil, have tightened fiscal policy to fight inflation. Developed equity markets in Europe carry material risk from the EU debt crisis. In addition, austerity measures like those enacted in Greece are likely to slow economic growth further and European banks may be forced to raise significant capital just to ensure their survival. Finally, the fixed-income market looks like a crowded trade, especially in the public and high-yield sectors.
Valuations in US equity markets are reasonable with profits and profit margins still recovering nicely from the recession lows. An uptick in merger and acquisition activity could provide a boost to multiples and further support domestic equity returns. Leadership in the market seems to have shifted from high-beta, low-quality and small-cap stocks to low-beta, high-quality and larger-cap stocks.
We believe we have entered a favorable environment for our Absolute Value style of investing. The Fund begins the third quarter above the midpoint of our normal net long equity exposure range at 64% (80% long/-16% short). The weighted median market-cap of the portfolio’s long positions is $3.6 billion, while the weighted median market-cap of the short positions is $1.7 billion. The opportunities we see available have led to greater long exposure to larger stocks and greater short exposure to small-cap stocks. Although optimistic that good results will continue if our outlook plays out as expected, our risk measures are designed to quickly alter exposures if we encounter unexpected changes along the way.
River Road Asset Management
20 July 2011
As of June 30, 2011, White Mountains Insurance Group comprised 3.62% of the portfolio's assets, Allegiant Travel – 2.16%, Ruddick – 1.67%, Big Lots – 3.00%, Artio Global Investors – 0.00%, Canadian Oil Sands – 1.59%, United States Oil – (0.70%), USG Corp. – (0.45%), Pitney Bowes – (0.88%), and R.R. Donnelley & Sons – (0.60%).
Note: Short sales may involve the risk that the Fund will incur a loss by subsequently buying a security at a higher price than which it was previously sold short. A loss incurred on a short sale results from increases in the value of the security, thus losses on a short sale are theoretically unlimited. Value investing often involves buying the stocks of companies that are currently out-of-favor that may decline further. Investing in exchange traded and closed end funds are subject to additional risk that shares of the underlying fund may trade at a premium or discount to their net asset value.
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.