3rd Quarter 2011
Stocks Plunge as Macro Risks Intensify
Equity markets plunged during the third quarter as investors reacted to a string of negative macroeconomic events beginning with the debt ceiling fiasco in Washington and the subsequent U.S. debt downgrade by Standard & Poor’s, followed by the deepening financial crisis in Europe and a general slowing of economic growth around the globe.
The broad market S&P 500 Index declined nearly 14% during the quarter, its biggest drop since the fourth quarter of 2008 and the second worst calendar third quarter since 1928. Small-cap stocks suffered even worse, with the Russell 2000 Index plummeting almost 22%—its second worst third quarter on record. We had warned investors about the overvaluation of small-cap stocks relative to large-caps for several quarters. That valuation gap collapsed amid the decline as small-caps underperformed large caps by more than seven percentage points (as measured by the Russell 2000 vs. Russell 1000 Index)—the widest spread since the first quarter of 1999.
Investors dumped both low-quality and high beta (volatility) stocks as the risk trade collapsed during the third quarter. Within the Fund’s Russell 2500 Value Index benchmark, the lowest beta stocks (first quintile) lost only 9% during the quarter versus a stunning decline of 36% for those with the highest beta (fifth quintile). In terms of quality, stocks in the top quintile for return-on-equity (ROE) outperformed the lowest ROE quintile by more than 7 percentage points.
Avoiding the Risk Bandwagon
The Fund significantly outperformed its benchmark during the third quarter, boosting its returns well ahead of the index for the year-to-date through the end of September. To put that into perspective, only 40% of active small-cap value managers outperformed the index during the quarter (according to Lipper Analytical Services and BofA/Merrill Lynch). Based on our historical observations, such weak performance is unusual in sharply declining markets. Conservative, value-oriented managers typically shine in environments of heightened risk and volatility. As mentioned in prior commentaries, however, we observed an unusually large percentage of small-value managers outperforming when the market was advancing sharply higher in the months following the announcement of the second round of quantitative easing (QE2). To us, this trend not only reflected heightened equity correlations, but also that value managers, as a group, were jumping on the risk bandwagon.
We believe investors and their advisors should take note of this trend. Not only is strategy consistency critically important in the context of an investor’s broader investment portfolio, but low-volatility stocks can help investors weather volatile periods without sacrificing long-term growth. Stocks that go down less require less upside to return to even, an advantage that can become especially valuable in a whipsaw, low-growth market.
We believe the key driver behind the Fund’s improvement during the third quarter was the market trend favoring lower-beta, higher-quality securities. The sectors with the highest contribution to relative performance were Consumer Discretionary and Industrials, highly cyclical sectors where our stock selection was distinctly less-cyclical, higher-quality, and somewhat more defensive. In addition, merger & acquisition (M&A) activity that carried over from the second quarter boosted returns. As noted in our last commentary, the portfolio experienced three transactions during a roughly 50-day period ending July 7. We were excited about the developing M&A theme, but when the market rolled over into the third quarter M&A slowed and no further deals occurred in the portfolio.
The top contributor to performance during the quarter was an acquisition target—Immucor. Healthcare technology company Immucor announced an agreement to be acquired by private equity firm TPG Capital for $27 a share—a 30% premium to the previous day’s closing price, and above that of our assessed Absolute Value. The potential for acquisition was part of our initial investment thesis due to the board-level involvement of ValueAct, an activist investment firm with a history of helping companies in its portfolio secure buy-out deals. We sold the stock upon the announcement near the $27 offering price.
Other notable contributors included closeout retailer Big Lots and footwear-maker Skechers USA. New store growth led to increased revenue at Big Lots during the second quarter despite a decline in same store sales. The management team also reacted quickly and decisively when speculation ended that Big Lots was an acquisition target of private equity. After its shares fell sharply, the company used its strong balance sheet to aggressively repurchase its own shares at a significant discount to our assessed Absolute Value. The stock remains one of our highest conviction holdings.
Skechers popularized toning shoes last year when they introduced their Shape-ups line. Its first generation of toning shoes sold quickly and the company restocked its inventory. The firm and its competitors then introduced sleeker, more-attractive toning shoes which led to excess inventory of the first generation of toning shoes. This temporary inventory overhang led to a sharp decline in the price of the stock, and the Fund subsequently purchased a small position. The stock continued to fall on negative investor sentiment. The company later announced it had successfully liquidated roughly half of its first generation toning inventory when it reported its second quarter results. The market reacted positively to the news and we took the opportunity to exit this lower-conviction name at a small loss to reduce the Portfolio’s overall consumer exposure.
What Didn't Work
The sectors with the lowest contribution to relative performance during the quarter came from Utilities and Energy. Results in Utilities suffered from a significant underweight position relative to the benchmark in an area that by far delivered the least negative returns. Energy was one of the worst performing sectors in absolute terms, but the negative relative effect was minimal and equally divided between stock selection and allocation. Among the biggest individual detractors from returns were Brink’s, WMS Industries, and Geo Group.
Security company Brink’s was the biggest individual detractor after it reported mixed second quarter results as its North American segment continues to suffer from pricing and volume pressures driven by aggressive competition. Weak organic growth and sovereign debt fears in Europe also pressured the stock. Industry consolidation fortunately eliminated a low-price competitor in March, which should help alleviate pressure in North America. A continuing bright spot for the company was in the Emerging Markets of Latin America and Asia-Pacific, both of which posted sizeable organic revenue growth. We maintained the Fund’s position in the stock on expectations of an improving outlook.
Gaming equipment manufacturer WMS traded down sharply after management lowered the top end of its 2012 revenue growth range and withdrew its margin guidance. Although overall quarterly results and guidance were in-line with our estimates, Wall Street was disappointed. The replacement cycle for slot machines has not occurred as quickly as anticipated and, in response, the company announced a 10% reduction in its workforce. Several sell-side analysts issued downgrades on the company as a result. We were encouraged that the firm repurchased stock during the quarter and Chairman and CEO Brian Gamache personally purchased a significant amount of the stock in the open market after the earnings disappointment. Despite WMS being a relatively new position, we trimmed the size of the holding due to its significant loss in the portfolio.
Private prison operator GEO Group reported strong second quarter results with higher revenue growth from two acquisitions and an increase in average inmate per-diems. On the new business front, the Florida legislature is seeking to privatize 29 state facilities in one ‘winner take-all’ contract that would be the largest state award in the industry’s history. On September 30, a Florida circuit judge declared the legislature’s privatization proposal unconstitutional. The state is expected to appeal the decision. If they request a Stay it would allow the state to move forward with the procurement pending the outcome of the appeals process. On the conference call, Chairman & CEO George Zoley noted the current environment is the “most active business development market we’ve ever seen.” We continue to view GEO as a high conviction position.
Positioning and Outlook
During the quarter, eight new holdings were purchased and 10 companies were sold from the portfolio. The new positions added were diversified across a broad range of industry groups, with two-thirds having a market-cap of less than $1 billion and only one, DreamWorks Animation SKG, having a market-cap greater than $2 billion. Among the companies sold, five achieved their Absolute Value price targets and six were sold due to either accumulated losses and/or a negative change in our fundamental outlook for the firm. Three of the six losers sold during the quarter were in the capital markets industry, including Federated Investors, Knight Capital Group, and Artio Global Investors.
Since the beginning of 2011, much of our outlook has been focused on how we believed the market would react to the expiration of QE2. From our perspective, the extraordinary liquidity provided by QE2 effectively extended the risk trade from April 2010 through February 2011. The average “early stage” recovery, when high-beta, low-quality and more-cyclical stocks tend to dominate, is about 14 months (excluding the tech bubble period). With QE2, the most recent high-beta recovery lasted 24 months. Since QE2 did little to stimulate actual demand for anything other than financial assets and commodities, equity markets became increasingly disconnected to the underlying economy. Prior to the recent correction, for example, small-cap stocks were experiencing the strongest post-war recovery on record, while U.S. Gross Domestic Product (GDP) growth was experiencing the weakest. Such gaps eventually close.
This is why we communicated our belief at the beginning of 2011 that the following two events would occur as the Federal Reserve began to wind down QE2: 1) investors would begin to de-risk their portfolios and 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 anticipated the correction would signal the market’s entry into the mid-stage of the recovery, where earnings (and investor expectations) begin to moderate, and that the Fund’s relative performance would improve substantially as these events unfolded.
We did not foresee the Arab Spring, the natural disasters in Japan, the European financial crisis, or the debt ceiling debate in Washington. Thus, although our outlook for 2011 was bearish relative to most of Wall Street, we did not anticipate the severe contraction in economic growth or the depth of the correction in equity markets. We simply knew speculative froth was high and the Fed had few remaining effective options. It was a time for caution.
Although investors still face many of the same challenges now as in early 2011, we believe the risk/reward proposition is greatly improved. Risk assets around the world have plunged in price, yet small-cap earnings have held up reasonably well. Many companies never unwound their austerity measures from the 2008 recession as they recognized, and subsequently learned how to manage in, a slow-growth world. Unlike 2008, corporate balance sheets are also in excellent condition.
Still, we think macroeconomic risks remain elevated. Since the end of June, the likelihood of a recession in Europe and the U.S. has increased substantially. The odds of a financial crisis (and associated contagion) emanating from Europe have also increased. Large U.S. banks remain weak, growth in key markets like China has slowed appreciably, and the political environment in Washington remains unstable and unpredictable. We believe that many of these risks have already been discounted in equity prices, however.
We are not suggesting that investors return to what has worked during the past two years—a high-beta, high-risk investment strategy—just the opposite. We think this is a mid-stage, cyclical transition in a low-growth environment. It is not the beginning of a new bull market. Thus, it is a time for investors to seek high-quality companies which, in many cases, were left behind during the earlier recovery. Investors should not rush to reinvest. Current volatility is likely to continue and we believe the market may remain trading in a broad range through the 2012 presidential election or beyond. For most, averaging-in over a period of months during pullbacks is better than rushing in only to question your decision if the market sets new lows. This certainly proved to be the case in 2008-2009.
Finally, the Fed remains both a blessing and a curse. Its actions are at least temporarily supporting the price of commodities and financial assets, but there appears to be limited benefits to the real economy. We believe that, ultimately, the Fed is making it more difficult for the financial system to purge its excesses and rebuild. If there is a QE3 and high-beta stocks have a temporary resurgence, we urge investors not to get caught up in the euphoria. We believe stocks could respond negatively to further quantitative easing, as they did following the announcement of “Operation Twist.” Thus, we urge investors to stay focused on high-quality portfolios of companies that can survive, and perhaps thrive, in a period of low economic growth.
River Road Asset Management
10 October 2011
As of September 30, 2011, Immucor comprised 0.00% of the portfolio’s assets, Big Lots – 4.59%, Skechers – 0.00%, Brink's Co. – 3.05%, WMS Industries – 1.03%, Geo Group – 2.83%, and DreamWorks Animation – 0.83%.
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.