4th Quarter 2011 Commentary - ASTON/River Road Independent Value Fund
4th Quarter 2011
One of the Most Volatile Years on Record
Stocks soared during the fourth quarter as investors responded to both improving U.S. economic trends and a series of actions taken by the European Central Bank intended to stabilize that region’s financial markets. Small-cap stocks led the rally, with the Russell 2000 Index gaining more than 15% versus just under 12% for the more large-cap oriented S&P 500 Index. For the full year 2011, however, large-cap stocks outperformed—with the S&P 500 and Russell 1000 indices posting modest gains versus a 4% loss for the Russell 2000. This marks the first year since 2007 that large-caps outperformed small-caps.
It was also a remarkably volatile year, with indices posting some of their best AND worst quarterly returns on record. According to Ned Davis Research, the trailing 100-day volatility of the S&P 500 was at a level only seen three times (1987, 2002, and 2009) since the 1930s. In addition, the 12 downward corrections of at least 5% experienced by the S&P 500 during 2011 was nearly double the long-term average. Among other major asset classes, US Treasury Bonds was the best performing for 2011, followed by Gold—last year’s leading asset class.
From a style perspective, growth outperformed value during 2011 among the component parts of the Russell 2000. This marks the third consecutive year that growth outperformed value. Defense was the best offense with Utilities and Health Care posting the highest total returns, while Telecommunications and Energy posted the lowest. Leadership transitioned to low-beta (volatility) and high-quality stocks—a stark contrast from the prior two years. Within the Fund’s Russell 2000 Value Index benchmark, the lowest beta stocks (first quintile) outgained the highest beta (fifth quintile) by a staggering 26 percentage points. From a quality perspective, stocks in the highest quintile for return-on-equity (ROE) returned 21 percentage points more than stocks in the lowest ROE quintile.
Another leadership theme during 2011 was dividends. According to BofA/Merrill Lynch analyst Savita Subramanian, dividend yield was the top performing quantitative strategy in the S&P 500, while within the Russell 2000 Value, dividend-payers bested non-payers by a healthy margin for the full year.
We noted early on in 2011 that given the market’s robust returns and high-beta/low-quality leadership, an unusually large percentage of small-cap value managers were outperforming the benchmark. From our perspective, that trend reflected not only heightened equity correlations, but also that value managers had jumped on the risk bandwagon. We warned that investors and their advisors should take note of the trend, as managers that were chasing risk were likely to underperform as the market transitioned into the mid-stage of the recovery. By the end of 2011, only 57% of active small-value managers had beaten the benchmark’s return.
Fourth Quarter Rally
In a reversal of the year’s trend, the fourth quarter equity rally was accompanied by a resurgence in high-beta stocks, which had underperformed the previous two quarters. Value outperformed growth across all market-caps. Within the benchmark, the highest beta stocks (fifth quintile) surged ahead of the lowest beta stocks (first quintile) by 16 percentage points. Lower quality stocks (in terms of ROE) continued to lag, however. All 10 economic sectors within the benchmark posted a positive total return, with Industrials delivering highest the highest total return and Telecomm the lowest.
The Fund substantially underperformed the benchmark during the quarter due to the portfolio’s cash position and ongoing defensive security selection. The strong recovery in the small-cap market that began in early October drove positive absolute returns.
The largest detractors from performance during the fourth quarter were American Greetings, Bill Barrett, and Federated Investors. Greeting-card company American Greetings declined after announcing disappointing third quarter earnings. Although the business generated higher than expected revenue growth, the cost to obtain this growth weighed heavily on operating margins. Our initial valuation assumed higher revenues and lower margins, but we did not expect the decline in margins to be so abrupt. While encouraged by American Greetings’ ability to grow revenues in a stagnant industry, we have slightly reduced our normalized free cash flow assumption until we can better determine the profitability of new business. We plan to update our valuation quarterly and continue to hold the position as long as the stock trades below that valuation calculation.
Natural gas spot prices declined 19% during the quarter, most likely contributing to exploration and production company Bill Barrett’s poor stock performance. Although Bill Barrett has hedged 50% of its 2012 production, an extended period of low natural gas prices would be concerning. We will continue to monitor this risk closely and expect to update our Bill Barrett valuation in early 2012. Federated’s money market business, which historically generated 50% of revenue, continues to be negatively affected by an extraordinarily low interest-rate environment. Earnings are likely to remain below normalized levels as Federated continues to waive a significant portion of the fees on its money market funds. The uncertainty is putting pressure on Federated’s stock, as is the industry’s widely publicized exposure to European banks. In August 2011, we reduced our normalized free cash flow assumption and corresponding valuation after the Federal Reserve indicated that short-term interest rates would remain depressed longer than we anticipated. We believe our revised valuation appropriately considers the risks noted above and the Fund continues to hold the stock.
Among the Fund’s winners during the quarter were Brown & Brown, Core-Mark Holdings, and UniFirst. Brown & Brown, the seventh-largest domestic insurance agency, reported positive organic revenue growth in three of its four segments. Although total organic growth remained negative, the firm continued to demonstrate excellent cost controls and reported strong operating profitability. The company also raised its dividend and authorized its first ever stock repurchase program during the period. Core-Mark is a market leading distributor servicing convenience stores. In November, it reported positive results that included solid sales growth and strong free cash flow generation. It also recently signed a contract with Couche-Tard, a leading convenience store operator based in Montreal, to service 980 convenience stores in the Southeast and Florida.
Incorporated in 1950, UniFirst is a market leading manufacturer and distributor of workplace uniforms. Although unemployment remains elevated, the company continues to report positive revenue growth in its core laundry business, generating strong organic sales growth during its fiscal fourth quarter of 2011. We believe UniFirst has adapted to a challenging operating environment and continues to win new accounts and gain market share. Management expects sales and earnings growth to continue in 2012.
Despite the lackluster quarter, the portfolio delivered solid gains for the year in outgaining the Russell 2000 Value by more than 13 percentage points as the benchmark lost ground in absolute terms during the year. The Fund’s results were driven by equity selection.
The top three contributors in the portfolio for the year were Aaron’s, Papa John’s International, and Total Systems Services. Aaron’s, one of the top two rent-to-own retailers, benefited from a stagnant economic environment and tight consumer credit which drove increased customer traffic throughout 2011. Pizza chain Papa John’s experienced strong sales comparisons in its network of stores throughout the year and improved profitability from its international operations. As the leading domestic third-party credit card processor, Total Systems Services posted favorable operating results, growth in same-client transactions, and increasing international market share.
The bottom three contributors for the year were American Greetings, Federated Investors, and ManTech International. In addition to the specific fourth quarter woes noted earlier, American Greetings suffered from concerns about the future growth of the greeting card industry as well as reduced profitability associated with its increased distribution. ManTech, a leading provider of information technology services to the U.S. military and government agencies, performed poorly due to concerns about contract delays and future reductions in federal government spending.
Cash levels in the Fund increased from 41% at the beginning of the fourth quarter to 47% by the end of the year. The opportunities that began to appear towards the end of the third quarter were fleeting as small-cap stocks vaulted higher early in fourth, with the Russell 2000 Value increasing more than 14% in October alone. Although we were able to take advantage of the volatility in the third quarter by increasing position sizes and adding new holdings, in hindsight, our gradual approach to investing cash may have been too conservative. As an absolute return portfolio, however, our objective is to avoid being overly aggressive until we can find enough opportunities at prices that offer adequate returns relative to their risk.
Prices in our opportunity set of small-caps clearly improved during the fall, but in our opinion, did not decline to levels that provided the attractive potential returns necessary to validate aggressive positioning. The lack of the required discount-to-value was especially noticeable among the highest quality businesses that we look at. With high-quality small-caps now in favor, it is increasingly difficult to achieve absolute rates of return that we require on potential new positions. Thus, the portfolio remains defensively positioned as we await a more favorable pricing environment.
The largest new position added during the quarter was Steris, a leading provider of infection prevention and sterilization products. As the only domestic provider of a full line of sterilization equipment, Steris benefits from being an ideal partner for large hospital networks and group purchasing organizations. Although the firm’s capital equipment sales are inherently cyclical and driven by hospital capital spending, its new management team has successfully increased its mix of recurring consumable and service revenue while controlling expenses in a strong bid to raise margins. A recent product transition, among other factors, has depressed margins and free cash flow generation the past year. We think that Steris is an established market leader with a strong balance sheet and free cash-flow generation capability that sells at a sufficient discount to our calculated valuation.
The information gathered during the quarter from the 300 small-cap companies we follow continues to indicate a slow growth operating environment. The majority giving guidance for 2012 expect a business climate similar to that in 2011. On average, margins and cash flows remain resilient as companies performed well in what most call a “challenging” environment. Although many raw material prices moderated during the fourth quarter, costs on average remain higher year-over-year. Most of the businesses we follow successfully passed on higher costs to their customers, although some experienced volume declines. Several businesses noted concern regarding a possible slowdown in Europe and China, but have yet to see meaningful declines in business trends. Companies have also communicated an elevated level of uncertainty in their forecasts even though operating results are not expected to change meaningfully in the near future.
As investors search for certainty in an uncertain economic world, we believe investors may be overpaying for quality and, ironically, could be increasing their risk exposure in their attempts to reduce risk. A popular investment acronym used by growth investors is GARP, which stands for “growth at a reasonable price.” To fit our philosophy, we modified this acronym to QARP, or “quality at a reasonable price.” A high-quality business can be a poor investment if the price does not provide the investor with an adequate return relative to risk. Although higher quality small cap businesses often have less risk, they are not risk-free—like all investments, a suitable return potential remains necessary.
Assuming investors continue to increase the price they are willing to pay for certainty in 2012, we expect to continue selling several of the portfolio’s core holdings that approach or exceed our valuation estimates. We plan to reinvest these proceeds into companies that we believe provide us with adequate potential returns relative to the risk assumed. Although several new positions in the portfolio have short-term operating challenges, such as the Steris product transition highlighted previously, we remain committed to only buying high-quality businesses. The Fund’s recent purchases have long operating histories, established market share positions, strong balance sheets, and a history of consistent free cash-flow generation.
The high degree of volatility in 2011 caused higher than expected turnover in the portfolio as the valuations of many of the small cap businesses we follow fluctuated meaningfully throughout the year. Assuming volatility remains elevated, we could experience above average levels of turnover in the portfolio again in 2012. With high cash levels and a long list of small-cap equity investments that we would like to own at more advantageous prices, we believe the Fund is well positioned to take advantage of future uncertainty and the resulting opportunities stock price volatility can bring.
River Road Asset Management
6 January 2012
As of December 31, 2011, American Greetings comprised 1.83% of the portfolio's assets, Bill Barrett – 2.62%, Federated Investors – 1.24%, Brown & Brown – 2.53%, Core-Mark Holdings – 3.14%, UniFirst – 2.45%, Aaron Group's – 0.00%, Papa John’s International – 1.25%, Total Systems Services – 3.47%, ManTech International – 1.55%, and Steris – 1.43%.
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.
Parameters set by the Subadviser are not a fundamental policy of the Fund and are subject to change at any time.
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.