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. The Fund’s Russell 2500 Value Index benchmark dropped 3.4%. 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 Dow Jones Industrial Average 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 2500. This marks the third consecutive year that growth outperformed value. Defense was the best offense with Utilities and Consumer Staples posting the highest total returns, while Telecommunications and Technology posted the lowest. Leadership transitioned to low-beta (volatility) and high-quality stocks—a stark contrast from the prior two years. Within the Russell 2500 Value, the lowest beta stocks (first quintile) outgained the highest beta (fifth quintile) by a staggering 29 percentage points. From a quality perspective, stocks in the highest quintile for return-on-equity (ROE) returned nearly 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 2500 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. We believe 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. From our perspective this occurred in 2011, with a disappointing 57% of active small-value managers outperforming in a negative return environment.
Fourth Quarter Rally
In somewhat of 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 12 percentage points. Lower quality stocks (in terms of ROE) continued to lag, however. All 10 economic sectors within the benchmark posted positive total returns, with Industrials delivering the highest total return and Telecomm the lowest.
The Fund underperformed the benchmark by less than a percentage point during the fourth quarter, albeit in delivering positive double-digit absolute returns, in finishing the year well ahead of the index. Despite lagging during the quarter, the portfolio captured close to 97% of the benchmark’s upside in a sharply rising market after outperforming by eight percentage points during the second and third quarter as the market transitioned away from its high-beta/low-quality bias of the past two years.
Poor stock selection in the Industrials sector and an overweight allocation to Consumer Staples were the main detractors from relative performance during the quarter. Private prison operator GEO Group was the biggest individual detractor as persistent budgetary pressures faced by its state clients weighed on the stock. Still, the company’s management team believes cost savings from new privatization projects will lead to more bidding opportunities and outweigh any per-diem pricing pressures on its existing contracts. Many of its state clients need additional beds as their inmate populations continue to increase. Since the states cannot afford to build new prisons, it makes sense to outsource these services. Yet, politics, bureaucracy, and judicial intervention have led to delays or cancellations of several new contract awards. If this continues, we expect GEO to more aggressively allocate its abundant free cash-flow to shareholders through debt reduction, share repurchases, and a possible dividend. GEO continues to be a high-conviction holding within the portfolio.
Staples stocks Industrias Bachoco and Cott Corporation were also among the Fund’s notable individual detractors. Bachoco is Mexico’s largest chicken and second largest egg producer. Falling prices from an oversupply of chickens in Mexico has hurt revenues while sharply higher feed prices have squeezed margins. Despite these industry challenges, the firm used its strong balance sheet to make opportunistic acquisitions during the quarter, announcing a deal to acquire integrated chicken and feed producer OK Industries. We think Bachoco’s dominant market share position, its integrated model, and cash-rich balance sheet will allow it to make more attractive acquisitions during the industry downturn and emerge larger and stronger when conditions improve.
Cott is the largest private label beverage company in the world and was unable to fully pass through higher commodity costs during its third quarter, negatively affecting operating margins. Management cut bonuses to offset part of the margin pressure this year but expects further commodity inflation in 2012. Unfortunately, the company is unable to hedge its largest commodity cost, polyethylene terephthalate (PET), since a futures market does not exist. We significantly trimmed the portfolio’s position in Cott due to large unrealized losses.
Lastly, movie animation studio DreamWorks Animation SKG, owner of the Shrek franchise and other popular titles, disappointed. The approaching expiration of its distribution agreement with Paramount elevated investor concerns that the company may transition from an outsourced distribution model. Although self-distribution would be a significant investment, the firm would save the 8% of gross revenues paid to Paramount. We anticipated this uncertainty at the time of initial purchase and have maintained the portfolio’s position in the stock.
An underweight position in Utilities and an overweight allocation to the Consumer Discretionary sector aided relative returns during the quarter. The top individual contributor was IT company NeuStar, which manages phone number portability, call routing, area codes, and the unused inventory of phone numbers in North America. The company announced the acquisition of TARGUSinfo, the largest independent provider of Caller ID information services that serves the same clients as NeuStar. Both companies employ a subscription-based business model with very similar margin and growth profiles. In our view, this acquisition optimizes NeuStar’s capital structure and also reduces its dependence on its largest contract, which is up for re-bid. It remains a high-conviction holding within the portfolio.
Other notable individual contributors were Rent-A-Center and Madison Square Garden Company (MSG) within Consumer Discretionary. Rent-to-own merchandiser Rent-A-Center announced solid third quarter revenue growth and strong 2012 initial guidance. Investors reacted enthusiastically to these organic growth estimates in a difficult retail environment. MSG reported better-than-expected third quarter results driven by strong affiliate fees and advertising growth. Along with its ownership of the Garden, the New York Knicks and New York Rangers, the company operates regional sports networks and produces concerts and shows including the Radio City Christmas Spectacular. More importantly, the end of the NBA lockout after 149 days led to a new 10-year collective bargaining agreement that increased the owners’ share of revenues from 43% to 50%, which should improve the financial health of the league. We maintained our assessed Absolute Value and position size in the stock during the period.
Reflecting on 2011, the portfolio’s best contributors were generally its largest holdings. Performance benefited from our opportunistic trading of close-out retailer Big Lots. When news reports circulated that the company was for sale and its shares rallied towards our Absolute Value, we trimmed the position. When the press reported that no transaction would occur and the stock retreated, we added back to the position as the company aggressively repurchased its shares at depressed prices. Even prior to its fourth quarter acquisition, NeuStar benefited from suggestions that it may retain its NPAC contract without significant price concessions. Ruddick posted strong results throughout 2011 in its Harris Teeter grocery segment, while the company sold its industrial thread subsidiary A&E to private equity. The proceeds will be used for debt reduction and new store development.
Looking back at the largest detractors from performance in 2011, we completely exited the Fund’s position in retailer OfficeMax early in the year once it became clear that office supply spending was not going to improve in the near term. By year-end, its shares had plunged an additional 49% from the portfolio’s average sale price. In August, we eliminated the position in money-market fund operator Federated Investors after the Federal Reserve’s announcement that it would keep interest rates low for the foreseeable future. Shares of Federated subsequently fell further. We also significantly trimmed the investment in IT defense contractor ManTech International as the stock suffered from the threat of sizable cuts to the national defense budget. Finally, we trimmed re-insurer PartnerRe after it experienced larger than expected catastrophe losses.
Six new holdings were purchased and two were sold from the portfolio during the fourth quarter, both sales having reached our Absolute Value price targets. Of the new positions added, three—Hill-Rom Holdings, Hanger Orthopedic Group, and Owens & Minor—were in the Healthcare arena, with Hill-Rom the largest position of the group.
Hill-Rom is the leading manufacturer and supplier of medical beds in North America, with 70% to 75% of the market share and only Stryker as a significant competitor. Roughly 40% of the firm’s revenues are recurring, derived from bed rentals, maintenance services, and healthcare IT software. The average life cycle for a bed frame is 12 to 13 years, thus only 8% of beds are up for renewal each year, dampening the potential volatility of its financial results. The biggest risks for the firm are the overhang from future healthcare spending austerity measures and the financial strength of its clients. In an environment of potentially weak capital equipment budgets, Hill-Rom must demonstrate to its customers that its new products can save money and improve clinical outcomes. The stock was trading at a 26% discount to our assessed Absolute Value at the time of purchase.
Investors are facing many of the same challenges today as in early 2011—a European debt crisis, a weak housing market, sustained high unemployment, and tensions in the Middle East. Thus, it would make sense to expect more of the same from stocks in 2012, as many analysts do. The landscape, however, appears different to us than it did in early 2011—it looks far better! We think small-cap stocks are attractively priced.
A key difference is valuation. At the beginning of 2011, we noted that according to our Absolute Value approach, “small-cap stocks [were] fully valued.” By other, more traditional measures (such as price/earnings and price/sales) they were expensive. Today, valuations are attractive by both our proprietary and other fundamental measures. The driver for this change is that during the past 12 months small-caps returned single-digit losses while earnings grew by double-digits.
Another key difference is market leadership. In early 2011, high-beta/low-quality stocks continued to lead the market, which is typical in the early stage of a recovery. When valuations are stretched, however, high-beta/low-quality leadership presents an unattractive risk/reward scenario. We believed that as the Federal Reserve’s second round of quantitative easing began to wind down investors would begin to de-risk their portfolios and the small-cap market would experience at least a modest correction. We further believed a correction would signal the market’s entry into the mid-stage of the recovery, where earnings (and investor expectations) would moderate and the portfolio’s relative performance would improve substantially, consistent with historical trend. Ultimately, these events unfolded as anticipated. Thus, we believe the market is now in the mid-stage of a low growth recovery and given current valuations the stage is set for high-quality stocks to deliver attractive returns in 2012.
Still, macroeconomic risks remain elevated. The persistent global financial problems we face, including the sovereign debt issues in Europe, are residual effects of a multi-decade global debt explosion that will require many years to unwind. Historically, hangovers from financial shocks are long and painful, with plenty of market volatility, social upheaval (e.g., Occupy Wall Street, Tea Party, Arab Spring), and accompanying policy mistakes. Much of this adds to the uncertainty that we believe will lead to continued volatility early in 2012. Investors thus need a plan to avoid being gripped by either irrational exuberance or unreasonable fear.
From our perspective, the most effective way to do this is by focusing on fundamentals. At the beginning of 2011, small-cap fundamentals (both absolute and relative) were not attractive. Today, we think they are. Stocks are attractively priced, earnings expectations are reasonable, and corporate balance sheets remain in excellent condition. Although small-cap margins have rebounded sharply, they remain well below historical highs (unlike large-caps, which are at peak levels). Small-caps also have about half the revenue exposure to Europe than that of large-cap stocks. Finally, we believe conditions are ripe for a resurgence in merger and acquisition activity, which would support upside momentum, particularly for small-caps.
Forgoing a collapse of the European Union or some other catastrophic macro event, we think earnings and the U.S. economy will grow at a healthy clip, providing significant potential upside for investors. We are also pleased with the quality and positioning of the portfolio, which remains focused on companies with stable growth, attractive valuations, healthy balance sheets, and other acquisition characteristics—traits we believe the market will reward in 2012.
River Road Asset Management
16 January 2012
As of December 31, 2011, GEO Group comprised 2.66% of the portfolio’s assets, Industrias Bachoco – 0.56%, Cott – 0.59%, Dreamworks Animation SKG – 0.66%, NeuStar – 3.35%, Rent-A-Center –3.33%, Madison Square Garden – 3.17%, Big Lots – 4.38%, Ruddick Group – 4.52%, ManTech International – 1.12%, PartnerRe – 1.68%, Hill-Rom Holdings – 0.62%, Hanger Orthopedic Group – 0.13%, and Owens & Minor – 0.45%.
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.