4th Quarter 2011
The volatility that dominated the stock market in recent years did not abate during the fourth quarter. The market oscillated between fear and greed, declining each time the perceived liquidity or solvency risk in Europe grew, only to rebound after each intervention by the European Central Bank. By year end, the trailing 100-day volatility of the S&P 500 Index 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 of seven per year. Although the S&P 500 Index surged ahead by nearly 12% during the fourth quarter, in the end there was little to show for all the volatility in 2011 as the S&P 500 ended the year at almost exactly the same point it started.
During the quarter, the cyclical Industrials and Energy sectors led the broader market (S&P 500) in significantly outperforming defensive areas such as Telecommunication and Utilities. That was a stark reversal from the trend for the year leading up to the period. A preference for stable cash flows was clear in the strong performance of more defensive-oriented Utilities and Consumer Staples in 2011. The ongoing turmoil in European financial markets played a clear role in the massive underperformance of the Financials for the year.
Exiting the Drawdown Plan
The Fund, along with most hedged-equity strategies, underperformed its Russell 3000 Index benchmark during the quarter. The average net long equity exposure of the portfolio was 41%, slightly less than the 45% average since the Fund’s May 4, 2011 inception. Virtually all of the relative underperformance occurred in October during the exceptionally strong market rebound that produced most of the positive results for the quarter. Underperformance was driven by the portfolio’s net long equity exposure, not stock selection. The long-only portion of the portfolio outperformed the benchmark by more than two percentage points in October, and the short portfolio outperformed as well. In October, net long equity exposure averaged only 20%, well below its normal range, due to the execution of our Drawdown Plan during the market’s third quarter sell-off.
The Drawdown Plan is designed to lower volatility and protect capital as the market declines. We progressively reduce net long equity exposure as the portfolio declines from its high water mark. Until the market regains its positive momentum, the portfolio will stay below its normal net long equity range of 50% to 70%. During October, we began increasing net long equity exposure (Draw-Up Plan), officially bringing the net long equity exposure back within its normal range on October 31. We expect to significantly lag the market every time we emerge from the Drawdown Plan as we did in October. We think the Drawdown Plan’s performance should be evaluated in its entirety. The Fund significantly outperformed the Russell 3000 from the market peak in July through the end of October with less volatility and a much shallower drawdown.
Positive stock selection somewhat muted the underperformance caused by the net long equity exposure during the fourth quarter. Despite experiencing correlations that were more than double long-term averages, the Fund’s individual long and short positions outperformed the benchmark. The long-only portion of the portfolio gained 17% during the quarter with an average exposure of 78%. Amid the market rebound, the discount-to-value indicator that we use increased in the long portfolio from 68% to 74%.
The stocks with the highest contribution to long portfolio return during the quarter were Equifax, NeuStar, and Western Union. Equifax, which is the largest credit bureau in the U.S., reported another solid quarter with positive organic top-line growth and expanding margins. The firm has spent the past 100 years building a database of more than 300 million consumer credit records that would be virtually impossible to replicate. It is one of three firms that dominate the industry and its business model requires minimal maintenance expenditures, which allows it to convert 20% of every revenue dollar into free cash flow with strong earnings margins.
NeuStar 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 which helped to optimize its capital structure and reduce its dependence on its largest contract. We exited the Fund’s position opportunistically during the quarter.
A solid third quarter and the positive resolution of a tax case dating back to 2003 boosted the stock of Western Union, the global leader in money movement and payment services. The firm benefits from scale and 470,000 agent locations worldwide as the incremental cost of processing additional transactions is minimal. The company used its significant free cash flow to repurchase its stock and raise its dividend in 2011.
General Motors, gaming equipment manufacturer WMS Industries, and private label beverage company Cott Corp. were among the poorest contributors to performance. We re-established the Fund’s position in GM in November at significantly lower prices than when it was last held in July. That price was below the firm’s level of cash and investment on its third quarter balance sheet. Since emerging from bankruptcy in July 2009, the company made massive cuts to rationalize their cost structure allowing them to remain profitable through the demand cycle while generating $4 a share of free cash flow.
WMS traded down after it issued results that were below expectations due to product delays, pricing pressure, and a decline in average revenue per day in the participating machine segment. As a result, management lowered its revenue outlook for 2012. As the stock hit our predetermined stop-loss price, we sold the Fund’s position. High commodity costs negatively affected operating margins at Cott. In addition, juice volumes suffered materially as customers cut back on purchases in response to price hikes. Management expects further commodity cost pressure in 2012, and we eliminated the holding due to the buildup of significant losses.
The short portfolio gained 4.5% during the quarter with an average exposure of -37%. The make-up of the short portfolio changed dramatically from the end of the third quarter of 2011, as we covered the large short position in the SPDR S&P 500 ETF (SPY) and replaced it with individual shorts from our watch list as they became overvalued. The individual short portfolio (excluding hedges) declined 1.4% during the period, benefiting overall portfolio returns.
Molycorp, The United States Natural Gas Fund (UNG), and Office Depot provided the best returns from the short portfolio. Rare earth oxide producer Molycorp tumbled as rare earth pricing declined more than 60% from summer highs due to slumping Chinese demand and an increase in China’s export quotas. Prices remain elevated compared to historical levels, however, and the market is expecting this to continue. We remain skeptical as demand has not grown in years and a massive increase in supply is expected to come online over the next couple of years.
We selected U.S. Natural Gas, an ETF, as a hedge against the long portfolio’s natural gas exposure. It attempts to track natural gas prices through investments in natural gas futures contracts. During periods of contango (a condition where the price of the forward or futures contract is greater than the expected spot price at contract maturity), however, the net asset value slowly deteriorates as the ETF rolls its futures contracts. As a result, the ETF has historically captured more of the downside moves in natural gas prices and less of the upside movements in the commodity.
Office Depot continued to struggle as same-store sales were down year-over-year and operating margins were barely positive in the third quarter. At half the size of industry leader Staples, Office Depot lacks the bargaining power, distribution efficiencies, and scale advantages to exercise pricing power. They have endured multiple government investigations into its pricing practices and a lack of stability in the executive suite. The company intensifies its problems with more leverage than all of its peers. After covering the position late in the fourth quarter, we moved the stock back onto our watch list and look forward to re-entering the position if the stock becomes overvalued again.
The positions with the lowest contribution to short portfolio returns were the SPDR S&P 500 ETF, Life Time Fitness, and Liz Claiborne. In October, Liz Claiborne announced the sale of its Liz Claiborne, Monet, Kensie, Mac & Jac, and Dana Buchman brands to several unrelated parties. The transaction was transformational and significantly improved the company’s prospects. Before the transactions, the company had a significantly leveraged balance sheet and a portfolio of predominantly challenged brands. Although we were not relying on bankruptcy as part of our investment thesis, it was a potential outcome. After the transaction, financial strength was restored and the remnant brands, which are the firm’s strongest, will receive the undivided attention of management. We underestimated the value and buyer interest in the divested brands. Due to its improved prospects, we eliminated the short position during the quarter.
Life Time Fitness is one of the largest fitness club operators in the country. We re-established a short position during the quarter just ahead of the firm’s third quarter earnings announcement. The firm’s in-center revenue growth and attrition rate were better than expected, but we continue to believe that operating fitness centers is a challenged business model with subpar returns on invested capital. The company struggles to add new members to existing centers and leverage prevents significant center expansion, both of which limit growth opportunities.
The short position in the SPDR S&P 500 ETF was selected solely as a market proxy to achieve the desired net market exposure under the Drawdown Plan. We do not have an opinion on the valuation of the S&P 500 Index. The short position was completely eliminated as we exited the Drawdown Plan and individual short positions became overvalued during the quarter.
Outlook and Positioning
Although still dealing with a long-term deleveraging cycle, economic indicators in the U.S. are picking up as consumer confidence, industrial production, and unemployment show improvement. The sputtering recovery must still contend with currency and economic issues in Europe as well as elevated oil prices. As we entered 2012, our valuation work suggested that equities were fairly valued and our net long equity exposure was within the normal range of 50% to 70%.
As the market rallied hard into the end of the year, we believe we found certain pockets of value being ignored by other investors. Many high-quality Healthcare companies with solid balance sheets and long histories of shareholder orientation were selling at levels close to those witnessed during the market panic of 2008-2009. As we meaningfully reduced the portfolio’s exposure to riskier stocks, we were pleased to find more defensive stocks trading at a discount to our assessed Absolute Values.
Our process was on full display during the fourth quarter. As the market collapsed during the third quarter, we aggressively reduced individual short positions as they neared our calculated Absolute Values. We shorted the SPDR S&P 500 to maintain low exposure to the market in the event the decline continued. As the market roared back during the fourth quarter, we completely covered the SPDR short and positioned the short portfolio with ideas like newspapers, printers, rural telecom providers, and airlines.
We designed our long-short strategy to be able to perform in a wide variety of market environments by leveraging River Road’s stock-picking ability and structured risk controls. The massive volatility of 2011 proved to be an excellent testing ground for this approach. The most important return driver, individual stock selection, drove performance results despite extraordinary correlations. Our primary risk control, the Drawdown Plan, tempered fourth quarter results, but ultimately served its purpose by lowering volatility and protecting capital as the market fell. Taken together, the Fund significantly outperformed the market (as defined by its Russell 3000 benchmark) since inception, with only 30% of the volatility. We suspect 2011’s historic volatility will continue into 2012 and provide sufficient opportunity to produce attractive risk-adjusted returns.
River Road Asset Management
15 January 2012
As of December 31, 2011, Equifax comprised 1.99% of the portfolio's assets, NeuStar – 0.00%, Western Union – 2.73%, General Motors – 2.05%, WMS Industries – 0.00%, Cott – 0.00%, Molycorp– (0.17%), The United States Natural Gas Fund ETF – (0.63%), Office Depot – (0.00%), SPDR S&P500 ETF – (0.00%), Life Time Fitness – (0.62%), and Liz Claiborne – (0.00%).
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.
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.