1st Quarter 2012 Commentary - ASTON/River Road Independent Value Fund
1st Quarter 2012
Stocks Extend Rally
Stocks delivered one of the best first quarter performances on record in 2012, extending the rally that began in October 2011 and lifting most major indexes to new 12-month highs. The Nasdaq exchange led with an astonishing 18% return, its best first quarter performance since 1991, while the S&P 500 Index gained more than 12%—its best first quarter since 1998. The Russell 2000 Index kept pace with the S&P 500, its best first quarter since 2006 and ninth best on record. The small-cap index has rallied more than 37% from its October 2011 low and closed the quarter within 4% of its all-time high. Surprisingly, the Russell 2000 lagged the large-cap oriented Russell 1000 Index during the quarter—a rare occurrence amid a period of such strong returns.
The key drivers of the equity rally have been widespread, including improved U.S. economic data, attractive corporate earnings growth, easing concerns over the Eurozone crises, and the extraordinary liquidity provided by major central banks across the globe. The “risk-on” nature of the recent rally is almost certainly the result of monetary stimulus and is evident in the continuing high-beta (volatility), low-quality leadership themes.
Within the Fund’s Russell 2000 Value Index benchmark, for example, the highest-beta stocks (fifth quintile) returned 17% during the first quarter versus nearly 5% for the lowest-beta stocks (first quintile)—a remarkable gap. From a quality perspective, the lowest return-on-equity (ROE) stocks outgained the highest 18% to 11%. Non-dividend paying stocks also outperformed stocks that pay a dividend by nearly five percentage points. Investors should note, however, that high-beta leadership faded in March, which may be a sign that the current quantitative easing (QE) fueled risk trade has run its course.
Active managers delivered impressive performance during the period despite a dismal March. According to BofA/Merrill Lynch and Lipper Analytical Services, 65% of active small-value managers outperformed the Russell 2000 Value, but only 21% outperformed in March. The significant underperformance by active managers in March appears to have coincided with the higher-beta leadership beginning to fade in the small-cap universe. We first commented in early 2011 that, based on similar performance statistics, small-value managers appear to have adopted a higher risk profile than has historically been witnessed. We concluded this trend would likely result in managers underperforming as the QE-driven risk trade diminished. Our conclusion was evident during the corrections that occurred in the second and third quarters of 2011, and again as the high-beta leadership faded in March.
Nine of 10 economic sectors in the benchmark posted a positive total return during the quarter. Consumer Discretionary posted the highest gains, while Utilities actually delivered modest losses. The Fund significantly underperformed the benchmark in delivering modest positive returns. The poor relative performance was a result of the portfolio’s cash holdings and security selection as the portfolio remained defensively positioned.
The largest individual negative contributor was energy exploration and production company Bill Barrett. Despite record production, cash flow, and reserves in 2011, the firm’s stock declined as natural gas prices reached a 10-year low at the beginning of 2012. Although a sustained period of low natural gas prices would eventually affect Bill Barrett’s cash flows, we believe the company has taken appropriate measures to weather the sharp decline in prices. During the past two years, management has focused its drilling program on natural gas liquids and oil, increasing its reserve diversification, and improving its average realized price on production. In order to ensure sufficient funding to support further natural gas liquids and oil exploration, the company issued $400 million in bonds maturing in 2022. Lastly, management hedged 65% of the company’s 2012 natural gas production in an effort to protect cash flows from further declines in natural gas prices. Our valuation of Bill Barrett’s natural gas and oil reserves remains unchanged and we expect to continue to hold the position.
Other individual detractors from performance included energy drilling contractor Patterson-UTI Energy and Tellabs. Similar to Bill Barrett, investors are concerned that lower natural gas prices would negatively affect Patterson-UTI’s business going forward. Indeed, the risk of a prolonged period of low natural gas or oil prices could negatively impact rig utilization. We use normalized (adjusted for cyclical ups and downs) calculations in assessing the required rate of return on prospective investments, and believe we have taken lower rig utilization and other risks into consideration when valuing Patterson-UTI. We will own and consider cyclical businesses assuming they pass two criteria—they have a strong balance sheet and the ability to generate positive cash flow throughout an economic cycle. Tellabs passed the first test with $1 billion in cash and no debt. Although it has historically passed the second requirement, its business turned cash flow negative in 2011 and we sold the stock as a result.
Among the top contributors during the quarter were Federated Investors, American Greetings, and Constellation Brands. Although asset manager Federated continues to be negatively affected by the impact of the extraordinarily low interest-rate environment on its sizeable money market business, a sustained economic recovery could cause the Federal Reserve to increase the Fed Funds rate sooner than expected. We believe investor anticipation of higher short-term interest rates was the main reason for Federated’s strong stock performance. Regardless of this possible earnings catalyst, we sold the position as it reached our calculated valuation.
American Greetings is the number two market leader in the greeting card industry. In our opinion, there was not sufficient news or a change in fundamentals to justify the increase in its stock price during the period. We believe the increase was a result of its depressed valuation created by poor stock performance in 2011 and the strong performance of Consumer Discretionary stocks. Our valuation and the Fund’s position size remained unchanged. Constellation’s strategy of focusing on its core premium brands and divesting underperforming businesses has increased its operating margins and free cash flow, which it then used to reduce debt and buy back stock—improving its balance sheet and leading us to increase our calculated valuation. Although we continue to believe the business will generate meaningful free cash flow in the future, we reduced the position as it approached that valuation.
Cash levels increased from 47% at the beginning of the quarter to 53% by the end of March. As the small-cap market marched higher with little interruption several holdings approached or exceeded their valuations and were either reduced or sold. With few stocks on our potential buy list trading below our calculated valuations, new purchases during the quarter were limited. The Fund remains defensively positioned as we await a more favorable pricing environment.
The largest new position added during the quarter was contract research organization (CRO) Covance, the second-largest provider of outsourced research and development services to pharmaceutical and biotechnology companies. The firm is unique in the industry as one of the few CROs that has a significant presence in both early-stage (45% of revenue) and late-stage (55% of revenue) drug development. During the past several years, a challenging early-stage funding environment has significantly affected Covance’s operating results, reducing margins in this segment due to lower utilization and increased pricing pressure. Its late-stage central lab also experienced elevated levels of cancellations that resulted in declining revenue. Furthermore, management recently announced several large IT projects that will increase capital expenditures and operating expenses over the next two years.
Despite these operating risks, Covance has a strong market share, attractive positioning in the industry, and a strong balance sheet. Using normalized margin assumptions for both the early- and late-stage segments as well as the expected future benefits from the firm’s large investment in IT, our free cash flow estimate for Covance is significant. By applying a conservative discount rate to these future free cash flows, we believe our calculated value appropriately compensates us for these assumed risks.
Thoughts on Managing Risk
The prices of small cap stocks approached or exceeded record levels during the quarter. Small-cap valuations appear elevated within the Russell 2000 and S&P 600 Indices based on aggregate price/earnings ratios. Unlike 2011, when periods of volatility in the small-cap market created opportunity, volatility was practically nonexistent during the first quarter, with the CBOE Market Volatility Index (VIX) reaching a five-year low in March. Periods of low volatility and near-record prices often cause investors to become complacent with regards to risk. We take the opposite view and believe risk levels increase when volatility is low and prices are high. As an opportunistic strategy, we welcome volatility as it often coincides with risk becoming attractively priced. As the Fund’s high cash level would suggest, we do not believe, on average, that investors in our small-cap universe are being adequately compensated for the risk being assumed.
We believe managing risk is one of the most important factors in determining long-term investment results. Establishing when to assume risk, what kind of risk to take, and what required rate of return to demand for accepting risk are the cornerstones of our investment process. The ability to assume risk and refrain from accepting risk requires flexibility and patience. In the current environment, with small-cap prices rising consistently and trading near record highs, it is increasingly difficult to remain patient and disciplined. Lagging peers and benchmarks can result in career risk and performance anxiety for any portfolio manager willing to go against the herd. These professional and relative risks can cause conformity and, in our opinion, are counterproductive in managing the risk that matters most—the risk of permanent capital loss.
We believe an accurate valuation is essential in reducing the risk of permanent capital loss. Most of our valuations are calculated by discounting a business’s future free cash flows to present value. Although discounting future free cash flows is a common form of equity valuation, our process differs from most in that we use normalized assumptions. We normalize future free cash flows in an attempt to smooth the booms and busts associated with an economic or industry cycle. The cash-flow cycles of most businesses are nonlinear and have differing degrees of cyclicality. Therefore, to reduce valuation error, we believe it is important to avoid forecasting peak or trough cash flows far into the future. Instead of extrapolating recent results, we attempt to determine the amount of free cash flow a business will generate annually, on average, over an economic cycle. With corporate profits at record levels, we believe that extrapolating current operating margins and cash flows may provide overly optimistic and inaccurate valuations.
In addition to normalizing free cash flow, we use a required rate of return, or discount rate, in our valuation model that we believe properly reflects the operating risks of each business under review. We demand a higher rate of return for a business with more volatile and less certain future free cash flows. Conversely, we require a lower rate of return for a more stable business with more certain future free cash flows. Our required rate of return is typically calculated by combining the rate of return required as a debt holder, plus an equity risk premium. Interestingly, the required rates of return we demand are often similar to the internal investment hurdle rates used by many of the businesses we follow and value. Historically, that rate has been between 10% and 15%. In essence, the required rate of return assumption we use in our valuation model is our absolute return objective for our equity investments.
In an environment with rising small-cap prices, record corporate profits, and low interest-rates, it is tempting to adjust our cash flow and required rate of return assumptions in order to increase our business valuations. Higher valuations would allow us to justify purchasing more of the holdings on our Focus List and reduce the portfolio’s high cash position. Before adjusting our cash flow and required rate of return assumptions, however, we would need to be convinced that the cash flow cycle and the risks to cash flows have been permanently altered. We believe there is insufficient evidence to support the assumption that the current cash flow cycle and the risks to these cash flows are materially different than past cycles. Instead of manufacturing opportunities by altering our valuation methodology, we believe patience is the preferable course of action.
The Fund’s current high cash levels (53% as of March 31, 2012) illustrate our patient stance. This is in stark contrast to the average equity mutual fund’s cash level, which is near a record low of 3.6% according to the Investment Company Institute. Holding a large cash position is not an attempt to time the market’s direction, but is a direct result of the lack of opportunity we believe is in our small-cap universe. As a strategy that focuses on absolute returns, it is essential that we limit mistakes caused by overpaying for small-cap equities. In addition to protecting capital when prices are high, cash allows the Fund to act decisively, without the need to liquidate existing holdings, when opportunities arise. In other words, in addition to reducing risk, we believe the ability to hold cash aids our effort to maximize future returns.
Although small-cap stock prices have increased and profits remain elevated, our perception of risk has not changed. Instead of altering our valuation methodology to fit the short-term fluctuations in small-cap prices and corporate profits, we will remain patient and allocate portfolio cash only when we feel appropriately compensated. We believe patience is one of the most difficult investment disciplines to practice, but one of the most important. Until volatility returns and prices improve, it is likely that the portfolio will remain defensively positioned. In the meantime, we will continue to refine our list of high-quality small cap businesses that we look forward to owning in the future.
River Road Asset Management
8 April 2012
As of March 31, 2012, Bill Barrett comprised 2.64% of the portfolio's assets, Patterson-UTI Energy – 1.55%, Tellabs – 0.00%, Federated Investors – 0.00%, American Greetings – 1.82%, Constellation Brands – 1.79%, and Covance – 2.14%.
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, consider the Fund’s investment objectives, risks, charges, and expenses. Contact 800 992-8151 for a prospectus or summary prospectus containing this and other information. Please, read it carefully. Aston Funds are distributed by Foreside Funds Distributors LLC.