2nd Quarter 2012
Stocks Finish Lower Despite Late Quarter Surge
Following a near record first quarter performance, the broad market S&P 500 Index declined 10% from April through May as investors responded to the spreading financial crisis in Europe and a marked slowdown in global economic growth. On both sides of the Atlantic, the lack of a strong policy response weighed heavily on risk assets. The trend reversed itself abruptly in June on dovish comments from various Fed officials that raised the expectation (once again) of additional quantitative easing following a particularly dismal jobs report. Two weeks later, however, investors were disappointed when the Fed announced the extension of Operation Twist rather than a third round of quantitative easing (QE3). On the final trading day of the quarter, however, equity markets surged higher as Germany finally indicated a willingness to back additional bailouts.
We stated in our first quarter commentary that high-beta (volatility) stock leadership had faded in March in a possible sign that maybe the QE-fueled risk trade had run its course. This was indeed the case. Within the Fund’s Russell 2500 Value Index benchmark, the lowest beta stocks (first quintile) outperformed the highest beta stocks (fifth quintile) by more than 14 percentage points during the second quarter. Dividend-paying stocks also outperformed, besting non-dividend payers by nearly four percentage points. From a quality perspective, the gap was less notable as high return-on-equity (ROE) stocks in the benchmark outgained low-ROE stocks by roughly one and a half percentage points.
Value outperformed growth across all market-capitalizations during the quarter. Financials (REITs, in particular) and Utilities boosted the value component of the Russell 2500 Index while growth suffered from larger positions in lagging Technology and Energy. Through the first half of the year, small-to-mid growth continues to lead small-value mostly due to a larger weight in Healthcare. Also of note from a market-cap perspective is that micro-caps led the market higher during the first six months, while mid-caps have been the weakest segment after an extended period on top.
Active small-cap value managers continue to disappoint investors when the market appetite for risk diminishes—a trend we have highlighted during the past 18 months. According to BofA/Merrill Lynch and Lipper Analytical Services, just 13% of active small-value managers outperformed the Russell 2000 Value Index during the second quarter, and only 27% for the year-to-date through the end of June. We first speculated in early 2011 that small-value managers had adopted a higher risk profile than has historically been the case. We concluded this trend would likely result in managers underperforming as the QE-driven risk trade diminished. This was evident during the corrections that occurred during the second and third quarter of 2011, and again this past quarter.
Notes on Performance
The Fund posted a slight gain during the quarter in outperforming the Russell 2500 Value, which declined roughly 3%. More importantly, it has performed exceptionally well for the 12 months ending June 30, 2012. The portfolio outperformed with significantly less volatility than the benchmark during a period of poor active manager performance and high equity correlations. A recent study from Steven DeSanctis at BofA/Merrill Lynch indicated that quality and valuation factors have delivered eight of the top 10 performances (among 46 factors) tracked within the Russell 2000 during the past year (Russell 2500 analysis was unavailable but should be quite similar). This has likely been a key factor in the Fund’s success as many of these quality and valuation factors align with River Road’s small-cap investment process. For example, “share repurchases” was at the top of the list of top performers, while a number of other top factors focused on free cash flow. Meanwhile, risk factors such as beta (volatility relative to the market) and price volatility were at the bottom of the list.
The Fund’s trailing three-year performance continues to lag the benchmark, however. Although disappointing, the comparison suffers from the rolling-off of its first quarter 2009 performance. Investors may recall that the portfolio outperformed the index by more than nine percentage points that quarter. Next quarter, the third quarter of 2009 will roll off, in which the portfolio lagged by more than 10 percentage points—just the opposite of the first quarter on 2009. Thus, while the snapshot picture currently appears poor at this time, the overall performance highlights the low volatility aspect of River Road’s approach particularly during a time when equity markets were gyrating wildly.
For the second quarter of 2012, the Fund benefitted from an overweight allocation and positive stock selection in Consumer Staples, plus strong stock selection in Industrials. Given the uncertainty in Europe, benchmark sectors with above average foreign exposure (including Energy, Materials, and Technology) consistently posted the worst returns, while sectors with below average exposure (Healthcare, Utilities, and Financials) consistently posted the best.
The top contributing holding was private prison operator Geo Group. After reporting in-line first quarter results, the firm’s management team revealed new shareholder-oriented actions. First, the board of directors accelerated the timing, and increased the amount, of its recently announced dividend. Second, the company negotiated the purchase of 11 prison facilities related to a previous acquisition, which was an important milestone as the company is now exploring the option of converting to a real estate investment trust company (REIT).
Other top contributors included Madison Square Garden, ICU Medical, and Capital Southwest. Madison Square Garden, owner of the “World’s Most Famous Arena” and a number of New York sports teams and affiliated regional sports networks, reported strong results driven by viewership gains and increased profits from completion of the first phase of the arena transformation project. Strong international growth boosted the results of ICU Medical. Management also noted a favorable product launch of its Diana machine, which improves the accuracy of mixing toxic oncology drugs without exposure to the administering nurses. We trimmed the position as it approached our assessed Absolute Value.
Capital Southwest is a venture capital investment company that invests in public and private businesses. In early May, the company reported that its Net Asset Value (NAV) increased by double-digits year-over-year, and we added to the portfolio’s position as its shares traded at well below its historical discount. We think the firm’s conservative accounting method understates its NAV, and the repurchase of a large block of shares at market value by one of Capital’s publicly traded investments highlighted management’s attempt to close the gap between its share price and the company’s NAV.
A substantial underweight position in outperforming Utilities and a slight overweight to the battered Energy sector detracted from relative performance during the second quarter. Among the biggest individual detractors were mostly retail-oriented and tech holdings.
The worst performer was Ascena Retail Group, operator of the dressbarn, maurices, and Justice specialty apparel concepts in the United States. The company announced and closed the acquisition of Charming Shoppes, the parent company of plus-size women’s apparel retailers Lane Bryant and Catherines, financed with a mixture of cash and debt. Details of expected synergies and additional integration particulars are to come during the firm’s September earnings call. Although the deal creates some near term integration risks, we think the company has a proven record of creating value for shareholders through opportunistic acquisitions (e.g. Justice). Despite the second quarter setback, the stock is still up significantly year-to-date and we continue to hold the position in the portfolio.
Another poor retail performer was Rent-A-Center, the largest rent-to-own operator in the U.S.
The company reported increased same-store sales growth—about a third attributed to customers using their tax refund checks to exercise early purchase options. Same store sales excluding the purchase options were still at the high end of its guidance range, and the firm reiterated full year 2012 guidance. We think there were two catalysts for the drop in the stock price. First, investors worried that same store sales for the remainder of 2012 will be weak due to the high number of customers who exercised the early purchase option. Second, Best Buy announced it was discontinuing the testing of Rent-A-Center’s new RAC Acceptance kiosks in its stores. We believe the market overreacted as these two concerns overshadowed what was a strong quarter and do not materially change the long-term outlook for the business.
Rounding out the bottom five underperformers were NeuStar, ManTech International, and Tetra Technologies. IT company NeuStar reported solid earnings with double-digit organic revenue growth and only a slight decline in margins due to one-time integration expenses from a recent acquisition. The firm also continued to use free cash flow to repurchase shares and lower net debt. We viewed these results favorably and our assessed Absolute Value subsequently increased slightly. We did not see a specific reason behind the stock’s decline, which was in-line with the sector return. Declining in-theater revenues in Iraq and Afghanistan and delayed or canceled contract awards related to the fiscal cliff have negatively affected the shares of tech defense contractor ManTech. We trimmed this losing position. Oil and gas services company Tetra felt the impact of low natural gas prices. Its investment in a wellhead compression company experienced margin declines and lower profitability due to decreased activity and lower fleet utilization. We trimmed it as well during the quarter.
Each year Russell rebalances its indexes. This year’s rebalancing occurred on June 22 and produced a number of important changes in the Fund’s benchmark. The largest sector weight increases were in Energy, Materials, and Technology, while the biggest decreases came in Financials and Consumer Discretionary. Also worth noting was that the largest holding in the index declined from a $11.8 billion market-cap to $6.8 billion. The weighted average and median market-cap fell only slightly.
Notable changes to the Fund’s sector positioning included increases in Consumer Discretionary and Industrials, and decreases among the portfolio’s Technology and Financials holdings. We initiated six new positions across five sector groups and exited one other position in increasing the number of holdings to 83. From a size perspective, purchases were weighted heavily towards the smaller end of the portfolio’s market-cap spectrum with five of the six having market-caps less than $750 million. We also strategically increased 16 existing positions during the quarter—an unusually large number for us. The majority of these came during the market decline in April and May, with the largest increases being in FirstService and Standard Parking.
The company sold was a losing position in interactive white-board manufacturer Smart Technologies. We initially believed that the weak funding outlook for education budgets was priced into the stock. The company’s fundamentals continued to decline, however, as did our conviction in the management team. Fortunately, the Fund’s initial position size only reached 25 basis points.
Volatility Equals Opportunity
As previously noted, we were busy during the decline buying both new ideas and increasing the positions of a number of smaller holdings at attractive prices. As we expected, the portfolio’s relative performance also improved when the market’s high-beta leadership began to fade. As “risk assets” sold off, we initiated new positions in the higher-beta Consumer Discretionary sector—a group we had reduced when valuations (and market/sector risk) were higher. Although the Fund’s consumer names tend to be much less volatile than the broader sector, we found the market indiscriminately liquidating higher quality franchises. In the case of a company like Abercrombie & Fitch, which has European exposure and thus more price and operating volatility, the market was simply throwing the company out the window—a bargain trading at less than four times our estimate of 2012 earnings. A previous holding in the Fund, we had an exceptional opportunity to rebuild the position at what we believe is a great price.
Our discount-to-Absolute Value indicator of the top-20 holdings in the Fund is at the higher-end of its historical range, but we think there remains room for upside. Aside from macro-driven threats, the upside is dependent upon companies meeting or exceeding our expectations, which are generally modest. In this environment, consensus small-cap earnings estimates on Wall Street are probably too high. This should lead to continued volatility. We believe Europe will continue to struggle and we have reduced exposure to that region. We have not eliminated all of the exposure, however, as seen with Abercrombie. Some bargains are just too good to pass up. We think additional opportunities are likely to present themselves in the months ahead.
From a macroeconomic perspective, we think risk has increased since the beginning of the year. For much of the world, including China and Brazil, growth is slowing. Employment is getting weaker in the U.S., and the record drought will likely increase food prices in the months ahead. We think there are also significant positives, however. Oil and other commodity prices are lower and the U.S. housing market appears to be stabilizing. In addition, central banks around the world remain committed to expansionary policy.
The unknown today is what will happen with the “fiscal cliff”, an event that threatens an estimated 4% (or $670 billion) of Gross Domestic Product (GDP). The environment in Washington appears as contentious and dysfunctional as ever. The fiscal cliff issue is weighing on CEO and investor sentiment. With the recent Supreme Court ruling on the Affordable Care Act energizing both sides of the aisle, the environment in Washington is unlikely to change between now and year-end. Given the lame duck session, the best we can hope is that Congress extends the status quo until it can form a consensus around a more permanent decision. What is almost certain is that taxes on items like capital gains and dividends will increase for many Americans.
Although times look tough, we do not think it is as bad as many believe. The economy is still growing and profits for companies in the portfolio are still expanding at a healthy rate. Barring a fiasco around the fiscal cliff or a sharp rise in oil prices, we continue to believe that small-cap stocks will deliver double digit returns in 2012—a belief we have held to steadfastly during the past six months. We see the fear and uncertainty permeating markets as an opportunity for the Fund. During the past year, stock mutual funds (small-cap, in particular) have seen record outflows and the vast majority of active managers have struggled against the benchmark. We think the Fund’s performance, however, has shown that volatility can indeed equal opportunity for the disciplined, well-prepared investor.
River Road Asset Management
17 July 2012
As of June 30, 2012, Geo Group comprised 3.66% of the portfolio’s assets, Madison Square Garden Co. – 3.77%, ICU Medical – 2.49%, Capital Southwest – 1.02%, Ascena Retail Group – 1.89%, Rent-A-Center – 2.55%, NeuStar – 2.98%, ManTech International – 0.35%, Tetra Technologies– 0.66%, FirstService – 0.62%, Standard Parking – 0.69%, and Abercrombie & Fitch – 0.71%.
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.