2nd Quarter 2012 Commentary - ASTON/River Road Independent Value Fund
2nd Quarter 2012
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). But on the final trading day of the quarter, equity markets surged higher as Germany finally indicated a willingness to back additional bailouts.
The Fund eked out a small gain during the quarter, outperforming the Russell 2000 Value, which declined roughly 3%. The Fund’s positive absolute and relative returns were the result of security selection, with above average performance in several of the portfolio’s consumer-related holdings.
The top contributor during the quarter was convenience store distributor Core-Mark Holdings. The company reported strong revenue growth as operating results benefited from a new contract with large convenience store operator Couche-Tard, growth in food sales, and positive results from its Forrest City acquisition. Although management expects to continue to generate meaningful free cash flow in 2012, we reduced the portfolio’s position on valuation concerns.
Another consumer-related holding that performed well was Cott, the leading producer of private label soft drinks and juices in North America. The firm’s business is relatively consistent and generates predictable free cash flow through products such as Sam’s Cola, Kirkland juices, and Publix soda. Rising commodity costs, especially higher resin prices, hampered operating results in 2011, but Cott was able to respond with increased pricing, reduced operating expenses, and by exiting a low-margin business. Gross margins improved sequentially, increasing our confidence that margins have bottomed. We maintained the position in the Fund.
CSG Systems International also boosted returns as the leading provider of billing and customer relationship software to the cable and satellite industry. The firm has historically generated attractive operating margins and strong free cash flow, and did so once again in its most recent earnings report. Management also noted that it is beginning to see improving trends from its recent Intec acquisition. We continue to hold the stock as it continues to trade at a discount to our calculated valuation.
The largest negative contributor during the second quarter was Pan American Silver, the second largest primary silver mining company in the world. Silver prices declined 15% during the period and geopolitical risk increased when Argentina nationalized oil company YPF. Pan American has one producing mine representing 18% of the firm’s total production in 2012 and one large undeveloped silver deposit in Argentina. Despite these near-term operating risks, the company has no debt and significant cash on its balance sheet. We think that allows us to be patient with the investment in the firm and the Fund continues to hold the stock.
Exploration and production company Bill Barrett suffered from depressed natural gas prices combined with falling oil prices that added to market concerns regarding its future operating results. With 70% of 2012 production hedged, however, we believe the company is well positioned to weather the current period of lower energy prices. In addition, the company has an unused $900 million credit line that should be sufficient to fund its 2012 and 2013 capital expenditure plans. We remain cognizant that the previous two years of capital expenditures have increased the firm’s debt levels, but these outlays also diversified its asset mix and increased reserves. Nevertheless, due to the increase in financial risk, we have not added to the position.
Also performing poorly was ManTech International, a leading provider of information technology services to the U.S. military and federal government agencies. ManTech reported disappointing operating results with a decline in revenues and earnings, and weak bookings for new business. Still, the company continues to generate abundant free cash flow and maintain a strong balance sheet. Although we share the market’s concern regarding the sustainability of government spending and the probable decline of wartime expenditures, ManTech’s stock trades at a discount to our estimated valuation.
Operating Environment Unchanged
Cash levels declined from 53% at the beginning of the quarter to 49% by the end of June. The increase in volatility during the quarter caused several of the businesses on our focus list to sell at adequate discounts to our valuations. In addition to new purchases, we added to several existing positions. Although the second quarter provided more opportunities, we continue to believe our focus list remains fairly priced to expensive overall. Thus, cash levels remain elevated.
The operating environment for most of the 300 businesses on our potential buy list did not change meaningfully during the quarter. Most companies continue to communicate that the economy is growing slowly and forecasting future results remains challenging. Profits and margins are elevated, but earnings growth appears to be slowing—often a result of difficult comparisons. The European crisis and slowing demand from China are common concerns for businesses with international exposure. There is also an increasing level of concern regarding currency movements and the stronger US dollar. Several companies noted that analyzing first quarter operating results was challenging due to the unknown impact from the very warm winter. Overall, uncertainty remains elevated, but the operating results of many small-cap businesses appear favorable.
Although the Fund’s small gain may have made it appear that the quarter was uneventful, it was not. It was a volatile quarter dominated by macroeconomic-related headlines. Markets moved erratically as investors responded to the latest news from Europe and increasing signs of a slowing global economy. Speculation regarding potential government and central bank policy response also added to daily market swings. Unlike the first quarter, when investors appeared to be accumulating equities with above-average risk, investors gravitated towards sectors with lower risk during the second quarter. As a result, there were meaningful dispersions between sectors. We welcomed the increase in volatility and sector dispersion as it allowed us to sell several of the portfolio’s consumer-related holdings at higher prices and purchase several energy stocks at more attractive prices.
Business Risk vs. Investment Risk
We noted in our fourth quarter 2011 commentary that it appeared investors were gravitating towards our type of core investment—small-cap businesses with consistent cash flows and strong balance sheets. This trend reappeared this quarter as rising uncertainty caused investors to seek businesses with steadier operating results. While we prefer businesses with predictable cash flows, high-quality businesses are not always good investments. As investors, we believe it is important to distinguish between business risk and investment risk. A business with low operating risk can have above average investment risk if the price of that business is too high. Conversely, a business with more volatile cash flows can be a good investment if the price adequately compensates the investor for the uncertainty of future cash flows.
As the price of many of the lower-risk businesses increased and the price of businesses with more volatile cash flows decreased, there was a gradual transition in the portfolio. Specifically, we sold or reduced several consumer-related businesses, such as Papa John’s International and Core-Mark, and purchased several energy holdings. The Fund’s weighting in Energy climbed from 4.8% to 8.7% during the quarter. In essence, we increased the operating risk in the portfolio by transitioning into areas where we are finding value and out of areas we believe are inflated by investors’ growing desire to avoid risk. Although the operating risks of the portfolio’s holdings increased, we believe the transition reduces investment risk—or the risk of owning overvalued securities.
When buying a cyclical business, such as an energy company, we demand two traits. First, we believe a strong balance sheet is essential for a cyclical business, as it improves the business’s ability to survive the trough of its business cycle and provides financial flexibility to take advantage of possible opportunities during periods of distress. Second, we focus on businesses that we believe will remain cash flow positive throughout the entire business cycle. This provides us with the confidence that the business will remain financially strong and can maintain necessary capital expenditures and investment. Thus, we will consider cyclical stocks that meet our criteria for purchase if priced attractively relative to the risk assumed.
Although the portfolio’s exposure to cyclical businesses increased during the quarter, the Fund remains defensively positioned given its elevated cash levels. Moreover, the majority of the holdings remain in businesses that we believe have below average operating and financial risk. As noted previously, however, we have incrementally increased our exposure to businesses with higher operating risks, which may increase the volatility of the equity holdings overall. We would also like to note that during periods of volatility and transition, as witnessed during the second quarter, turnover in the portfolio may increase. We believe turnover is necessary in order to reduce exposure to businesses that we think are not properly compensating us for their risk, while adding to those investments that are. We believe the Fund is well positioned to take advantage of future volatility and are prepared to make further changes in the portfolio when opportunities arise.
River Road Asset Management
17 July 2012
As of June 30, 2012, Core-Mark Holdings comprised 1.64% of the portfolio's assets, Cott – 1.33%, CSG Systems International – 2.69%, Pan American Silver – 2.58%, Bill Barrett – 2.18%, and ManTech International – 1.00%, and Papa John’s International – 0.00%.
As of 6/30/2012, the average international revenue for the Fund’s stock holdings is 20%.
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.