3rd Quarter 2012
Stocks Surge on Pledge from ECB
After drifting sideways in July, stocks surged in August following comments from Mario Draghi, head of the European Central Bank (ECB), that the bank would use the full force of its balance sheet to support the euro and suppress the high borrowing costs of struggling nations such as Spain and Italy. Although the action did not address the debt and deficits at the root of the crisis in Europe, it reduced concerns about the ongoing support from central banks in the region.
The rally lasted through mid-September when the US Federal Reserve formally announced another round of quantitative easing (QE3)—a program targeting $40 billion a month in bond purchases—and its intent to keep interest rates “exceptionally low” through at least mid-2015. To the surprise of many, the S&P 500 Index peaked just one day after the Fed’s announcement, drifting steadily lower thereafter. Even a subsequent announcement by the Bank of Japan that it would expand its asset purchase program by 10 trillion yen failed to reverse the market decline.
It is unclear whether the reaction to the Fed announcement was a classic case of “buy the rumor, sell the news” or whether investors believed that additional quantitative easing was unlikely to have a meaningful impact. Mounting research demonstrating that each successive round of easing has had a diminishing impact on markets, interest rates, and the economy supports the latter theory. Even the deputy governor of the Bank of England (BoE), Paul Tucker, recently made the statement that while BoE’s QE program still worked, it lacked the “bite” it once had.
Although economic growth during the third quarter likely topped the 1.3% rate experienced during the second quarter, it will be far from robust. Durable goods orders declined, company surveys remained gloomy, job growth was anemic, and the Conference Board’s Leading Economic Index (which small- cap stocks closely track) turned negative during the period. The housing sector provided a rare bright spot, with the S&P Case-Shiller Index rising 11% (on an annualized basis) during the prior three months. Data also showed notable improvements in home construction, sales of existing and new homes, pricing, and the inventory of distressed properties.
Mixed Market Signals
Large-cap stocks outperformed small-caps for the third consecutive quarter, sending mixed signals on the market’s perception of risk. On the surface, it is surprising that small-cap stocks underperformed during what, in many ways, appeared to be yet another liquidity-driven, “risk- on” quarter. In the six weeks following the ECB announcement, small-caps did indeed outperform, but large-caps significantly outperformed in July and during the period following the Fed announcement—periods that could be characterized as more “risk averse.” It is also interesting to note that market-cap performance year-to-date has assumed a somewhat barbell-like pattern, with micro- and mega-cap stocks both leading small- and mid-caps.
There were other characteristics during the third quarter that looked a bit unusual for a “risk-on” rally that presented a somewhat barbell-like pattern as well. While high-beta (volatile) stocks in the Fund’s Russell 2500 Value Index benchmark led during the quarter, the margin of outperformance was comparatively low. In addition, the middle quintile of beta underperformed the extreme high and low quintiles. High-quality also continued to perform surprisingly well. Unlike small-caps (as measured by the Russell 2000 Value Index), however, dividend-paying stocks underperformed in the small-to-mid and large-cap universes. We believe that the mixed signals we are seeing indicate a wider dispersion of stock performance, which was evident in both the Fund’s performance during the quarter and the lower correlation among equities overall. The somewhat unusual and bifurcated nature of performance factors suggests that the market may be entering a transition period from the early to late stage of the current cycle. The timing of such a transition would be in-line with the average market cycle, which tends to last a little more than four years.
The Fund underperformed its benchmark for the quarter and trails the index year-to-date through September. Although we are disappointed to be lagging the benchmark, we are pleased with the Fund’s absolute returns and think that the relative performance is in-line with a period of higher-beta leadership and aggressive benchmark returns. We further believe it would be unwise to shift our time-tested investment approach, including our high-quality threshold for bank investments, in an attempt to outperform over the short-term.
During the third quarter, stock selection in the Consumer Discretionary and Energy sectors hurt relative performance, with retailers Big Lots and True Religion Apparel among the biggest individual detractors in the portfolio. Big Lots reported disappointing results and lowered its earnings guidance for 2012, as same-store sales and margins declined. The company’s Chief Merchandising Officer resigned as a result. The company did, however, repurchase stock and announce an initiative to improve the consistency of its results, including revamping its rewards program and remodeling old stores. We added to the Fund’s position late in the quarter.
True Religion Apparel, seller of high-end denim jeans and other apparel, reported increases in same-store sales but margins declined slightly as the company missed the fashion trend with some of its new women’s collections and had to take higher markdowns to clear the inventory. The company’s balance sheet remains strong with plenty of cash and no debt. Subsequent to quarter-end, the firm’s Board of Directors formed a special committee to explore strategic alternatives, including a possible sale of the company.
Other notable underperformers included Ingram Micro and Nordion. IT product distributor Ingram signed a deal to acquire Brightpoint, a global mobile telecomm distributor, at a 66% premium. This was the first significant action made by Ingram’s new CEO Alain Monie. The company, which actively repurchased its own stock in recent years, also announced that they do not plan to resume repurchase activity this year. We lowered our calculated Absolute Value on potential dilution and increased risk from the acquisition. Due to declining conviction in the shareholder orientation of the management team, we significantly trimmed the position at a small loss. Healthcare company Nordion lost a two-to-one arbitration decision seeking monetary damages in a lawsuit against the Canadian government. This disappointed investors, but it did not affect our conviction or Absolute Value. Since we planned to complete our target position after the decision, we subsequently added to the investment.
Strong stock selection in Technology and an underweight stake to the lackluster Utilities sector aided relative performance during the quarter. Among the top individual holdings were prison operator Geo Group and IT company NeuStar. Shares of Geo have rallied the past several quarters after the Board of Directors substantially increased its dividend and announced the possibility of converting the company into a REIT. The firm submitted a request for a private letter ruling to the Internal Revenue Service during the third quarter, which we think will get a positive ruling given that the company spun-out out a subsidiary as a REIT in 1998 and later repurchased it in 2007. A conversion into a REIT would greatly improve the tax efficiency of the company.
NeuStar manages phone number portability, call routing, area codes, and the unused inventory of phone numbers in North America. The company reported double-digit organic revenue growth and margin improvement, which led management to increase guidance for the year. In addition, the FCC finally issued the request for proposal for the new Number Portability Administration Center (NPAC) contract, which accounts for half of NeuStar’s revenues and expires in June 2015. The language in the RFP suggested a strong likelihood that NeuStar will retain the contract.
Another notable contributor was ICU Medical, a manufacturer and distributor of disposable IV connection systems and critical care devices. A top holding during the second quarter, ICU continued to perform well as the company reported significant gross margin improvement due to a better product mix and manufacturing efficiencies. Price stabilization in its critical care segment, favorable management commentary on new product development, and a strong balance sheet led us to increase our multiple on the stock. Nevertheless, we trimmed the position as the stock price approached our newly revised Absolute Value.
The Fund ended the quarter with the same number of holdings, 83, that it began the period after purchasing five new stocks and selling five others. The five new holdings came from four different sectors of the market. The purchases were weighted heavily toward the smaller end of the market-cap spectrum, including one with a market-cap of less than $500 million. We also strategically increased 15 existing positions, largely during late September as the market climbed and other holdings were being liquidated at their Absolute Values.
Among the companies sold, three achieved their Absolute Value price targets and two were sold due to a combination of accumulated losses and a decrease in our conviction. The latter included slot machine manufacturer WMS Industries and defense IT-provider ManTech International. At a sector level as a result of the changes was a decrease in the Fund’s Consumer Discretionary position and an increase in its Healthcare stake.
The largest new position added during the quarter was the previously mentioned Nordion, which develops and distributes radioactive isotopes used for the diagnosis and treatment of disease. We think the company’s business lines present significant barriers to entry for competitors, as they are highly regulated by government and require large amounts of upfront capital for infrastructure. Nordion has exclusive access to certain radioactive isotopes derived from nuclear reactors, extensive processing capabilities, and a strong reputation due to its long record in the field. In addition, the company’s Sterilization Technologies franchise is the world’s biggest supplier of cobalt, used for the sterilization of single-use medical products, with two-thirds of revenues coming from long-term contracts with annual price escalators.
The primary risk to the investment is the long-term viability of its medical isotopes unit, though this business only accounts for 14% of our assessed Absolute Value. It relies on an old facility that is prone to unscheduled shutdowns and scheduled to close in 2016. In the lawsuit against the Canadian government, it was found that the company was not entitled to monetary damages and could not force the government to open new reactors to supply a certain isotope. Overall, the company has a strong balance sheet with access to an untapped credit facility. At the time of initial purchase, the stock was trading at a 35% discount to our Absolute Value.
Despite the flood of liquidity provided by central bankers around the world, valuations still matter to investors. We were not surprised by the weak response to the announcement of QE3. Unlike prior QE programs, the market rallied strongly into the announcement, pushing our proprietary portfolio discount-to-Absolute Value indicator to its upper extreme. In addition, the market has recently demonstrated a weak response following Fed announcements, including the announcement of Operation Twist last fall and its subsequent extension during the second quarter.
As mentioned at the beginning of this commentary, we see the recent performance of certain factors as a sign that the current market cycle may be entering its late stage. Another interesting data point may support this conclusion. Capacity utilization and operating margins of businesses typically move together, but there has been a recent divergence with small-cap margins stalling below peak levels and utilization soaring to cyclical highs. We believe this divergence is due to the weak nature of the recovery combined with restrained investment by most companies. This underinvestment has helped support higher margins in the face of weak demand. If demand accelerates, tight capacity would lead to pricing power that could push margins even higher. Unfortunately, the lack of investment in new capacity will ultimately limit earnings growth, and combined with higher prices could usher in a wave of inflation.
As we listen to both company management teams and investors, it is clear that there is a crisis of confidence—confidence in policy makers, confidence in regulators, and confidence in markets. While confidence was not high at the beginning of the year, it has clearly deteriorated. In essence, this is why CEOs do not want to invest, banks do not want to lend, and consumers do not want to borrow or spend. In the near-term, earnings are unlikely to provide a significant boost. Although the third quarter may beat overall expectations, the pace of growth is almost certain to slow and guidance ratios among larger companies are running strongly negative. Without a significant upside surprise in growth or job creation (both highly unlikely), any near-term rallies on economic data are almost certain to prove fleeting.
Secular de-leveraging combined with underinvestment by companies and a liquidity-fueled equity rally has led to an unprecedented divergence among the economy, corporate profits, and the stock market. We believe that it is unlikely that all three will converge in a positive and orderly fashion. If the economy improves, underinvestment may lead to below average profit growth due to the constraints of peak capacity. If inflation picks up beyond the healthy levels targeted by the Fed, Chairman Bernanke would face pressure to quickly remove liquidity programs. Such an action could trigger higher interest rates and weaker than normal market returns. In this scenario it is uncertain whether the market recovery in equities can be self-sustaining.
We believe a fundamental change in Washington would help facilitate a positive convergence. Whether this means a change in Congress, a change in the White House, or a change in how the two major parties work together, more of the same is unlikely to improve sentiment—just the opposite. Politics aside, American business clearly needs to see Washington work toward a sustainable and united platform for growth, fiscal responsibility, and regulatory visibility. Absent change, the economy faces many more years of muddle-through growth, ineffective monetary and fiscal stimulus and ultimately an even larger crisis to test our nation’s resolve. The looming “fiscal cliff” threatens an estimated 4% of the economy. How Washington tackles this issue will be vital, and telling about how Washington will function in the coming years.
As our comments would imply, we are hesitant to present an outlook for 2013 until after the election and the third quarter reporting season. Overall, we expect management teams will continue to be cautious. Our assessment is that the operating environment slowed as the quarter progressed. Consequently, how management teams view demand trends and inflationary pressures and plan to sustain margins will be insightful. With this in mind, we continue to position the Fund for a sustained period of below trend growth. We also stand poised to take advantage of any volatility and accompanying price dislocations that may emerge in coming months.
River Road Asset Management
16 October 2012
As of September 30, 2012, Big Lots comprised 3.10% of the portfolio’s assets, True Religion Apparel – 0.62%, Ingram Micro – 1.43%, Nordion – 0.88%, Geo Group – 4.35%, NeuStar – 3.48%, and ICU Medical – 2.37%.
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.