23 Nov 2011 Thornburg Value Fund - Q3 2011 Commentary ( Portfolio )
Overall, our overweight in financials was a drag on performance relative to the S&P 500 Index, as was our underweight consumer staples exposure. On the other side, our overweight in energy helped, as did our underweight in industrials.

The Hartford, Bank of America, and Genworth are each priced as though they are in imminent need of additional capital. We have done a lot of work on each name, and we do not believe this to be the case. We know The Hartford well. During the 2008–2009 financial crisis, we amassed a $100 million position in Hartford debt between numerous accounts at Thornburg Investment Management at around forty cents on the dollar. As the crisis unfolded, our debt positions increased in price, even as it became clear that The Hartford might need to raise capital. We proposed to senior management a debt-for-equity swap at seventy cents on the dollar for the debt we purchased. This would have increased the Hartford’s capital levels in two ways – retiring debt for less than par is accounted for as a gain, and the additional capital that came in through the equity issuance would add further capital. The Hartford management did not take us up on our offer, but all’s well that ends well – we sold our debt for higher prices in the market and bought equity anyway. Our point being that we know The Hartford very well; we’ve been through a similar situation before, and we believe that The Hartford is in a much stronger financial position today than it was during the late-2008 to early-2009 period.

The same can be said for Bank of America. We believe their balance sheet is much cleaner today than it was during the financial crisis. While Bank of America will have further settlements to come on representation and warranty claims from counterparties (the mortgage-related lawsuits that you’ve likely read about in the press), we have run very pessimistic scenarios, in terms of loss levels for loans on their balance sheet and future mortgage settlements, and even in those scenarios, we believe Bank of America has adequate capital levels. Part of the equation is the strong pre-tax, pre-provision earnings that Bank of America’s leading deposit banking franchise generates in the U.S.; close to $40 billion per year. This serves as a tremendous buffer to absorb losses as they may crop up in the future. We believe that time is on Bank of America’s side.

Genworth offers mortgage insurance, as well as other specialty insurance products including Long-Term Care insurance. Mortgage insurance bridges the gap between a homeowner’s down payment and the required 20%. This puts mortgage insurance in a first loss position, behind only the initial equity loss of the homeowner. While mortgage insurance results have been very weak industry-wide over the last few years, we believe you can estimate future losses based on current new delinquency trends and the existing pipeline of non-performing loans. Given our current loss estimates in Genworth’s mortgage insurance businesses, especially considering it accounts for just one-sixth of their overall operations, we believe Genworth to be adequately reserved and capitalized.

In each of these companies (The Hartford, Bank of America, and Genworth), current market valuations are less than 50% of book value. In each case, we believe the company can grow book value over the next few years and eventually trade at a premium to book value.

U.S. Steel has been very challenging over the last few months. Over the latest business cycle, U.S. Steel earned $17 per share in EPS and approached a peak price of $200 per share. We initially purchased U.S. Steel at $40, had trimmed our stake above $60, and added again to our position at much lower levels. From there, the stock has been cut nearly in half. We believe U.S. Steel’s competitive position has improved over the last few years as the U.S. dollar has weakened against currencies in developing markets, such as Brazil and China. Additionally, wage rates are increasing in those countries relative to the company’s U.S. labor costs. As the relative cost of making steel in the United States declines, U.S. Steel should be better suited to compete against steel imports.

MEMC Electronics installs solar panels and manufactures silicon wafers for the semiconductor and solar industries. While the company’s end markets are currently experiencing a period of oversupply, the solar installation and semiconductor wafering businesses are holding up relatively well. It appears to us that fears of excess capacity have led to a stock valuation that is at a dramatic discount to our sum of the parts calculation.

Transocean is the leading deepwater drilling contractor globally. It has been plagued by concerns about potential legal liability associated with the Macondo drilling disaster. The rig downtime associated with upgrading rigs to meet tighter regulatory standards has also been a headwind for the company. The stock tends to move with oil prices and perceptions of the economic outlook. The price of crude oil declined by $10 per barrel during the quarter and investor pessimism increased. The price of most oil sensitive energy companies declined during the quarter and Transocean was no exception.

While, in many cases, the stock prices of the companies that we own have declined dramatically, our calculated worth of these businesses has not moved nearly as dramatically, if at all. Today, there is a much greater discount to intrinsic value embedded in the portfolio because of these dramatic price movements.
Top contributors over the year included energy-related holdings Baker Hughes and Inpex, as well as Monsanto, Comcast and KDDI, a mobile service provider in Japan. Of these five, three were sold during the year (Baker Hughes, Monsanto and Comcast) at satisfying valuations. Inpex and KDDI remain appealing investment opportunities. Inpex is the largest oil company in Japan and is currently working on two Liquefied Natural Gas (LNG) projects that will deliver LNG for electricity production in its home country. Given the tragedy during the year regarding the Fukushima Daiichi Nuclear Power Plant, natural gas will be a more important part of the power generation equation in Japan moving forward. KDDI is one of three large mobile operators in Japan, and stands to benefit as the Japanese consumer adopts smart phones.