17 Jul 2012 Thornburg Value Fund - Q2 2012 Commentary ( Portfolio )
Portfolio performance for the Thornburg Value Fund for the second quarter of 2012 has been disappointing. For the three-month period ended June 30, 2012, the fund returned -13.37% for the A shares at net asset value, versus -2.75% for the benchmark S&P 500 Index. We regret the strain this performance has placed on Thornburg shareholders and acknowledge the concerns you may have about Value Fund performance. Going forward, we intend to communicate more information, more detail, and more color on the factors that underlie current performance and on factors that have the potential to drive future returns.

The Risk-On/Risk-Off Climate

We are long-term, bottom-up, fundamental investors. But in this risk-on/risk-off environment, fundamentals are being ignored. As the crisis in Europe continues, relative performance has been driven more by the risk-on/risk-off exposure than by the fundamental development of individual companies.

Interest-Rate-Sensitive Issues Punished

A variety of companies suffer declines in profitability during periods of near-zero interest rates. For banks, net interest margin tends to be compressed. For life insurers, whose assets are mostly high-grade bonds, expected return on their asset portfolio tends to decline. Investors have reacted to this environment by selling banks and insurers. Our view is that the near-zero interest rate environment is temporary and that both banks and insurers are trading very cheap relative to normalized profitability.

So far, these cheap stocks have gotten cheaper, but we believe the underlying value of the companies has actually been growing as companies have generated earnings and used them to strengthen their balance sheets. Most of our financial holdings have been significant detractors including Metlife, Genworth, Citigroup, Hartford Financial Services, Bank of America, JPMorgan Chase, and Charles Schwab.

Companies with a Perceived Cyclical Tilt under Pressure

Just as we believe interest rates are likely to normalize over time, we believe that the U.S. economy will experience a positive economic cycle. Markets, driven by generalized fears of deep European recession and moderating U.S. and Chinese growth, appear to be pricing in major cyclical headwinds.

Two examples of Value Fund holdings with high perceived cyclical exposure are United States Steel Corp. and Tokyo Steel, each of which were among top detractors for the period. U.S. Steel serves markets that are picking up: oilfield services is experiencing strong demand due to increased U.S. oil and gas production; the U.S. auto sector is in the midst of a robust recovery; and there are signs of life in commercial real estate construction. Importantly, the company’s competitive position has improved since the last cyclical peak as wages and currencies have appreciated in China and other emerging market steel producing countries (with those in the U.S. flat). Tokyo Steel is unusual among steel companies in that it has no debt, no pension liabilities, and the ability to flexibly adjust production. The company’s new plant, when operating at full capacity in a normal steel price environment, should justify the company’s market capitalization by itself.

Staples, Inc., another of the top detractors from performance, trended lower due to demand concerns, weak employment growth, and sagging business confidence — all of which weighed upon the stock. Inpex, a leading Japanese oil company, declined along with the oil price. We believe the company’s Ichthys LNG development in Australia will drive strong growth in production and profitability through 2016. The valuation of Inpex does not appear to adequately reflect the potential profits of the Ichthys development.

Some Stocks Were Resilient

SoftBank Corp. was the top contributor to performance for the period. SoftBank owns a large stake in China’s Alibaba group, which is the leading provider of e-commerce services in China. SoftBank and KDDI, another fund holding, each appear poised to benefit from growth in data associated with smart phones.

Community Health Systems was also a leading contributor to performance for the period. Community Health has a long history of consistent earnings growth, yet traded at 6x earnings at the beginning of the quarter. The recent U.S. Supreme Court healthcare decision positively impacted the stock and the market has begun to recognize the company’s strong growth, yet the stock still trades at what we believe to be a low multiple.

Other top contributors to performance were Pulte Homes Inc., Gilead Sciences, Yahoo! Inc., Facebook Inc., Gap Inc., and Total S.A.

Notable Sales and Purchases During the Period

We sold ON Semiconductor Corp and bought Intel Corp., which offers better-defined prospects and a higher dividend yield. Apache Corporation was sold due to political risks in Egypt and Argentina; we bought Total, which offers a more consistent business and a 6% dividend yield. Dell suffered fundamental deterioration and was sold; we bought the better-positioned EMC Corp., which benefits from a strong product portfolio and a robust trend of growing data storage. Sandridge Energy was sold when it was revealed that its CEO, Tom Ward, had been running a hedge fund along with Chesapeake CEO Aubrey McClendon while Ward was the President and Chief Operating Officer of Chesapeake Energy. Ward and McClendon’s behavior may have been legal, but it appears to us to have been inappropriate.

We have also added a few new consistent earners to the portfolio. Autozone is an auto parts retailer and offers countercyclical characteristics: as economies slow, people tend to drive their cars longer and invest in more replacement parts. Potential growth is seen in the company’s commercial segment and in the Mexico market, which is 6% of sales. YUM! Brands is best known in the U.S. for its KFC, Taco Bell, and Pizza Hut chains, but it’s less well known that the company is among the best positioned quick-serve restaurant chains in China.

Conclusion

Last quarter, we concluded our commentary with the following: “There is always the possibility that unexpected events may cause investor risk aversion to rise rather than dissipate. Uncertainty regarding European sovereign debt, the fate of the euro, instability in the Middle East, the price of oil, and government budget deficits in the U.S. and China all have the potential to create downward volatility in the equity market.” Rising risk aversion associated with these factors has, in fact, hurt the fund’s relative performance over the past quarter. We cannot be sure that risk aversion will not increase further due to these and other factors. We believe, however, that the divergence between top-down macro driven share price movements and improving bottom-up company specific fundamentals will ultimately be resolved in favor of the company specific fundamentals. We have looked long and hard to find a realistic mechanism whereby macro developments would justify the kind of share price movements that have occurred. Our conclusion is that the share price movements were not justified and that at current prices the stocks in our portfolio are unusually attractive investments. That having been said, we are constantly monitoring and re-evaluating the companies in the portfolio and we are intent on managing the portfolio with an eye toward controlling risk as well as seeking return.

We invest in promising companies at a discount. By having a focused portfolio of companies that we know well, we are able to identify such promising companies and also mitigate risk. During periods where top-down macro factors are moving share prices, our approach may seem less relevant. We believe the opposite is true. It is in moments such as these that a differentiated, fundamentally driven stock-picking approach can add the most value. We are long-term investors, focused on the fundamentals. While the current market climate has hurt trailing performance, it has created great opportunity.