31 Jul 2012 FPA Capital Fund - Q2 2012 Commentary ( Portfolio ) Portfolio Commentary
In the second quarter and year-to-date, the portfolio has underperformed the relevant indices. Our technology and industrial companies underperformed as fears of a cyclical slowdown grew in the second quarter, as did our oil service and oil and gas company investments with oil prices down about 20%. We took advantage of reduced prices. For instance, we bought back some of what we had sold during 2010 and 2011 of both Newfield Exploration (NFX) and Patterson-UTI Energy (PTEN). We also added to our positions in two more recent investments, Devry (DV) and InterDigital (IDCC), we initiated in 2011 as their prices became more attractive in the quarter.
We find it interesting that the P/E ratio of the Russell 2000, which is our fishing hole, actually has increased year-to-date, from 23.0x to 23.3x, up 1%, while the FPA Capital Fund’s, our investment strategy’s mutual fund, P/E ratio has decreased from 12.4x to 10.8x, down 13%. The already very large valuation advantage your portfolio enjoyed at the beginning of the year has expanded further. To equal the Capital Fund’s current P/E ratio, the Russell 2000 would have to drop by 54% or its earnings would have to grow 116% or a combination of both.
Our technology companies were the worst performers during the quarter with a negative contribution to the portfolio of 3.87% and a weight of 21.3% using the Capital Fund as a proxy. Western Digital (down 26%) subtracted 1.4% from performance, Arrow Electronics (down 22%) 1.3% and Avnet Inc. (down 15%) 1.0%. Fears of a slowdown and the uncertainties in Europe pressured our technology stocks. Western Digital was in addition hurt by concerns of excess supply of hard drives due to a recovery from the floods in Thailand. We believe these concerns are short sighted and that the earning power of Western Digital has been greatly enhanced by its merger with Hitachi Global Storage. This combination should drive sizable synergies and the consolidated industry is likely to exhibit better price discipline going forward. Western Digital is selling at below 7x earnings and 3.5x EBITDA. This is before the expected synergies from its merger with Hitachi, which we believe will be substantial. Arrow Electronics and Avnet, the two leading global electronic component distributors, were also impacted by concerns of the economic slowdown and are currently selling for 6-7x earnings, 1x book value and 0.2x sales. These are depressed valuations for such leading businesses.
The industrial sector had a negative contribution of 1.23% in the quarter, the vast majority from Trinity Industries (down 24%), the leading railcar manufacturing and leasing company. A cyclical downturn hurts Trinity’s earning power and the stock price is reflecting such a slowdown. Factoring in the value of its owned fleet of railcars for lease, the adjusted earnings multiple is in the single digits.
As oil prices fell during the quarter, the combined negative contribution from the oil service and oil and gas sectors was 3.78%. These two sectors had a portfolio weight of 29.3% combined at the end of the quarter, and the worst detractors were Rosetta Resources (down 25%), SM Energy (down 31%) and Newfield Exploration (down 15%), negatively impacting performance 1.2%, 0.4% and 0.3%, respectively. As a result of these price declines, we added to our position in Newfield Exploration across the board and to Rosetta Resources in the portfolios that were underweight it. We also added to our position in Patterson-UTI Energy, the leading land rig company, in the quarter. Patterson is selling for 6x earnings and 0.8x book value. It has upgraded its fleet over the last three years and now has state of the art rigs able to drill horizontal wells at record speed.
Even though a cyclical slowdown and lower oil prices would hurt our energy sector earnings, we believe this will be temporary. The world needs oil to grow real GDP over the longer term. Studies on global non-OPEC marginal cost curves indicate that there are three million barrels or more of marginal production costing $90 per barrel to bring to market. Even though we are using substantially lower prices when valuing our energy investments, it is likely that over the long-term, oil prices will vacillate around the marginal cost of production, with ups and downs as temporary surpluses or shortages develop.
We last invested in the energy area in the first quarter of 2009. Between then and last quarter using the Capital Fund as proxy, we sold 135% of the dollars we had invested in oil and gas companies starting Q2 2009 and 84% of our dollars invested in oil service companies. Despite the profit taking, these two sectors remain number two and number three in the portfolio because of their capital appreciation. It is this discipline of profit taking when our stocks reach fair value or a premium to fair value that allows us to reinvest the proceeds in the same or new stocks when they become
attractively priced.
We were curious as to what drove performance in our relevant benchmark, the Russell 2000 (R2K). Those companies that have either never earned any money or are overvalued based on their price to current earnings seem to have largely driven the R2K performance year-to-date. Approximately 7% of the R2K constituents experienced a stock price increase of 50% or more year-to-date. Less than half of these companies were profitable in 2011, the average P/E of the profitable ones was 41x. The average price to book stood at 6.4x and the average debt to capital was 37%. Highly-levered, marginally profitable, richly-priced stocks had an overwhelming impact on the index’s year-to-date returns. These are the types companies we stay away from.
Although the Russell 2000 is our target universe, we do not seek to invest in companies without a history of profitability or companies with little to no earnings which trade at ultra-rich multiples of their normalized earnings. We do not want to subject our clients’ capital to these speculative securities. While we cannot control other investors from investing in such securities, we can protect our clients’ capital by buying firms with market leadership positions, a history of profitability, strong management teams and balance sheets, and valuations far below intrinsic value based on earnings, cash flows, and balance sheet values.
Economic Commentary & Outlook
Over the past couple of years, we have outlined in our quarterly letters the unsustainable high levels of sovereign debt in the Club Med countries, notably Portugal, Italy, Greece and Spain. We mentioned that there could be over €2 trillion, or approximately $2.5 trillion, of combined debt these countries may not repay to bondholders. We discussed this issue because Europe represents roughly 25% of world GDP and the high debt ratios could not be sustained indefinitely.
The creditor nations’ economies, such as Germany and Finland, clearly benefitted as they financed their sub-prime neighbors to the south over the past decade. For instance, Germany’s unemployment rate was nearly 10% in 2002 at the beginning of the euro’s existence, and today the country’s unemployment rate is closer to 6% and Spain’s is sitting at roughly 25%. The creditor nations did not have to finance the Club Med countries by buying bonds issued by Greece, Spain, et al, they could have used their current account surpluses to consume products and services produced by their southerly neighbors. They chose, instead, to save rather than consume their surpluses, and now they are stuck holding hundreds of billions in Euros of under-water sovereign debt.
Unfortunately, unlike U.S. banks that can seize property from borrowers who default, Germany cannot foreclose on Greece and take back the Parthenon, which interestingly was once used by the Greeks as their Treasury. Nor can Germany seize Spain’s island of Majorca, where thousands of Germans descend every year to holiday and drink sangria. Thus, the creditor countries are left with a Hobson’s choice when deciding whether to bailout the Club Med countries.
From our perspective, we would rather see the creditor nations bolster their own banks by injecting an enormous amount of capital, wipe out the bank’s current equity holders and even some bond holders, and then try to negotiate with their borrowers the best loan workout deal they could muster. Short-term, the hit to the global economy would be hard and U.S. equities would suffer, too. The Euro-zone could likely split into at least two pieces, but the global economy would settle into a more sustainable equilibrium that allows investors like us to more accurately judge a company’s truer earnings power. Once the risk of sovereign debt implosion is removed, all else being equal, we would be more inclined to deploy risk-based capital.
While the above scenario is certainly possible, we think the European politicians who are in a position to effectuate this outcome will try to avoid the pain for as long as they possibly can, take smaller hits along the way, and encourage their banks to continue to buy and hold the respective sovereign debt. Thus the drama might last longer than many people either expect or hope. Of course, this scenario assumes that bank depositors do not panic, pull their money and cause a banking crisis, something that cannot be entirely ruled out.
In either scenario, the global economy will feel this headwind. As the headwinds buffet the global economy, we believe aggregate corporate earnings will be challenged to grow as fast as what is embedded in the price-to-earnings ratios, particularly for companies that make up our universe; the Russell 2000 and 2500. The P/Es for these two indices at the end June were 23.3x and 20.7x, respectively, versus the S&P 500 at a materially lower level of 15.3x.
However, there is one caveat, if the European Central Bank (ECB) decides to directly and rapidly monetize a substantial amount of the Club Med sovereign debt, the European and global nominal GDP could accelerate from the current pace. Currently, the ECB is facilitating European banks purchases of their own country’s respective sovereign debt and, thus, indirectly monetizing government debt through their Long-Term Refinancing Operations (LTRO).
Should Germany, and its Constitutional Court, allow the ECB to directly purchase massive amounts of sovereign debt the banks could then resume lending their capital more aggressively into the private sector. This scenario cannot be ruled out because there is a tremendous amount of pressure being applied to Germany to do something other than force austerity programs on the Club Med countries’ fiscal policies. The U.S. dollar could temporarily strengthen further.
We say temporarily because the U.S has its own set of debt and long-term liability issues, as yet unresolved by our political leaders. Our country is currently running an annual budget deficit of roughly $1.2 trillion. Congress and the White House have failed to agree on a coherent plan that would reduce the deficit to a more manageable level and, at the same time, not harm the growth potential of the economy.
Both democrats and republicans have made clear what they fundamentally believe needs to occur in order to reduce the deficit, but the differences in philosophy are fairly profound. We are skeptical that anything will be accomplished until after the national election in November, and believe any resolution to the oft discussed fiscal cliff will be deferred into 2013.
This would result in automatic spending cuts to take place in the Department of Defense and other programs not tied to Social Security, Medicare, Medicaid or other entitlement programs. The so- called Bush tax cuts and other temporary tax cuts will also expire at the end of this year. All of this fails to inspire businesses or individuals to feel confident about the economic outlook for this country. Unless Congress and the White House agree to reduce the growth of entitlement spending, enact meaningful tax reform, and remove the regulatory burdens on businesses, we believe these headwinds will continue to exert downward pressure on the growth rate of our economy.
Should our national politicians in Washington D.C. continue to neglect their duty to construct a responsible budget that does not jeopardize the fiscal soundness of our country’s Treasury and economic growth, we will remain concerned that the Federal Reserve (Fed) will re-insert itself into the mix and make the environment more uncertain. TALF, Quantitative easing, QE2, Operation Twist, these are all programs sponsored by the Fed to induce economic growth. The results have been anything but spectacular and the average American business person is either confused or disgusted with questionable monetary policies Chairman Bernanke and his team have supported over the past few years.
We would prefer to see the Fed implement policies that support a strong and stable currency. This will help provide confidence to global investors, including businesses, to direct their capital allocations towards America. The need to subsidize our banks’ balance sheets with ultra-low interest rates so they can earn a profit and then write off their bad loans has, unfortunately, come at the expense of savers. A well-functioning economy cannot repress savers for too long or mal-investment and other sub-optimal decisions will be made.
For instance, are investors holding onto over-priced stocks because the alternative of 0% bank deposits rates is neither attractive nor helping to achieve one’s long-term financial goals? By our definition, the Russell 2000 and 2500 are richly valued at 23.3x and 20.7x, respectively, as we mentioned earlier in this letter. Clearly, with the U.S. economy showing sluggish growth at best and some of our major trading partners at or near recessionary levels, earnings are not likely to grow fast enough to justify the steep values for many companies in our investing universe.
Summing it up, we remain very cautious with respect to U.S. economic growth and believe stocks, in general, are not adequately priced to warrant a more aggressive allocation to equities. We believe earnings growth for many companies will be challenged and fail to meet the high expectations embedded in the Price-to-Earnings ratios. We believe it is prudent to continue to maintain a high level of liquidity in your portfolio so we will have the ability to quickly deploy cash into attractive investment opportunities should they arise.
Deployment of capital in this fashion is no different than what we have done over the many cycles. Late last summer when the market rapidly declined approximately 20% we purchased several new stocks for a total of seven new securities last year alone. In late 2008 and early 2009 we were even more aggressive deploying capital as valuations were very depressed and remained there for a longer period of time than the two-month downdraft we capitalized on last year. The key here is that the stocks needed to get cheap before we deployed the capital.
Our team has never had a shortage of good ideas in the pipeline. What we at times lack is an environment where stocks are cheap enough to warrant deployment of your capital. Our strategy will, at times, underperform. The underperformance can continue for a prolonged time. The FPA Capital Fund has been in operation for 112 quarters and we have underperformed in 43 of these quarters. Often, a period of underperformance was followed by outperformance because we have not and will not compromise quality and valuation. Patience and discipline were critical factors in establishing our past investment returns and will remain so going forward.