From FPA Capital Fund:
Realistically, the Federal government will continue to spend money far beyond what it collects in revenue for the foreseeable future, higher oil prices will eat into the scarce discretionary income of consumers, and the sovereign
debt problems will eventually take its toll on investors. We have tried our best to position your portfolio to withstand a permanent loss of capital from the above risks. At the same time, the securities that we purchased over the past several years exhibited very attractive valuations, and ones that we expected would prosper during these challenging times.
As the companies in your portfolio proved the strength of their business models and generated excellent profits and cash flow, their share prices appreciated — in some cases quite substantially. Yet, no company, not even Apple, will grow forever and produce ever-rising profits. It is for this reason, among others, why we are more cautious about stocks in general and why we have reduced the shares in a number of the holdings in your Fund’s portfolio. Your Fund has considerable liquidity which can and will be used strategically to purchase securities when valuations hit our target levels.
In light of this, we did not add to any existing stocks and added only one small new position to the portfolio during the past six months. Ironically, despite the large gains over the last six months and past two years, we have a handful of
attractive companies that we are monitoring very closely and which are close to an entry-level valuation for your Fund. We continued to perform due diligence, during the quarter, on a few companies by visiting their operations and talking with management and industry experts to ascertain the individual company’s risks and prospects. However, none of the five or six stocks which we are closely monitoring currently provide an adequate risk-reward ratio that would give us confidence to initiate a position. Patience is a key attribute and distinguishing characteristic of our investment process, and one which appears to be in scarce supply today across the broader investment management industry.
We did, however, reduce a number of positions during the past six months. While the majority of the stocks we reduced were energy related, we also cut back our exposure in technology, retail and industrial companies.
Two stocks worth highlighting in the most recent six month period were Trinity Industries (TRN) and Patterson- UTI (PTEN). TRN gained almost 65% during the six months ended March 31 and closed at $36.67. We had believed that the market was not properly valuing the company, based on our view thatindustry railcar shipments would get back to more normalized levels. We also believed that TRN’s profits would rise substantially as the company’s railcar shipment growth mirrored the industry’s growth, and the company’s barge business continued to produce good returns. As the backlog of railcar orders for the company accelerates, TRN’s consensus earnings for next year is expected to nearly triple last year’s roughly $0.85 per share. With the stock recently doubling, and more than tripling from late 2008, we trimmed back TRN as the company’s valuation is now closer to our estimate of fair value.
PTEN also performed well over the past six months, appreciating over 72% and closed at $29.39. PTEN is among the largest land-based oil & gas drilling rig operators in North America, with ownership of approximately 350 rigs. PTEN added to its pressure pumping services line of business with the acquisition of Key Energy’s pressure pumping and wireline services assets last year. This acquisition more than doubled PTEN’s pressure pumping horse power to nearly 420,000hp, and also expanded the company’s geographic reach from the northeast U.S. to the Permian Basin and Eagle Ford Shale areas in Texas. Investors have bid up PTEN’s shares because the daily rental rates for the company’s drilling rigs are increasing, and pressure pumping services are in greater demand as more exploration and production companies require these assets to fracture shale rock to release the oil and gas for production. PTEN achieved $0.76 in EPS last year, but the consensus EPS for next year is $2.14. We trimmed back the position as more investors are now seeing this higher profit potential for the company.
Finally, over the past six months Foot Locker (FL) was up just over 35%. We believe Ken Hicks, FL’s CEO, is doing an excellent job focusing the company on better inventory management, meeting the needs of its customers, and
generating higher returns on capital. Although there are no guarantees, we would not be surprised to see FL earn nearly $1.50 in EPS this year, relative to current EPS of $1.07, should the company’s apparel business turn around its
recent lackluster performance and the economy does not fall into another recession.
Outlook
Two themes are foremost in our current thinking. Firstly, growth in corporate profits will slow considerably, and could turn negative, which will provide little support to currently elevated valuations, and secondly, we feel that the U.S.economy is not on a healthy growth path with fiscally irresponsible trends which, if they continue, should lead to far greater financial market volatility. As both become more apparent to market participants, the stock market rally that we’ve seen should peter out and may reverse.
Growth in corporate profits has had a large impact on the rally in the stock market. How sustainable is this profit growth? With corporate profit margins hitting multi-decade highs, our view is that it is not sustainable. At best,
corporate profits are likely to grow in line with GDP growth, should margins hold at current peak levels. And that is the big question. The current after-tax corporate profit margin level of 9.5% of national income is fifty percent above
the long-term average margin for the last sixty years of just above 6%. Besides the last decade, the after-tax corporate margins have only barely surpassed the 8% level three times in the previous five decades. We wouldn’t bet that margins are going to stay here forever or go higher.
Valuations have been supported by the rapid profit growth, driven primarily by the corporate profit margin expansion, but also by the Fed’s record low interest rate policy. Current price to earnings ratios are 29.9x for the
Russell 2000 and 25.3x for the Russell 2500. These valuations are not being impacted much by the non-recurring charges that hit earnings in 2009. We have difficulty seeing how valuation multiples will expand from here, and expect them to contract over time to more normal valuations in the teens. A likely scenario in our eyes is a contraction in multiples, a contraction in profit margins, and higher interest rates. Should all or just a couple of these occur, we could have significant capital destruction in the stock market again, like we had in 2008. We would not be surprised if this happens at some point in the next several years, because of the excesses that are building in financial markets as a result of record low interest rates, excessive growth in money supply, and fiscal irresponsibility with large deficits and rapid growth in our treasury debt.
Current bullish sentiment and record low cash levels at equity mutual funds show that caution is being thrown out the window in the search for returns. In a low yield environment, the “yield pigs” are in charge. We can see this in the low number of qualifiers from our screens that search for undervalued securities. In normal years we get about 200 qualifiers, when fear is rampant the number goes north of 300, and when people are bullish it is less than 100. We are now getting less than 50 qualifiers.
Capital destruction is the underworld in the investment arena. Big setbacks are hard to recover from, hence our focus on capital preservation. In addition, emphasis on capital preservation can also enhance long-term returns. There
are three ways to destroy capital in our book: pay too much, buy a bad balance sheet, and/or buy into a business model that fails or flounders. Our strategy to avoid these risks and preserve capital is fourfold: buy stocks far below their
intrinsic values, with strong balance sheets, good management teams and leadership positions in their niches. The larger the discount to intrinsic value, the better the downside protection and the better the upside returns should the investment work out as contemplated. The stronger the balance sheet, the lower the risk that the company will fail or have to issue shares below intrinsic value. A leadership position in a niche and a strong management team serves to reduce the risk that the business model will flounder, even though that has happened to us too; several occasions come to mind.
Our second theme, that the U.S. economy is not on a healthy growth path, is supported by the fact that despite tremendous levels of monetary and fiscal stimulus during and coming out of the recession, the recovery has been one
of the weakest on record. Fiscal negligence is rampant with federal deficits at record levels and treasury debt growing quickly. Should these trends continue, which we think is more likely than not, they could lead to a fiscal and/or financial crisis of size that could challenge the one in 2008.
Debt levels continue growing alarmingly fast. A treasury debt explosion is following the consumer debt explosion that took household debt from $7 trillion in 2000 to close to $14 trillion by 2008. Debt issuance by the
government is rapidly escalating due to current record deficits and spending on social security, health care and other programs ramping up during the rest of this decade and beyond. Gross U.S. Treasury debt is currently $14.2 trillion or 97% of GDP. We will most likely cross the 100% level of debt to GDP this year. We currently rank as the number twelve highest debt to GDP nation in the world. This puts us in close company with Iceland at 115% debt to GDP and Greece at 130%. We don’t think this is a desirable place to be in, and we regard this growth in debt to be a very serious issue for the country.
One of the core problems is spending on mandatory programs, which will grow to over $3.3 trillion by 2021 from $2.1 trillion now, according to the Congressional Budget Office. This $1.2 trillion or 57% increase in mandatory spending over the next decade is the Achilles heel of the budget. Mandatory spending as a percent of total federal receipts has grown from 33% in 1970, to 47% in 2000, 61% in 2005, 90% in 2010, and finally to 101% in 2011. In other words, if we cut out all of our discretionary spending programs, we’d still be running deficits and be adding to our $14 trillion debt.
Discretionary spending is one third of the federal budget or $1.2 trillion and includes military spending, health, government, veteran’s benefits, transportation, environment, housing, etc. The growth in mandatory spending the next decade dwarfs any cuts that could be made to discretionary spending. If you find yourself in a hole, you have to first stop digging and then figure out a way to climb out. With deficit spending at record levels in 2011, estimated at 10% of GDP, we are still frantically digging. We must first stop adding to our debt, and then figure out how to reduce it. Liquidity by central banks around the world, and especially the U.S. central bank, is keeping a lid on volatility in the financial markets while the excesses are building. The question is how sustainable this calm in the financial markets is, especially when reflecting over the risks that are building. There is no question that the low volatility we’re experiencing in financial markets can go on for an extended period of time, such as the 2004 to mid-2008 period, but it will come to an end at some point. At that time, it will be the investors who are ready to take advantage of attractive opportunities that will benefit, not the ones who are stretching to get that extra bit of yield today.
The Fed’s determination to stimulate the economy via low interest rates and an increased money supply is creating excesses that will not be easy to unwind. Anything inside a six-month T-Bill gives you less than 0.1% and the one-year T-Bill is barely above 0.2%. More concerning has been the last several years of increased money supply, since this hits at the core of the U.S. dollar. Before the recent recession, the U.S. money supply was sitting at around $800 billion.
It had grown steadily to this level from about $400 billion 15 years earlier. This translates to roughly 5% annual growth in the money supply the 15 years before the recession. In the last three years, the money supply has tripled to a current level north of $2.4 trillion. This equates to over 40% annual growth in the money supply the last three years. Since the beginning of 2011 alone, the money supply has expanded more than 20%. Should the velocity or turnover of all this money pick up from current levels, it will be imperative that the Fed rapidly reduce the money supply to avoid a serious inflation problem. The question is “What’s the likelihood that the Fed will be successful in doing just that?” We are not convinced that this is a high probability outcome. Ludwig von Mises discusses the problem with the Fed manipulating interest rates and money supply in his treatise on economics. Mises says “…a monetary expansion results in miss investment of capital and over consumption.
It leaves the nation as a whole poorer, not richer. The cyclical fluctuations of business are…a product of government interference with business conditions designed to lower the rate of interest below the height at which the free market
would have fixed it.” The record low interest rates the Fed put in place after September 2001, created a large credit expansion that led to the large excess of housing stock we now have. The effects of this are still apparent with
11.1 million or 23.1% of residential properties having mortgages with negative equity according to CoreLogic, and another 2.4 million having less than 5% equity. The aggregate negative equity is $751 billion. Nevada has the highest
negative equity with 65% underwater, followed by Arizona 51%, Florida 47% and California 32%. Had the Fed not lowered rates so dramatically, we would argue that the mis allocation of capital in housing would not have taken place.
Even though this was a very serious mistake with tremendous ramifications in the U.S. and around the world, we are asking ourselves if the Fed is not committing an even more serious mistake now by keeping rates at record lows for as long as it is and tripling the money supply. The Fed’s track record in managing the economy the last two decades is one of ever increasing excesses. Why will this time be any different? Our answer is, it will not.
Because of our downward bias to U.S. growth, which we’ve had for many years, the portfolio is greatly skewed to companies that are exposed to global growth. Of the portfolio’s equity investments, more than three quarters have a
heavy exposure to global-demand growth, as opposed to U.S.-demand growth. This includes our oil service, oil and gas exploration, and technology companies. Our oil and technology investments are a backdoor way to participate in global growth and emerging markets. Developing markets constitute a large share of incremental oil demand and their fortunes
can have pronounced impacts on oil demand and prices. Oil also has a severe decline curve which makes it harder to increase supply. The International Energy Agency estimates that fields at maturity have a decline curve of 9%. Oil in the ground and equipment used to produce it are real assets that are likely to provide a store of value against potential future monetary inflation. We continue to like our investments in the oil service, oil and gas exploration and technology areas for these reasons.
Despite this, we have trimmed more than half of our oil and gas exploration investments and a large amount of our oil service investments over the past twelve months. These industries are cyclical and when sentiment turns decidedly positive, valuations move up. As a result, our cash level has moved up. This does not trouble us. Cash is a residual of investment opportunity and currently there is a lack of opportunities available to us. We are the opposite of other equity managers that are now at record low levels of cash, just as they were in the summer of 2008. Keynes said “It is better for reputation to fail conventionally than to succeed unconventionally”, and most investors are acting accordingly.
We believe that prudence and capital preservation will serve us well in these times. By sticking to our discipline and waiting for the opportunities that fit our criteria, we will be ready to take advantage of dislocations when they occur.
We thank you for your continued support during these challenging times, and will strive to retain the confidence you
have expressed in us.
Respectfully submitted,
Dennis M. Bryan
Co-Chief Executive Officer and Portfolio Manager
Rikard B. Ekstrand
Co-Chief Executive Officer and Portfolio Manager
April 20, 2011
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