From Dan Loeb’s Q4 letter to Investors (see section on Dow Chemicals here).
Fourth Quarter 2013 Investor Letter
Review and Outlook
At the beginning of 2013, we identified four areas we expected would drive performance in the coming year. We explained in our January 2013 Investor Letter that: 1) reduced macroeconomic volatility would lead to less correlated markets and increased rewards for superior stock picking; 2) the same phenomenon would drive capital flows into equities, increasing equity valuation multiples generally; 3) corporate activity would increase and finally; 4) Abenomics would cause Japanese markets to outperform. Most of our predictions proved to be correct, although we underestimated the magnitude of multiple expansion and extent of the market rally that occurred during the year.
Our overall returns were arrayed across the portfolio. Of the year’s ~26% gains, equities contributed ~18%, corporate credit added ~3%, structured credit contributed ~3%, and macro investments added ~2%. We generated meaningful alpha in Technology, Media and Telecom investments, European equities, performing credit, and U.S. residential mortgage-backed securities. While overall performance was solid, there were certain areas where we could have done better. The Japan portfolio disappointed later in the year as Sony underperformed the broader market, and we missed a number of event-driven opportunities in the Health Care sector.
In 2014, we believe still-improving global economic conditions will deliver better growth. In the U.S., it appears now that we will avoid a budget impasse. Closely monitoring communications from the Federal Reserve remains critical, as any signs that rates will rise sooner than currently expected will act as a ceiling on multiples. Unfortunately, well-intentioned government policies and regulation have dampened economic growth and workforce participation and thus, overall employment. We believe that potential tapering will be mitigated by the continuing weakness in job growth.
Although “Street” sentiment has become more negative recently, we expect earnings to rise modestly and the economy overall to surprise to the upside from these increasingly pessimistic projections. Japan will be a high-beta trade. Gains will be driven by BOJ policies and potentially by Japanese citizens investing in the markets in anticipation of inflation. Both scenarios, however, face a road block in the form of the increasing consumption tax. We expect continued growth and stability in China.
While market multiples have re-rated, an environment of accelerating GDP growth combined with low inflation and low short-term rates is more likely to result in continued multiple expansion rather than contraction. We are concentrating on identifying companies that have been under-earning relative to normalized earnings power. Corporate credit opportunities will most likely be slim pickings, with exposure levels close to those in 2013. It should be another interesting year in structured credit, particularly as we look beyond the U.S. in both residential and commercial mortgage bonds. We believe our portfolio is well-positioned with a number of event-driven situations, and we expect corporate activity to create compelling opportunities for our investment style.
Of course, any outlook presented is a base case for our expectations of general market conditions and represents our most likely scenario today. We are constantly on the lookout for threats and are prepared to change course should events in the U.S., Europe or Asia unfold differently than anticipated.
Quarterly and Yearly Results
Set forth below are our results through December 31st and for the year 2013:
Offshore Fund Ltd.
S&P 500 2013 Fourth Quarter Performance 6.1% 10.5%
2013 Year-to-Date Performance*
32.4% Annualized Return Since Inception* 18.0% 7.3%
*Through December 31, 2013. ** Return from inception, December 1996 for TP Offshore Fund Ltd. and S&P 500.
Select Portfolio Positions
Equity Position: The Dow Chemical Company
Third Point’s largest current investment is in The Dow Chemical Company (“Dow”). Dow shares have woefully underperformed over the last decade, generating a return of 46% (including dividends) compared to a 199% return for the S&P 500 Chemicals Index and a 101% return for the S&P 500.1 Indeed, in April 1999, nearly 15 years ago, an investor could have purchased Dow shares for the same price that they trade at today! These results reflect a poor operational track record across multiple business segments, a history of under-delivering relative to management’s guidance and expectations, and the ill-timed acquisition of Rohm & Haas. The company’s weak performance is even more surprising given that the North American shale gas revolution has been a powerful tailwind for Dow’s largest business exposure – petrochemicals.
We believe that Dow would best serve shareholders’ interests by engaging outside advisors to conduct a formal assessment of whether the current petrochemical operational strategy maximizes profits and if these businesses align with Dow’s goal of transforming into a “specialty” chemicals company. The review should explicitly explore whether separating Dow’s petrochemical businesses via a spin-off would drive greater stakeholder value.
Dow’s transition to a true “specialty chemicals” company focused on attractive end-markets such as agriculture, food, pharmaceuticals, and electronics. Second, the standalone Dow Petchem Co. could realign its strategy away from largely focusing on downstream migration/integration and towards overall profit maximization.
The optimization of Dow Petchem Co. combined with the significant step-up in earnings from organic growth initiatives already put in place by management – the PDH plant, the Sadara JV, and the U.S. Gulf Coast greenfield ethylene cracker – could translate into future EBITDA well in excess of $9 billion on a stand-alone basis. This would be before any improvement attributable to what management refers to as the “ethylene upcycle”. Both the “self-help” and cyclical upside opportunities create a compelling investment case, which is not reflected in Dow’s current share price considering the entire company’s 2013 EBITDA base is ~$8 billion.
Despite Dow’s best efforts to migrate downstream and become a specialty chemicals company, the market remains unconvinced. By creating Dow Petchem Co., the strategic direction of these businesses would no longer be dictated by the broader Dow strategy of becoming more specialty-focused. Instead, management could transform these businesses into a best-in-class, low-cost commodity petrochemical company.
The remaining Dow Chemical (“Dow Specialty Co.”)3 would be the specialty chemicals leader that Dow has aspired to become over much of the past decade. Here too, we see meaningful upside over the coming years:
– In Dow’s Agricultural Sciences segment, significant investments have been made in R&D which have yet to translate to profits, most notably in the development of Dow’s ENLIST trait package. We are optimistic that ENLIST will be successfully adopted in the South American soybean market, where it has a natural first-mover advantage given that the 2,4-D herbicide is approved for use in Brazil and Argentina. The South American soybean opportunity alone for ENLIST could increase divisional EBITDA by 30-40% once fully penetrated.
– In the Electronics & Functional Materials segment, we see niches with strong end-market growth and high barriers to entry, leading to above-GDP growth rates and sustainably robust returns on invested capital.
– Finally, the Dow Corning JV represents a valuable call option on solar power adoption as total system costs for solar continue to compress and become increasingly competitive with other fossil-fuel electricity alternatives in much of the world.
Dow Specialty Co. should command a premium to Dow’s current multiple, and potentially a premium to other specialty chemicals companies given its attractive EBITDA growth prospects. The market is skeptical of Dow’s divisional margin targets given the lack of clarity around how