FPA Capital Fund commentary for the second quarter ended June 30, 2016.
H/T Dataroma
Introduction
The second quarter of 2016 will be remembered as the time when the United Kingdom (UK) voted to divorce from the European Union (EU). The UK and the EU have been together since 1973, but the British decided that the relationship was no longer in their national interest, and on June 23, their citizens voted to “leave” the EU.
On voting day, as soon as it became clear that the “leave” campaign had the majority of votes, the global capital markets experienced the equivalent of a financial earthquake. Based on the Richter scale, the Pound Sterling’s rapid decline of 10% versus the U.S. Dollar would be similar to a 7.0 quake, and there could be economic aftershocks in the months ahead as divorce discussions get underway. The subsequent two-day U.S. equity decline of roughly 5% could be characterized as a more modest 5.0 magnitude trembler, yet it was still large enough to unnerve many investors.
The net result for U.S. equity investors is that the second-quarter and year-to-date returns, respectively, were in the low single-digit category. The second-quarter and year-to-date return for the S&P 500 was slightly above 2%, and a shade below 4%, respectively. For the Russell 2500, second-quarter and year-to-date returns were both around 4%. The Capital Fund’s second-quarter and year-to-date returns were 2.52% and 1.89%, respectively.
However, just as an earthquake-rattled house can look fine on the outside and be wrecked on the inside, the moderate year-to-date returns in the U.S. equity markets are a facade that masks hidden volatility. For instance, from the beginning of the year to its low in February, the Russell 2500 declined nearly 15%. Then it reversed course and appreciated nearly 25% from its February low to its pre-Brexit June high.
Perhaps the increased volatility in the second quarter portends a change in the seven-year bull market. On the other hand, we have seen the equity markets tremble a couple of times since the great recession ended in 2009, only to resume their seemingly inexorable appreciation. This latest episode may be just another period where equity investors grab a quick rest before returning to the market to satisfy their appetite for more risk.
FPA Capital Fund – Market Commentary
As we mentioned above, the most important event that occurred in the second quarter was that the UK voted to exit the European Union. While we do not fashion ourselves to be geopolitical experts, we believe it is necessary for our shareholders to hear our thoughts on what this momentous vote means.
In the short-run, say over the next year, we do not believe the so-called Brexit (Britain exit from the EU) will have a substantial impact on the global economy. The reason is that we believe it’s very unlikely that the UK will actually exit the EU within the next twelve months. On the other hand, there will likely be an economic slowdown in the EU region, with the UK experiencing a more pronounced slowdown due to the vote. This is because businesses and investors, at this time, are very uncertain of what the final divorce settlement will look like. Thus, there should be a natural slowdown of capital expenditures and investments in both regions. Nonetheless, both sides have stressed that they want to preserve as much of the EU economic relationship as possible, at least in the short term.
Obviously, some industry sectors will experience greater short-term impact than others. For instance, City of London commercial real estate tied to the financial services sector could see less incremental demand than retail sales at Burberry’s stores in high-traffic tourist locations. This is because the cheaper pound will likely stimulate more tourist activity in the latter, but Brussels will likely try to claw back more capital-market trading and clearing activities from the former for its remaining EU member states. There will also be currency translation issues for multi-national companies doing business in the UK and Eurozone (EZ), but these currencies have been weak for two years, and most of the decline had already occurred before the Brexit vote.
Turning to the long-term ramifications of the vote, it is unclear what the outcome will be for the global economy. On the one hand, there is a large tail risk to the capital markets should other EU members choose to exit and, as a result, call into question the viability of the Euro currency as it is currently constructed. Some politicians in Denmark, Sweden, and the Netherlands have agitated for their respective ruling governments to hold a Brexit-style referendum on EU membership. Most people would question the economic logic for any of these three countries leaving the EU. However, many UK “leave” leaders were driven by their desire for the country to regain its independence from rules and regulations from Brussels—directives they considered an infringement on the UK’s sovereignty. In other words, economics played second fiddle to the political choice of regaining an independent, sovereign country.
Italy and Greece are being deluged by substantial numbers of migrant refugees from other parts of the world. Politicians from both countries have expressed dissatisfaction with Brussels’ response to the migrant crisis thus far. Italy also has a brewing banking crisis, and the current Italian Prime Minister wants to subvert the EU’s bank “Bail-in” rules because they could hinder Italy’s preferred method to recapitalize its major banks. As a reminder, the Italian banking sector has a current non-performing loan (NPL) ratio1 of 17%, which is more than triple the NPLs held by U.S. banks at the height of the financial crisis in 2009, according to the Wall Street Journal2. Moreover, the Five Star political party in Italy recently won the mayoral election in Rome. This is noteworthy because the Five Star party has campaigned for Italian voters to decide whether the country should retain the Euro as its official currency.
On July 5, 2016, Hungary announced that it will hold a referendum on October 2, 2016 that will allow voters to decide whether the country should abide by mandatory EU migrant quotas. This referendum and other potential European referendums threaten to further destabilize the EU and potentially cause a domino effect, where more countries could follow the precedent the UK established. Businesses and investors are rightly concerned about the ramifications of the EU splintering into two or more pieces. From our perspective, if European political leaders do not find acceptable solutions to major grievances from their member countries, Brexit may be just the first domino to fall.
On the other hand, the UK has not officially filed the divorce papers–known as Article 50 of the Lisbon Treaty—and there is no guarantee that it will. If Theresa May, the new UK Prime Minister, is able to negotiate with the EU leadership an amicable agreement whereby the current EU migrant policy is halted and the UK is allowed to put in place some reasonable immigration caps, it is entirely plausible that the UK will not sign Article 50.
This outcome would be viewed, in our opinion, as a net positive by the equity markets–at least in the short run. That’s because the large tail risk of an EU political collapse would be shelved for the time being. Obviously, the currency and credit markets would also adjust, which could shorten the equity rally depending on how much adjustment occurred in each market. However, this scenario would avoid the enormous economic realignment that could be required if the EU splintered into two or more groups.
In summary, we believe the UK Brexit vote will have a small effect on the global economy in the short run, but that the UK and EU countries will take the brunt of any reduced economic activity. In the longer term, however, the Brexit impact to the global economy will likely be predicated on the negotiated settlement between the UK and EU, and whether the UK ends up being just the first of several dominos to fall. Unfortunately, there’s a wide range of outcomes, in our opinion, and much is dependent on whether other countries follow the UK’s exit path or continue to stay in the EU.
FPA Capital Fund – Portfolio Commentary
Before we discuss the activity in the portfolio during the second quarter, we will address how Brexit may impact the investments in the portfolio and, importantly, how we may allocate the Fund’s large cash position in what could turn out to be a very volatile next few quarters.
First, the Fund does not have any direct exposure to the UK, EU, or U.S. financial services or real estate sectors. Interestingly, German, Italian, and French bank stocks have declined more than UK bank stocks two weeks post the Brexit vote. While we believe U.S. banks have relatively stronger balance sheets and are better positioned to deal with any financial distress than their European competitors, a global slowdown in lending activity will likely have some secondary effects on other parts of the economy and not just real estate or banks. The degree to which any one sector is negatively impacted will be largely centered on how acrimonious the potential split up is between the two regions.
When we drill down to the Fund’s investments and any one particular company’s exposure to Brexit, we look at two criteria. The first is revenue exposure, and the second is whether the end product is highly discretionary or more of a basic need. Out of all the Fund’s current investments, AGCO Corp. has the highest concentration of revenues originating from Europe. In 2015, AGCO derived roughly 50% of its revenues from Europe, with most of those sales tied to the richer northern European countries. While agriculture is clearly a cyclical industry, Brexit is not likely to have much of an impact on food consumption or prices. On the other hand, a stronger dollar makes U.S. agriculture products more expensive in Europe, which could provide a slight advantage to AGCO’s European farming customers. Thus, Brexit might only have a modest impact, if any, on AGCO’s business.
Three of the Fund’s technology stocks have much less exposure to Europe than AGCO. Avnet, Arrow Electronics, and Western Digital have less than 30% of their respective revenues coming from Europe. However, in their financial disclosures, these companies lump in Africa and Middle-East sales with European sales into one broad category called EMEA (Europe, Middle East and Africa). Thus, it is reasonable to assume that these companies may have exposure in the low 20% range or less to the EU. Moreover, all three companies’ products and services have good secular tailwinds, like cloud computing and digital storage, helping to mitigate any Brexit fallout.
Overall, we believe the Fund has only a very modest exposure to any potential negative consequences of the Brexit vote. Nevertheless, the vote impacted the portfolio’s performance greatly. The Fund was up 4.51% YTD the night before the Brexit vote. Five trading days later, at the end of the second quarter, the Fund was up only 1.89% for the year. The Fund is also well positioned to seize any domestic opportunities that may present themselves if investors cut equity exposures in general by taking on less risk due to European political issues. We believe our large cash holding will help cushion any systemic market decline and should give us the liquidity to buy good companies should their stock values decline as other shareholders reduce their equity weightings.
Let’s now discuss what impacted the portfolio in the second quarter and the trading activity during the period. On the positive side of the ledger, the energy companies in the portfolio did well across the board. On the negative side, a hodgepodge of companies in the portfolio performed poorly. This included a couple of industrial companies, an education stock, a technology company, and a retailer. Given the volatility in the quarter, we either trimmed or added shares to all but three investments.
In terms of individual portfolio weightings, the largest percentage increase during the quarter was Houghton Mifflin (HMHC), which more than doubled in size from a little over 1% at the end of the first quarter to roughly 2.5% by the end of June. HMHC declined nearly 22% in the quarter to $15.63, due primarily to concerns about how fast school districts would adopt new K-12 learning material and what the company’s “win rate” would be in the states awarding new contracts. We believe the stock has been overly discounted on these concerns and, trading at less than 10x free cash flow, represents a compelling value.
The stock that detracted the most from the Fund’s return in the quarter was Dana Holdings (DAN). The company is generally lumped into the auto supplier industry group even though approximately 50% of their business is tied to commercial and off-highway vehicle markets. DAN has been weak over the past 1.5 years as investors continue to worry that the company’s commercial vehicle and off-highway markets won’t recover from their depressed levels, and that the strength of the light vehicle market will soon roll over. We purchased more shares of DAN in the quarter because we believe the stock was cheap when it was trading at less than 11.5x our downside case owner’s earnings.
Shifting gears to what worked in the quarter, we can sum it up by saying what did not work over the prior year finally turned around. Both DeVry Education Group (DV) and Apollo Education Group (APOL) showed modest but positive results in the quarter, and we trimmed more APOL as investors await regulatory approval of the buyout offer announced earlier this year. The biggest positive contributors, however, were energy stocks. In fact, the top five positive contributors were energy stocks, with Patterson-UTI (PTEN), SM Energy (SM), and Cimarex Energy (XEC) all adding nearly equal amounts to the Fund’s return. The primary factor that drove the stocks higher was oil prices rising nearly 30% in the quarter to close above $48 a barrel for West Texas Intermediate (WTI).
There are several theories that could explain why oil prices continued to rise after touching about $27 a barrel in early February, but we believe oil prices are rising because supply and demand are moving back toward equilibrium. On the supply side, non-OPEC oil production has declined by more than 1 million barrels per day, while demand has increased by more than 1 million per day over the past year. If recent supply and demand trends continue, Raymond James4 and Cornerstone Analytics5 believe the global oil market could be undersupplied in the second half of 2016. Moreover, there is anecdotal evidence that the record high global inventory numbers are starting to decline, and will decline further if demand exceeds future oil production.
Despite their roughly 70% increase from the trough prices set in February, oil prices are still far below where they were two years ago. Yet, we trimmed our energy positions because there is still a lot of uncertainty about the strength of the global economy and whether the growth in oil demand is sustainable. Should Brexit lead to a collapse in the EU, the global economy will likely suffer a recession, and oil demand could start declining instead of continuing to grow. As we mentioned earlier in the letter, the odds are not high that the EU will collapse in the near term, but the risks have clearly increased with the recent UK vote. Nevertheless, we remain vigilant to the large geopolitical risks, and we anticipate responding to any opportunities that may arise from the potential chaos.
In closing, we remain confident about our strategy’s future. Our pipeline of potential investments remains robust, as evidenced by the new retail stock that went into the portfolio during the second quarter. This is an example of a domestic company’s stock being depressed partly because of global issues that we believe will have very little impact on its business or profits. Volatility is our friend and we are prepared to aggressively deploy more of the Fund’s liquidity into good businesses selling at cheap valuations.
We thank you for your continued trust and confidence in our strategy.
Respectfully submitted,
Arik Ahitov
Portfolio Manager
Dennis Bryan
Portfolio Manager
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