FPA Capital Fund webcast audio, transcript And slides for the second quarter ended June 30, 2016.
FPA Capital Fund 2Q16 Webcast Audio
FPA Capital Fund 2Q16 Webcast Transcript
Arik Ahitov: Let me go over our strategy briefly. We are a long-only absolute value fund that is benchmark-agnostic. We look for marketing-leading companies with a history of profitability, strong balance sheets, and good management teams. Once we identify and research these companies, we buy when there is a compelling risk-to-reward ratio. The resulting portfolio tends to be concentrated. As many of you know, our Fund has been closed the majority of its life, and both Dennis and I are shareholders alongside you.
We are benchmark-agnostic. As of the end of last quarter, two sectors—mainly information technology and energy—made up about 50% of the assets. (01:56) You can see on this slide that our portfolio is very differentiated from Russell 2500 and it was not expected to behave similarly to the Index.
Many of you met me or Dennis before. Our team also includes two analysts. Chris has been with us since 2014 and we have introduced him here before. Sean recently joined our team straight for the UCLA Business School where he was, among many other things, an Edward Shapiro Investment Management Fellow, a Director of the Anderson Investment Association, and a Member of the Student Investment Fund. His last full-time position before he attended busies school was with the Office of the Comptroller of the Currency.
Our performance has been weak since the fourth quarter of 2014. The cumulative effect of this two-and-one-half years shows itself as unfavorable, long-term numbers. As we mentioned before, these multiyear performance numbers are very endpoint-dependent and we believe can improve substantially as quickly as they deteriorated. As disappointed as we are with our result in the past six quarters, we are optimistic about our portfolio prospectively.
There are a few reasons why we are confident about the future. The volatility we have been expecting seemed to finally arrived, which should allow us to take advantage of more opportunities. As some longtime shareholders already know, this is not the first time the Fund has underperformed to this extent. In both prior occasions the Fund’s performance during the ensuing time periods have allotted to not only make for lost ground, but also surpass the performance of this benchmark once again.
(3:45) We do not believe that it should be any different this time around. Our process has not changed over the past 30 years. Our portfolio is filled with strong-but-cheap companies. In addition, the Fund has ample liquidity with over 25% cash to take advantage of this volatile time for the stock market.
The portfolio continues to be cheap. Our holdings trade at a significant discount both in price-to-earnings and price-to-book terms versus our benchmark. Keep in mind that the price-to-earnings ratio shown here is based on current earnings, which are really depressed for a meaningful part of our portfolio. The price-to-earnings ratio calculated based on normalized earnings would depict even a stronger advantage versus the indices.
Let’s talk about what we have been doing. Since the middle of 2014 all prices decreased substantially, yet we continue to buy during this downturn. You can see what we did by looking at the blue bars that show the change in our allocation in energy names. The gray bars show the oil price change. You can see that in the second half of 2014, the price of oil decreased by about 50%, but our allocation decreased by only 20%. In the first quarter of 2015, we continued buying as the price of oil decreased. You might recall, the end of second quarter of 2015 oil prices moved up quite a bit and we took advantage of that increase by selling some of the shares we bought earlier. The next two quarters, oil prices continued to decline and we continued to increase our exposure.
Here is a good example of what we did in the first quarter of 2016. As you can see on this chart, oil prices started the year at $37 a barrel and ended the first quarter only marginally higher but the price at $26 in the quarter. If you look at this chart on the right, you can see that one of our portfolio companies, SM Energy, looks like had no change in price but all the volatility. (06:02) And now you see that our share count did not change when one compares the beginning-of-the-quarter share count with end-of-the-quarter share count. But this is what we did. We bought over 400,009 shares during the first half of the quarter, which translates to more than a 50% increase. And we sold almost all the incremental shares in the second quarter at higher prices.
The volatility continued in the second quarter and we started utilizing covered calls to take advantage. We executed three covered calls in the quarter. All, as you can imagine, were in energy due to high volatility and, hence, high premium.
Here is another example. This one is not the short-term fate, but an example of how we flex up and down on ownership based on the estimate of intrinsic value and the prevailing stock price. On this chart you see that we have owned Western Digital for a long time. But at different times we increased our position substantially and at other times we sold into strength. The last major change has happened over the past 12 months when we increased our position again from the third quarter of 2015 to the end of second quarter of 2016.
The top performer for the quarter was Patterson. Patterson is a domestic land-drilling company in the energy sector. The bottom performer was Dana Holdings, which is an auto-parts supplier. After the end of the second quarter, Dana reported its quarterly earnings and the stock price moved up 25% since then.
Our portfolio remains concentrated. Almost half the portfolio is in technology and energy. We now own two high-yield bonds. Cash is the residual of all investment ideas and it stood at about 27% at the end of the second quarter.
(08:00) We have been very active year to date. We initiated two new positions and exited three. We had a net increase or net decrease in almost all our positions.
With that, I will turn the call over to Dennis.
Dennis: Thank you, Arik. Let’s first review some equity market data. This chart shows the rolling 10-year return difference between value and growth stocks. As we can see from 2004 through 2015, value stocks have underperformed growth stocks, just like two prior periods over the past 80 years. Remember, these are rolling 10-year numbers; thus, when the blue line crossed zero percent at the end of 2013, that meant value stocks had underperformed growth stocks over the prior 10 years.
Interestingly, this cycle has yet to turn back up and value stocks have now underperformed for more than 12 years on a 10-year rolling basis. However, as one can clearly see, not only have value stocks reversed their underperformance in prior periods, but also value stocks outperform growth stocks for the vast majority of any rolling 10-year period.
Equity valuations are sensitive to interest rates and there's been a lot of talk about whether the Fed is going to raise rates later this year. So let’s look at a few slides that encapsulate the reasons not to raise rates versus why the Fed could justify raising rates. While the data on this chart is over a month old, expectations for future rates have only marginally changed since then. At the time when Evercore ISI published this data, they believed there was a zero percent chance of a Fed rate hike this fall. Interestingly, they also believed that there was a rising probability that the Fed could cut rates. However, these probabilities change week to week and even day to day.
(10:15) So let’s look at a couple slides that support the Fed holding off raising rates. This graph shows that there's a fairly strong positive correlation between the growth rate of corporate profits and the changes to employment growth. It also shows that corporate profits are declining, which portend weaker job numbers in the future. Given the weak profit numbers, the Fed may want to wait until corporate profits rebound before considering whether to raise rates later this year.
This chart also illustrates one of the reasons why the Fed has been reluctant to aggressively raise rates. This chart shows that nominal GDP growth has been weak over the last five years, averaging roughly 3½%. In prior discussions, we have shown the rising inventory level—that's the blue line—and suggested that elevated inventory numbers could retard future growth. We got an excellent example of that issue last week when the Commerce Department announced that the second quarter GDP growth was only 1.2%. The expectation was over 2½%. And this followed an even weaker first quarter growth of 1.1%.
Now let’s look at some information that may support the Fed raising rates. First, this chart shows that there does not appear to be any stress in the financial system despite Brexit, despite the Europe banking problems and low global economic growth. Normally, the Fed raises rates when the economy and financial systems are robust. If the Fed wants to raise rates, they are likely no longer too worried about the financial system as they were several years ago.
(12:24) If the Fed is going to raise rates soon, another reason could be due to an improving job market and, thus, an acceleration of wage inflation. Notwithstanding the earlier slide that showed a strong correlation between profits and growth, wages are currently growing. Last Friday, the Bureau of Labor confirmed the rising wages exhibited in this chart by announcing that the Employment Cost Index rose at an annual rate of 2½% in this year’s second quarter. So in summary, despite a number of fed governors discussing higher rates, we continue to be skeptical that the Fed will raise rates aggressively over the near term.
June durable goods orders fell a surprising 4%, adding more concern about future growth. On the other hand, employment and wages continue to growth at perhaps a 25-basis-point increase later this year cannot be entirely ruled out.
Okay, let’s now turn to a few energy slides given the continuing volatility in the oil market. The first energy slide shows that the International Energy Agency, or IEA, still believes oil demand for this year will grow nearly 1.5 million barrels per day compared to last year. Given the weak global economic growth thus far in 2016, the 1.5 million barrel increase is relatively strong.
(14:01) Subsequent to the end of the second quarter, oil traders have pushed prices lower due primarily to concerns that Brexit and the increasingly very-public terrorist activities will slow economic growth even further. However, the IEA has not altered its forecast that the world will consume nearly 97 million barrels a day on average during the fourth quarter.
Regarding oil supply, non-OPEC supply, particularly U.S. shale oil supply continues to decline. This chart shows that U.S. crude production has declined by more than 1 million barrels per day over the past year. Looking forward, some analysts are now projecting U.S. crude production will decline at least another 300,000 barrels next year, even if oil prices rebound sharply later this year.
Now, we understand non-OPEC oil supply is in decline. Can OPEC increase its production? Should the IEA’s demand forecast be reasonably accurate? This chart shows that OPEC might have a challenge meeting increased demand due to OPEC’s current production getting close to its theoretical capacity. This is why a few analysts have recently suggested that rising oil demand could result in a substantial drawdown of global oil inventory in the second half of this year.
Okay, our last slide. And this is a little busy so I apologize up front. But it has some important information about the near-term fundamentals of the oil market. Let’s look at the chart on the upper left. This shows that the oil market started the year with record-high OECD inventories, or about 300 million barrels above the five-year average. The chart on the upper right shows that there's been some very modest monthly draws, but nothing really to impact oil prices at this time. (16:19) However, the chart on the lower left is Cornerstone Analytics’ forecast of where global oil inventories may decline to at the end of 2016. Interestingly, it shows oil inventories may fall by roughly 300 million barrels and back to the five-year average.
Their assumptions for this inventory decline are on the lower-right bar chart. These assumptions were made at the beginning of this year, so they are likely to be different from the actual numbers. For example, global oil demand will likely rise 1.5 million barrels per day versus Cornerstone’s 1.8 million. On the other hand, non-OPEC oil supply will likely decline by over a million barrels per day and not the 830,000 depicted here.
Summing it up, we recognize that value stocks have underperformed, but we are also aware that these trends reverse. And over the long term, value stocks have performed very well for investors. Regarding whether the Fed will raise or not raise rates, there's been some rhetoric from various fed governors about higher rates, but nominal and real GDP have been weak this year.
And the presidential election is in three months. Thus, in our opinion, it is unlikely the Fed will raise rates the rest of this year. Finally, despite recent volatility of oil prices, it appears that the market is moving back into balance and the record-high inventories will continue to decline, which should support higher prices in the future.
See the full transcript below.