Dan Loeb Q1 Letter below
First Quarter 2017 Investor Letter
Review and Outlook
During the First Quarter of 2017, volatility declined and most markets rose in anticipation of global reflation. Third Point generated returns across credit and equity strategies and most sectors through successful security selection and portfolio repositioning. New investments during the quarter were initiated primarily in the financials, industrials, and energy sectors.
We expect the favorable environment for our investing style to continue for three reasons: 1) Corporate activity should pick up as President Trump’s tax plans are detailed and enacted; 2) Opportunities for activist and constructivist investing are robust; and 3) Combining security selection with a reasonable interpretation of the macro continues to be critical. While we recognize that we are in the late stages of an economic cycle, experience has taught us not to miss the end of an expansive period. This is especially true following Trump’s election. Animal spirits matter in markets and despite the obstacles that the new administration will face in passing legislation, the overall pro-business environment is in sharp contrast to the last “you didn’t build it” administration’s attitude towards business, enterprise, and free markets.
We have been more focused on improving global growth than on the “Trump trade”. The Goldman Sachs global GDP forecast for 2017 is +4.2% vs. +2% a year ago. We are seeing more opportunities in Europe because of strong and improving economic data, a trend that will likely continue now that the French elections have passed without incident. Although S&P earnings were flat over the past three years, we are expecting earnings growth to drive gains and cyclical names to get a tailwind from US policy shifts this year.
So what are the risks? While we think legislative failure on tax reform could be negative in the back half of this year, we are encouraged that BAT seems to be off the table. There is a risk of inflation catching the Fed flat-footed, but we see this surfacing later in 2018 or 2019, if at all. Recent dampening of data in the US, particularly in consumer spending, has raised a red flag and we will know more when we see Q1 GDP. Chinese nominal GDP growth has potentially peaked, but the main event there will be the change of government this fall and so we expect a muted status quo until then.
We have actively positioned our portfolio to absorb modest S&P sell-offs in order to remain aggressive buyers at appealing prices. For example, we were able to temporarily reduce over 20% of our equity exposure in advance of the French election at a relatively inexpensive cost of about 20 basis points. We continue to maintain the bulk of our exposure in equities, including in several new initiatives where we believe the environment is ripe to take actions to remedy poor performance.
Equity Investment: Honeywell International Inc. (“Honeywell”)
Honeywell is an industrial conglomerate with a $100 billion market capitalization organized into four primary business segments: Aerospace, Home and Building Technologies, Safety and Productivity Solutions, and Performance Materials and Technologies. The company is a key player in an IoT (Internet of Things) world that is becoming more automated, connected, and energy efficient. Honeywell recently named Darius Adamczyk to succeed long-time CEO David Cote. We are pleased by Mr. Adamczyk’s appointment based on his track record, initial communications to shareholders, and our personal interactions with him.
During Mr. Cote’s tenure, Honeywell shareholders enjoyed an 11.5% annualized return (with dividends reinvested) versus the comparable 7% return of the S&P 500. During this period, Honeywell executed a successful operational turnaround and achieved peer-leading earnings growth and returns on invested capital. Through disciplined capital allocation, such as the recent acquisitions of Elster and Intelligrated, as well the AdvanSix spin off, the portfolio has been gradually upgraded in quality. However, despite the attractive positioning and financial characteristics of Honeywell’s assets today, the stock trades at a substantial discount to its industrial peer group.
Mr. Adamczyk has committed to enhancing the company’s organic growth profile and is actively evaluating the portfolio with the assistance of the Board of Directors. Third Point believes that a separation of the Aerospace unit via a spin off transaction would result in a sustained increase in shareholder value in excess of $20 billion. Spinning off Aerospace would transform Honeywell into an industrial growth company with a focus on automation and productivity. The large-cap industrial peer group that most closely resembles Honeywell (ex-Aerospace) in terms of profitability, returns on capital, growth characteristics, and end market exposures consists of Emerson Electric, 3M, Fortive, Rockwell Automation, and Illinois Tool Works. This peer group currently trades at an average forward P/E multiple of 23x, a nearly 30% premium to Honeywell’s forward P/E multiple of 18x. A more focused Honeywell should match or exceed the multiples of its peer group, especially if management delivers on its commitment to return to free cash flow conversion in excess of 100% by 2018.
It is clear to us, as well as several sell-side analysts, that Aerospace’s presence in the portfolio is the chief cause of Honeywell’s discounted valuation and that Aerospace would be better off as a stand-alone entity. Its organic growth has lagged its US large-cap aerospace equipment peers and was the main driver behind recent earnings disappointments. An independent Aerospace public entity would be in a better position to invigorate growth by aligning management incentives with long-term value creation and deploying capital to enhance its strategic position. It would also benefit from increased management accountability and a dedicated Board of Directors with relevant industry experience. While some successful new product introductions such as JetWave are encouraging, we are concerned that annual margin improvement has come at the expense of investments to drive growth.
The industrial landscape is rich with examples of corporate separations that have created more focused companies and delivered tremendous shareholder value. Prominent examples include Tyco, Ingersoll-Rand, ITT, and, more recently, Danaher. We believe the case for Aerospace’s separation at Honeywell is just as compelling as these precedents.
Equity Investment: UniCredit SpA
The First Quarter of 2017 marked a turning point in both capital and credit in European financials. As the reflation trade has picked up steam, European banks have maintained lower valuations than US banks (0.7x vs. 1.2x book), driven by a lack of confidence in capital and an inadequate clearing mechanism for legacy non-performing loans (NPLs). The ECB recently noted there were still €921 billion of NPLs at significant EU financial institutions with NPL ratios >3x the level of US and Japanese banks. However, its guidance on NPLs, released in March, offered a firm but pragmatic approach to accelerate NPL resolutions and Q1 2017 was the second biggest quarter for announced capital issuance in over five years. While at home the opportunity in financials is linked closely to rising rates, banks in Europe offer a different hook: tangible progress on balance sheet clarity.
Third Point recently made an investment in UniCredit SpA, which raised €13 billion in fresh capital in March, the largest rights issue in European financials since 2009. UniCredit