FPA Capital Fund commentary and webcast slides for the second quarter ended June 30, 2017.
FPA Capital Fund 2Q17 Commentary
Introduction
The second quarter of 2017, compared to the prior couple of quarters, experienced relatively few events that the equity markets were not anticipating. One of the more notable surprises was the election of Emmanuel Macron as the President of France. Macron’s La République en Marche! party also won a decisive majority in the French Parliamentary elections. While one should not underestimate the power of French civil servants and employee unions to defend their short workweek and generous benefits, President Macron has the necessary votes to materially reform French labor laws and the tax regime that has held back the growth potential of the French economy for too many years. German Chancellor Angela Merkel hinted at cooperating with the new French president to reduce European Union (EU) austerity measures that have retarded economic growth in Europe. Should President Macron be successful in fulfilling his campaign initiatives, and Chancellor Merkel relaxes her strict austerity plans for the continent, we believe European GDP growth over the near-term horizon could accelerate and help push global growth higher.
Europe provided another notable event in the second quarter: The poor election results for the United Kingdom’s (UK) Prime Minister Theresa May and her Conservative party in the early June snap elections. At this time, it appears Prime Minister May will retain power in a coalition government, but the conservatives will hold a very slim majority in the UK Parliament. While it is difficult to predict what all of this means for the UK, we would not be surprised if the hard Brexit rhetoric takes a backseat to a softer Brexit. A softer exit stance by the UK may trigger a more moderate response from its EU partners. Thus, we believe that the dire economic forecasts for the UK, which were predicated on a hard Brexit, may be avoided, assuming all of the partners in the EU sandbox play nicely.
In the United States, the Federal Reserve again raised short-term interest rates by 0.25%, or 25 basis points. However, the Federal Reserve telegraphed its most recent interest rate increase well in advance of the actual day in June when the new rate took effect. The domestic equity market shrugged off the latest interest rate increase and marched to new heights, much like it did when rates rose earlier this year. Apparently, there is no kryptonite to weaken the current equity-market Superman.
Portfolio Commentary
We are disappointed by the Fund’s performance in the quarter. It underperformed the Russell 2500 by 345 basis points. Value stocks in general continue to underperform growth stocks. For example, the Russell 2500 Growth Index increased 4.13% in the second quarter and 10.63% year-to-date, while the Russell 2500 Value Index increased only 0.32% in the second quarter, and 1.95% year-to-date.
Several of Fund’s stocks that performed poorly in the first quarter rebounded in the second quarter, but those gains were not enough to offset the declines in the portfolio’s energy companies. Oil prices fluctuated wildly in the second quarter, but on June 30th oil closed a shade above $46 a barrel, down less than 10% for the quarter. Even so, the equity market was merciless with individual oil company stocks. For instance, 22 energy companies in the Russell 2500 Index2 declined over 30% in the second quarter, and 12 declined more than 40% in the June quarter. In many cases, energy stock prices approached the depths they hit when oil was $26 a barrel. Yet, the June 30th oil price was roughly 75% higher than the bottom reached 18 months ago.
With such a sharp selloff, one would think the fundamentals of our energy companies had deteriorated commensurably. However, that is not necessarily the case with the Fund’s energy investments. For instance, Cimarex’s (XEC) most recently reported quarterly results showed its revenues increased 17% sequentially from the prior quarter, and its adjusted operating profit improved to $222 million, up 147% from $90 million in the prior quarter. More importantly, consensus analyst revenue and profit estimates for the remainder of the year show higher expectations for the subsequent quarters.
Analysts’ consensus revenue and profit estimates for the Fund’s other energy investments show that they expect three of the Fund’s energy investments to improve throughout the year, one company to exhibit flat to minimal growth, and one company to experience declining sales and profits. Thus, five out of our six energy investments are expected to produce flat to materially better results this year versus last year. Notably, as of early July 2017, those five companies had already reported better results for their most recently reported quarter.
Notwithstanding the above comments, the two stocks that detracted the most from the Fund’s performance were Rowan Companies (RDC) and Cimarex (XEC). RDC is an offshore drilling rig owner that until very recently produced excellent earnings and free cash flow. The protracted energy downturn has caused RDC’s customers to cut back on offshore drilling projects, which has negatively affected the company’s backlog. While Rowan has been able to retain its strong position with Saudi Aramco in the Middle East market, it has not been as successful retaining its lucrative deep-water drilling contracts. The company’s rig fleet remains one of the youngest and most technologically advanced in the industry, so we believe that RDC is in a good position to win new contracts when the market turns around.
We understand the market’s bearishness on RDC since the offshore drilling market’s recovery has lagged the U.S. shale oil recovery, but Cimarex’s second quarter stock performance strikes us as an over-reaction to oil’s roughly 10% price decline. As we noted above, XEC can produce excellent profits when oil is around $50 a barrel. The reason is that its oil reserves are among the lowest cost and highest productivity of all U.S. oil shale companies. Let’s look at the numbers. In the first quarter of this year, XEC generated a remarkable 50% adjusted operating profit margin, compared to 9.5% for ExxonMobil and 11.5% for EOG, the self-proclaimed low-cost producer. While most E&P oil companies struggled to make little or no money in the first quarter, XEC crushed the ball out of the stadium.
Moreover, we estimate that XEC’s net asset value (NAV) is over $207 per share using $70 as the price of oil. However, at $60 oil, XEC’s NAV is roughly $162 per share. Thus, at the above range for oil prices, XEC is trading at nearly a 40% to 55% discount to our estimate of its NAV, and that assumes no improvement in any of the company’s outstanding oil shale reserves and projects. Even we accept the oil bear’s long-term price of oil at $50 a barrel, XEC is trading at a 13% discount to our estimate of its NAV. Again, this assumes no enhancement to the company’s best-in-class assets.
Let’s now review a couple of stocks that performed well in the quarter. The top positive contributor this quarter was Aaron’s Inc. (AAN). Aaron’s has been in the portfolio for several years, and it’s a holding we have described in the past. In short, Aaron’s is categorized as a “Rent-to-Own” (RTO) business. There are two somewhat related divisions owned by AAN. The first division includes AAN’s physical stores, which offer consumer electronic products, furniture, appliances, and other household products to individuals on lease terms with the option to buy the product through over 1,800 company-operated and franchise brick & mortar retail locations.
The second business, Progressive Finance Holdings, is a virtual RTO operation. Progressive is a virtual operation because all of its business is handled through third-party retailer relationships. Essentially, Progressive buys the product from the retailer and immediately leases it to a customer after Progressive has approved the customer’s credit application. According to Progressive, prime and secondary lenders reject 40% of their clients’ applicants. Progressive approves 60% of those rejected, which provides 6-10% incremental revenue to their partners.
AAN shares appreciated over 30% in the quarter after the company reported better-than-expected results, and Progressive exhibited strong financial performance. We anticipate near-term growth to continue its upward momentum at AAN, and at Progressive in particular.
Babcock & Wilcox Enterprises (BW) also performed well in the quarter. We discussed BW in our first quarter letter and pointed out that management made a poor strategic decision in its fast-growing renewables business, and that the stock was hit hard during that quarter for that mistake. Subsequent to publishing our first-quarter letter, BW hosted a quarterly earnings conference call and provided positive news on the company’s progress in fixing its problems. The near-term stock price performance now largely rests on the company’s ability to continue fixing the renewables problems and preventing further cost overruns in that division.
During the second quarter, we added three new stocks to the portfolio and eliminated three other companies. The three new stocks are in three different industries: one is an airline, another is a financial services company, and the other is a retailer. Two of the new stocks are what we refer to as ‘old friends’ because the Fund has invested in the companies before.
The one new stock that has not been in the portfolio in the past is Allegiant Travel (ALGT). ALGT is a no-frills, discount airline operator that caters to the budget-minded leisure customer. One way ALGT saves money for its passengers is by flying into and out of smaller regional airports. For example, instead of flying into Orlando International Airport in Florida, ALGT operates out of the Orlando Sanford International Airport, which is roughly 25 miles north of the bigger international airport. Further, because of its unique focus on smaller airports and cheaper, used aircraft, 81% of ALGT’s scheduled routes have no competition. ALGT also is transitioning its fleet to Airbus A319 and A320 planes. Those planes are fuel efficient, and they use the similar engines and parts, which allows for much lower maintenance costs.
ALGT has declined roughly 30% from its peak a couple of years ago, partly due to flight operation issues with its older MD-80 planes, and partly because of lower operating profits tied to rising operating costs as the company invests in its fleet transition and future route expansions. We believe the MD-80 issues are short term and will cease once the company fully transitions to the Airbus A319/320s. Furthermore, as ALGT expands the number of routes it flies, we believe that revenues will increase. We assume no material change to operating profit margins, but earnings could rise substantially as the number of paying customers increases. To that end, on June 20, the company announced 28 new routes and service to three new cities. We believe revenues from this expansion will start later this year and accelerate in 2018.
Once ALGT transitions to the A319/320 platform and achieves a similar load factor on its new routes that it realizes on its existing routes, we believe the base-case EPS will be roughly $16.70. Earnings would rise to approximately $19.20 in our up-side case, which assumes ALGT is successful in further expanding its route schedule by adding 15 planes to the 110 planes in our base case. Thus, at $150 a share or below, we believe ALGT provides the Fund’s shareholders a reasonable reward-to-risk opportunity.
Last, as mentioned above, we eliminated three stocks from the portfolio. We sold DeVry (DV) in the mid- to high $30s after the stock rebounded in the wake of last year’s presidential election. Given all the ups and downs of the for-profit education industry in the past few years, we are pleased we made a return on the Fund’s capital on this investment. We also eliminated Akorn Inc. (AKRX) after it received a buyout offer from Fresenius SE. The Fund made a quick short-term profit on this investment. We also eliminated a small position at a modest loss.
Market Commentary
For the second quarter, as mentioned earlier, large-capitalized stocks performed better than small-cap stocks. The NASDAQ was the best performer, helped by the gain achieved by the omnipresent Amazon (AMZN) and other mega-cap technology stocks. While different styles generally have some dispersion in returns from quarter to quarter, this past period was very dramatic. We expect this wide dispersion in returns to narrow in the future.
In last quarter’s letter, we discussed the trend of investors allocating more of their capital to passive strategies like index funds and exchange-traded funds (ETFs) and away from active managers. AMZN and other stocks in the S&P 500 are where the large flows of capital have headed. It is worth noting that the 2017 ETF inflows, depicted below, are through the middle of June, so we are on pace to double the record inflows experienced last year.
Currently, passive investors own roughly 15% of AMZN’s equity through index funds, ETFs and the like—or roughly $70 billion worth of AMZN’s value. They hold nearly 18% if you exclude what Jeff Bezos owns. A decade ago, passive investors owned just a few percent of Amazon’s stock. Because index funds and ETFs buy and sell stocks in their respective index, or sector, based solely on flows of money into and out of their funds, by nature these passive strategies are indifferent to valuations—including outrageously over-valued securities. Obviously, AMZN is a dominant web retailer with a profitable cloud-service segment that is growing rapidly. However, AMZN is trading at 40x EV/EBITDA and 190x EPS. We believe some of AMZN’s rich valuation, and that of other stock’s as well, is attributable to the passive investment strategies’ indifference to valuations. These passive investors and benchmark-hugging active-management strategies are often the marginal buyer and, as mentioned earlier, they do not consider a stock’s valuation as a pre-requisite for buying or selling any security.
We recently analyzed the largest 15 U.S. publicly traded companies by market capitalization and found that the average P/E ratio was 36.3x versus 21.5 for the entire S&P 500 index. Moreover, passive investors own between 13% and 21% of the equity for each of these massive companies, or an average 17% ownership rate. Interestingly, just like with Amazon, passive investors owned just a few percent of each of these companies a decade ago.
We also found that the volatility, using the average five-year beta as a volatility proxy, of the 15 largest mega-cap companies in the S&P 500 in aggregate was identical to the market itself. The smallest market cap companies by decile of the S&P 500, on the other hand, had on average a beta 30% higher than the index.
This difference in volatility makes sense, and the following example illustrates why. Assume an active small-cap manager with $2 billion in assets is fired, and the manager’s largest position was a 5% weighting of a $1 billion market-cap company. Therefore, the manager has a $100 million investment in the company, which represents a 10% ownership stake. Depending on how fast the position is liquidated, the sale of 10% of the shares outstanding could have a very substantial impact on the price of the security. On the other hand, if an active large-cap manager with $2 billion in assets is fired, and the manager’s largest position is also a 5% weighting, but of a $200 billion market-cap stock, the impact on price will be negligible. The reason is that the manager’s largest position would represent only 0.5% of the company’s value. Clearly, we believe that there is an enormous difference in selling one-half of 1% of a company versus 10%, which often leads to greater volatility.
We believe the mega-cap’s lower volatility is also a significant factor in attracting capital from passive strategies, as well as capital from active-management strategies that are trying to keep up with the benchmarks. As more capital flows into these mega-cap stocks, the valuation for most of them becomes richer. Thus, the lower volatility of these mega-caps feeds a self-perpetuating cycle of more money being funneled into these mega-cap equities, which then helps drive the return of the passive strategies.
The superior performance of the passive strategies attracts more capital, which then starts another cycle of buying stocks in the various indices, and more outperformance, and so on and so on. Because of their valuation indifference, the passive investment approach pushes valuations into higher territory for the largest market caps of any specific index or passive ETF. We wonder if investors in these passive strategies are aware, or even care, that the funds in which they have an investment are oblivious not only to the valuation of the individual securities embedded in the passive strategies’ portfolios, but also to the basic fundamentals of the individual businesses.
For instance, we surveyed a number of executives at companies in which the largest shareholders are passive equity funds. In most cases, passive investors were three of the top four shareholders of the companies we reviewed. Every executive we spoke with said no representatives of the passive investment funds ever listens to the company’s quarterly conference calls. Moreover, none of these passive investors ever calls to discuss the company’s strategy, the industry outlook, the current business climate, or any other factor that should be of interest to a long-term shareholder. However, the executives noted that each of the passive investment fund companies has one person who calls once a year to discuss the annual proxy statement.
In the extreme case where passive strategies own 100% of the equity, who will ensure that the executives operating the business will do so as efficiently as possible? Theoretically, an activist investor would not be able to buy shares of that company unless there was an outflow of money from the passive strategies. If we take it one-step further, what happens if passive strategies own 100% of all of the companies in the index? Some may think this is farfetched, but a recent Bernstein Research report predicted that 50% of all assets under management in the U.S. will be passively managed by early next year. Furthermore, Marko Kolanovic, global head of quantitative and derivative research at JPMorgan, recently estimated that “fundamental” asset managers account for only 10% of trading volume in U.S. stocks.
We have asked the question before, but it bears repeating: How does the equity market establish credible price discovery for stocks when valuation-indifferent passive funds and quantitative algorithm traders, who might be in and out of a stock multiple times a day, are producing 90% of the equity market’s trading volume? Our simple answer is that credible price discovery is not occurring in today’s equity market.
We are not the only active managers who have discussed the consequences of the shift from active managers to passive strategies, and we believe Steven Bregman, co-founder of investment advisor Horizon Kinetics, summed it up best last October at a Grant’s Investment Conference. Bregman said this about Exxon (XOM) being included in various passive funds:
“…aside from being 25% of the iShares U.S. Energy ETF, 22% of the Vanguard Energy ETF, and so forth, Exxon is simultaneously a dividend growth stock and a deep value stock. It is in the USA Quality Factor ETF and in the Weak Dollar U.S. Equity ETF. Get this: It’s both a momentum tilt stock and a low volatility stock. It sounds like a vaudeville act.”
Bregman offered a hypothetical case to illustrate his point. Say it’s 2013, and you came upon a page torn from an ExxonMobil financial statement that a time traveler from 2016 left behind. You’ve got Exxon’s financial results three years into the future. “You’d know everything, except, like a morality fable, the stock price. Oil prices down 50%, revenue down 46%, earnings down 75%, and the dividend payout ratio more than 1.5x earnings,” Bregman said. But if you shorted Exxon based on that knowledge, he added, “you would have lost money.”
Bregman’s comments do not portray a market with credible price discovery. Three passive asset management firms own roughly 18% of Exxon. Another substantial percentage of ownership is held by funds that hug the benchmarks, which must include it because of its $350 billion market cap. We verified Bregman’s conclusion that an investor would have lost money by shorting XOM three years prior to his comments at the Grant Conference. Incredibly, despite the enormous volatility in oil prices and stock prices for the vast majority of other energy stocks, XOM’s five-year average beta is actually 15% below the market’s volatility. This is the epitome of size having an advantage.
As active managers, we ask ourselves every day if a stock’s current valuation provides an adequate reward-to-risk ratio to warrant your capital being deployed into risky assets called equity. Unmistakably, deep-value stocks are currently out of favor, and mega-cap growth stocks are in vogue –perhaps for sound and reasonable assumptions, or not.
So, let us check what assumptions may be embedded in AMZN’s valuation. We first need to make some assumptions on our part, and we admit that some investors will take issue with our assumptions. To start, we assume AMZN will trade at 20x EPS in 10 years (June, 2027) and its shares outstanding will grow 1% annually over that time, which is roughly a third lower than its current annual growth rate of shares outstanding. We also assume that its operating profit margin will increase 50% from what it most recently achieved. The future margin we chose for AMZN is consistent with the current operating profit margin for Wal-Mart and just 30 basis points below Whole Food’s margin, which we believe is a reasonable starting point. Our last assumptions are less controversial. We assume AMZN will not incur any interest expense by eventually eliminating all of its current $21 billion of debt, and that its future tax rate will be 30%.
Under those assumptions, AMZN will need to increase its annual revenues by 20% or more each year for the next 10 years. At that point, AMZN’s revenues would be greater than $820 billion. As a side note, if AMZN were to buy the equivalent of a Whole Foods Market each year for the next 10 years, AMZN would still need to grow its incremental revenues by $520 billion.
Continuing with our example, if we further assume that U.S. GDP grows at a 3% annualized rate, AMZN’s sales alone would represent 3.3% of U.S. GDP in 2027. Even if we believe Amazon is able to achieve these results, the analysis strikingly assumes no change to AMZN’s current stock price over the next 10 years. That is, we held constant Amazon’s current stock price to check the embedded growth rates in AMZN. We then asked ourselves, are investors really buying AMZN today expecting no return? Of course not. Investors are warmly embracing AMZN shares today because they believe Amazon will grow faster or will be trading at a richer multiple than 20x net earnings in 10 years. It is also possible that the marginal AMZN investor does not even worry about growth rates or valuation, and that the marginal buyer is merely buying the stock because it has to.
According to Jeremy Grantham, founder of the widely respected asset manager GMO, there are good reasons to own large global companies trading at rich valuations. Many of you are familiar with Grantham and his former dedication to reversion-to-the-mean and value investing. Grantham is famous for calling the crash of Japanese stocks, the dot-com bubble, and the housing bubble. Yet, Grantham says higher valuations are here to stay, according to a June 2 article in the Financial Times. “This time is very, very, different,” Grantham said in a recent client letter. “You now have to treat previously cast-iron rules with suspicion. They’re more like aluminum rules now.”
As dedicated value investors, we find it sobering to read that Grantham believes higher valuations are here to stay because, in his opinion, globalization will continue to drive profits higher for multi-national companies, and because of the growing political influence of companies, more onerous regulations, and the secular decline of interest rates.
Frankly, we believe Grantham has thrown in the proverbial towel on his reversion-to-the-mean philosophy and joined the consensus. We could take the other side of every one of Grantham’s points and argue for a different outcome, but our message is broader than merely arguing each individual point. That is, when someone of Grantham’s stature capitulates and casts aside an investment approach that has worked for nearly five decades, it speaks volumes about the tremendous amount of pressure even the most successful investors face today. What the Financial Times did not report is that Grantham’s assets under management have declined by over $40 billion, or 35%, over the last two years.
In closing, we remain confident about our strategy’s future. Our pipeline of potential investments remains robust, as evidenced by the three new stocks that went into the portfolio during the second quarter. As we have mentioned numerous times, volatility is our friend, and we are prepared to 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
See the full PDF below.
