GoodHaven Fund 2013 Letter (Fairholme alums)
Dear Fellow Shareholders of the GoodHaven Fund (the “Fund”):
For the Fund, last fiscal year was a tale of two six-month periods. In a red-hotstock market, we ended the first six months up roughly 17%
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, slightly outperforming the S&P 500 index despite a large cash position and maintaining a significan t advantage versus the S&P since inception. For the second six months, the value of the Fund rose further, as we ended the year up nearly 20%, but far less than the S&P 500 as the broad stock indexes continued to rocket higher. Since inception on April 8, 2011 and through November 30, 2013, we’ve earned about 14.7% per annum and have roughly kept pace with the S&P 500 Index. Relative returns are important, but absolute returns are ultimately what can be spent. In our opinion, we and our fellow shareholders have little reason to complain so far.
Without overly weighting recent results, we think it’s appropriate to identify for you the reasons why recent performance diverged from indexes – something we expect (in either direction) from time to time. First, there was a lack of volatility to help us purchase securities at advantageous prices. Second, general price levels rose significantly, with increasing ly speculative activity. In simple terms, investors decided to pay much higher prices for not much more in earnings. Third, we didn’t swing at some hittable pitches and paid a price for hesitating. Fourth, a few of the Fund’s holdings are insensitive to broad market movements, and are expected to modestly offset market declines – qualities that proved unnecessary and unprofitable over the last twelve months. Last and perhaps most importantly, large subscription inflows nearly doubled the Fund’s size since last November, temporarily leaving us
with more cash than sensible opportunities. Currently, cash and equivalent holdings are substantia l but down slightl y from mid-year as a percentag e of the overall portfolio despite inflows.
All of the above said, we are not overly concerned about short-term results, are not crying over positive double-dig it absolute returns, and are not changing the consiste ncy of our approac h or our strategy. During 2013, many asset classes experienced de minimus or negative returns.1 We are pleased that since the inception of the Fund, we have kept pace with the S&P 500 Index during a period of strong absolute returns while retaining significant liquidity, flexibility, and a risk profile we believe to be lower than many competitors.
Today,new opportunities seem more limited than those of a couple of years ago, and though we are optimistic about the long-term, the investment world has grown more ebullient than we prefer. However, like the weather on Mount Washington in New Hampshire, conditions on Wall Street can and do change fast. Berkshire Hathaway’s Warren Buffett and Charlie Munger have often observed that having liquidity when others don’t and being prepared to react quickly can be huge strategic advantages. The greatest difficulty for most is remaining sufficiently patient to allow these strategies to play out.
We belie ve that the Fund’s current liquidity may prove to be a significant advantage in today’s investment world at a time when many seem to think that risk has disappeared. Investors tend to hoard cash when securities bargains are plentiful and complain about it when its value (in terms of what it will buy) is about to soar. In 2013, after five years of market rally with leading indexes nearly tripling in price, investors treated cash holding as trash. We recognize that there has been an opportunity cost to holding cash this year, but too many managers are willing to accept the risk of large loss for small prospective returns. We won’t. We simply try to employ as much of the Fund’s cash as we think prudent given the opportunities we see.2
During our tenure, we have also tried to avoid large amounts of interest rate risk, given a common sense belief that the Federal Reserve’s quantitative easing and zero interest rate policies cannot permanently suppress bond yields at or near generational lows. Extended attempts to mani pulate bond yields lower are likel y to have significant negative effects. Though U.S. Treasury yields are still at absolutely low
levels, U.S. ten year notes and thirty year bonds saw recent yields bottom at 1.43% and 2.46%, respectively, and current yields now sit at approximat ely 2.97% and 3.88%.3 The three-decade tailwind of falling rates seems to have disappeared. What worked yesterday may not work tomorrow.
Investors should also be questioning whether recently low levels of inflation will persist. Historically, inflation has been a pernicious tax on low and middle-income citi zens and a problem for many businesses. Yet today’s central bankers are desperately trying to create it. Instinct says the bankers should probably be mindful of exactly what they are wishing for – once out of the bottle, the inflation genie doesn’t like to go back. Paul Volcker, former Chairman of the Federal Reserve during it darkest days of inflation fighting in the early 1980s, was an early skeptic of the benefits of inflation as an economics student. Volcker recalled,
“It all sounded too easy. Push this button twice and out pops full employment. Equations do not work as well on people as they do on rockets. I remember sitting in class at Harvard listening to [fiscal policy expert] Arthur Smithies say, ‘A little inflation is good for the economy.’ And all I can remember after that was a word flashing in my brain like a yellow caution sign: ‘Bullsh**’. I’m not sure exactly where that came from…but it’s a thought that never left me.”4
We think Volcker was right to inherently distrust inflation, which is more palatab le to politicians than unemploy ment, and remai n skeptical that current confidence in central bank policies is warranted. Ultra-low rates and significant money printing are historical ly assoc iated with inflationar y busts. Given high sovereign deficits, massive and growing sovereign debts, and accommodative central bankers, we believe investors should be concerned about the possibility of future inflation or associated currency weakness, though neither is yet evident in most government statistics.5
While limited with respect to certain investments, the GoodHaven Fund has the ability to invest in a wide variety of securities and asset classes. No matter the environment or potential clouds on the horizon, we assume that most of the time there will be potentially interesting investments to make out there – we just have to keep searching and find one or two that can move the needle. And while it is not
always apparent , we have been look ing dil ige ntly (see our discuss ion about Harbinger Group and Stolt-Nielsen below). However, rapidly rising equity prices mean that we are being asked (generally) to accept less value in exchange for our cash when we buy a new investment. Given the magnitude of Mr. Market’s price rise, we won’t automatically buy more of what the Fund already owns as new cash comes in unless the price is right for a new purchase. Chasing new highs is not a value investing strategy.
We belie ve our current equ ity portf oli o has significant roo m for further appreciation. For example, when appropriate adjustments are made to translate GAAP6 to cash earnings, we believe our ten largest investments sell at a significant discount to the market as a whole when measured by either adjusted cash earnings or book value.7 These valuations did allow us to add materially to some existing holdings as cash came in the door, as we believe our portfolio has less downside and significant upside when compared to market indexes.
Our largest and most profitable investment to date remains Hewlett-Packard, on which we have today a significant unrealized profit. Even after gains, HP is still modestly valued – currently trading at about eight times 2014 estimated cash profits. We have written about HP extensively in the past: to summarize, we believe the business is beginning to stabilize overall even as the mix of products and services is changing. The printing business – an important source of cash generation – appears to have stabilized already. If the rest of the business develops as expected, we believe there is additional room for profit.
We also continue to maintain investments in technology giants Microsoft and Google. Microsoft has appreciated since we began to buy over two years ago, but remains modestly valued due to fears over potential erosion of its Windows near- monopoly and ongoing losses in its consumer and Internet businesses. Nevertheless, our research suggests that not only is Microsoft deeply embedded in large and mid- sized businesses in a variety of ways (Microsoft Office, Server Tools, etc…) but that many information technology officers are impressed with the strategic focus of
Microsoft and its relevance to their operations. Consumer miscues are and continue to be a side-show to the business-facing goliath that composes the largest part of the Microsoft business. The company may also face a transition where its Windows operating system franchise erodes, but other parts of the company are growing, most are generating significant free cash flows, and the company has a number of important product lines that remain essential in today’s business world. We believe that the appointment of a new CEO may serve as a catalyst to unlock further value from Microsoft shares.
Google continues to perform financially and its stock price has responded, rising significantly above our cost. Our research continues to suggest that Google has huge reinvestmen t opportunit ies for its cascade of cash resulting from except ional operations in its various divisions, most of which center around advertising. Of all of our holdings, Google may be the closest to fair value, however the business is so exceptional and the growth profile so compelling that we are reluctant to part with the shares.8 Given historical earnings volatility, we may get another chance to buy more down the road. Worthy of note, both Microsoft and Google retain huge cash hoards that have contri buted almos t nothing to earnings in a zero interest rate environment. Rising rates should help, not hurt.
In the aggregate, we now have a reasonably sized holding in the energy business, particularly focused on natural gas. Huge discoveries of “shale gas” in the United States led to a drilling boom and then a sharp decline in gas prices.9 We made our initial investments over a year ago as panicked investors drove gas prices to $2 per thousand cubic feet (“MCF”), well below the level that most need to generate profits. Current natural gas pricing is closer to $4 per MCF. Our current holdings consist of Devon Energy, Exco Resources, WPX Energy, and Birchcliff Energy. Of these, Exco and WPX recently experienced leadership changes, which we believe may act as a catalyst to improve operations.
Although natural gas prices are heavily influenced by weather, there are some good reasons to think that another huge price bust may not occur for a while. Crude oil contains about 6 times more energy than natural gas while the price of crude oil has recently ranged between 20 and 25 times the price of natural gas. We expect that gap to narrow as industrial users attempt to make substitutions. More importantly, severe regulatory restriction s on the burning of coal and the building of new
coal-fired plants continue to increase the market share of natural gas in electrical generation. Furthermore, a small but growing part of the commercial transportation business is converting from diesel to natural gas. Lastly, there are a number of permits in progress to create modest but meaningful export capacity for natural gas to take advantage of large price differentials, such as in Japan where landed prices per MCF are more than four times U.S. wellhead prices. Given relatively soft valuations and a bright longer-term outlook, we continue to look for additional opportunities in this area.
Late in the fiscal year, the Fund bought a modest number of shares of publicly- traded Harbinger Group in a pri vate and tem porar ily illiquid transac tion . Partic ipatin g with Leucadia Nationa l and other investors, we bought at a 15% discount to publicly quoted market value and a much larger discount to our estimate of intrinsic value. The transaction came about when a hedge fund manager was forced to sell a sizeable number of shares of this public company to meet hedge fund redemptions and we were able to help facilitate the sale. Unfortunately, we were unable to purchase as much as wanted, but our pre-tax profit on this investment is roughly 35% to date. This was a good example of the flexibility that the Fund has to participate in a variety of asset classes and security types and we try to keep our eyes open for similar potential investments – hopefully where we can deploy a greater percentage of capital.
We also invested a small percentage of capital in Stolt-Nielsen, a leading global provider of bulk-l iquid transporta tion, storage, and distri bution services. The company is listed on the Oslo Stock Exchange, has significant owner/managers, has an excelle nt reputation, and has been able to grow over time. Some of Stolt’s competitors were hit hard by the most recent economic downturn and there has been consolidation in the chemical shipping industry, which is highly specialized. The price jumped shortly after our initial purchase and we have not had an opportunity since to meaningfully increase the investment at a compelling price. However, hope springs eternal.
During the year, we also made a substantial purchase of some gold-miningsecurities after the price of gold plunged and industry stock prices collapsed. In a grand tradition of running toward the smell of smoke, we continue to look for similar opportunities and recently added to common equity investments and bid on some distressed debt in this area. We believe that Barrick Gold is particularly timely given the magnitude of the price decline, disappointment regarding recent dilution – which dismayed many investors but improved the balance sheet, management and board changes, and a renewed focus on cash flow and profits rather than size. Barrick owns unique and valuable assets with low operating costs and any rebound in metals prices should benefit the company’s stock price disproportionately.
Despite a general lack of obvious alternatives to deal with burdensome debt loads around the world, few are seriously contemplating the possibility of high inflation today. Our metals and energy investments hurt performance last year but were acquired at what appear to be bargain prices compared to cash flows, asset values, and past stock market valuations. Gold is down nearly 40% from its peak of a couple of years ago with silver down even more, while natural gas has recouped a bit off extreme lows even as crude oil has declined. We think our current holdings represent long-dated and valuable warrants with huge profit potential should the central bankers’ money-printing games not work out so well.
The two of us have been managing investment portfolios long enough that we have a strong (though admittedly imperfect) sense of speculation and emotional excess. Recently, we have seen record stock market highs (after indexes roughly tripled from crisis lows), record corporate profit margins (which tend to regress to the mean), rapidly increasing amounts of corporate debt (with fewer and fewer protections for debt holders and record amounts of borrowings), near record margin debts (usually associated with market peaks), rising intermediate and long term interest rates (but from extraordinarily low absolute levels), extreme bullishne ss among investment advisors (normally a contrary indicator), and fairly high average equity valuations (and higher than they appear if you believe profit margins will recede).
In addition to the above factors, central bankers are still flooding the world with cash and record levels of sovereign debt continue to climb. Our normally active caution gene should be (and is) working overtime. When we can identify a better business opportunity and are convinced that the Fund is getting far more than it gives, we will happily part with cash as we’ve done in the past – regardless of economic concerns. But frankly, we prefer to see more stressed or volatile markets than the euphoric one that we seem to have entered. Buying high to sell higher is not a strategy that interests us.
To paraphrase Ben Graham, the dean of fundamental securities analysis, the return of one’s capital is just as important as the return on one’s capital. We are significant shareholders of the Fund and act like it, only buying for the Fund and its shareholders at a price we are willing to pay ourselves. Furthermore, we continue to behave as though each of our shareholders has entrusted a material portion of their accumulated wealth to us and that your investment is truly important to you. We can’t control the market’s ups and downs, but we can work hard to avoid permanent loss of capital.
Any fool can look like a hero by rolling dice or using leverage in a rising market. We’re in a different game, trying to earn competitive returns while working hard to avoid foolish risks. To put it in the terms of the classic board game of Monopoly, we’ve worked too hard and too long to go back to GO. Our first goal is to preserve capital and our second is to earn the highest returns consistent with the former. Notwithstanding the occasional bumps in the road, our conclusion to date is: so far, so good.
We appreciate your trust and support.