Value Investing

FPA Capital Q3 Letter: Small-Cap Valuations Still Troubling

FPA Capital Q3 Commentary

 

Introduction Is the market finally correcting the recent excesses of stock valuations, particularly in the small-mid-cap area? The admittedly arbitrary definition of a stock market correction is when an index declines 10% or more from its recent level. Based on this, the Russell 2000 (R2000) recently fell into correction territory while the S&P 500 has declined 9% over the past month (as of 10/14/14). Moreover, the Russell Microcap Index is down more than 17% from its high earlier this year, with microcap technology stocks down nearly 25% since March. Thus, small-cap stock valuations, relative to large-cap valuations, are in the process of reverting back toward historical averages. In some ways, the smaller decline in the S&P 500 has masked the broader correction for a number of industry sectors. Besides those mentioned above, large-cap automotive stocks are down 18% since July, and energy stocks are also getting hit with the S&P Oil & Gas Exploration & Production index down 25% since this past summer. While your portfolio is not immune to this correction, we believe the companies we own have strong balance sheets, providing management teams an ability to take advantage of any good opportunities to buy assets on the cheap – should any opportunities present themselves. We have managed this strategy through a number of corrections and each time, while we take temporary hits to capital, we have been able to take advantage of opportunities that present themselves during these periods of dislocation. Our strategy’s three-decades of history shows that we can deploy capital very rapidly when valuations are depressed and when fear and uncertainty are high. On the other hand, we have exhibited tremendous patience in holding higher than normal levels of liquidity when valuations are rich. The last couple of years tested our patience, but we were fortunate to have discovered stocks that still met our stringent investment criteria and deployed some of your capital into these new investment opportunities. In recent weeks we deployed incremental capital as selling pressure accelerated. If the current volatility continues, we fully expect that we will be more aggressive in deploying your capital as valuations become even more attractive.

Market Commentary

Over the past year or so, we have been asked a number of times, “What does the current market remind you of?” Our response has been that it reminds us of the late 1990s, when there was a large valuation difference between large-cap stocks and small-cap value stocks, except that this time small-caps have been more expensive. At the end of 1999, the S&P 500 traded at 32x earnings per share, while the R2000 value traded at 17x earnings, a 15 point spread. Earlier this year, the R2000 traded at ~37x earnings versus roughly 19x earnings for the S&P 500, an 18 point differential. Lately, this gap has narrowed to 14 points as small-cap stocks have declined more than larger-cap stocks, we expect the gap to narrow further (rationale is highlighted below).

It is impossible, at least for us, to predict exactly how wide a valuation spread between two different indices might become or when this spread will peak and then contract. However, over the past year or so, we have expressed our view both verbally and in writing that we believe small and mid-cap stocks in general were, and still are, overvalued. For example, if we assume that the R2000 is one large conglomerate with two thousand subsidiaries, and roll up each of the individual company’s net income to get an aggregate net income, the R2000 would actually trade at 61x earnings at the end of September. It is striking that nearly one-third of the companies in the Russell 2000 have lost money over the past twelve months.

The reasons for the difference in the stated P/E of 32x versus 61x based on the method above is that Russell correctly uses a weighted average market-cap method but incorrectly in our opinion, typically excludes companies with negative P/E ratios. By not fully incorporating companies with negative earnings

into the calculations, Russell unfortunately biases the index’s P/E lower. Nonetheless, even at 32x and 26x earnings, respectively, both the Russell 2000 and 2500 are excessively priced, in our opinion.

Going forward, we believe earnings for small-mid-cap companies will need to experience accelerated growth to support their elevated valuations, or valuations will likely continue to decline toward more historical levels. However, we could be wrong and the market may continue the positive trend of the last few years despite anemic earnings growth. That is, investors may not care as much about earnings growth and continue to buy stocks because of no better alternative for their capital.

Perhaps the market’s attitude of the past couple of years is similar to the recent Silicon Valley approach to investing and buying into other companies. Larry Page, Google’s CEO, has coined the term “the Toothbrush Test”1 for deciding whether to acquire another business. The Toothbrush Test is simply a determination of whether companies possess a product or service that is used once or more a day, and makes your life better. Apparently, Mr. Page believes this test is superior to diligently analyzing the financial statements and valuation of a targeted company, which may explain Google’s recent acquisition of Nest, a thermostat company, for $3.2 billion, or Facebook’s purchase of WhatsApp for $19 billion.

Google, Apple, Facebook and other Silicon Valley companies are now often by-passing investment banks and relying on their own internal business development teams to scrutinize merger & acquisition deals. The frumpy banks tend to use old-school valuation metrics to help assess the merits of a deal, and thus are losing out on lucrative M&A deal fees. Sadly, the banks have not invested enough in training their key personnel, who can assiduously measure whether “The Toothbrush Test” is passed by a targeted company! Undoubtedly, the Harvard Business School will need to add a new class to their curriculum if they expect their future graduates to be hired by these leading global banks.

Over the past few years, we have favored the economic “slow-growth” view, but not the more pessimistic “recession camp”. While we continue to believe the growth trajectory of the U.S. economy over the next year will average 2% or so, we think the recent dollar strength highlights how poor some of our global trading partners’ economies are performing – particularly in Europe. Yet, we cannot rule out a much slower U.S. growth scenario, or even a recession, if Europe deteriorates even more from its current malaise.

The U.S. dollar has rallied from roughly 1.40 to 1.25 against the Euro over the past six months, and from 94 to 1.10 against the Japanese Yen since June 2013. We believe these foreign currencies are declining because their respective Central Banks are trying to stimulate their mercantilist economies by keeping sovereign interest rates lower than those of U.S. Treasuries for similar maturities. All else equal, lower government interest rates normally imply weaker currencies. And lower currencies make export products more competitive in the global market place in relation to goods produced in a stronger-currency country.

Japan, which started depreciating its currency earlier than the ECB, has recently experienced more robust exports and a rising stock market. We think the Europeans are playing catch up to the Japanese, and this strategy of currency depreciation could eventually spill over into China.

There is some recent evidence that the stronger dollar could weigh negatively on domestic manufacturing growth. For example, the September ISM Manufacturing Index was down 2.4 points to 56.6 from 59 in August. While the index still points to decent economic expansion, the index declined in September because of slower new orders, which may be a harbinger of slower future growth.

The latest softer ISM index numbers comes on the heels of construction spending declining in August by 0.8%, weaker than expected. Furthermore, there were downward revisions to construction spending for June and July, and September sales were down 0.3%, again weaker than expected. These are merely some indicators that the economy may not be as strong as some in the financial community believed or expected just a month or so ago, which fits with our narrative of a slowing economy.

The stronger dollar, or perhaps weaker than expected economies abroad, is also negatively impacting a number of basic commodities. For instance, the Commodity Research Bureau’s Spot Raw Industrials

index has declined from approximately 545 to 505 over the past five months. Oil prices are down nearly 20% over the same time frame, albeit from elevated levels due to production issues in Libya that are, for now, behind them. Obviously, the better than expected employment numbers refute the belief by some of an imminent collapse of the economy.

In summary, we believe the U.S. economy rebounded nicely in the second quarter from its depressed March level, as we expected. However, we do not believe the economy will be able to maintain the 4.6% growth rate pace of the June quarter for the second half of the year. There is some anecdotal data, such as softer new orders, weaker commodity prices, and slowing retail sales, which suggest the economy is expanding at a slower rate than the second quarter. Therefore, earnings growth expectations embedded in recent stock valuations, per the above analysis of the Russell 2000 will, in our opinion, likely prove to be too optimistic.

Portfolio Commentary

Your portfolio underperformed the benchmark in the September quarter, but continues to outperform year-to-date. While roughly 25% of the stocks in the portfolio produced positive results in the quarter, we had a number of companies decline as the market sold off the past couple of months. Our technology, education, industrial, and energy companies’ stock prices contributed to the negative performance.

The technology sector continues to be our largest allocation to any one industry group. The next two largest sector weightings are Oil Field Services and Oil & Gas Exploration & Development industries. The latter two are currently getting a lot of media coverage, given the recent decline in oil prices. We will again review our investment thesis for these two sectors.

First we will provide a quick history of the strategy’s investments in the energy sector. Prior to 1999, the strategy had very little or no allocation to the energy space since its inception in 1984. In early 1999, the strategy made an investment in Ensco International (ESV), but sold the entire position in the middle of the year 2000, after the stock more than tripled. Soon after September 11, 2001, the strategy again established an energy position by accumulating several oil field service companies and an oil equipment company.

Roughly six years later we had trimmed back many of these positions and eliminated the oil equipment company. At the depth of the financial crisis in late 2008, we started investing in E&P companies and bought additional shares of the oil field services companies. All of these stocks performed well over the subsequent several years, and a few greatly exceeded our expectations.

Fast forward to today, we continue to manage the portfolio based on a strict set valuation metrics. For instance, we eliminated two energy stocks in the third quarter, Newfield Exploration (NFX) and Patterson-UTI (PTEN), because they hit our price targets. We also trimmed back a number of other energy stocks this year as oil prices rose above $90 a barrel. Subsequent to the quarter end, we sold the remaining small position of Baker Hughes, generating good long-term gains for our clients and shareholders.

To reiterate, our investment thesis in the energy sector is predicated on natural gas trading in and around the $4.00/mcf (currently $3.95/mcf) and oil prices trading in and around $85 a barrel (Brent is currently ~$84.50/barrel). These figures are based on where the marginal producers’ cost curves of these commodities are relative to demand, according to data provided by Sanford Bernstein Research. If an energy company cannot generate a return on capital that exceeds its cost of capital, the company is not adding value for shareholders.

Our outlook for annual global oil demand is roughly 1% growth. Despite many European economies currently being in a recession, or experiencing no growth, and the Chinese economy exhibiting material deceleration, the International Energy Agency (IEA) this month revised their oil demand forecast for 2014 to 92.4 million barrels per day versus roughly 91.7 million barrels/day in 2013. This represents a growth rate of 0.76% year-over-year. The IEA also revised its 2015 oil demand forecast to 93.5 million

barrels/day, or a 1.2% growth rate. Thus, our long-term oil demand expectations are quite close to IEA’s forecast, and both reflect a weak global economic growth outlook. On the supply side, the OPEC countries are currently producing approximately 31 million barrels of oil per day, or approximately one-third of global oil production. According to Howard Weil, an energy focused brokerage firm, OPEC’s oil production peaked in July of 2008 at 32.8 million barrels/day, and plunged more than 5 million barrels/day to 27.7 million barrels/day by March of 2009. Oil production from Africa, ex the OPEC countries, has been relatively flat over the past five years. Oil production from Europe (including Russia), Asia, and Latin America increased marginally over the past five years. However, oil production from North America, notably from U.S. shale, has increased by more than 4 million barrels/day since the end of the financial crisis. Thus, the vast majority of incremental oil supply has come from OPEC and America, over the past five years.

Let us now discuss some of our energy investments. Rowan Companies (RDC) is an off-shore drilling rig owner and operator. RDC provides offshore oil and gas contract drilling services utilizing a fleet of 30 self-elevating mobile offshore “jack-up” drilling units and four ultra-deepwater drillships, two of which are currently under construction. Until this year, Rowan focused on high-specification and premium jack-up rigs, which its customers use for exploratory and development oil & gas drilling. A couple of years ago, RDC signed contracts with Hyundai Heavy Industries for the construction of four ultra-deepwater drillships. In January 2014, the company took delivery of the first of these drillships, the Rowan Renaissance. The Renaissance commenced drilling operations under a three-year contract in the deep waters off the coast of West Africa in April 2014. The last of the four new drillships will be delivered in March of 2015, and all four of the new ships are under firm, multi-year contracts. With the acceptance of the fourth drillship next March, RDC will have among the youngest fleet of ultra-deepwater (UDW) drillships and high-spec Jackup rigs in the market. This is an important factor because oil & gas exploration & production companies will likely migrate to the youngest and best possible rig for a given job, should oil prices continue to decline or even stabilize around the $80/barrel level.

Rowan’s young fleet is outfitted with some of the most advanced and safest equipment of any offshore rig. For example, all four of RDC’s new UDW drillships come with dual blow-out preventers, which could have helped prevent the horrific Deepwater Horizon accident in the Gulf of Mexico in 2010. Additionally, the drillships will be self-propelled vessels equipped with computer-controlled dynamic-positioning thruster systems, which allow them to maintain position without anchors through the use of their onboard propulsion and station-keeping systems.

Despite the decline in Rowan’s stock price over the past few months, our earnings expectations, as well as Wall Street’s analysts who follow the company, point to higher EPS over the next couple of years. For instance, the consensus EPS estimate for this year is $2.16, but that increases to $3.93 and $4.09, respectively, for 2015 and 2016. Furthermore, Rowan has roughly 76% and 68%, respectively, of its 2015 and 2016 revenue expectations under firm contract. As a side note, Ensco has roughly 75% and 51%, respectively, of its 2015 and 2016 revenues under contract. Atwood has 92% and 71%, respectively, of its 2015 and 2016 revenues under contract.

Current market sentiment toward energy companies, particularly to offshore rig companies, is obviously very negative. However, when the average small-mid-cap stock trades at roughly 30x earnings, we would rather allocate capital to companies like RDC which we believe is trading at close to 5x each of the next two year’s earnings expectations. Even if we are wrong and RDC earns $3.00 in 2016, the stock trades at nearly 7x earnings. In our opinion, RDC’s earning power is greater than $3.00.

Another energy company that declined substantially during the last few months is SM Energy (SM). Again, the strategy initially purchased SM Energy in late 2008/early 2009 at substantially lower prices than even its currently depressed price. SM is an exploration & production company that derives approximately 75% of its production from Texas (primarily the Eagle Ford Shale area), 15% from the Rocky Mountain region (primarily Bakken/Three Forks area in North Dakota), and the remainder split between the Permian Basin in west Texas and the Mid-Continent in Oklahoma.

Revenues from oil represented roughly 55% of the total June quarter revenues, with natural gas and natural gas liquids (NGLs) generating 28% and 17% of the revenues. SM Energy is currently earning roughly $20 per share of ebitda and is trading close to 4x enterprise value to ebitda, versus Athlon Energy that just announced its being acquired at roughly 15x ebitda. Granted, the recent decline in oil prices will negatively impact SM’s near-term revenues and profit. However, assuming no growth in production from the June quarter level and no additional hedges were put in place this quarter (SM will report Q32014 results on October 29th), SM has roughly 50% of its 2015 oil and gas production hedged out at approximately $90/barrel and $4.00/mcf.

Besides reducing the risk to shareholder profits from lower commodity prices by hedging out some of its future production, SM also boasts among the lowest finding & development (F&D) cost for US shale oil producers. We estimate SM’s F&D costs at about $13/barrel, which allows the company to have a much lower break-even cost than many highly levered U.S. shale producers. SM’s strong balance sheet gives the company the option to purchase good oil & gas assets from potentially distressed sellers, should oil prices fall below $75/barrel.

Both RDC and SM are representative of our investments in energy companies. That is, our investments are in companies with strong balance sheets, seasoned management teams, and good prospects to generate strong financial results despite oil prices declining $20/barrel from its recent level of approximately $105. There has been too much capital spending on tertiary U.S. shale oil projects over the past few years. High oil prices and cheap capital seduced many investors into businesses that they do not understand, nor do many of these companies have the capital to weather the inevitable down cycles.

We do not pretend to have a crystal ball and know for sure where oil prices are going to settle out over the next year or two. However, the laws of supply and demand have not been abolished, and we believe oil prices should settle eventually around the $85/barrel range. If the IEA’s estimate of roughly 1 million barrels of demand growth occurs each year for the next five years, suppliers will need to produce an incremental 5 million barrels over that time frame.

Over the next five years, we think the economic sanctions on Iran will eventually be lifted, which means they could add 700,000 barrels/day to future supply. Libya could produce an additional 400,000 barrels/day if their civil war ends. Iraq is on a steady trend to add 1.5 million barrels/day by 2019, assuming ISIS is prevented from damaging the large oil infrastructure in the southern section of Iraq. If we are correct, these three countries alone could produce roughly 2.5 million barrels/day of the expected 5 million barrels/day increase in demand over the next five years. That leaves approximately 2.5 million barrels/day for other oil producers.

Clearly, there are some major oil basins that will not be able to grow production at $80 oil, and some have actually experienced production declines despite higher oil prices. Saudi Arabia has some spare oil production capacity and most likely endeavors to maintain their respective market share. However, with U.S. oil shale production growing at roughly 1 million barrels/day over the past couple of years, some of which is uneconomical at even $100/barrel, the longer-term supply and demand picture risks becoming unbalanced. Thus, we believe the Saudi’s recent move to cut prices, rather than oil production, is sending a strong signal to uneconomic oil producers to stop their investments.

Our investments in Cimarex (XEC), Rosetta Resources (ROSE), and SM Energy (SM) reflect a desire to invest with some of the lowest cost oil producers in the U.S. Similar to SM, XEC’s F&D costs are approximately $13/barrel and ROSE’s cost are closer to $11/barrel. ATW, ESV, and RDC have a substantial portion of their 2015 and 2016 revenues are already under firm contract. Not only do we expect these companies to survive in a lower cost oil-price environment, but also we expect they will be in a position to pick up some good assets from their weaker competitors as they are forced to shed assets to pay down debt. These six energy companies are trading very inexpensively, based on expectations for $85 oil.

In closing, we remain very enthusiastic about our strategy’s future. Our pipeline of potential investments is very robust. For the past couple years, we have expressed our concern about the market’s rich valuations and our desire to allocate your capital only when valuations declined to attractive levels, but

not knowing exactly when that time would arrive. In some ways, it is similar to young child being promised by his or her parent to be taken to Disneyland, but (perhaps cruelly) refusing to state the exact date. We have been going to bed every night hoping the next day was the day for the Magic Kingdom. We have prepared our bags, mapped out the theme park, and negotiated the order of attractions with the rest of the family. We can now hear the garage door being opened. But we need to remain patient and not jump in the car too soon, and risk that the car ride will end up in the wrong zip code.

As long-term investors, our time horizon is at a minimum three years, but more ideally five years and longer. As mentioned earlier in this letter, we are deploying your capital as stock valuations decline to more depressed levels. This is the essence of our deep-value, but patient, investment strategy. When fear is rising, as it is today in the energy and other market sectors, we believe the market offers much better reward-to-risk opportunities for those who can look out farther than the next few of quarters. We thank you for your continued trust and confidence in our strategy.

Respectfully submitted,

Dennis Bryan

Chief Executive Officer and Portfolio Manager

Arik Ahitov

Managing Director and Portfolio Manager

October 16, 2014

FPA Capital Q3 Letter: Small-Cap Valuations Still Troubling