FPA Capital Fund‘s commentary for the fourth quarter 2014.
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FPA Capital Fund: Introduction
What a difference one quarter can make. Until October, the Russell 2000, a good proxy for small-cap stocks, had generated a negative return year-to-date but its fourth-quarter return of nearly 10% quickly changed that result. At the same time, the nine-month return for the Russell 2500, a reasonable benchmark for small mid-cap stocks, was essentially flat through September. However, the index’s strong fourth quarter return resulted in the Russell 2500 producing an approximate 7% return for the year. Thus, the mini correction of small-mid-cap stocks during the middle of the year ended just as quickly as these indices, along with the S&P 500, reached all-time highs during the strong fourth quarter performance.
The FPA Capital fund’s outperformance through the first nine months of the year was reversed in the last quarter as the rapid decline in oil prices negatively impacted the energy investments. While the sudden and precipitous fall in oil prices during the last few months of the year was greater than we would have expected, given that oil demand is still growing, albeit at a lower rate than what we expected at the beginning of the year, this is not the first time we have experienced such a decline in the commodity. We will discuss the energy markets in greater detail in the Portfolio Commentary section, but investors need to remember that small changes in either supply or demand compared to expectations can result in much greater swings in the price of the underlying commodity.
While it is frustrating to see the negative impact that the portfolio’s energy companies had on the overall portfolio, we remain resolute in executing our strategy of buying stocks when their values are depressed and reducing or eliminating stocks when they are richly priced. Moreover, the increased volatility allowed us to add to positions that had been substantially reduced over the past two years.
FPA Capital Fund: Market Commentary
2014 experienced some noteworthy reversals. First, as mentioned above, oil prices plunged roughly 50% in the second half of the year after having traded between roughly $80 a barrel and approximately $105 for West Texas Intermediate (WTI) since September, 2011. Second, while the dollar continued to strengthen against the yen in 2014, it markedly strengthened against the Euro having weakened in 2013. This dollar strength has not been seen since 2006 when the U.S. economy was being fueled by the enormous credit expansion and the widely-reported housing boom.
We believe these seemly independent factors are related to each other because oil prices are denominated in dollars for all global customers. For example, as the dollar strengthens against the yen, oil prices will increase in Japanese terms as they need to exchange more yen for dollars to purchase the commodity. In a well-functioning market, the price of oil will decline to offset the strengthening value of the dollar. If oil prices do not adjust downwards, Japanese demand for oil may recede due to the higher price. All else being equal, lower demand from Japanese and other global customers who are experiencing currency weakness versus the dollar should result in lower oil prices. Thus, it behooves Saudi Aramco and other oil exporters to lower the price of oil during periods of dollar strength in order to maintain global unit demand, and not risk losing market share to alternative energy sources.
We are not presumptuous enough to claim to be global macro-economic experts, but these significant reversals and the speed at which the dollar has strengthened and oil prices have declined portends more volatility in the future. While the initial reaction to lower oil prices and a stronger dollar may be greeted warmly by some, a closer inspection reveals that there are offsets to that analysis.
True, according to AAA, lower crude prices may mean American drivers could save upwards of $75 billion in gasoline outlays in 2015, but there also will be costs to the economy from lower oil prices. For example, according the Oil & Gas Journal, U.S. energy companies spent roughly $338 billion in capital expenditures (Capex) in 2014, with approximately $250 billion of that being spent on exploration and production projects. Recently, several brokerage firms estimated that the U.S. energy industry will cut their 2015 exploration & production budgets by 30% because of lower crude prices. If this forecast is correct, the potential $75 billion in consumer savings would be offset by the possible $75 billion reduction in capex.
This impending $75 billion reduction will impact future shale oil production and could mean nearly 800 land-based drilling rigs, compared to a recent peak of roughly 1,600 land rigs, are abandoned this year along with their crews and other service related personnel. There will be secondary effects as well. In early January, U.S. Steel announced that it will likely close at least one of its tubular steel plants that manufactures drill pipe and that over 600 workers will be laid off. These laid off steel workers, along with the thousands of highly-paid energy workers that likely will be laid off, could put a crimp in the housing recovery – particularly in Texas and Oklahoma where housing demand has been among the strongest in the country.
As we know, oil is pervasive throughout the global economy. Its rapid decline will likely have negative consequences for seemingly unrelated industries. For instance, base metals such as iron ore and copper are and will be negatively impacted by lower oil prices. The reason why is that energy is a sizeable component of the total cost to bring these metals to the market. The lower-cost producers will try to squeeze out the high-cost producers by passing on the savings from lower energy costs to their customers, and profits and employment in those industries, therefore, will be challenged. In addition to copper price declines of nearly 30% over the past few months and roughly 50% from the high set a couple of years ago, nickel and iron ore also are off roughly 50% from their prior peak levels.
These enormous commodity price and currency exchange rate swings could eventually alter current monetary policy at the Federal Reserve (Fed) and European Central Bank (ECB). The conventional wisdom is that Fed is about to tighten monetary policy and will soon raise rates and the ECB is about to embark on its own version of Quantitative Easing (QE). Henceforth, currency traders, macro hedge funds, and speculators behave accordingly. That is they buy dollars, sell Euros, and sell oil. These trades push the dollar higher, the Euro and oil prices lower, reinforcing the traders’ confidence to continue with the strategy. However, these trends cannot continue forever without material consequences.
In summary, we believe the U.S. economy will benefit from lower oil prices, but not quite as much as some might expect. This is because the U.S. energy industry is larger today than the last downturn in 2008-2009 and, thus, more oil & gas projects and workers will be negatively impacted. We also have our doubts about the stronger dollar being a positive for investors. While consumers should see stable or lower import pricing for many goods due to dollar strength, foreign currency translation of overseas profits will likely weigh on corporate earnings over the next few quarters.
Expectations that lower crude prices will stimulate consumer spending may also be premature. For example, the recent Commerce Department’s release of December retail sales shows store sales actually declined in December and November’s sales were revised lower from the initial release’s report. Gasoline prices at the pump reached multi-year lows in late 2014, yet consumers chose to hold on to those “savings” and not to go on a spending spree.
Finally, the dollar’s rapid ascent versus the euro, yen, and other foreign currencies over the past year is becoming worrisome for investors. This is because U.S. GAAP accounting practices require foreign earnings to be translated into dollars at the end of the reporting period. A weaker functional currency vis-a-vis the dollar translates to lower earnings for shareholders. Moreover, rapid changes and high volatility in currencies make it a challenge for businesses to estimate what the return on capital will be for foreign direct investments. This slows the wheels of commerce and inevitably global economic growth.
FPA Capital Fund: Portfolio Commentary
The FPA Capital fund underperformed the benchmark YTD and in fourth quarter 2014. Nearly all of the underperformance was due to the portfolio’s energy investments. Energy stocks accounted for approximately 22% of weighting and roughly a combined 11% underperformance for the year (about 7% for the quarter). Over the past few years, we trimmed nearly every energy stock or eliminated several outright from the portfolio when oil prices were trading above $80 a barrel. For example, we cut the number of Rosetta Resources shares by roughly 77% from the end of 2009 to the end of 2013. However, it is clear that we did not anticipate the free-fall in oil prices that has transpired over the last four-to-five months. Our thesis on the energy stocks in the portfolio has been predicated on oil prices trading at $80-$85 a barrel, which is what many oil experts believe is the global marginal cost of production (MCP).
We did not underwrite our energy investments with a $100/barrel price, or higher, into our analysis. We carefully reviewed many energy reports and talked with energy executives and experts about what is the long-term sustainable price of oil. The answer we generally received is that oil prices, like any other commodity, should converge toward the industry’s marginal cost of production. This MCP concept is a fundamental rule of basic economics. Short-term price swings above and below the marginal cost of production are not infrequent and should be expected. However, large deviations above or below the MCP, similar to the recent decline, are much rarer. Nonetheless, history shows that whatever the factors were that drove the big swings in oil prices above or below the marginal cost of production they eventually abated and oil prices converged back toward the MCP.
This historical pattern and economic logic facilitated our analysis and partly explains why we eliminated or reduced certain of our energy investments in 2013 and the first two-thirds of 2014, when oil prices were above of the industry’s MCP. On the other hand, once oil prices declined below the marginal cost of production, we added to the portfolio’s energy investments that we believe will prosper should oil prices rebound and move back toward its central tendency of the industry’s marginal cost of production. For example, we purchased more Atwood Oceanic (ATW), Rosetta Resources (ROSE), Cimarex Energy (XEC), Ensco (ESV), Rowan Companies (RDC), and SM Energy (SM). We will highlight attributes of two of these holdings.
See full FPA Capital Fund Q4 Commentary below.