GoodHaven Fund semi-annual report for the period ending May 31, 2015.
Dear Fellow Shareholders of the GoodHaven Fund (the “Fund”):
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The business of money-management can be a rewarding, but unforgiving profession. Even when portfolio managers have a pedigree of performance and sensible behavior, most investors are entranced by looking in the rear-view mirror, assuming that the foreseeable future will resemble the immediate past. This sort of thinking (a bias toward overweighting of recent events) is not only common but is typically destructive to long-term investment returns.
Despite long careers in the investment management business, our tenure as founders at GoodHaven recently passed four years and can be roughly described as a tale of two time periods. From inception through May 31, 2014 (one year ago) and despite sizable cash inflows, we generated a double-digit annual rate of return (13.43%) that slightly lagged the S&P’s annual return (14.95%), beat the Russell 2000’s annual return (11.52%), and far exceeded the annualized returns of the HFRI Fundamental Growth Hedge Fund Index (1.35%), the HFRI Fundamental Value Hedge Fund Index (6.52%), and the CS Hedged Fund Index (4.45%). By almost any standard, these results showed attractive risk-adjusted performance during a period when “safe” investments, such as short-term government bonds, yielded almost nothing. Our investors were happy, cash inflows were strong, we were showered with compliments, and all was right with the world.
The last twelve to eighteen months have been a different story. We underperformed large cap equity indexes by a sizeable margin and had negative absolute returns last year for a variety of reasons – most discussed at length in our Annual Report of November 2014. As equity indexes climbed higher, momentumdriven investors turned their backs and our reputation flagged. We never like going through such periods but recognize they are inevitable, have experienced them before, and know they are not a reason to become despondent. Following a weak three months after the end of the fiscal year, it appears that February marked our recent low point – since then we have begun to regain some absolute and relative ground.
In both periods, we have been the same motivated and experienced investors, with the same philosophy, pursuing the same sensible strategies since founding GoodHaven. There is one small difference – both of your portfolio managers bought additional shares of GoodHaven Fund in the last year and we are among GoodHaven Fund’s largest individual shareholders. We remain confident in our ability to invest profitably over time and for the long-term. More importantly, we are convinced that our largest current investments are worth far more than recent trading prices.
In 1986, V. Eugene Shahan wrote an article in the magazine of the Columbia Business School titled, “Are Short-Term Performance and Value Investing Mutually Exclusive? The Hare and The Tortoise Revisited.” The piece analyzed the records of several outstanding investors that had been highlighted by Warren Buffett in an earlier article extolling the Graham and Dodd value investing philosophy.2 All of the investors cited had handily outperformed equity indexes over an extended period of time – some for decades. However, the article was quick to point out that these investors did not beat their benchmarks all the time – far from it. This wonderful group of investors, who had exceeded market indexes by a large margin over a couple of decades, underperformed benchmarks roughly one-third of the time. On average, one year in three was a relative dud!
Investing in concentrated portfolios means accepting a certain amount of volatility – with the goal that sensible security selection will lead to good long-term average returns. However, being a disciplined concentrated investor means being prepared for volatility. It is easy – and pleasurable – to enjoy periods when a concentrated portfolio outperforms. However, investors need to also mentally withstand periods when such a portfolio is out of sync with indexes and understand that such periods are a feature, not a flaw, of value investing. We have just been through such a period and believe that the worst is over. In the last few months, relative performance has been improving and we are positioned conservatively in a market that is expensive by historic standards of valuation.
GoodHaven Fund – Portfolio holdings
As of the writing of this letter, our largest investments are WPX Energy, Walter Investment Management, Hewlett-Packard, and Barrick Gold, followed by significant positions in Google, Dundee, Staples, and White Mountains. As a group, these companies look almost nothing like the S&P 500 and our fellow investors should expect divergences – both positive and negative – particularly when viewed over short time periods. We continue to believe that our aggregate portfolio appears significantly cheaper than the broad market as measured by price-to-earnings multiples and discounts to reasonably calculated net asset values. For example, if we divide our portfolio into two buckets – one measured by earnings and cash flows metrics and the other by asset appraisals or net asset values, we find that the first bucket’s forward price-to-earnings multiple is approximately 12.5 times based on FY 2016 estimated earnings compared to that of the S&P 500 at 17.7 times, while the second bucket appears to sell at about a 40% discount to our estimate of intrinsic value (on average).
Set forth below are descriptions of our major holdings as of May 31. We caution that existing investments may be sold and new positions may be acquired that are significant since the end of the semi-annual period, the writing of this letter, or prior to a subsequent filing or shareholder report.
Energy equities account for about 15% of our current portfolio, with our largest investments inWPX Energy and Birchcliff Energy. Both are primarily producers and owners of natural gas, although WPX has been rapidly growing its oil production, primarily in the Williston and San Juan basins. Birchcliff is a Canadian company that has approximately doubled production and reserves in the last four years, operating primarily in the Montney formation in western Alberta.
U.S. Industrial natural gas consumption has grown steadily since 2009 as the shale gas revolution has led to displacement of coal in electrical power generation as well as the new construction or relocation of energy intensive facilities (such as those making certain chemical precursors) to the United States. Utilities shut 4,100 megawatts of coal-fired generating capacity in 2014 and are on track to close an additional 12,800 megawatts in 2015. Most will be replaced by cost-competitive gas-fired generators. Switching to gas from coal benefits utilities by nearly eliminating sulfur dioxide, nitrogen oxide, and mercury emissions. Also benefitting demand is the developing market for natural gas exports.
While gas supplies have grown dramatically in recent years, the Energy Information Administration (EIA) forecasts that consumption of natural gas will average roughly 25% higher in 2016 compared to 2009. However, a material amount of natural gas is also produced as a by-product to the drilling and production of shale oil wells. The count of active drilling rigs has collapsed in half as the price of oil declined from $100 to roughly $40 early this year before rebounding to about $60 per barrel presently (notably, natural gas prices did not fall as much). We believe the decline in drilling over the last six months should slow the growth of new oil and gas supply and improve the supply-demand equation with industrial demand continuing to grow. Natural gas prices are also weather dependent, so root for hot summers and cold winters.
As for oil, last fall’s crash in prices led to a sharp contraction in drilling of oil shale formations with the number of working rigs declining by 50%. However, what many have overlooked is that the highly inflated cost structures that prevailed at $100 per barrel have collapsed. To paraphrase the words of one long-time oil driller, $65 oil may be nearly as profitable as $90 oil was a year ago. This entrepreneur further related that the most money he ever made on developing properties was after the oil price crash in 1986. When developments are still economic at low prices and when they have a reasonable lifetime of cumulative production, they tend to be more rewarding than most expect at the time of development given the optionality of a higher price at some point in the future.
Low cost conventional supplies of oil are in decline. Many alternate sources of oil are high-cost. Politics in the Middle East – the source of about 1/3 of the world’s oil supply – are much worse – and more dangerous – than they were a decade ago. Although the Saudis have pushed oil down in the short term by raising production, we anticipate that domestic supplies of oil and gas will remain an important portion of our energy needs, even as renewables grow. At present, this is an industry in retreat, with many stock prices weaker than the more ebullient parts of the market. That usually spells opportunity. We continue to search the energy bargain bin for possible debt and equity investments.
GoodHaven Fund – WPX Energy
Our largest investment in energy is WPX. In hindsight, the timing of our initial purchases was far from optimal given the rapid decline of oil prices last fall (which contributed to our weaker performance last year). However, we bought most of our investment shortly after a new CEO was appointed that we believed would be able to galvanize a sleepy and inefficient company with a large and valuable asset base and put the company on a multi-year path of growth. At the time, we thought the assets of WPX were worth far more than the market was indicating. So far, we have seen nothing to challenge these assessments of management’s skills and company resources.
Since taking over at WPX, CEO Rick Muncrief has done a superb job controlling what is controllable over the last 12 months. He has refinanced debt, reworked a $1.5 billion credit line (largely unused), sold non-core assets for roughly $800 million, consolidated and reduced office overhead, and sharply cut the cost of drilling a well. Industry costs are coming down fast and, despite lower oil prices, near term cash flows are well protected. The company has large and valuable assets in attractive basins. Natural gas remains about 70% of reserves, although oil reserves and production are growing in importance. Based on comparable transactions, we believe WPX is capable of significant growth and today appears to be worth double its current stock market price.
GoodHaven Fund – Birchcliff Energy
In addition, GoodHaven Fund owns a stake in Birchcliff Energy, a growing producer of natural gas in Canada that is roughly 26% owned by Canadian business magnate Seymour Schulich, a founder of the original Franco-Nevada Royalty Trust and a past Chairman of Newmont Mining’s Merchant Banking division. Birchcliff owns a significant stake in the gas-rich Montney formation in Alberta. As mentioned in our November 2014 Annual Report, in early 2012, Birchcliff was nearly acquired for approximately $15.007 per share, however the deal fell through during a time when Canada was questioning foreign purchasers of Canadian assets. At the time, the company was producing approximately 20,000 barrels of oil per day equivalent (boe) and now produces nearly twice as much. Following the collapse of the transaction and a weaker gas price, the stock fell to about $5.85 where we made our initial purchases.
Subsequently, the stock has traded as high as nearly $13.80 before falling back to about $6.00 again during the latest energy panic. In the last few months, we have seen significant unrealized gains evaporate as all energy-related assets were rapidly thrown away by investors and traders spooked by a rapid decline in oil prices.
Birchcliff has the resources and operating skills to continue to grow production and reserves for the foreseeable future. In addition, the company owns most of its gas processing facilities, giving it one of the lowest cost structures in the western Canadian gas industry. As the company continues to gain heft, we expect it to become more attractive as an acquisition candidate, with a large owner that is rational and likely to be a willing seller at the right price.
The primary risks in Birchcliff are a prolonged period of unexpectedly low natural gas prices, political changes taking place in the energy ministry of Alberta that could change the royalty regime, competition for eastern Canadian markets from low-cost natural gas production in the Marcellus and Utica shale formations in the eastern United States, and a lack of capacity to move Canadian gas south or west for export (although the latter should be partly addressed by the enormous proposed export pipeline and facility in the works by Petronas, the national energy company of Malaysia). However, given the company’s low cost structure, we believe they can tolerate adverse conditions better than most.
GoodHaven Fund – Walter Investment Management
Over the last two years, Walter Investment Management has been through a period of adjustment as compliance rules changed dramatically in the mortgage business. As a reminder, Walter is one of the three large servicers of credit-sensitive mortgages (as well as a significant mortgage originator). When we first bought shares of Walter, the company was servicing about $40 billion of mortgages. Today, the company services about $250 billion of mortgages, originates both forward and reverse mortgages, and has a small business managing credit assets for others. Despite this significant growth, the stock price has retreated sharply from its highs of two years ago as the company was required to revamp processes and procedures in response to tighter regulation. However, the stock price has gained roughly 40% since November 30, 2014.
Additional regulation is a double-edged sword. On the one hand, there is no question that Walter’s short-term costs increased in order to adjust procedures, reprogram systems, retrain workers, and generally comply with new regulations. Many of these costs are now starting to decline. On the other hand, the increased industry scrutiny has created a significant barrier to entry and is rewarding servicers and originators with scale. Smaller companies just can’t absorb increased overhead and potential regulatory penalties that threaten their businesses. This should lead to significant industry consolidation. Notwithstanding Walter’s recent CFPB settlement, our research suggests that the company’s reputation for compliance within its industry is very strong.
In the last few months, Walter settled its CFPB investigation for amounts already accrued, sold non-core assets for roughly $200 million, and announced its first stock repurchase authorization. We believe the company is also raising money for its affiliated capital entity, WCO, which offers the potential of significantly increased cash flow to Walter as well as the freeing up of balance sheet assets. A return of private label mortgage securities issuance (which seems to be in the early stages) is likely to result in much higher servicing fees to the company. We continue to believe Walter generates significant cash earnings and that the company’s intrinsic value is well above the market capitalization implied by its current stock price.
GoodHaven Fund – Hewlett-Packard
In December and January, we sold roughly half of our large investment in Hewlett-Packard, having more than doubled our average investment. At the time, given the price (over $40 per share), and despite believing that there was still further potential for appreciation, we believed that an outsized position was no longer warranted given the stock’s rise and some new headwinds from a much stronger U.S. dollar (HP gets about 65% of its revenue from outside the United States). In hindsight, and given some renewed softness in personal computer sales, that decision looks particularly appropriate.
However, we did not expect HP’s stock price to decline by more than 20% since our sale late last year. HP still generates significant free cash flows, its end markets are still large and somewhat stable, and we believe splitting up of the company into an enterprise facing business and a personal computer and printer business should result in significant value creation for shareholders. Over the last two or three years we have extensively discussed HP’s business prospects and our rationale for making HP a significant investment. As we write, the company’s stock is still one of the least expensive securities in the S&P 500 based on recurring and significant free cash flows. While waiting for the split in October 2015, the company continues to pay a meaningful dividend and repurchase shares at prices that are anti-dilutive to earnings.
GoodHaven Fund – Barrick Gold
Barrick Gold continues its transformation under new Chairman of the Board John Thornton. Thornton is known for helping to build much of Goldman Sachs’ international business in recent decades, is very close to the leadership of China, and by self-description, is not a gold bug. He is instilling new capital discipline, selling non-core assets, properly aligning compensation incentives, and creating financial alliances that should benefit future performance – all sensible policies designed to create and foster long-term shareholder value.
Barrick continues to have some of the richest reserves and one of the lowest cost structures in the industry – it is a world class collection of mining assets. That said, Barrick’s prospects are still tied to the price of gold and other metals, which have been under significant pressure for the last three years, with gold falling from nearly $1900 per ounce to less than $1200 per ounce over that time frame.
Although Thornton is taking steps to reduce debt, the company still has too much of it – more than $12 billion – and we think that is creating the opportunity. Although little is due in the next few years and most of its obligations are long-dated and lowcost maturities, the debt load has constrained the company. To date, Barrick has already announced assets sales of approximately $800 million to reduce debt and expects to reduce it by another $2.2 billion prior to year-end. Offsetting this debt is about $2 billion in cash and significant cash flow, even at relatively low metals prices.
We think about Barrick as a long-dated and inexpensive warrant on the price of gold, an especially non-correlated asset when compared to the large capitalization equity indexes. In a different sense, Barrick also represents a sensibly-managed put option on confidence in central bankers and their programs to flood the world with newly created money and credit – actions that throughout history have usually resulted in an eventual depreciation of fiat currency, sometimes modest, sometimes more disruptive. Although we have no assurance that gold prices will act as we might expect under inflationary conditions or currency upset, it would be imprudent to ignore those risks given the magnitude of central bank interventions.
Three years ago, with gold at $1900 per ounce, Barrick earned more than $3.75 per share and sold for more than $50 per share. Not long ago, John Thornton and other insiders bought millions of dollars of stock in the open market at about $12 per share – higher than recent quotes. We judge that the potential benefit of having a hedge against long-term currency upset is worth the risks that higher leverage and a commodity business bring to the table – especially given the large and rich nature of the company’s world-class mining assets.
GoodHaven Fund – Dundee Corporation
Dundee Corporation was built by highly successful Canadian entrepreneur Ned Goodman and is now run by his son, David Goodman, who previously ran the successful Dundee Wealth affiliate (Ned remains a senior consultant and board member; he also recently increased his stock ownership). Dundee had previously built one of the biggest mutual fund and investment businesses in Canada that was sold to Bank of Nova Scotia for a big price a few years ago. Flush with cash, the family set about rebuilding a valuable set of assets, including a growing alternative investment management business.
In Dundee, we are reminded of our past experiences with Leucadia National, a business that has created enormous shareholder wealth over many years by assembling a disparate, complicated, and valuable collection of businesses and investments. Today, Dundee has stakes in the investment world, in agriculture, in organic proteins, energy, real estate, and precious metals. In the aggregate, we believe that the company’s assets are worth more than C$20 per share while the stock recently sold at around C$11.11 Over time, we expect David and Ned to continue to add value, find ways to grow the business, and close the gap between the stock price and intrinsic value.
GoodHaven Fund – Google
After more than doubling from our initial purchase cost shortly after we started GoodHaven, Google’s stock price has been moving sideways for some time, despite continued growth in revenues and cash flows. Today, many are concerned that Google’s growth is slowing and that it has become a distracted company, with fanciful efforts far from its core business of search.
Certainly, there is some risk in search as a chunk of the market migrates to mobile and as Apple, Facebook, and Amazon continue to develop their own search capabilities. However, we believe these concerns are generally overstated – Google remains a search giant, with market shares and algorithms that are the envy of the industry. Moreover, we think the company’s disciplined efforts to reinvent itself and reinvest cash flows in projects with ultimately huge potential are an enormous long-term positive for investors. Recently the company hired a new CFO with a sterling reputation and a keen sense of shareholder value.
We sold some shares of Google over a year ago as the company’s stock price exceeded $600 per share (post-split), however the company’s continued growth in the last couple of years means that today’s price at about $550 is not as expensive. With about $94 of cash per share and selling at about 19 times projected net profits (16 times less cash), Google looks undervalued. Few businesses have ever achieved similar dominance in their core business, and even fewer have created the optionality to participate in multiple large and growing businesses. At a price, we would be happy to increase our stake.
Staples is a company in transition. Its online business continues to slowly grow as its brick and mortar business shrinks. Presently, the company is attempting a merger with its direct rival, Office Depot. If consummated (there are significant antitrust considerations in one segment of the business), we believe Staples would be worth far more than its recent stock price would indicate. Without the merger, the company would still generate significant cash and would almost certainly continue to gain share from Office Depot. Although there is some temporary price risk to Staples stock should the merger not proceed, we think the company will retain its present share and begin to grow – albeit slowly, as store closings slow and online efforts gain traction (Staples is still one of the largest e-commerce companies in the world with immense logistical assets).
GoodHaven Fund – White Mountains
White Mountains stock price has risen since our initial purchases, which were made at a large discount to tangible book value. With sensible and cautious management, WTM has kept its bond durations short – hurting recent income statements but protecting the balance sheet. Although the reinsurance business has become more competitive, WTM retains significant optionality in its strong balance sheet, municipal insurance business, and other lines. Its management is pre-disposed to behave rationally, having bought back nearly one-third of outstanding shares at a large discount to book value during the financial crisis and increasing value sharply for remaining owners on a per-share basis.
The current environment continues to present challenges for value investors. Traditional measures of aggregate equity valuation are at or near record highs. Many of these measures are correlated with poor future returns over a decade sort of time frame – similar to the period of the tech bubble that ended in March of 2000.13 In the ensuing decade, the large equity indexes gave shareholders a de minimus return while active value-investing managers generally performed well.
Warren Buffett is fond of saying that investors should be greedy when most are fearful and fearful when most are greedy. Today’s equity index valuations demand some measure of fear and require discipline in selecting new investments. It has been roughly three or four years – since October of 2011, that we have seen a 5% decline in the broader equity averages – an extraordinary period without substantial volatility. Lack of downside and historically low interest rates have emboldened investors and caused fear to recede to a dim corner of the room. Looking in the rearview mirror, investors have little reason for concern. But risk is where you are going, not where you have been.
GoodHaven Fund – Accelerating rush into equity index products
In recent years, there has been an accelerating rush into equity index products – with much of the capital coming out of actively managed funds.14 To some extent, these waves of indexation are self-fulfilling as large capital flows beget buying in the same smaller list of securities, which then begets temporary strong performance, which leads to additional inflows – and for a time – a seemingly perpetual profit machine. However, if there was an optimum time to have money mimic an equity index, it was in the depths of the 2008-2009 crisis – not nearly seven years later after indexes have roughly tripled in price.
From late 1998 through early 2000, “experts” preached that the tech age rendered traditional business valuation metrics obsolete – what counted were eyeballs rather than cash flows or valued assets. The steady rise of index valuations is again causing investors to ignore extremes. We believe it makes more sense today for investors to stick with investments or managers not well-correlated to large equity indexes, but where concentrations and mean reversions hold out the prospect for performance that is different – and hopefully better – than indexes over the next several years. Should speculation and valuation metrics in equity markets continue to increase at a rapid rate, we are likely to see GoodHaven Fund’s liquidity grow. We are more concerned with seeking to avoid large losses than keeping up with the Dow Joneses.
In one of our first letters to shareholders, we wrote that the financial crisis was a debt crisis – and that the logical solution to too much debt could not possibly be large amounts of additional debt. However, since then, most categories of debt have grown significantly. Businesses are adding leverage at a record pace. Total corporate debt looks to have grown from about $4.5 trillion in 2007 and is now nearly $8 trillion. Sovereign debts continue to mount rapidly and eventually are going to create problems in markets – as we see with the current pre-occupation of sizeable debt on top of tiny Greece. Growth in debt has been facilitated, if not encouraged, by the willingness of central banks to suppress interest rates for an extended time.
These enormous corporate and sovereign obligations would seem to argue for future inflation or currency depreciation – how else do these debts get resolved? It has been 108 months since the Federal Reserve increased rates by even one-quarter of 1%. Expect higher rates in future years and higher costs to service debts going forward as eventually markets may move with or without the Fed’s blessing. Today, there may be high risk in certain leveraged bond strategies and bond ETFs where trading activity in the ETF’s shares vastly exceeds the ability of the ETFs to transact in the underlying bonds. The alternatives are further mis-allocations of capital that should meaningfully lower corporate profit margins and affect markets in ways that today may not be well understood.
In recent months, we have slowly been regaining some lost ground, though our progress has been somewhat masked by currency weakness outside of the United States (about 20% of our portfolio is denominated in a currency that is not the U.S. dollar). Over that time frame, we have seen several positive and significant business developments in our largest holdings that do not appear adequately reflected in their underlying stock prices. We have the liquidity to behave opportunistically and we do not own any obviously overpriced securities, many of which have sizeable weights in major equity indexes.
We understand the difficulty of staying the course with a GoodHaven Fund that has recently underperformed – something we have seen in our careers on more than one occasion over many successful years – and thank you for your patience. We believe our portfolio is conservative, has significant potential for profit, and is not impaired. GoodHaven Fund has enough liquidity to behave opportunistically and we continue to search diligently for sensible new investments – but will not part with hard-earned capital simply because there is pressure to invest as indexes rise. We are among GoodHaven Fund’s largest individual shareholders and nobody is working harder to regain both reputation and profits, while at the same time attempting to avoid outsized risks.