GoodHaven Fund semi-annual report for the period ending May 31, 2015.
Dear Fellow Shareholders of the GoodHaven Fund (the “Fund”):
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