2015 was one of the most challenging years we’ve faced as a value-oriented manager. Our investment style, broadly classified under the banner of value investing, was out of favor during the year and suffered almost double-digit underperformance compared to growth investing. The Russell 3000 Value Index was down over 4.0% while the Russell 3000 Growth Index was up over 5.0% in 2015. This bifurcated market was made worse by company-specific setbacks. However, we believe our portfolios are coiled for success. While we were down 6.0% during the year, our portfolios look priced to deliver double-digit percent average annual returns over the next several years.
While our results were weighed down by value weakness in general, a series of non-correlated negative events struck some of our individual holdings. Poorly-timed new investment commitments and missed opportunities to monetize gains didn’t help. Each year brings its own surprises–that’s why investors should build diversified portfolios–however, 2015 brought many challenges together at the same time. Our largest winner (GE, up over 23%) righted some of the wrongs. We weren’t alone in our struggles.
The following are some of the greatest investors in the world, all of whom we deeply respect, and all of whom struggled mightily in 2015:
We do not share this list as if to say, “hey, we weren’t as bad as them.” We take responsibility for our year. We do share the list, rather, because it is informative. The fact that so many of the world’s greatest investors had tough years as a group, compared to a small gain from the S&P 500, should make it apparent that there was a structural challenge for value-oriented, long-term focused, research-driven, business owner type investing.
I am reminded of a day on the golf course with my brother David. He struck a brilliant 5-iron shot, the fruit of his implemented swing changes, a good twenty yards over the green and into a lake. Frustrated, he looked to me for what I think was sympathy. Instead, I stated, “Great shot.” Indignant, he asked if I hadn’t just seen him put it in the water. “Focus on the process. Not the outcome. You just hit a 5-iron twenty yards longer than you ever have. Don’t worry about the outcome on this one attempt. Keep getting the process down and the results will come.” And so, I say the same thing now about our investment approach.
If an investment strategy worked year in and year out it would be pursued by everyone and cease to work as investors bid away its advantage. The fact that value investing doesn’t work every year is the reason it works long-term. The value premium, historically an extra 2.5% per year on average above growth stock returns, still exists and will assert itself again. And so we stick to the process. We can’t promise a certain return in any given month, quarter, year, or even a string of years. We can only promise to deliver a repeatable process that logically should lead (and historically has) to superior long-term performance.
THE CHALLENGES
We manage a relatively concentrated portfolio of individual common stocks–20 at year-end. This number of securities sufficiently reduces the risks of under-diversification while allowing each position to meaningfully impact portfolio performance. We had seven securities that declined more than 10% during 2015. The companies struggled for reasons unrelated, which makes their 2015 clustered occurrences so unusual. We’ll discuss two of our largest detractors in detail and have a few other notable mentions with specifics below. But the point is, we believe last year’s largest detractors will be tomorrow’s biggest winners.
2015’s performance, in our opinion, is transient. There is no doubt that the intrinsic values of some of our businesses have been impacted, but the companies’ stock prices have fallen far more than those business values. Because we intend to own them for the next several years, if not longer, the respective troubles should dissipate and disappear altogether in time. When they do, we expect the securities to return to levels that will still represent double-digit returns from our original commitments.
THE SUCCESSES
First, despite numerous calls for an imminent recession in the United States over the last several years, we noted again last January that “the current economic landscape is favorable to growth.” The U.S. economy did in fact grow in 2015. Today, we are watchful that the industrial weakness in the U.S. economy doesn’t spread into other sectors. Our baseline expectation is that the U.S. economy will expand over the next few years. Though, there is an elevated risk of recession due to the downturn in the oil & gas sector, the strong U.S. dollar, and international weakness. The fact that housing starts, new home sales, and auto sales continue to make new highs gives us some comfort that a more widespread downturn remains unlikely. That bodes well for stocks in general and our portfolio in particular.
Second, we nailed the Federal Reserve rate increase. We stated in January that the September meeting would be the earliest that the Fed would move. We noted in September that we thought the Fed would raise rates in December. At the Federal Reserve’s December meeting, the Fed raised rates for the first time in nearly a decade.
Third, we stated that broad stock markets were priced for low returns and alas, the S&P 500 delivered a paltry 1.4%. We think the stock indexes–and investors in passive index funds–will earn somewhere between 4% and 6% per year on average over the next ten years–a far cry from what our portfolio of individual common stocks is priced to deliver.
We got these big picture themes right.
THE PROMISE
As stated above, we do not promise a certain return in any given month, quarter, year, or string of years. We instead promise to methodically and repeatedly follow a logical process to find good companies at good prices, to research them diligently, and to buy them when we think the chance of losing money long-term is low and the probability of better-than-market returns is high. As golfing great Sam Snead said, “forget your opponents; always play against par.” Likewise, we focus on letting our process work long-term.
We believe our individual company research and security selection will deliver higher long-term returns, net of all fees, than can be achieved by investing passively. We also strive to manage business cycle risk, through both our company research and our proprietary economic research. Combined, we expect to outperform the broad markets by at least a few percent per year, on average, across market cycles. “Across market cycles” is key. A market cycle encompasses an economic boom as well as an economic recession; it contains a bull and a bear market.
Since Black Cypress’s inception in 2009, the S&P 500 has returned over 15% per year. Markets are yet to experience a negative year and there has not been a recession in the U.S. to date. Not only have broad market indices not experienced a material and persistent downturn, growth stocks have outperformed value stocks since 2009. And yet we’ve more than held our own (we’re still ahead of both market indexes and value managers as a group since inception) in an unfavorable environment to our investment approach.
We expect the headwinds to shift, the tide to turn, and better days ahead. If we can generate high market returns in spite of numerous challenges, what might our performance look like when it isn’t an inhospitable environment for value-oriented, risk-aware managers? As they say, “you ain’t seen nothing yet.”
Thank you for your continued trust. May 2016 be a year of blessing for Black Cypress, its clients, and all of our families.
THE SPECIFIC CHALLENGES
Below we discuss company-specific events that detracted from performance during the year. If you’re interested in the ‘why’ of our company-specific struggles, read on.
Currency Hit – FMC Corporation
The largest detractor on the year was FMC Corp (NYSE: FMC). We purchased the stock because (1) its product markets have long-term growth opportunity, (2) it generates solid returns on capital, (3) its then pending and now closed acquisition of lower-margin Cheminova represents substantial margin expansion potential, and (4) it had an apparent inexpensive valuation.
FMC’s stock price peaked at $83 in March of 2014, a year into falling crop prices and on the precipice of farm income declines (prices lead incomes). We first purchased the stock at $50 per share in October of that year, assuming that much of the weakness of lower commodity prices and more normalized farm incomes was priced into the stock.
FMC’s largest segment, Agricultural Solutions, the crown jewel of the company’s portfolio, generates returns on assets approaching 30.0%. About 40% of the segment’s 2014 revenues came from Brazil, the world’s third largest exporter of agricultural products. That exposure is the primary cause of the stock’s decline during our holding period.
Since we purchased FMC, the U.S. Dollar has appreciated 68% against the Brazilian Real. As such, the company’s Brazilian revenues have plummeted in U.S. dollar terms. Aggravated by a globally strong dollar, agriculture prices, and therefore farm incomes, have fallen further. Ag Solution revenues will likely finish 2015 down 20% (pro forma including Cheminova) and probably won’t grow in 2016. The segment’s operating margins have averaged close to 25.0% but are expected to be around 16.0% for full-year 2015.
Between currency woes and volume declines, management guided full-year adjusted earnings per share to be $2.35, down 42% from 2014. We did not foresee a near-70% depreciation in the Brazilian Real during our holding period. That currency miss cost us.
Today, FMC trades for $34 per share, less than 12x our distressed 2016 earnings per share expectation. We believe this deeply undervalues FMC. Investors don’t appear to fully grasp the changes wrought in the company’s repositioning.
Prior to the company’s M&A and divestiture activity over the last year, about 4% to 5% of revenue converted to free cash flow. Based on the repositioning of the firm (exiting the soda ash business, investing further in Ag Solutions with Cheminova) that figure could more than double over the next several years as less capital-intensive, higher margin business remains. Management noted that after investments and debt reduction, up to $10 per share should be available to return to investors–30% of today’s market price–over the next several years. 2016 is likely to be an another difficult year for ag markets and the company, but the long-term is promising. We expect double-digit average annual returns over the next several years.
Massive (Unexpected) Wage Increases – Wal-Mart Stores Inc.
The second worst performing security in our portfolio was Wal-Mart (NYSE: WMT). The stock peaked early in 2015 at over $90 and finished the year down over 28%. We expected the company to earn a little over $5.00 in fiscal year 2015 and $5.20 for fiscal 2016 (period ending 01/31/2016). At a little over 17x forward earnings, Wal-Mart wasn’t cheap, trading above its 16x historical average multiple. But at the same time, the S&P 500 was trading for 20x peak earnings, well above its own long-term average. By our estimates, Wal-Mart still offered better long-term returns than the broad stock market, bonds, and cash. Then management threw a wrench in the works.
In February, Wal-Mart management announced a new $1.2 billion investment in wages. Instead of earnings growing in the year ahead, the new investments would push earnings down into a range of $4.70 to $5.05 per share. In October, management announced an incremental $1.5 billion of wage investments for FY17. FY17 earnings were guided down 6% to 12% from FY16. After two years of new investments and a strong U.S. dollar, FY17 earnings are likely to fall between $4.00 and $4.30 per share.
Management permanently reset earning levels with its $2.7 billion investment in wage increases. Earnings may not return to peak levels until 2020. And we, and most of Wall Street, didn’t see such a shift in management to increase wages.
Management laid out its multi-year plan in October 2015. FY17 should be the earnings trough–barring a recession or geopolitical shock–and earnings per share should be growing at a 5% to 10% clip by FY19. With that in mind, we think Wal-Mart will be back above $80 per share by 2019, pay increasing dividends over that timeframe, and buy back at least $25 billion worth of stock (over 12% of today’s market cap). That should translate into average annual total returns of at least 9.0% per year from today.
Poorly-Timed New Investment Commitments – The Gap and WESCO International
We entered the month of August 2015 with nearly 15% cash, waiting patiently for good ideas to present themselves. The market declined rapidly in August, pushing the S&P 500 down over 12% from its high. On August 24, the day before the market low of 2015, we took the opportunity to increase our exposure to a few existing positions and added four new commitments. Two of our new ideas, The Gap (NYSE: GPS) and WESCO International (NYSE: WCC) have since declined over 20%. Admittedly, it was a poor use of that cash to date.
The reason we purchased the Gap is straightforward. The company, still an iconic brand in our opinion, lost its way over the last couple of years, missing fashion trends with poor fit and silhouette, which was compounded by the fact that the company operated too many stores in the internet age. Its stock topped out in the mid-$40s and fell to $31 per share in August. Just two months earlier, CEO Art Peck announced the closure of 175 Gap stores located in its least promising locations. The company acknowledged its fashion missteps and has a new product line that intends to be on-brand, “casual, opportunistic, and American,” hitting stores throughout 2016. The company has also made substantial investments in e-commence and speed to market that should make it more competitive and improve inventory management and ultimately margins. Management has maneuvered aggressively to address the company’s problems and evidence of success should start to show up this year. Athleta, Gap’s high-end women’s active wear brand (Lululemon quality at better prices), was acquired in 2008 and could become a dominant force in its own right. In the meantime, the company trades for just 10x depressed earnings, yields 4.0%, and has a 10% free cash flow yield to plow into stock repurchases.
WESCO International is a wholesale distributor of industrial-related parts and services. It operates through 485 branches and 9 distribution centers. Its revenues are likely to be down for the second year in 2016, perhaps by as much as mid-to-high single digits, as the company feels the effects of the oil & gas-driven worldwide industrial slow down. We purchased WESCO for a variety of reasons. The company, in our opinion, represents a lower-risk bet on an oil & gas recovery. It has just 7% direct exposure to the industry (10% direct O&G sales in 2014 down 30% in 2015) but is leveraged to a snapback through the knock-on effects that oil & gas has on the broader industrial complex. 2016 pre-tax profits are likely going to be down 30% from 2014; the stock is down over 50%. Management, helmed by John Engel, continues to improve the company’s mid-cycle margins (down-cycle operating margins bottomed at 2.3% in 2002, 3.9% in 2008, and should remain around 4.8% in this cycle). We think earnings are back above $5 per share in 2018 and the stock above $70, a double from today’s price. Yet, the market continues to punish the name as commodity prices have shown little signs of bottoming. Despite what we feel is an unduly punished name with high long-term expected returns, we can only surmise the market is unhappy for two reasons. First, WESCO’s end markets are still contracting. Second, the company’s leverage ratio is already above the company’s preferred target of 2.0x to 3.5x EBTIDA, which may limit the buyback and significantly decreases the likelihood of a transformative acquisition. We concede these points. We think the oil & gas sector will bottom this year or next and growth will resume. The stock is too cheap to ignore for investors with a multi-year time horizon. We purchased the stock too soon but expect to still make a solid return from original purchase and certainly from today’s price.
Missed Opportunity to Monetize Gains – Baker Hughes
We first bought Baker Hughes in late 2012 for $40 per share. There were a couple opportunities to liquidate our holding at substantial gain that we did not capitalize on. Like nearly everyone, we didn’t expect oil prices to crater 70%. Oil prices had already declined 30% by October 2014 and with it, Baker Hughes. We added to our stake in the low-$50s. Then Halliburton offered to buy the company and each share of Baker Hughes for 1.12 shares of itself plus $19 per share in cash. We thought Baker Hughes was a buy at $52 per share and so must have Halliburton. We made 23% on our new additions to Baker Hughes and now had substantial short-term capital gains. The companies expected the acquisition to close in the second half of 2015, which would have theoretically meant that if we held our positioning, the short-term gain would have had the chance to transition to long-term treatment. Plus, the acquisition spread still implied additional upside. Halliburton stock appeared inexpensive, so owning the combined and much stronger company after the deal closed seemed to make sense. Then the bottom dropped out from under oil and gas prices. Also, the deal has hit regulatory scrutiny and risks being blocked. Baker Hughes has round tripped to our original purchase price of $40 and the deal is now less valuable than on the day it was announced due to Halliburton’s 50% decline to $29 per share (1.12 x $29 + $19 = $51.5).
We take away three lessons from this ordeal. The first is that the anti-trust risk was far higher than estimated and needed to be better assessed. Halliburton and Baker Hughes are the #2 and #3 operators in the oil & gas servicing industry and we should have expected that regulatory bodies would push back. Both companies continue to insist the deal is good for the industry–we are inclined to agree–and the $3.5 billion break-up fee that Halliburton will pay if the deal fails due to regulatory impendent gave us confidence that the two management teams had properly assessed the deal’s chance.
The second is that acquisitions financed with stock can be unwound quickly if the acquirer’s price declines. This point is of course obvious and wasn’t overlooked, but wasn’t weighed heavily enough. Halliburton is down 50% since it offered to buy Baker Hughes. Our October 2014 purchases are down 25%.
Finally, we let taxation cloud our judgment. We could have liquidated the stock owned with long-term gains but didn’t because we overly focused on short-term tax exposure. Thinking through the tax implications of selling with a short-term gain, which is always the right thing to do because we want to create the highest take-home returns, caused us to overweigh the benefits of holding until the deal closed. This decision was a mistake in hindsight. The reasons we purchased Baker Hughes in 2012 still exist today. Plus, there is a chance, albeit a lower probability than originally thought, that the deal with Halliburton might still close.
