FPA Capital Fund webcast audio, transcript And slides for the fourth quarter ended December 31, 2015.
FPA Capital Fund 4Q15 Webcast Audio
FPA Capital Fund 4Q15 Webcast Transcript
Arik Ahitov: Before we start, let me go over our strategy very briefly. We are a long-only absolute value fund that is benchmark-agnostic. We look for market-leading companies with a history of profitability, strong balance sheets, and good management teams. Once we identify and research these companies, we buy when there is a compelling risk/reward. The resulting portfolio tends to be concentrated. As many of you know, our FPA Capital Fund has been closed the majority of its life, and both Dennis and I are large shareholders alongside you.
Our performance has been very weak since the fourth quarter of 2014. The cumulative effect of these four or five quarters shows itself as very weak three-, five-, and ten-year numbers. As we mentioned before, these multiyear performance numbers are very endpoint-dependent and we believe can improve substantially as quickly as it deteriorated. As disappointed as we are with our result in the past five quarters, we are very optimistic about our portfolio prospectively.
There are a few reasons why we are confident about the future. First of all, this is not the first time our portfolio has underperformed to this extent. In both prior occasions, our performance during the ensuing time periods have allowed us to not only make for lost ground but also surpass the performance of our benchmark once again. We do not believe that it should be any different this time around. Our process has not changed over the past 30 years. Our portfolio is filled with strong but cheap companies. In addition, the FPA Capital Fund has ample liquidity, with almost 20% cash, to take advantage of this volatile time for the stock market. We’ve already started to deploy capital during these turbulent times and our cash level has decreased as the market weakened.
Our stocks have already taken major hits. Both the energy and education sectors have underperformed our benchmark significantly. For instance, 2015 marked the fifth straight year the all service sector has underperformed the Russell 2500, but there have been many periods where the opposite was true. Later in the presentation, we will go through why we believe energy should do well over the long term for our shareholders.
The most important reason why we are very optimistic about the future is the makeup of our portfolio. Our portfolio is very cheap today. Our holdings trade at a significant discount both in price-to-earnings and price-to-book terms versus our benchmark. Our portfolio companies in aggregate are both very profitable and have strong balance sheets. Keep in mind that our price-to-earnings ratio is based on current earnings, which are really depressed for a meaningful part of our portfolio. All our cyclical names, especially our investments in energy, are currently generating significantly lower earnings than their normalized earning powers. A price-to-earnings ratio calculated based on normalized earnings would depict even a stronger advantage versus the indices.
Our portfolio remains very concentrated. A little over half the portfolio is in technology and in energy. These two sectors are followed by about 11% education and 8% in industrials. Cash is a residual of all investment ideas, and it stood at 19% at the end of 2015.
We have been very active in the fourth quarter. We initiated two new positions. Mifflin is a leading provider of K to 12 instructional materials for the classroom. Ninety percent of the market is controlled by only three companies. Mifflin has over 40% market share in the top disciplines of math, reading, and science. There are significant barriers to entry in this business. It takes a lot of time to prove that your curriculum works and then convince state and school districts to adopt it.
Sanderson Farms is one of the largest chicken processors in the United States. Chicken has several advantages over competing proteins. It is healthier than beef and pork, and it requires less feed. We had a chance to invest because of recent export bans caused by avian influenza.
Our third new investment in the quarter was a high-yield bond. It is the first high-yield bond in our portfolio in a long time. As you might recall, we owned the equity of Atwood in the past. Atwood is an offshore driller. We bought their 2020 maturity bonds in December at about 25% yield-to-worst. Atwood’s fleet is young and high spec. The replacement cost of their asset is $4.8 billion compared with $1.7 billion of total debt. The stock is trading at 10% of its tangible book value, less than one time of its last 12-month earnings, and about four times next year’s EBITDA. The company has a long-term track record of industry-leading margins and performance.
We eliminated two positions in the fourth quarter. We sold out of BWX Technologies due to valuation. You might recall that we bought Babcock & Wilcox in late 2014. The company split into two in July 2015. We kept and increased our position in Babcock Enterprises and sold out of BWX Technologies.
The second position we eliminated was Federated Investors. We initiated our Federated position in August 2011 when it was the most shorted asset manager in the United States. We more than doubled our money with this investment and had an IRR of almost 25% over a four year period.
Let me talk about our worst two performers. Apollo Education Group was our worst performing stock in 2015. We have spoken and written about Apollo many times in the past, so I will not go into detail on their business model. If you’re not familiar with the company, please refer to our most recent investment letter and also our older letters.
The big development on Apollo’s case is the market rumors that there’s a suitor for the company. The rumored price is about 50% higher than today’s price, but we communicated the inadequacy of this price both with call to the management team and a letter to the board. We continue to believe that Apollo is worth over $30 a share, and you can see our sum-of-the-parts analysis in this slide. If the company is indeed sold for $1 billion, the management team will be selling out the business at less than 1.5 times enterprise value to EBITDA. To put that 1.5 times number in perspective, over the last 15 years, private equity firms have paid an average multiple of almost nine times. Apollo’s that are listed on their own proxy are trading at nine times on average. Today over 80% of the company’s market cap is in cash, and the stock is trading at less than one time current and forward EBITDA.
Our second worst performing stock was Western Digital. We have owned Western Digital for a long time, and this stock has been a very strong contributor to our performance for many years. We’ve decreased our share count by over 90% since 2011.With the recent weakness, we started buying Western Digital shares again. You might recall that Western Digital is a storage company. They are known for hard disk drives where they have 45% market share. During the last several years, the hard disk drive industry has consolidated substantially, and the top three companies now control 100% of the market. Management team has done a superb job of returning the firm’s strong and consistent free cash flow to shareholders with both buybacks and dividends.
Western Digital recently made a serious of somewhat gamechanging announcements, which on the whole we consider to be a positive. They announced close to a $4-billion equity investment from a Chinese firm called Unisplendour; received approval to fully integrate their Chinese asset we believe which… this could add moire than $1.50 to earnings; announced a deal to acquire SanDisk, propelling Western Digital into a leadership position in solid state drives. Despite these positive developments, the stock price has come down substantially. You can see our pro forma model based on successful combination with SanDisk here on this slide. The upside-to-downside ratio is very high. Therefore Western Digital is once again a very large position for us. To put it in perspective, the company’s trading at three times current and forward EBITDA, with a 15% free cash flow yield.
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