GoodHaven Fund annual report for the year ended December 31st, 2015.
Dear Fellow Shareholders of the GoodHaven Fund (the “Fund”):
In our decades of experience managing money, 2015 was one of the most difficult years. While it was a very tough year for many well-known “value” investors, we are chagrined by our performance and understand that the last eighteen months have caused a loss of goodwill in the eyes of our shareholders after a solid first three years (and decades of experience at prior firms). In many ways, it was a “perfect storm” with outlier percentage declines in certain commodities and extraordinary strength in the U.S. dollar. That said, we believe that most of the potential damage is in the rear-view mirror and that the GoodHaven Fund’s aggregate portfolio is not impaired. We believe we own securities trading at valuations that are far below those of broad equity indexes (as indicated by common valuation metrics discussed below) and have the liquidity to behave opportunistically.
While we explain in this letter why this past year was so difficult, the more important question is where we stand prospectively. Please read further and try to look objectively at why we believe the GoodHaven Fund has an opportunity for much better results. We are optimistic – not just because we think we own cheap securities and certainly not because we have a Panglossian world view, but because in a world of uncertainty, we can point to a number of concrete factors, such as corporate developments, valuation metrics, sensible corporate share repurchases, and insider trading activity, all of which suggest that our portfolio today is far cheaper than broad market indexes. Both of your portfolio managers maintain a significant investment in the GoodHaven Fund, and both have added to our holdings in recent weeks.
A number of our companies made significant business progress in the last twelve months, yet all positives were overwhelmed by negative macro factors that we try not to predict. First, let’s take a look at where we suffered this year. Most of our weak performance came from half a dozen securities with exposure to oil, natural gas, gold, or a rapid increase in the U.S. dollar compared to most other currencies. Such a rapid currency swing helped to depress the prices of most commodities as well as the reported earnings of U.S. companies with significant overseas revenue. Although we invested with what we believed was a margin of safety based primarily on significant management, ownership, and governance changes rather than overt commodity or currency views, we got the commodity and currency price movements almost entirely wrong (we do not try to predict currency movements and try to build a margin of safety into commodity companies). These mistakes overwhelmed a number of sensible management moves.
GoodHaven Fund Performance Detractors: Dundee Corp, WPX Energy, Birchcliff Energy, Exco Resources and Barrick Gold
Among the companies suffering from commodity-related declines were Dundee Corp (“Dundee”), WPX Energy (“WPX”), Birchcliff Energy (“Birchcliff”), Exco Resources (“Exco”), and Barrick Gold (“Barrick”). In addition, we also saw a sizeable decline in Hewlett-Packard (“HP”), a decline in mortgage servicers, and more modest declines in Leucadia National (“Leucadia”), Systemax, and Staples.
Dundee was hit by a triple whammy. Although the company still appears to be selling at a sizeable discount to a reasonably calculated net asset value, its corporate investments (beyond its investment management and agricultural businesses) in oil, gas, real estate, and metals were heavily pressured, and the Canadian Dollar fell roughly 15% against the U.S. Dollar during the fiscal year (over 25% for the last 18 months), reducing the value of all Canadian assets when translated back into U.S. dollars. During the year, we sold some Dundee shares to realize tax losses to offset capital gains taken earlier in the year. Even so, the mark to market decline has continued unabated and the discount to our estimate of net asset value has continued to widen.
In Dundee, we believe our original cost is likely (but not certainly) impaired, although we also believe the stock is trading at a fraction of the value of all of its various parts when measured at today’s depressed prices. Controlled by Canada’s Goodman family (responsible for building a hugely successful predecessor company before it was sold to a large Canadian bank), Dundee is involved in industries that the family knows well and in which they have enjoyed prior successes. The Goodman family has “skin in the game,” purchased shares during the year, and we believe their game plan, though not easy, is quite sensible.
Canadian companies with resource exposure have been under significant selling pressure in recent months, some of which may abate with the end of tax-driven trading strategies or a slowing of the relentless decline of the Canadian dollar. Dundee’s parent holding company has moderate debt, significant corporate assets, and available bank credit.1 However, the values underlying a large portion of assets are significantly stressed. In our current valuation, we have taken these into account and believe our current appraisal is realistic. We had reduced our Dundee position modestly over the summer and the company currently represents roughly 1.5% of the portfolio. With some modest recovery in underlying values, we would consider increasing our stake.
That this year has been particularly difficult for investors with any exposure to energy does not excuse our performance, but does explain part of it. The rapid decline in the price of oil from over $100 two years ago to just above $37 per barrel as of late December 2015 (natural gas has also declined) now represents the largest two-year decline in oil prices ever (surpassing the previous record declines of 1985-1987 and 1997-1998, and the significant decline of 2008-2009, all of which were followed by large percentage gains in crude prices). Recent weakness in oil prices has been engineered by Saudi Arabia which appears to be producing and discounting as much oil as it can; their maximizing production and price discounting has led to a collapse in the price of most oil and gas equities.
Frankly, what we thought was a significant margin of safety in energy prices turned out to be not nearly conservative enough – at least in the short-term. However, based on the rapid decline in drilling activity (U.S. rigs working have declined by more than 50% in a year), the cancellation of $380 billion or more of capital expenditures across the industry, and general depletion, history would suggest a significant bounce in prices, although we cannot predict the timing. Ben Graham’s use of a quote by the Roman poet Horace in Security Analysis seems apt here: “Many shall be restored that now are fallen and many shall fall that now are in honor.”
In companies whose primary business is energy, we suffered from our investments in WPX, Birchcliff, and Exco. In the case of Exco, we were simply wrong and in hindsight had been too anchored by management’s efforts to take the company private, first at $20 per share, then later in the teens. Despite well-known investor/shareholders with good reputations on the Board, the company had too much debt, had natural gas assets that were not of best quality, and had management whose prowess seems to have been more a function of high prices than skill. Though not a large investment, we sold all of our Exco shares (purchased on average in the midsingle digits) during 2015 to realize tax losses, which contributed to our ability to avoid a taxable distribution in a loss year.
We originally purchasedWPX because of a significant management upgrade in a company that owned extensive proven reserves and resources. Our assessment of management was spot-on and led to a significant improvement in asset quality and liquidity, however, our commodity timing was terrible.3 Since taking over in mid- 2014, Rick Muncrief of WPX has made enormous progress in repositioning the business by selling non-core assets, reducing costs, streamlining operations, and recruiting talented management. In mid-summer 2015 with oil prices having declined from $100 to about $50 per barrel, WPX consummated a large acquisition (privately held RKI) which we think added very valuable assets to the company despite adding financial leverage at a time when most had soured on the industry.
The share price of WPX has declined further since its acquisition of RKI, which owns extensive acreage, producing wells, and mid-stream assets in the heart of the Permian Basin (and notwithstanding fifteen separate insider purchases at much higher prices immediately following the acquisition).5 Thus far, comparable proposed transactions in recent weeks suggest that the price for RKI was fair in today’s depressed market and is unimpaired.
We still believe WPX is worth far more than its recent stock market quote, even with recently depressed commodity prices. The company is two-thirds hedged for 2016 at more than $60 per barrel and $3.50 per mcf gas and has some additional hedges in 2017. The company is currently using about $200 million of its $1.75 billion credit line, although we expect that pending sales of non-producing assets should, if consummated, reduce the balance on that line to zero, offering additional financial flexibility. In today’s environment, Mr. Market does not appear to care, however even a modest bounce in energy prices could lead to significant appreciation.
In the case of Birchcliff, the company’s stock price was hit hard by low gas prices and a very weak Canadian Dollar despite maintaining its low-cost production, low finding costs, and positive cash flow. Birchcliff’s management has performed well and despite low prices, reserves and production have continued to grow. The company’s largest shareholder, Canadian investor Seymour Schulich, recently acquired another two million shares in the open market (with management and directors also buying lesser amounts) and now owns roughly 27% of the company.
Importantly, there are reasons to believe these declines will not repeat. We believe there will be a regression to the mean sometime in 2016 or early 2017 that will result in substantially higher energy prices for the reasons mentioned above. There may be some interesting opportunities in energy related debt as well as equity. A recent Credit Suisse poll indicated that investors are more bearish on energy than they were at the depths of the financial crisis. In addition, the percentage that energy companies constitute of the S&P 500 Index (as a percentage of market value) was recently near 40 year lows, closing on 6% of the index’s value. Our current portfolio has an aggregate of roughly 10% allocated to energy related equities.
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