GoodHaven Fund semi-annual letter to shareholders for the period ended May 31, 2016.
Dear Fellow Shareholders of the GoodHaven Fund (the “Fund”):
Despite a poor December following the end of our fiscal year, we have seen conditions change, with a significant bounce in some of our larger holdings leading to much better performance in recent months. For the calendar year-to-date through May 31st, the Fund has gained 11.67% compared to a gain of 3.57% for the S&P 500 Index assuming reinvestment of dividends, a positive trend that has continued in June through the date of this letter.
GoodHaven Fund- Portfolio Review
Barrick Gold Corporation (Barrick) is now our largest investment. From its lows near calendar year end, Barrick has tripled in price and we now have a significant unrealized gain on our average cost. WPX Energy (WPX) nearly doubled in price after significant capital allocation moves and a modest oil price recovery, where the worst of oil’s decline now seems to be in the rear-view mirror. Importantly, we remind our fellow shareholders that both of these investments were not simple or binary commodity bets – both had large and valuable asset bases and had undergone material governance changes that we thought could lead to dramatically improved financial results – something that now appears to be well underway. Although commodity prices will ebb and flow and share price volatility is expected, we believe the benefits of that insight are not over.
While gratified that the Fund seems to have exited what appeared to have been a “perfect storm” over the last eighteen months, we believe there is more improvement to come. We are grateful to our fellow shareholders who have maintained a long view and who understand that focused value investing means having periods where the Fund will zig while the market zags. Last year, the zigging was particularly painful; so far this year, the zagging has been more to our liking. Nevertheless, we still have much to prove.
As noted above, the last six months have seen a significant bounce in some of our larger investments, leading to better relative and absolute performance (despite a large drag of a sizeable holding that is now far smaller – more below.) As should be obvious, if you want something other than index performance, your portfolio can’t resemble the index. Massive money flows have poured into passive investing strategies, index funds, and exchange-traded funds (ETFs) in recent years, helping to inflate index prices that appear richly valued by historic metrics. We believe looking different is likely to be a material advantage for quite some time to come and, on average, the Fund owns securities that seem materially cheaper than indexes on common valuation metrics. As is our goal in these communications, we will try to discuss our most important investments with you in the same way we would want if our roles were reversed.
Barrick is continuing its process of transformation in response to the governance changes that we have chronicled in past letters. Under the guidance of Chairman John Thornton, the company has significantly reduced debt and lowered operating costs. Perhaps more importantly, the company has been on a mission to assemble a talented and experienced management team that is capable of creating a growing world-class business to match Barrick’s world-class asset base. Although the company has approached our earlier estimate of intrinsic value, metals prices have risen and we believe John and his team are capable of growing that value over time by a meaningful amount. After the end of the semi-annual period, we slightly reduced our investment near recent highs as a prudent portfolio management step. However, we believe there is significant optionality associated with a company that has an improving balance sheet, clever management team, a large and efficient asset base, and a core commodity price that has risen only moderately over recent multi-year lows.
Another important holding is WPX, which appreciated significantly during the semi-annual period. Certainly, we never imagined that oil prices would fall into the $20s per barrel and our initial purchases turned out to be very poorly timed. Notwithstanding these industry stresses, WPX has managed to not only survive, but to reposition itself to take advantage of a rebound in prices. Recently the company
raised cash through an equity offering that should serve to accelerate its growth plans. While we never like dilution, we believe the trade-off of a stronger balance sheet and better growth prospects should offset the additional share count.
CEO Rick Muncrief and his team have proven themselves able to execute capital allocation actions under stress and to continually improve the company’s cost structure. WPX started as a large pile of assets spread across the country (and in Argentina), with mostly natural gas reserves. Despite difficult conditions under which to reallocate capital, WPX has remade itself over the last two years as one of the best positioned shale oil companies in the United States. The company has significant acreage in the central and low cost parts of the Permian and Williston Basins, as well as the San Juan. A greatly improved balance sheet, sharply reduced cost structure, and a far more focused asset portfolio should allow for material growth in intrinsic value. In addition, in what can only be described as a brief period of complete panic in the high-yield bond market in early 2016, we bought some shortterm WPX bonds maturing in 2017 at a yield-to-maturity of close to 14%. While short-dated, these bonds have appreciated and the company has the cash in the bank to pay off the remaining tranche of this issue at maturity early next year.
While pleased with performance in recent months, it frankly should have been far better. The first half of the year saw a dramatic decline in the price of Walter Investment Management (Walter), making overall performance appear good when it should have been spectacular. We attribute the price weakness to the failures of management to execute on previously announced liquidity and capital initiatives and, following a December rate hike by the Federal Reserve, a completely unexpected and massive decline in interest rates on 10-year U.S. Treasuries in the last six months and particularly toward the end of the semi-annual period.
This unexpected bond rally has led to accelerated amortization and sizeable noncash write-downs of the carrying value of mortgage servicing assets, creating net losses and reducing Walter’s net worth during a period where the company should have been moving much faster to reduce leverage and its cost structure. We actually sold a few shares in January but stopped selling as the price declined amid widespread expectations for interest rate increases, which would reverse negative accounting losses. In hindsight, we should have continued.
Recently, after a search initiated by large shareholders on the newly constituted Board of Walter, the company recruited an Executive Chairman and interim CEO from the outside who has an impressive background (he takes the helm on June 30). However, despite Walter’s position as one of the few scale non-bank servicers (a processing business with little or no credit risk), the company’s reputation and financial standing has suffered, made worse by recent additional interest rate declines. While the Board seems to be acting sensibly