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 and with a sense of urgency, delays in executing transactions may mean that some previously planned actions are no longer feasible. Only time will tell.
In this investment, we frankly made an error that was avoidable, and became a frog in a slowly warming pot of water – something that we try hard to avoid. As we write, Walter represents less than 2% of the overall portfolio. The damage is essentially done, though new management should be capable of making a difference to what should be a valuable franchise in mortgage servicing and lending that is capable of generating very significant cash in relation to the share price if properly run.
During the semi-annual period, there was other positive movement. A number of our companies made significant business progress and saw their shares appreciate – some of these are discussed below. Other than Walter, the only material decliners were Staples and Sears Holdings. Staples dropped in the wake of the government’s rejection on anti-trust grounds of its proposal to acquire rival Office Depot, a negative mark we expect will prove temporary. Staples generates significant free cash flow in relation to its stock price, has a strong core business (commercial contract, where it dominates according to the U.S. government’s anti-trust lawsuit) and has been selling online for many years. Its competitive position seems reasonably strong and we added modestly to our investment near recent lows. Sears, a much smaller position, declined in response to continued losses amid little evidence that it has been able to redeploy its extensive asset base in a way that would reduce operating losses.
Last fall, Hewlett-Packard split into two companies, HP Enterprise (Enterprise) and HP Inc. (HP), with Enterprise consisting of the Server, Storage, Networking, Services, and Finance businesses and HP consisting of the personal computer and printing businesses. We thought both were materially undervalued given significant cash generation, modest leverage, and low prices in relation to our estimates of free cash flow – some of the lowest multiples of companies within the S&P 500.
Since the end of the fiscal year, both have rebounded modestly, yet both remain inexpensive. Recently, Enterprise announced several significant capital allocation moves, including the sale of a majority stake in its Chinese networking business and the combination of its services business with that of Computer Sciences Corporation (CSC), another large public company. When the deal closes, Enterprise shareholders will receive shares in a new company combining the services business of Enterprise with those of CSC that will trade publicly. This combination should result in significant reduction in costs from the elimination of overlapping expenses and should afford the hardware side of Enterprise greater opportunities (though with no guarantees) in selling to large corporate and government customers. The cash received from the deal should also accelerate Enterprise’s plans to return capital through stock repurchases. As both companies become more focused and more nimble businesses, market valuations should improve.
HP has struggled with declining revenues as personal computers and many printing segments are stagnant or declining, exacerbated by a strong U.S. Dollar, which negatively affects reported income given that nearly two-thirds of the business is outside the United States. Nevertheless, the company continues to generate large cash flows that we think can be deployed for the benefit of shareholders through dividends and advantageous stock repurchases at low multiples to cash flow. The printer and PC markets are large and will remain so for some time to come. HP is currently priced as though the business will shrink about 8% per annum in perpetuity – something we think is unlikely. However, notwithstanding a very low valuation, we expect at least a few more quarters of tough comparisons before the company should appear stable. In the interim, we have received a dividend yield on recent purchases of between 4% and 5% per annum while we wait.
Since our initial purchases of Spectrum Brands Holdings, Inc. shares at roughly one-quarter of current prices, the company has developed into a collection of premier consumer branded businesses in diverse end markets. The company appears to be capable of sustaining significant and growing free cash flows over time and has been an adroit acquirer of businesses. The company has more debt than we would prefer, although its obligations are low cost and most of its business segments are recession resistant. There are certainly opportunities to do “bolt-on” acquisitions and increase market share. Recently, its insect repellant brands (Cutter, Hotshot, Black Flag, and others) got a boost from the “Zika” virus. The company also entered the automotive products vertical through the acquisition of Armor All and STP, which we think has worldwide potential.
Quietly and steadily, White Mountains Insurance Group (White Mountains) has seen its share price continue to appreciate. We now have a meaningful gain since our initial purchases as the company continues to sell assets and pile up cash. White Mountains was originally created by insurance industry legend Jack Byrne and has been ably managed for years under the leadership of Jack’s successor, Ray Barrette.
Moreover, management has proven to be a paragon of capital allocation over the years, buying in massive amounts of stock at a discount to tangible book value and selling assets at a significant premium to book value. All of this value-accretive activity has left the stock selling for roughly its book value with a highly liquid balance sheet and a very conservative investment portfolio. We think it is worth more. Eventually, we expect that White Mountains will continue to return capital to shareholders in an efficient manner, or they will find something truly attractive to buy.
Early in 2016, we bought a small stake in an industrial company (a new investment) that immediately leaped after our initial purchase. We sold the position roughly three months later up about 70% and trading for roughly what we thought the business was worth. While the dollar gain was not trivial, neither did it move the needle very far. The overall benefit to the Fund would have been much greater had the investment declined after our initial purchase and given us the opportunity to increase the size of the position. Instead, we ended up with a large percentage gain in a short time on a small position. As you know, the Fund’s turnover is fairly low compared to most active managers and we do not need to be highly active. However, we do need just a couple of really good opportunities in a year to make that year worthwhile – but we need to make them significant. This was a missed opportunity.
The overall investment environment continues to be problematic amid what appears to be a soft business climate, many inflated asset classes, and few areas of growth. Without officially entering recession, industrial production has decreased for nine months. Factory orders have been weak for eighteen months. Tax receipts have also turned down and it appears that perhaps due to the energy industry, commercial bankruptcies have turned up. We are mindful that negative headlines can often precede better markets, however, general valuation levels temper those thoughts. We continue to try to focus on businesses that generate cash and which can “help themselves” during a period where growth has been hard to find.
At the moment, cash effectively earns no return, though it remains a significant and strategic asset for the Fund. Financial company spreads are also compressed. Fund holdings such as Federated Investors, White Mountains, Leucadia National, and Walter have been negatively affected as short interest rates have not turned up as expected and remain extremely low. But we note that with the exception of Walter, these companies have continued to build value during this period of depressed spreads, have paid dividends, and have maintained or improved already strong balance sheets.
Although it remains sensible for these and other inversely correlated businesses to expect an eventual (and perhaps outsize) benefit to more normalized interest rates, we recognize that as Dorothy exclaimed to Toto, “we’re not in Kansas anymore.” Around the world, central bankers continue to go deeper and deeper down the rabbit hole of negative interest rates.3 Today, roughly $10 trillion of sovereign debt currently trades with negative yields as a direct consequence, not of market forces, but of central bank’s efforts at central planning.
That so much debt trades with an effective interest rate below zero is historically an anomaly and is almost certainly encouraging significant mal-investment, rapidly rendering pensions and other entities dependent on long-dated returns insolvent, and causing conservative investors to reach for both yield and risk. At the height of the Great Depression in the 1930s, considered the worst economy of modern times with 20% or more unemployment, negative yields occurred briefly, but were rare and short-lived. However, for most issuers, you can go back hundreds of years and not find any period with rates at zero, let along below zero. For investors with decades of experience and some study of history, the prices of long dated sovereign bonds seem somewhere between ludicrous and insane, especially given rapid appreciation, negative returns to maturity, and a significantly increasing supply.
Corporate debt has also risen significantly since the financial crisis of 2008. Rather than using cash flows to reduce leverage, corporations have, on average, borrowed more to facilitate actions that would not be economic and would likely fail the test of reasonableness without an extraordinary low cost of capital, including many, but not all, acquisitions and share repurchases. We make no pretense to offer any sort of certainty as to how this all works out, except to report a nagging and deep suspicion that current trends are unsustainable. If so, the current situation will not end well for owners of high-priced and low-coupon debt, or investments that depend on ultra-low rates and yields continuing over the long term. Longer-dated sovereign and high grade corporate asset classes represent ponds in which we have no desire to fish.
During the last six months, both of your portfolio managers bought additional shares of the Fund as large holdings came under stress. While nobody is immune from mistakes, we are trying to remain conservative amid unusual conditions. General equity valuations are on the high side. Sovereign and high-grade bonds seem excessively priced. And the more central bankers try to avoid even the hint of recession, the more likely an eventual downturn will show up, as it always has.
That said, the Fund owns securities that appear (on average) priced with the potential to make us money, trading at a discount to our estimate of intrinsic value.6 The trends that caused us pain last year appear to have reversed and appear to now represent a tailwind. We constantly are reviewing a long list of businesses we find attractive as well as a variety of distressed securities and have the liquidity and the ability to react to conditions opportunistically.7 What we will not do is take risks with your money that we are unwilling to take with our own. Although it guarantees nothing, our personal investment in fund shares continues to rank us among the largest individual owners of the Fund, aligning our money with yours.
Sincerely,
Larry Pitkowsky
Keith Trauner
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