Inside The GoodHaven Fund, A Top-Performing Value Fund In 2016
July 19, 2016
by Robert Huebscher
Baupost's investment process involves "never-ending" gleaning of facts to help support investment ideas Seth Klarman writes in his end-of-year letter to investors. In the letter, a copy of which ValueWalk has been able to review, the value investor describes the Baupost Group's process to identify ideas and answer the most critical questions about its potential Read More
The GoodHaven Fund (GOODX) is managed by Larry Pitkowsky and Keith Trauner of GoodHaven Capital Management, LLC. For most of the previous decade, Larry and Keith held research, portfolio management and executive positions with Fairholme Capital Management, LLC and its affiliated Fairholme Fund.
As of July 13, the fund had returned 12.75% year-to-date, as compared to 3.84% for the S&P 500, placing it in the top 2nd percentile of its Morningstar peer group.
The fund’s mission is to make a few intelligent business decisions with the money its shareholders have invested (including significant sums of their own), earn a competitive rate of return over the long-term when compared to lower risk alternatives, and do it without relying on risky leverage to magnify the results.
I spoke to Larry and Keith on July 8.
Your performance this year has been exceptional; your returns are in the top 1% of your Morningstar peer group. What have been the key contributors to your success this year?
Larry: Although this was not the only reason, we saw a material price increase in two of our largest holdings, Barrick Gold and WPX Energy. The stock prices of both of them suffered last year, despite both companies making meaningful fundamental progress. This is still the beginning of some mean reversion for these two companies, which had been so out of favor. A disadvantage and advantage of being a focused fund that looks nothing like the S&P 500 is you will have periods of crummy relative performance from time to time. But we hope over an extended period of time it’s also a big advantage and you can have much better performance than the index, if you know what you are doing.
You’re Graham and Dodd acolytes. You are devotees of the margin of safety, which you expressed and our previous interview. What is the margin of safety in your fund’s largest investment, Barrick Gold?
Keith: In none of our companies was our primary focus the fact that there was an underlying commodity. But here you’ve got an interesting position. First, we bought most of the position as the gold market was going through one of the two or three worst bear markets of the last several decades. Most of it was bought near four- or five-year lows in the commodity. We were starting with a depressed underlying commodity and that helps when you’re talking about a margin of safety.
Second – and this is something that I don’t think a lot of people really think through – just like Hewlett-Packard, which was a significant moneymaker for us after they made a terrible acquisition and Meg Whitman came in and took over, Barrick went through a very similar event where they made a bone-headed deal and leveraged the balance sheet. It resulted in a forced governance change at the company. Most of the management team was replaced. The Chairman of the Board was replaced with a very smart guy, John Thornton. You had costs that were bloated. There was low-hanging fruit to pick. The company attracted top-flight management to complement their very valuable asset base.
When you’re talking about safety, there were a lot of costs that could be reduced. You had a very large and valuable asset base. Barrick’s core properties have reserves with a grade nearly twice that of its largest competitors, meaning their reserves are more concentrated and more efficient. You have extremely low cash operating costs, which the company has been able to reduce even further.
The company generates free-cash flow at a very low price of its underlying commodities – approaching $1,000 or less per ounce of gold. That gives us a significant margin of safety. Given that you’ve had a modest but not a huge rally in metals prices cash flow is going to increase further and should significantly increase the margin of safety.
One of your larger investments is in Walter Investment Management. The stock is no doubt depressed but the price is not wholly unwarranted based on the fundamentals (e.g., profit margins, ROI, ROE and debt-to-equity). Improving those metrics from these levels would seem to require a change in the macro environment (something that in our previous interview you dis-avowed as part of your investment process) or a turn-around (something that many if not most value managers avoid). Furthermore it is not clear where the margin of safety is. What would Benjamin Graham see here that I am missing?
Keith: Walter is probably our most frustrating investment, but it is no longer even close to being one of our largest. It is about 1.5% of the portfolio. Some criticism here is warranted and we sized it wrong and that hurt us in the past. But at the core, the company is essentially a processing business that takes very little credit risk. It is also in a sector that has only a handful of scale players, which should be a big advantage.
I’ll give you three reasons why the company has performed poorly. One, management clearly did not move quickly enough to adjust its cost structure to a new compliance environment. Costs were coming down, but not nearly fast enough. Two, you had a huge decline, contrary to the expectations of almost everybody, in 10-year Treasury rates, which negatively affected the balance sheet, because it forces a non-cash write-down to mortgage servicing assets. Third, although management had expressed on numerous occasions their concrete plans to reduce leverage, they have not been able to execute on a number of those actions.
In the last several months, the two largest shareholders joined the board. Those two shareholders control almost half the company. They recruited a new executive chairman and interim CEO. All of those parties, the entire board and the new management are all on the same page trying to move very quickly to resolve the issues that I just discussed. They are behind the 8-ball, but we are trying to give the new chairman a chance to get some things done.
In fairness, this is a case where we overestimated the margin of safety and underestimated the odds that worldwide interest rates would decline materially even seven years into an economic recovery. That is something that hurt servicers generally across the board, but which probably won’t last much longer
Larry: Berkshire Hathaway owns two substantial companies that are in the servicing business, Vanderbilt Mortgage, part of Clayton Homes, and half of Berkadia, which they own in conjunction with Leucadia National. Vanderbilt is on the residential side, while Berkadia is a commercial-mortgage servicer. There are reasons that Berkshire owned both companies through the different cycles and found it to be, if run properly, a sector that has interesting profit dynamics.
In late June Walter Investment Management extended their shareholder rights plan for another year. As professed long-term investors, how do you view shareholder rights plans in general and specifically how do you view it at Walter Investment Management?
Larry: Generally, we believe in measures that treat all shareholders fairly and prevent management from becoming entrenched with respect to a potential transaction that could be beneficial. Given that there are now two large shareholders on the board at Walter who control about half the shares, we believe that governance at Walter is headed in the right direction and that the renewal of the rights plan for an additional year is not something that we view as harmful to minority holders, including ourselves.
Walter Investment Management recently made a multi-million dollar payment to its departing CEO. How does a value manager justify paying such a sum?
Larry: Management should be paid well for success conceptually, and not be paid for failure. In this case, most of that payment was pursuant to an employment contract and was not discretionary. It’s a little hard to stomach given the recent results, but it is a function of having a contract in place when they retained the executive in question. It does appear to be a relatively common type of agreement for a public company.
Keith: It’s an issue across public companies generally. When you try to attract management, very often boards feel compelled to enter into agreements that pay them on the back end if you’ve got to get rid of them.
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