FPA International Value Fund webcast audio, transcript and slides for the second quarter ended June 30, 2016.
FPA International Value Fund 2Q16 Webcast Audio
FPA International Value Fund 2Q16 Webcast Transcript
Pierre Py: As always, we will start with performance. During the second quarter of the year, the Fund returned a negative 3.09% in U.S. currency, which compared to a negative 0.64% for the MSCI All-Country World Index. (01:55) Since the beginning of the year, however, the Fund has returned a positive 0.69% compared to a negative 1.02% for the Index. As in the first quarter, there was significant volatility during the period with stock prices having come down materially following several weeks of positive performance on the news that Britain had voted by referendum to leave the European Union on June 23rd. As always, we encourage shareholders to focus on returns over a multiyear period if not through a full market cycle rather than short-term performance; in particular, when short-term performance is impacted by big macro or political events such as the European referendum.
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To this point, we would note that our FPA International Value Fund is appreciated by an annualized rate of 5.3% net of fees and expenses versus 3.77% for the Index since its inception on December 1st, 2011. Along with these performance numbers, it is worth noting that since inception, our cash exposure has averaged 30 to 35% and it has fluctuated from around 10% to more than 40% depending on the availability of suitable investment opportunities.
At the end of the period, the Fund was a little over 80% invested. While this is effectively unchanged from the reported figure at the end of the first quarter, there were significant fluctuations throughout the quarter. Prior to the results of the European referendum, the Fund’s cash exposure had increased to levels in excess of 25% as markets continued to rise and our portfolio holdings even more so. But following the results of the European referendum, we took advantage of depressed valuations to deploy more capital. And as a result, our cash exposure fell back to about 20% at the end of this second quarter.
(03:52) As mentioned, we prefer not to comment on short-term performance which we consider to be of little relevance to our long-term investment approach. Similarly, as bottom-up investors, we would prefer to refrain from commenting on microeconomic or capital markets developments. However, the historic decision by the British people to leave the European Union, known as Brexit, had a material impact on the Fund’s return in the quarter even though it happened on June 24th, less than a week before the end of the period and for reasons that need to be made clear.
To understand how sharp of an impact the Brexit vote had on absolute performance this quarter, it’s worth considering the following: By June 23rd, which was the day of the vote, the Fund had returned a positive 3.17% for the quarter versus 2.88% for the Index and had a year-to-date return of 7.2% versus 2.49% for the Index. Yet, by June 24th, one day after the results, the Fund had returned a negative 3.01% for the quarter versus a negative 3.34% for the Index. At that point the Fund’s year-to-date return was 0.78% versus a negative 3.71% for the Index. That’s how sharp of an impact the Brexit vote had on absolute performance this quarter.
Now, in terms of its impact on relative performance, the Fund actually held up better than the Index on the first day of trading that followed the results of the vote. But on that same day, as I noted earlier, we took advantage of the price valuations and made several investments which then cause the Fund to significantly underperform. On June 24th, as the markets panicked, we deployed 8% of the Fund’s asset, mostly in several U.K. small caps that I experienced price dislocations north of 20% on average. (06:01) These stocks sell by roughly another 20% on the next trading day, June 27th, when we invested another 3% of our assets. As a result, the Fund declined by close to 6% on that Monday, so on June 27th, almost 300 basis points worse than the Index. So by aggressively taking advantage of exceptional volatility, we effectively “gave up” in one day almost two-thirds of the Fund’s excess performance for the year. I would not on that front that at the same time as we put a significant amount of capital to work in these couple of days, I actually personally increased my investment in the Fund by more than 20%, my single-largest increase since the inception of the Fund back in December, 2011.
Now, in hindsight of course, I guess we should have waited another day. And, of course, I’m being factious here. But we can never predict how long a window of opportunity we are going to be dealing with. The discounts on that couple of days were such that it was clear what needed to be done and we didn’t think twice about the impact on the Fund’s short-term returns. This is precisely the type of situation that we long for and we were all too happy to take advantage of it. While others seem to be resorting to bookies and volatility forecast in order to position their portfolio for one outcome or the other in the months ahead of the referendum, we simply continued to research and value companies so as to be ready to move promptly if markets panicked. And when it happened, obviously we took advantage of it.
To be clear, we did not buy a variety of expensive names that came down a few percentage points on that day and have since bounced back to their previous levels. Rather, we invested in U.K. businesses where share prices fell as in one particular instance from $7.56 on June 23rd to $4.51 on June 27th, i.e., down 40% in s single day of trading on no new business-specific news. (08:06) In this case, it was a company we had actually long followed and valued. We knew the management and we knew the business to be of high quality, but we had found it unattractively priced up until then.
Now, this discipline can cause the Fund to underperform in the face of “market corrections” in the short run as we make aggressive investments in stocks that experience material dislocation while others hold up better. But this is a function of our unaltered focus on buying intrinsically cheap businesses rather than on manufacturing short-term paper returns. It also reflects growing valuation asymmetries in the markets between two types of companies in our view. One type is big and liquid companies often perceived as unlikely to negatively surprise that can be used to capture some marginal spread versus artificially-deflated interest rates. The other type is typically smaller, less predictable companies that tend to be overlooked and are fundamentally undervalued. With more capital pressed to adopt a similar approach and chasing the same names, share prices benefit which can make the trade look compelling in the short term. But longer term, however, it could translate into permanent capital destruction once focus is put back on business fundamental. So we are not interested in playing that kind of game.
I’m now moving on to the key performing holdings in the quarter starting with the right side of the slide, i.e., the worst-performing holding for the period. Our worst-performing holding this quarter was Countrywide which was down 41.29% in U.S. currency in the period. Based in the U.K., the company is the country’s leading residential real estate brokerage network. The group also operates one of the largest home rental businesses in the U.K. and provides a broad range of real estate-related services such as property appraisals, similar to its peer, LSL Property Services. (10:05) Real estate as a sector is often subject to a lot of media attention. It is also a natural ground for political interventions and it’s sensitive to consumer sentiment. It can be highly volatile as a result.
Through our multiple access points into the U.K. real estate market, we have been made aware of a likely softening in market conditions in the middle of this year, in part due to political instability. We expected potentially significant short-term volatility as a result and possibly the opportunity to buy in at low prices in the coming months. Instead the opportunity was brought forward by the European referendum, which is not to say that we couldn’t experience further volatility in the stock later in the year. But by June 23rd, Countrywide’s share price was down 6% and it fell to 25% on June 24th alone and another 15% the following trading day on June 27th. So we took advantage of these severely-depressed valuations to add to our existing position. Longer term, Countrywide presents several compelling characteristics.
Property transactions in the U.K. remain significantly below both big demand and multidecade averages. Irrespective of when the market may return to its long-term trend, the group can continue to build its rental business and other property-related activities. The company has a sound balance sheet with net debt just north of 1½x EBITDA. The business requires little tangible assets and negative working capital, thus generates triple-digit levels of return on capital employed and is highly cash-generative.
A significant portion of this cash has been returned to shareholders via dividends and buybacks which are creative to value at current prices. The relatively-new CEO, Alison Platt, who comes from a non-real estate and non-traditional background, has led some dramatic organizational changes at the company that have yet to prove successful. (12:06) The group has also unfortunately failed more recently to properly execute on integrating rental acquisitions and the business remained exposed to an industry downturn and increased pressure from market newcomers. Nevertheless, with a double-digit free cash flow yield, we believe that we are getting well rewarded for our resilience to volatility and our patience towards an improvement in U.K. property markets conditions.
Our best-performing holding this quarter was TOTVS, which was up 27.47% in U.S. currency in the period. Based in Brazil, TOTVS is the country’s leading provider of enterprise software solutions primarily to local small and medium-sized businesses. We first invested in TOTVS less than a year ago in the context of a rapidly-deteriorating political and economic environment in Brazil associated with weakness in the national currency, the Brazilian Real. The group had also announced a sizeable acquisition which many, including ourselves, expected would be challenging to integrate. However, TOTVS continued to generate solid results in the months that followed and the group’s stock price recovered strongly leading us to significantly reduce our position.
At the end of last year, TOTVS’ management team then experienced significant disruption as Rodrigo Kede, who had been hired from IBM Brasil and was expected to succeed the company’s founder, Laércio Cosentino, as CEO, announced that he was stepping down. The decision was publicly attributed to a serious health issue only for IBM to report a few days later that Rodrigo would be rejoining the group as head of its Latin American business. This caused TOTVS’ share price to fall back to previous depressed levels.
(13:54) Despite our initial concerns with the announcements, we were able to gain confidence from multiple conversations with various parties involved that the situation wasn’t symptomatic of more serious issues at the company and we subsequently took advantage of the opportunity to rebuild the position. Since then, TOTVS’ share prices benefitted from continued good results despite short-term headwinds from challenging macroeconomic conditions and the integration of Bematech.
We think TOTVS is a high-quality business with a well-established dominant position in the market that is both difficult to penetrate and constantly changing. Its solutions are high value added and a must-have for customers. Similar to an SAP, the world’s leading player in the field of ERP solutions, the company benefits from high margin, recurring maintenance and service-type revenues. The business has consistently generated double-digit growth, margins above 20%, returns on capital employed in excess of 80%, and high free cash flow generation. TOTVS is undergoing a shift towards a subscription model which negatively impact result in the short term, but should prove very beneficial longer term.
The Bematech acquisition, while challenging to integrate, is opening new market opportunities for the group. The balance sheet is net cash positive and despite the recent snafu, the CEO has an exceptional track record in the industry and remains a large shareholder in the company. So even after the recent increase in TOTVS share price, we continue to think that the stock is trading at a large discount to the intrinsic value of the business and we remain interested in being shareholders in the company at current valuations.
I am now moving to portfolio activity for the quarter. Once again, this quarter the sharp shift in trend during the period led to a high level of activity for the Fund. While we pulled back on several investments that had performed strongly earlier on, we bought into some new names and added to several existing positions towards the end of the quarter. (16:01) We made five new purchases in the quarter, including Metso and Signet. Based in Finland, Metso is a world-leading manufacturer of heavy equipment, typically for the mining industry. The group also provides related engineering and maintenance services. Based in Bermuda, Signet is the largest specialty jewelry retailer in the United States.
In addition to these new purchases, we also disclosed two new positions that we had recently been building, Burberry and Konecranes. Based in the U.K., Burberry is one of the world’s top luxury brands. The company designs, produces, and distributes, in part through its own global retail network, a broad range of apparel and accessories. Based in Finland, Konecranes is a leading producer of electrical lifting equipment primarily industrial and port cranes. The group also provides related engineering and maintenance services.
On the flipside, we monetized three positions during the period: Intertek, G4S, and TNT Express. Based in the U.K., Intertek is a leading global provider of inspection and certification services. The company’s stock had seen a material increase in price since the original purchase at the beginning of last year and had reached our assessment of intrinsic value per share. We continue to view Intertek as a well-run, high-quality company and we remain interested in becoming shareholders, but subject to an appropriate margin of safety.
As we reported in past commentaries, TNT Express was acquired by FedEx in the second quarter of last year. The transaction finally closed this quarter and we received cash in exchange for our shares in the company. Our sale of G4S, though, was a different situation. We had commented last quarter that after years of being invested in the group and having gone through significant challenges and ups and downs, a change in management and a difficult turnaround, we expected to see our thesis play out at last in the coming months. (18:08) We still trust that this will happen and we suspect the company’s share price will react positively to future results. Yet, we had also shared in the commentary our frustration with management and the need for the balance sheet to be strengthened.
Two things transpired during the quarter that, combined with these two issues, ultimately dictated our decision to sell. One was the terrorist attack in Orlando as the gunman turned out to be an employee of G4S. Despite multiple research calls, we struggled to assess the potential liabilities, if any, for the company and we found management’s response to this crisis to be inadequate. The other was the British vote to leave the European Union and the subsequent sharp weakening of the British Pound. With a large portion of its debt denominated in U.S. Dollars, we estimated that the group could run into liability management issues which could then undermine the pending turnaround. These issues, combined with an often-hard-to-reach management, led to the decision to sell the position as our investment discipline would dictate.
While our overall investment in G4S actually proved net positive for the Fund this is quite a frustrating outcome, especially after so many years as shareholders. We think the business itself is worth significantly more than what the current share price implies and we would be interested in becoming shareholders again, but we would want to see the aforementioned issues addressed. Our experience with G4S will fare as yet another reminder of the importance of strong execution in the face of challenges and of a very robust balance sheet. Bad things happen to good businesses and sometimes several times over in a short period of time. Without the financial strengths to weather the storm, these can trump even the best fundamentals.
(20:07) Beyond these transactions we continue to actively manage the portfolio throughout the quarter. Obviously, we added at the margin to several of our positions and we made meaningful additions to several existing holdings, in particular following the results of the European referendum including Countrywide, LSL, and Michael Page, which is now known as the PageGroup. We also reduced the weights of several investments that have performed positively based on lower discounts to intrinsic value both on an absolute basis and relative to the other portfolio holdings.
I will now proceed with the review of the portfolio at the end of the quarter. Net of the transactions discussed above, our portfolio remained relatively concentrated at the end of the second quarter. We held 31 disclosed investments with weighted average discount to intrinsic value was close to 40% at June 30, up somewhat from just over 35% at the end of the first quarter. We remained focused on our best ideas with the Fund’s top ten holdings accounting for more than 40% of the assets and the top five holdings accounting for more than 25% of the assets. These top holdings include Fenner, LSL, and the PageGroup. In our first quarter webcast we talked about Fenner and LSL, but the PageGroup has recently become a top holing, even though it was previously a holding in the Fund to begin with.
Read the full transcript below.