FPA Capital Fund commentary for the third quarter ended September 30, 2016.
Dear fellow shareholders,
For the third quarter of 2016, the Fund appreciated by 10.20% and is now up 12.28% for the year. We are pleased with these results. We note that these strong returns were achieved while carrying, on average, 27.6% cash for the quarter and 26.0% for the year. In addition to this sound showing, we are excited prospectively. Most of our companies reported solid earnings and many pointed to better days ahead. Despite a frothy market (the Russell 2500 is only 2.6% off its five-year and all-time high), our portfolio companies are on average 36.0% off their five-year highs (and off even further from their all-time highs.
[drizzle]Our backlog of analyzed (but unattractively priced) securities continues to grow. This is akin to having acquired the seeds but waiting until the right season to plant them. Our investment thesis on oil is starting to play out now that we have seen production in the U.S. continue to fall. This is akin to green shoots from seeds we planted a while ago beginning to blossom. Other ‘green shoots’ include Western Digital Corporation (Nasdaq: WDC) continuing to find ways to realize synergies and lowering borrowing costs, and Arris International plc (Nasdaq: ARRS) getting closer to a new capex cycle after a lull in spending by some of its largest customers amid industry consolidation. We continue to increase the sizing of our positions when the market disagrees with our long-term view, and to do the opposite when the market ceases to provide us with an adequate margin of safety.2
As value managers, we seek to increase the size of our positions when the market disagrees with our long-term view, and do the opposite when the market ceases to provide us with an adequate margin of safety. We don’t always get it right, but InterDigital, Inc. (Nasdaq: IDCC) epitomizes such behavior. When the market failed to recognize IDCC’s normalized earnings power, we reviewed our thesis, worked through our upside/downside case, and then took action by substantially increasing our position. Finally, this year, the seeds blossomed and we have substantially reduced our position.
We exited one name during the quarter. We sold out of SM Energy Company bonds – one of our two high-yield bond investments. You might recall that we bought our entire position in mid-February 2016 at around 48.50 cents on the dollar, when oil prices were hitting multi-year lows. We sold out of the position at above par and also collected one semi-annual coupon.
We initiated one new position. We are still in the process of accumulating this equity so we will not disclose the name of the company yet. It is a spin-off of one of our former investments. We monitored the parent company since our exit and followed its offspring after the spin for over a year.
We continued to be active in our existing positions by adding to those that showed higher upside to downside ratios and trimming those that increased in price without a commensurate improvement in outlook.
Our best performing investments came from the technology sector this quarter. Arris International plc, InterDigital, Inc., and Western Digital Corporation have performed superbly (up 35.16%, 42.60%, and 24.78%, respectively in the quarter). We discussed all these names in our first quarter letter3 so we will not spend additional time on our investment thesis on these companies in this letter.
Our two other large technology investments, Arrow Electronics, Inc. (NYSE: ARW) and Avnet, Inc. (NYSE: AVT) were also up, but not as significantly (by 3.34% and 1.78%, respectively).
Arrow and Avnet act as the distribution arm for component and computer equipment manufacturers. Essentially, Arrow and Avnet consolidate the sales force, provide inventory management, and offer tech support for their vendors, allowing them to reach a broader customer base than they otherwise could. Arrow and Avnet’s customers benefit because a single distributor can provide rapid access to and expertise around multiple products and short-term financing.
There is a lot to like about these businesses. They have a diversified customer base, supplier base, and geographic revenue mix. To-date they have each delivered what in our view are reasonable returns on capital. And they have the potential to generate strong free cash flow during a downturn as inventories are paired back and accounts receivables are collected. In addition, we think these are relatively difficult businesses to disrupt because the distributors are not reliant on any single technology. Both firms also benefit from their scale as increasing size attracts both more customers and more vendors creating a network effect.
Avnet recently announced several big changes. First, the company replaced its CEO after several quarters of underperformance in its Technology Solutions (TS) business and a misstep in business management software implementation. Second, Avnet purchased Premier Farnell, a UK-based company focused on early design-stage customers, for about $1 billion. Finally, the company sold off its underperforming TS business for $2.6 billion. In aggregate, we have confidence these changes have improved the overall business quality and increased Avnet’s optionality via a de-levered balance sheet.
Arrow continues to execute well and is making changes to improve its business. For example, Arrow’s Enterprise Computing Solutions business has become more software driven, and this could lead to margin expansion. In addition, as the components business begins to take on more design work and offer more service-based solutions, we believe that margins in this business could also expand.
Our investments in the energy sector continued to be volatile. They have been strong contributors to our year-to-date performance, but with the exception of two, they have either detracted from or were small contributors to our performance in the third quarter. For instance, Rowan Companies plc (RDC) was one of our detractors this quarter: the stock was down 14.16% for the quarter and detracted 37 bps from the performance. Another energy name that was down in the third quarter was Noble Energy, Inc. (NBL), which was down 0.07% and detracted less than 1 basis point from the performance. Our thesis remains intact with both demand and supply moving in the right direction. In China, for instance, oil demand was up by almost a million barrels per day year-over-year for the month of August, and its domestic production was down 300,000 barrels.4 In Iran, where many pundits are looking for supply growth, production has plateaued at 3.6mm barrels per day, according to the International Energy Agency. Meanwhile, the National Iranian Oil Company needs $100 billion of new investment to hit their oil production goal of 4.5 million barrels per day by 2021.5 The news of continued military activity in Nigeria and Libya and social unrest in Venezuela will likely lead to continued pressure on oil production in those countries.
U.S. supply peaked at 9.6mm barrels of crude oil per day in June 2015, and it’s fallen by approximately 1.1mm barrels since then.
Just before the quarter came to an end, on September 28, OPEC agreed to a framework that would cut