Thornburg Value Fund commentary for the third quarter ended September 30, 2016.
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- Q3 2016 hedge fund letters
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Rather than spend much time on what we think might happen as a result of November’s U.S. presidential election, let’s reflect on a campaign many years ago. Up against George H.W. Bush in 1992, Bill Clinton was handed “It’s the economy, stupid” by campaign manager James Carville. In this vein, if we tagged a similar slogan to explain recent stock market activity, it would be “It’s interest rates, stupid.”
If there is one factor driving stock performance over the last few years, it is interest rates. We have written much about them in our quarterly letters and white papers, and, in particular, about what low interest rates have done to valuations of what we call “expensive defensives.” We have also heard the term “bond proxies” used to describe large companies that the market today perceives to be stable, with high dividend yields and sky-high valuations. We have worked hard to position our portfolio defensively in this environment, though we have also striven to avoid buying overpriced current market darlings. As highly active managers, Thornburg Investment Management is always on the hunt for promising companies selling at a discount to our calculation of their intrinsic value. Consequently, expensive defensives have seemed to be neither promising nor discounted to us for some time now.
This has created a headwind to fund performance, especially during the 12 months ended June 30, 2016. During this period, rates on the U.S. 10-year Treasury dropped from nearly 2.5% to below 1.5%. In this environment, Thornburg Value Fund lagged its benchmark.
We hope, however, when we look back on the current environment years from now, the third quarter of 2016 will mark a turn for the better. Already, interest rates during the third quarter increased from 1.47% on June 30 to 1.59% on September 30. While not much of a move, the 0.12% increase was enough to cause a reversal in sector leadership during the quarter. The table at right shows recent performance of the overall market and each of the sectors that we believe typify the expensive defensives.
The 0.12% increase in rates benefited fund performance. This makes sense to us, albeit not because we are using the fund as a vehicle to bet on a rising interest rate environment (though to shareholders it may seem that way sometimes). We instead focus our research on valuing underlying investments.
Our outperformance during the quarter makes sense because our work on the underlying fundamentals of businesses in the U.S. is leading us away from areas that tend to benefit from lower interest rates. Instead, we’re moving into investments where the interest rate impact is either neutral or positive. This flexibility in our mandate is exactly why we believe we can add value with active management over the long term. When the market is too focused on one thing or another (e.g., performance chasing of low volatility, high dividend payers) money gets sucked out of other areas of the market, creating opportunities for long-term focused active investors to find good bargains.
We hold no false conviction that interest rates are now set to go up steadily over the next few years, but we think the portfolio can perform well if rates stay low, or increase. Compared to the overall market, our current portfolio has both a lower price-to-earnings (P/E) ratio (16.3x vs. 17.9x for the index) and slightly higher expected earnings growth (11.3% vs. 11.0% for the index). This is largely a function of avoiding expensive defensives, which tend to be high P/E and low growth. If rates continue to stay low, the earnings power of our portfolio may have the potential to outgrow the market (the growth rate above is based on consensus estimates; we think our investments will do better). If rates increase, the portfolio could still grow faster, with the added benefit of our portfolio’s P/E converging with the market multiple.
For the third quarter of 2016, Thornburg Value Fund outperformed nicely, beating the S&P 500 Index by over 1.50%. The fund returned a solid 5.44% (A shares without sales charge), while the index posted 3.85%. As we mentioned above, investors seemed to lose some of their enthusiasm for expensive defensives and this helped the fund.
There was no particularly strong individual sector tilt that was responsible for any big chunk of returns during the period. Being underweight real estate and overweight financials certainly helped. We examine financials in detail later. Meantime, security selection in health care and consumer discretionary names also helped, although the performance advantage realized by fund holdings in these sectors was partially offset by negative stock selection in energy. Being underweight in this sector helped to lessen the drag from our energy names as a group. Within the space, Enterprise Products Partners, L.P. (EPD) was a primary detractor. Enterprise is one of the largest and most stable master limited partnerships in the oil/gas/natural gas liquids space (NGL). After a strong stock move during the second quarter (along with the rest of the energy complex), EPD gave back some gains in the third quarter as oil prices retreated a bit and production increases among U.S. shale producers paused in tandem with the overall pause in commodity prices.
And then there were information technology (IT) stocks, four of which made their way onto the list of our top/bottom performers. Among the stronger performers were HP, Inc. and Facebook, Inc. HP continues to be a market leader in their core segments, gaining share in both their printing and PC end markets. On top of this, management has reiterated intentions to return about 75% of cash generation to shareholders via stock buybacks and dividends. HP currently trades at a 12% free-cash-flow yield. Facebook continues to outperform as its gigantic user base steadily grows. Monthly active users recently topped 1.5 billion worldwide, with over 1 billion of those logging in each day. Facebook continues to monetize its user base better than expectations, aided by additional contributions from Instagram. Revenue generation potential opportunities from subsidiaries Messenger, WhatsApp, and Oculus (VR) are beginning to take shape as well.
At the other end of the IT return spectrum were Cognizant Tech Solutions Corp. and SolarEdge Technologies, Inc. We have owned SolarEdge since late May 2016. The U.S. residential solar market has slowed during 2016, with prospects for 2017 worsening as well. While SolarEdge has continued to take share and improve margins in a tough environment, its stock price has fallen along with its peers. Cognizant was the portfolio’s worst performer during the quarter. Cognizant is a recent purchase for us. On September 30, 2016, the company released a filing disclosing two things; the resignation of their long-tenured second in command, and the beginning of an investigation into potential bribery/violation of the Foreign Corrupt Practices Act. The stock finished the last day of the quarter down some 13%, but already has recovered about half these losses since the end of the third quarter.
As a group, the fund’s health care names treated us well, though there was a bit of a performance dispersion between the fund’s top and bottom holdings in the sector. Leading the pack was Phibro Animal Health Corp., a company we’ve written about before. Phibro has been a good holding for the fund since our initial investment in early 2014. We had trimmed our position significantly during 2015 as the stock approached our price target. Soon after, it dramatically declined following Hillary Clinton’s now infamous health care–related tweet “heard ’round the world,” and some challenges in Phibro’s medicated feed additive business segment. We began to add to our position in response to the low stock prices during the second quarter and saw the stock rebound significantly in the third quarter as sentiment improved.
Bringing up the rear in health care was Envision Healthcare Holdings, Inc. (EVHC), a top detractor during the period. After an excellent second quarter, EVHC pulled back with the rest of the health care provider space. Among the general market concerns were: 1) the volume tailwind provided by the Affordable Care Act may be abating; 2) a few non-core short-term issues hit margins during the second quarter that created additional uncertainty.
Other notable contributors included Citizens Financial Group, Inc. and International Flavors & Fragrances, Inc. Citizens performed well as interest rates moved higher during the quarter; higher interest rates make the company’s job a little easier. In addition, Citizens has been improving its subpar return on equity (ROE). Shares of International Flavors& Fragrances climbed on improving organic growth in both primary divisions. The stock rose to an increased valuation premium, due to the company’s stability and structural growth opportunities as a result of an oligopolistic market. Rounding out the list of notable third-quarter performers was Mead Johnson Nutrition Co. The stock had a difficult quarter. At an investor conference, Mead Johnson was cautious on their near-term growth prospects and called out challenges in emerging markets. As a result, the company now expects 2016 financial performance near the lower end of their previously stated range.
We have worked hard since June of 2012 to bolster the consistent earning characteristics of the portfolio. Specifically, we want to be positioned to protect if we see a significant market pullback in conjunction with lower U.S. interest rates. Given our underexposure to expensive defensives, this is more challenging for the fund. To offset our lower exposure to these sorts of holdings today, we are carrying higher exposure to our portfolio diversification basket, known as Consistent Earners, and lower exposure to companies in our other two baskets: Basic Value and Emerging Franchise companies. We have also been carrying higher cash than normal. This potentially will hurt us in a rising market, but should aid portfolio performance during a pullback. Following are highlights of new stock positions and liquidations during the third quarter.
Thornburg Value Fund – Purchases
- Cognizant Tech Solutions Corp.
Cognizant (CTSH) provides information technology consulting and technology services in North America, Europe, and Asia. We see significant future growth opportunities for CTSH, arising from growth in consulting, digital initiatives, geographic expansion, and new customers. So far, our judgement is that quarter-end developments do not hamper the long-term opportunity for the company.
- Avinger, Inc.
Avinger (AVGR) is an early-stage medical device company (for us, an Emerging Franchise). The company designs, manufactures, and sells image-guided, catheter-based systems that are used by physicians to treat patients with peripheral arterial disease. AVGR has an intuitive, best-in-class, competitively priced product with demonstrated efficacy and safety results that launched in early 2016. Excitement in the medical community around this product is evident, and its differentiation at the same price should allow success in this market.
Netflix (NFLX), another Emerging Franchise investment for the fund, operates as an internet-based subscription service company, providing online streaming movies and other content as well as DVD rentals by mail. NFLX is the leader by far in streaming video— the company bids for content at a fixed price and amortizes across a growing global subscriber base. This creates a nice virtual cycle as more content gets more subs that get more content. While the promise here is evident, we also see a discount in a sum-of-the-parts valuation approach, separating their domestic, mature international market and new international market streaming businesses.
- Devon Energy Corp.
Devon (DVN) is an independent energy company involved primarily in oil and gas exploration, development and production, the transportation of oil, gas, and NGLs, and the processing of natural gas. The company also has marketing and midstream operations primarily in North America that include gas, crude oil, and NGLs. DVN has an attractive set of under-earning assets in the industry in the Permian and STACK basins and their production rate of change should expand significantly. In addition, the company has a strong balance sheet, allowing investment in strategically important assets. Cash-flow-generating assets in the Canadian Oil Sands and the Eagle Ford Shale also provide upside not captured in the stock price and could potentially provide DVN with an advantage in funding new rigs versus competitors.
- Express Scripts Holding Company
Following the disclosure of contractual disagreements with their largest client during the first quarter, we trimmed our position materially. We completed our exit during the third quarter as further internal research has again brought Express Scripts’ role in the health care industry as a cost saver into question.
- Tesla Motors
We exited our position in Tesla and put the cash to what believe is a better opportunity in Netflix (see previous page). Following Tesla’s announced acquisition of Solar City, as well as the presentation of their new long-term plan, it seems to us that Tesla management may be biting off more than they can chew. While exciting, founder and CEO Elon Musk’s very ambitious plans (including manned trips to Mars) seem to have increased the possibility of failure since our initial investment earlier this year.
- Chevron Corporation
We exited our position in Chevron in order to redeploy capital into Devon Energy Corp. (see previous page).
- T-Mobile US, Inc.
We liquidated T-Mobile in order to pursue what we believe are better opportunities across the portfolio. Thank you for investing in Thornburg Value Fund.
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