FPA Capital Fund commentary for the third quarter ended September 30, 2016.
Dear fellow shareholders,
For the third quarter of 2016, the FPA Capital 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).
FPA Capital Fund – Portfolio Commentary
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.
The performance shown reflects the performance of a single portfolio holding and does not reflect the performance of the Fund. Portfolio composition will change due to ongoing management of the Fund. References to individual securities are for informational purposes only and should not be construed as recommendations of the Fund’s portfolio managers. It should not be assumed that future investments will be profitable or will equal the performance of the security example shown. Past performance is no guarantee of future results. Please refer to cover page this commentary for important disclosures.
Activity
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.
Technology investments
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.
Energy investments
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-overyear 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 its production by about 700,000 barrels per day. The actual limits for each member should be finalized by November 30, when member countries meet again. We believe the major proponent of the deal was Saudi Arabia, since it faces a deficit equal to 13.5% of its GDP (to put it in perspective, the U.S. figure was 2.5% in FY 2015, Greece’s stood at 7.2%. Of course, that is the short-term explanation. Quite possibly the real reason is the long-term one: Saudi Arabia’s miscalculation of how little money would be invested for future production in this low-price environment actually sets up an even scarier scenario, one where oil prices spike to unprecedented levels and trigger demand destruction – more hybrids, more electric vehicles, more of everything that requires less oil.
At the end of the third quarter, our Fund owned six energy names: three exploration and production companies and three service companies. As we have discussed in previous letters, we tilted our service company exposure from offshore to onshore because we believe the U.S. shale companies are more competitive than their offshore peers in the short-term. In the U.S. land driller space, we decided to focus our attention on alternating current (AC) rigs, which are more energy efficient and can operate at higher top-drive speeds with more torque than siliconcontrolled rectifiers (SCR) and mechanical rigs. These advantages allow operators to drill more wells per rig/year, thus accelerating cash flows because wells come online sooner than with legacy rigs. We believe that AC rigs should continue to take market share as upstream producers demand higher rig specifications in order to meet increasingly complex horizontal drilling criteria (i.e. longer laterals) and productivity requirements (i.e. pad drilling, automated pipe handling, and increased mobility). Therefore, we believe that companies with the largest Tier 1 AC rig fleets and best ability to fund upgrades will likely capture an outsized share of demand from large E&P operators. Helmerich & Payne, Inc. (HP) and Patterson-UTI Energy Inc. (PTEN) are the two onshore drilling companies that best demonstrate these characteristics. Unconventional decline rates imply a higher rig count just to maintain existing production while further upside exists should U.S. shale become the global swing producer.
Utilization (left hand graph) and market share (pie charts) by type of rig:
Companies with large AC-weighted fleets increased market share from Q3 2015 to Q2 2016, with HP making the biggest gain (~5%) and PTEN making the second-biggest gain (~2%) relative to other large AC drillers. The charts below show historical rig count and market share through the downturn for HP and PTEN6.
Moreover, HP and PTEN have stronger balance sheets than peers, and therefore, more flexibility to fund rig upgrades. HP has a net cash position of $524 million. PTEN’s net debt to LTM7 EBITDA is 1.8x vs. an average of 5.9x for its non-HP competitors (Nabors Industries Ltd., Precision Drilling Corporation, Unit Corporation, and BR, PDS, UNT, and Pioneer Energy Services Crop.8).
Market commentary
In the 5,000- or so year-history of interest rates, now is the first time we have experienced negative rates. Approximately 30% of global sovereign debt requires the lender to pay the borrower. This phenomenon is not limited to short-term debt. On July 13, Germany became the second G7 nation (after Japan) to sell negative-yielding 10-year bonds. Switzerland, not to be outdone, sold a 42-year bond with negative yields. We do not know whether rates will continue to stay low, but what if they go up? Goldman Sachs calculated that a 100bps increase in yield would cost over $1 trillion dollars of value destruction in the U.S. bond market alone.9 The goal of low (or zero, or negative) interest rate policy is to jump-start a lackluster economy, but we do not see any proof that these actions are actually working. What is a central bank to do when its ever-increasing efforts fail to produce any fruit? Now Bank of Japan and Swiss National Bank, among others, are buying large equity stakes. We are not convinced that these experiments will end well.
In the fourth quarter of 2007, we wrote extensively about our worries about the extreme valuations in the stock market. Today, both gross and net leverage are higher than they were at the end of September 2007. Most strikingly, the Fed Funds Target Rate was 5.25% and the Federal Reserve balance sheet stood at $890 billion in 2007, compared to today’s 0.50% and $4.5 trillion, respectively. The low interest rates, not surprisingly, resulted in elevated debt to EBITDA level.
Yet, despite all these efforts, the robust GDP growth has been elusive. The New York Fed, in their Nowcasting Report, lowered its third quarter and fourth quarter 2016 forecasts by 50bps,10 so brace yourselves for a slower second half. We worry that the growth in money printing and credit availability, combined with a lack of growth in GDP and high asset valuations, is like a powder keg with a fuse of unknown length.
The last time the S&P 500, Nasdaq Composite, and Dow Jones Industrial Average indices set a record on the same day was December 31, 1999. Those records fell on August 11, 2016 – a feat that was repeated again on August 15. These recent record closes came on the heels of weak corporate earnings. The second quarter of 2016 marked the fifth consecutive quarter of earnings declines for the S&P 500 and the third quarter would be the sixth despite previous projections of growth. This is the longest stretch since 2008.
On August 26, 2016, Fed Chair Janet Yellen suggested that “the rate hike case has strengthened in recent months.” But exactly a week later, on September 2, 2016, the Fed received some contradicting news. The Jobs Report depicted only a 151,000 increase in payrolls for the month of August. That is a low number for an economy of this size, and it was accompanied by hourly wage growth of a measly 0.1% and average weekly earnings that fell from $884.08 to $882.54.11
In closing
If our assessment of the situation is correct, the market – as a whole – is expensive. Some try to justify it with P/E ratios, as if the 29.8x P/E multiple for the Russell 2500 is low. For starters, that multiple only includes the companies that have positive earnings. How about the 30% of the Russell 2500 companies that have negative earnings? Perhaps the best way to look at it is to assess where we are historically. The chart below shows that, as of the end of the third quarter, the Russell 2500 was only 2.6% off its recent all-time high. Guess when the enterprise value-to EBITDA -multiple (EV/EBITDA) hit its peak? On Sept. 30, 2016, the Russell 2500’s EV/EBITDA stood at 19.3x – significantly higher than its 11.9x average over the last decade-plus. It is also interesting to note that EV/EBITDA hit its low of 6.9x in November 2008. Since the market bottomed on March 8, 2009, the Russell 2500 has increased by 277%, the cumulative EBITDA increased by 57%, and the EBITDA multiple increased by 142%.
If and when market participants come to the same conclusion (like they did during the dot-com bubble and the great financial crisis), many would try to go through a narrow door all at the same time. During such a time, we would expect a high level panic, which will create forced selling. An elevated level of forced selling, combined with a lack of liquidity, might result in challenges for many fully invested products such as index funds, many ETFs, and funds that have no to very low levels of cash cushions. Many investors put very little value on cash, arguing that cash’s current low yield makes it a poor investment. However, we believe cash’s value comes not from its current yield, but from its optionality. In a down market, cash helps mitigate losses and affords one the opportunity to buy when others are being forced to sell (generally the best time to buy). As we near the 8th year of the current bull market, it can be tempting to forget that nasty downturns happen with some regularity, and there is never a bell rung to announce their arrival.
We continue to be on high alert. Our portfolio is filled with companies trading at substantial discount to market multiples (and, more importantly, at discounts to our intrinsic value estimates). Our cash level remains elevated. We urge extreme caution.
Respectfully submitted,
Arik Ahitov
Portfolio Manager
Dennis Bryan
Portfolio Manager
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