GoodHaven Fund annual letter for the year ended December 31, 2016.
To Our Fellow Shareholders of the GoodHaven Fund (the “Fund”):
Measured by either a calendar year or fiscal year basis, 2016 was a good year for the Fund. For the calendar year ended December 31, 2016, the Fund gained 20.13% compared to a gain of 11.96% for the S&P 500 Index. For the fiscal year ended November 30, 2016 (and after a rough first month of December), the Fund gained 13.89% compared to 8.06% for the S&P 500 Index.1
As discussed in prior letters, outlier declines in oil, gas, and metals in 2015 overshadowed some positives and led to unusual portfolio weakness throughout 2015 and early 2016, which affected our historical and relative results. This weakness appeared to end in February of 2016 and has been followed by a sharp recovery in some key investments. Most of the factors that resulted in the weak results of 2015 appear to have been attenuated or reversed.2 Throughout this unusual volatility, we did our best to behave consistently, did not overreact, and bought under pressure when our research told us that values were intact.
We continue to own a portfolio that we believe is materially less expensive than the S&P 500 as measured by some common historical valuation markers and remain disciplined when looking at potential new investments. The Fund also continues to hold cash, reflective of generally high valuations, which allows us to behave opportunistically. We try to invest to the extent that we find sensible things to do and remind our fellow shareholders that our personal stakes in the Fund are material. We are not willing to do something for you that we are unwilling to do for ourselves.
Perhaps more importantly, we are increasingly confident that some of our headwinds are turning into tailwinds as we enter 2017. The overall environment seems to be friendlier to our approach despite stretched index valuations. While we do not pretend to have a crystal ball that predicts future economic conditions or commodity prices, most market trends regress toward the mean over time. In other words, very expensive securities tend to become less expensive given time, while bargain securities tend to become less of a bargain, barring some permanent change in demand.3
In addition, many industries tend to have cycles. However, it usually pays to hang on to a good business through cyclical moves unless that business becomes materially overvalued. Here’s why: a good business run by smart people has the opportunity to significantly outperform its direct competition over an extended time period. In other words, you don’t want to overweight cyclical influences, especially when good capital allocators are running an enterprise.
In that vein, we note that several of our investee companies improved costs and operations in significant ways or re-allocated capital in a shareholder friendly manner. For example, Alphabet (formerly Google) adopted new financial discipline in pursuing its non-advertising “moonshot” venture investments (which currently cost shareholders about $3 billion annually, or a penalty of nearly $5 per share pre-tax). Barrick Gold has reduced its “all-in-sustaining-costs” per ounce of gold from over $1,000 four years ago to just above $750 today while also reducing debt by over $4 billion in the last two years. WPX Energy reduced the cost to drill a well in the Bakken formation from $11 million a few years ago to about $5.5 million today and made a major acquisition in the Permian basin in 2015 that now appears to have been a huge bargain. White Mountains Insurance sold some subsidiaries and used a portion of the proceeds to repurchase shares at or near tangible book value. And Birchcliff Energy, already a low-cost operator, recently upgraded its asset base through a major acquisition of overlapping properties, which should improve efficiencies and reduce risk going forward.
These types of changes, when sensibly implemented, make these companies more valuable, irrespective of cyclical influences. Improving cost structures, reducing leverage, and making sensible capital allocation decisions all add to value. While volatility may result from changing economic conditions or commodity prices, we think the medium-term demand for products and services offered by these businesses will remain robust and that intrinsic values will grow. Generally speaking, these businesses have tremendous optionality.
In past letters we have cautioned that while we could not predict when, the likelihood of interest rates rising from at or below zero was a virtual certainty. Although a recent increase in the federal funds rate was indeed small, subsequent bond market losses exceeded a trillion dollars.4 While we cannot predict the timing, further increases seem likely over time, particularly if inflation starts to heat up. In addition to the recovery in energy and metals this year, higher interest rates should help some of our other investments going forward, like Leucadia National, Federated Investors, White Mountains Insurance, and Berkshire Hathaway.5
Over time, we prefer to invest in companies that not only appear to offer business value well in excess of recent market values, but which also have strong balance sheets and shareholder friendly management. We are continually looking to upgrade what we own – but only if we can buy at an advantageous price. We have identified a number of companies meeting these criteria that await prices offering potential returns higher than what exists today.
GoodHaven Fund – Portfolio Review
Currently our largest holdings are WPX Energy, Barrick Gold, Alphabet, Birchcliff Energy, White Mountains, and Leucadia. Somewhat smaller positions include Hewlett Packard Enterprise, Spectrum Brands, Federated Investors, Staples, and Verizon. While we feel good about all of these companies we must continue to ensure that we are sizing the investments commensurate with their risks.
WPX had a good year, and began to reap the benefits of its extensive reorganization, its purchase of very valuable RKI in the Permian Basin, and a material recovery in the prices of oil and natural gas. While the investment community seems split as to whether prices will rise further or decline, our expectation is for limited downside and reasonable upside due to: a deep and pervasive decline in capital spending across the oil and gas industry over the last two years; the lowest rate of new oil discoveries in seventy years (according to consultant Wood McKenzie); producer nations whose economies are deeply stressed at lower price levels; a recent OPEC agreement to limit production; and domestic inventories that, while still high, appear to have peaked.
WPX weathered the staggeringly large decline in oil prices (from over $100 per barrel in mid-2014 to less than $30 per barrel in early-2016) with some dings, but emerging as a much better business. In early 2014, natural gas dominated the business and it had holdings in the eastern and western United States and Argentina, which included a bloated overhead structure, large and fixed natural gas
transportation agreements, and other onerous expenses. After consummating a number of tough dispositions at reasonable prices during a difficult period, the company acquired a sizeable position in the Permian basin in mid-2015 – a deal our research suggests has added billions of dollars of value to the company.6
As a result, WPX has streamlined its holdings into three main areas – the Permian, the Bakken, and the San Juan