FPA Capital Fund portfolio commentary from q4 letter.
FPA Capital Fund: Introduction
Who said thirteen was an unlucky number? It must have been an equity short seller because the thirteenth year of the new millennium was an incredible year for shareholders of U.S. publicly-traded companies. The Dow Jones Industrial Average gained 26.5%, the S&P 500 appreciated more than 32%, and the Russell 2500 outdid them both by gaining over 36%. The Russell 2500’s performance was its third best showing since we started managing the FPA Capital Fund (Trades,Portfolio) in 1984 (only eclipsed by the performance in 1991 and 2003). To put that 36% into perspective, if one were to invest $46,200 and achieve a 36% annual compounded return, one would become a newly minted member of America’s millionaire club in just ten years. Or, one could merely start with $100,000 and thirty years later be a billionaire, if one were to realize a 36% annual compounded return.
Market Commentary
We begin this section with further analysis on the Russell 2500 index. In our opinion, this index most closely (while not exactly) represents companies which could be investment opportunities for our strategy. The ability for the Russell 2500 to repeat recent returns, in our opinion, is highly unlikely. Here is why:
At the end of 2013, the Russell 2500’s Price-to-Earnings ratio (P/E)1 was 27.8x, and this is with near record highs in corporate profit margins. If you recall, the S&P 500 traded at approximately 30x earnings in the year 2000 and then collapsed nearly 50% between the years 2000 and 2002.
To see how challenging it would be for the Russell 2500 to produce a 36% compounded annual return over the next ten years, let alone the next thirty years, let’s assume earnings will grow 10% each year for the next decade, despite the fact that earnings for the market have grown less than 7% annually since the year 2000 and roughly 7% annually over the past eighty years. Thus, the Russell 2500’s P/E ratio in ten years would be over 230x if that index were to achieve an annual compounded return of 36% for the next decade and earnings were to grow 10% annually. We do not believe there are enough “supporters” who could keep that enormous bubble afloat, but the Pols in Washington are a determined group that continually prove folly has no boundaries.
Some people might ask, why are we so fixated on the P/E ratio? The answer is simple. If one were to invert the P/E ratio (E/P), one would get the cash-on-cash return of that investment if one were to acquire the entire company. For our illustrations, we are ignoring the accounting timing differences for working capital and assuming depreciation equals capital expenditures. Therefore, net income, or earnings per share, equals free cash flow in our example. Thus, with the Russell 2500 trading at 27.8x, investors are currently realizing just a 3.6% return on their invested capital. A P/E of 230x equates to a cash-on-cash return of 0.4%, or four-tenths of one percent. At that valuation, one might want to consider playing the Powerball lottery and buying Mega Million tickets for a better return, instead of endeavoring to become the next Warren Buffet.
When we explain this simple math to people they intuitively understand it is better to buy equities with a lower P/E because the cash-on-cash return is higher. The problem everyone has, including us, is that nobody knows with 100% confidence what earnings will look like next year, in three years, or in five years or longer. The stock market cares about future earnings, not last years or prior year earnings.
While we do not pretend to have a crystal ball that gives us perfect insight into future earnings, we can make some educated assumptions about how to think about future earnings. In recent letters, we mentioned that we were expecting very modest economic and earnings growth. This outlook was predicated on a myriad of factors, but sluggish wage growth and high debt levels were material factors. Our modest outlook for earnings growth proved correct in 2013, with earnings growing roughly 4.5% for the Russell 2500, despite the index appreciating more than 36% last year. In other words, nearly 90% of
The point in analyzing these scenarios is to objectively evaluate the viable outcomes, based on a set of relevant input factors. Our team does this with stocks all of the time to gauge the base case, downside case, and upside case for individual securities th at go into the portfolios we manage. This rigorous and quantitative analysis helps us frame the risks and return opportunities for an investment. We applied this analysis to the Russell 2500 merely to illustrate the plausible market scenarios so our invest ors and shareholders have a better understanding of the market risks. It is important to note that we are bottoms up investors and put very little weight on the macro factors, especially when we can invest in market – leading companies at very cheap absolute valuations.
Portfolio Commentary
Speaking of bottoms up analysis, the companies in the portfolio performed very well in 2013. More than 50% of the companies in the portfolio appreciated 42% or more during the year, and 40% of the stocks rose double digits in the fourth quarter. There was one disappointment in the portfolio that we will discuss later, but even that company performed well operationally.
There were no thematic winners or losers last year. Our best performing stock was a technology company, but our worst performer was a tech nology stock as well. Our second best performer was an energy company, but our second worst performer was also an energy company. Our retailers performed well, as did our education and industrial companies.
Importantly, we like the industry in which Centene (CNC) competes. Some of our investors might recall that one of our prior investments, Amerigroup, was acquired in 2012 by Wellpoint at a val uation that allowed us to achieve a return on investment of greater than 100% over the roughly one – year time period that we owned the shares. Medicaid managed care companies not only save states money but also offer better service; therefore, more states a re letting managed care companies run their Medicaid programs. To that end, states are expanding both the geographies carved out to managed care companies and the types of programs. The next phase of growth will come from the dual – eligible population. D uals (or dual – eligible population) are 8.3mm 3 people in the U.S. that are eligible to receive both Medicare and Medicaid benefits (mainly low – income seniors). According to the Kaiser Foundation, Duals accounted for almost 40% of Medicaid spending although they made up only 15% of the Medicaid population. We believe there are ample growth opportunities for CNC and other companies to meet the challenges of managing these disparate Medicaid members for the foreseeable future.
As we alluded to above, CNC inc urred some unusual expenses in 2012 due to a bad contract in the state of Kentucky. Thus, in 2012, CNC barely earned any money for the year, but we believed that was a temporary situation. Sure enough, CNC exited the Kentucky market and should earn close t o $3.00 per share in 2013 once it reports its fourth quarter’s earnings in early February. Our base case estimate has CNC earning $4.30 over the next couple years, and significantly more over the longer term, so it appears that management and the company a re well on their way to achieving that metric.
Unfortunately, we only have a small position in CNC as the stock took off as we were trying to accumulate our position. Nonetheless, should CNC have a hiccup and the stock decline to a more attractive valuat ion, we have the financial wherewithal to substantially add to our position.
As for Apollo Education Group (APOL), the situation is different than Centene’s in that the For – Profit Education industry is currently experiencing a declining enrollment environment, v ersus the large growth in new members for Medicaid services. However, despite all of the negative news on the education industry in general, and Apollo specifically, we are highly encouraged with APOL’s current profit level and its ability to generate abun dant free cash flow.
Long – term investors will recall that we highlighted the education services sector as the worst performing industry group in the US in 2012. Nevertheless, we ended up investing in two companies in that industry: Apollo and DeVry. Both of these companies p ass our criteria of investing in market leading companies with a history of profitability and pristine balance sheets that are run by capable management teams. The main question to answer is a simple one: will we need education in the future? If yes, who will deliver this education and how will it be delivered.
APOL operates the online school called the University of Phoenix (UoP) as well as several international schools. UoP generates more than 90% of Apollo’s revenue but 100% of its operating earning s. That is, the international schools are losing money, which we estimate was roughly $60 million in 2013. With a new management team now running the international schools, we could envision this division potentially earning $50 million in operating profit s over the next few years. This would be a swing of approximately $1.00 per share in operating profits should the turnaround occur. To put that into perspective, APOL earned nearly $3 a share in fiscal 2013, before considering restructuring charges.
The c ore operation for Apollo is UoP, which is the largest independent online university in the US. UoP was the first For – Profit company to offer online degrees over thirty years ago. The University of Phoenix is a well – known brand, but one that is in the proce ss of being upgraded. The company has embarked on a new determination to be more selective in choosing students who enroll at UoP. The main goal is to find students who will persist through every semester until they graduate rather than to fill the classro om every semester just to find a replacement when that student drops out.
Most investors, analysts, media, and government officials say this should always be the goal, and they are right. However, UoP’s typical students are not the eighteen year olds grad uating from high school figuring out whether they should attend a private or public university. UoP’s typical student is single, twenty – eight years old, a minority single – mother, first in her family to attend college, and someone who is 3 Centers for Medicare & Medicaid Services (CMS) via WellCare Health Plans, Inc. 2012 Annual Report on Form 10 – K trying to improve h er career skills and compete in today’s fierce labor market. Among the biggest obstacles for this cohort is keeping their child, or children, healthy and in school so they can finish school themselves.
The company has re – invested a tremendous amount of ca pital into superior software programs not only to educate students, but also to provide a more timely feedback loop to professors who are teaching classes. The company is also spending more money per student on student advisors, to intervene earlier and pr ovide help when a student is in danger of withdrawing from the program.
APOL is also aggressively courting businesses not just to place their graduates in a well – paying job, but to partner with them and tailor a certificate program, for example, that prov ides students with skills specific to an individual company or industry. Many CEOs will tell you that there is not a jobs problem in America but a skills problem. That is, many traditional, not – for – profit universities in America are not educating students and imbuing them with skills for the 21 st century global labor marketplace. APOL is now working with hundreds of companies to deliver graduates, whether they are fully credentialed students or students with a narrower certificate degree, to businesses that are looking to hire qualified people.
These initiatives will take time to fully implement and for shareholders to see tangible benefits. In the meantime, APOL management is cutting expenses to reflect the lower enrollment numbers, like marketing and recr uiting, to maintain healthy profits and free cash flow at the company. On the most recent quarterly conference call, APOL’s CEO announced that the company upped its total fixed costs cuts to a minimum of $675 million, $350 million of which has already been cut from the budget.
While we are pleased we were able to accumulate a full position below the $19 level, pleased that APOL appreciated nearly 50% in 2013, and pleased the stock is up another 25% during the first three weeks of 2014, we believe there is still a lot of upside potential in the stock should the company ever be able to monetize its software investment.
Currently, the Department of Education does not allow universities to share Title IV funding revenue dollars. Title IV funding is essentiall y the government guaranteed loans students use to finance their education. If this restriction is removed, APOL would be in a very strong position to forge relationships with the thousands of universities and colleges in the U.S. and effectively become the on – line outsource partner for these schools. The long – term trend in education is toward more distance or on – line learning, and APOL has the some of the best technology to deliver the highest quality service to millions of potential students. Today, this s oftware technology is an inexpensive call option for shareholders, but one that could be worth a lot of money down the road should this archaic restriction be eliminated.
The most disappointing investment in the portfolio for 2013 was InterDigital (IDCC). This stock declined approximately 28% during the year, despite posting roughly 25% operating margins. Our thesis on IDCC is that the company should benefit from its wireless technology patents as more smartphones and mobile tablets are connected to the in ternet. IDCC creates wireless technology, applies for patents for the technology it creates, and then licenses its technology to manufacturers who produce the aforementioned products. In the past, Nokia, Samsung, Apple, LG, and many other manufacturers hav e licensed the company’s technology to use in their products and paid IDCC royalties.
Typically, in the past, IDCC would receive royalty payments fixed for a certain period of time, for example four years, and then its customers would renew its license fo r another period of time and likely with some additional patents thrown into the agreement. However, as IDCC switched to receiving a royalty on a per unit sold basis and the number of smart phone units sold worldwide has exploded to the upside over the pas t couple of years, some of the company’s traditional customers have chosen not to sign new license agreements and pay IDCC. The failure to pay, but still use IDCC’s essential patents in the manufacturer’s products has prompted IDCC to sue some of its large st customers.
Suing your customers is not an ideal business strategy, but one, unfortunately, that is all too commonly deployed in the technology industry. These lawsuits are not only expensive, but also can drag on for years as the suits wind their way t hrough both the International Trade Commission and the Federal Circuit. At the end of the day, IDCC has prevailed in prior lawsuits and won large judgments or settled with the likes of Nokia and Samsung. Most investors do not have the patience to withstand all of the ups and downs of the legal process. When there are temporary setbacks to IDCC’s legal process, investors sell their stock, and this is what we believe largely transpired in 2013.
However, we do not view the prospects of a legal victory as the only means to the success of IDCC. In fact, the company can monetize its patent portfolio by selling non – core patents to other companies. For example, in 2012, Intel paid IDCC $375 million for a couple of hundred patents, out of a portfolio of over 20,000 patents. IDCC can also enter into joint venture agreements, such as the agreement signed with Sony in 2013, to generate value for shareholders. Instead of suing its potential licensees, IDCC can enter into binding arbitration with manufacturers.
Moreover, IDCC has not ruled out eventually developing products employing its patents, and then selling these products to its customers rather than licensing them the technology. Thus, there are multiple ways for IDCC to get paid for the value it creates, and it does not have to be a binary situation as some ill – informed investors might believe.
The one risk that we need to watch closely in the coming months and quarters is the political risk. There is some discussion is Washington about the merits of pate nts in our fast – changing, technologically – advanced society. Some people will argue that patents do not have as much value today as in the past. Their reasoning is that product life cycles are much faster today and new things are always being created to rep lace the older generation of products. However, perhaps the life cycle of products is shortening because there is payoff to those who create the technology in the first place. If inventors and scientists are not paid for the stuff they create, what is the incentive to create the new technology? Our view is that inventors, musicians, writers, and scientists should have their new ideas and products protected from being copied for a reasonable period of time, and get paid a royalty should someone or a company want to use their creation. However, we need to be cognizant that our opinion could be refuted in a political environment that has a different agenda. While the risk of a massive overhaul of our patent laws is small, we cannot fully discount it occurring.
Thus, we will be diligent in adding to our IDCC position and ask for an extra discount before buying more shares. The company’s balance sheet remains exceptionally strong with about half of the company’s market value consisting of its net cash position. The management team has also been very good stewards of shareholders capital, and the market for smart phones, tablets and other mobile devices connecting to the internet remains very robust.
In light of the above, we remain ever vigilant of valuations ac ross those companies that meet our business criteria and will continue to aggressively deploy capital when valuations meet our targeted entry levels. While there is currently a dearth of opportunities, we have exhibited an ability to find a few gems and lo ok forward to uncovering more over the months to come.
We thank you for your continued trust and confidence in our strategy.
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