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Thornburg Value Fund 2Q16 Commentary “factor investing”

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Thornburg Value Fund commentary for the second quarter ended June 30, 2016.

H/T Dataroma

It has been a tough few years for active management, which in the past had grown significantly. But as many managers in large asset categories disappointed (often by closet indexing—i.e., charging active management fees but providing a benchmark-like portfolio), the trend turned. Passive flows now dominate in a number of the largest, most-crowded style boxes. And a new twist on the active/passive debate is the significant growth in popularity of “alternative beta” products. These portfolios charge lower fees and use computers to pick a group of stocks based on certain characteristics or factors. Below you can see flow data from Morningstar showing how smart beta investing has grown dramatically.

Count us skeptical. We’ve written in past commentaries about the long-term challenges presented by performance chasing. Forget which fund or manager investors choose, the biggest obstacle to achieving their long-term goals is so often their own timing decisions. Simply not acting in March of 2009 would have been the most valuable decision that many investors could make in their lifetimes. So what sort of impact do we think smart beta will have?

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There seems to be a new type of performance chasing: factor investing. While here are many flavors of “smart beta” portfolios (including equal-weighted, value, growth, etc.), the most popular this year carry a similar theme. They often advertise low volatility, high-dividend yield, or, even better, both! We think the low-interest-rate trade has been the dominant force in the markets recently, and these factor-driven funds have been some of the greatest beneficiaries. We have thought “expensive defensives” (high dividend yield, thought to be steady businesses) overvalued for some time. Our guess is that smart beta products are exacerbating this issue, driving more capital toward these already expensive holdings in part because they have outperformed—a self-reinforcing, increasingly risky dynamic.

Warren Buffett wrote about cash and bonds vs. equities in his 2011 annual letter. We wonder if this shouldn’t be modified to apply now to “expensive defensive” equities, which are sometimes also called bond proxies as many traditional fixed income investors buy them for additional yield. “Most of these currency-based investments are thought of as ‘safe.’ In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge,” Buffett pointed out. We get the feeling we’ve seen how this one ends before.

While reviewing mutual fund flow data can get depressing for a manager of an active “Large Core” or “Large Blend” mutual fund in the U.S., we think over the long term, these trends could create strong investment tailwinds for us. We believe that through in-depth fundamental research of individual investments, paired with the flexibility that is part of our DNA at Thornburg Investment Management, we can add value with active management. The more that things other than intrinsic value drive stock prices (i.e., index weighting or factor scoring), the more opportunities we will have to discover promising investments at a discount for you, our fellow shareholders.

Since we bolstered the consistent earnings characteristics of the portfolio in mid-2012, the last four years have been very good for the Thornburg Value Fund, even though the environment has been a tough one for active managers. We have returned 15.1% (A shares without sales charge) annualized vs. 13.8% for the S&P 500 Index over the period (July 1, 2012 to June 30, 2016). We should note that the S&P 500 Index has been one of the best stock indices in the world during this timeframe, and one our peer group has lagged dramatically. These results put Thornburg Value Fund A Shares in the top 4% of similar funds in the Large Blend category (1,414 funds) over this period (July 1, 2012 to June 30, 2016), according to Morningstar, based on total return without sales charge as of June 30, 2016.

So, how’d we do this quarter? Well, point-to-point, not a whole lot happened. The Thornburg Value Fund returned 1.78% (A shares without sales charge), trailing the S&P 500 Index return of 2.46%. Good stock selection in consumer staples and information technology wasn’t enough to offset some weak, near-term stock picking results in the consumer discretionary and health care sectors. The impact of having less of the portfolio in the rebounding energy sector than the benchmark during the quarter was more than offset by our underweight position in weaker information technology stocks. Overall our positioning; i.e., which sectors our stocks are grouped under, didn’t have much of an impact on performance during the period. Our large cash position, however, did weigh somewhat on our results.

Let’s touch on the macro environment. We were on a red-eye flight from San Francisco to the East Coast following medical technology-focused research meetings the night of the June 23rd U.K. referendum on its continued membership in the European Union, commonly referred to as “Brexit.” It was a JetBlue flight, so it had both good internet and a live TV feed. Many members of Thornburg’s investment team were watching the unexpected results come in live, and there was a healthy exchange going on over email. We were working through potential ramifications. Polling firms and betting houses had highly favored the “remain” vote, for which many investors had been positioned. The market selloffs over the following two sessions likely reflected the unwinding of those positions as well as the uncertainty generated by the result. Yet three weeks later, new all-time highs for the S&P 500 Index have been hit. Brexit and the ensuing market action since the referendum highlight the virtue of focusing on the fundamentals and investing in individual companies, not predicting macro events that may or may not impact a company’s business in a meaningful way.

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Our top contributors included two recent additions: Enterprise Products Partners, L.P., and Envision Healthcare Holdings (EVHC).

Enterprise is one of the largest and most stable MLPs in the oil/gas/natural gas liquids space (NGLs), but was hit hard with the rest of the energy sector early this year, creating a nice purchase opportunity. It is the largest player in the NGLs space and derives most of its revenues from long-term, fixed-price minimum volume contracts, while benefitting from growing volumes moving through its Gulf Coast network. Enterprise is run by a conservative and long-tenured management team that has shown discipline with the balance sheet, allowing them to raise their shareholder distribution the last 46 consecutive quarters.

Envision is the largest independent provider of emergency room outsourcing for hospitals and emergency response (ambulance) contracts for municipalities. It has shown consistent organic growth through new contract wins in these areas, while also adding growth through numerous bolt-on acquisitions, a key part of their growth strategy. It has supplemented these core businesses with a small but rapidly growing Evolution Health segment, which combines the firm’s capabilities to provide value-based post-acute care for patients. Evolution grew revenues 177% year-on-year in the first quarter, which now makes its growth a meaningful contributor to the company’s overall revenue growth. EVHC is currently in a pending merger with Amsurg (AMSG), which would create the largest physician outsourcing business in the country.

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Our weakest stocks during the quarter included Phibro Animal Health, Office Depot, and American Airlines. We wrote at some length about Phibro in our last quarterly letter. The stock has moved lower still, while our calculation of intrinsic value has hardly moved. This company continues to look very compelling to us at its current valuation.

Office Depot seems to be yet another victim of a very active Federal Trade Commission. Despite what seemed to us to be very compelling evidence that would support the proposed merger of Office Depot and Staples, a judge ruled against the deal. Office Depot picked up a breakoff fee and continues to run a strong delivery business, which we believe justifies upside from post-deal low-stock prices.

American Airlines was initially a good investment for us, as it exited bankruptcy and merged with US Airways. At first, the stock market didn’t seem to value the potential synergies when combining the two airlines and this drove strong stock performance. We took advantage of early strength and trimmed our holding as we approached price target. Since then, the going has been tougher. While the U.S. airline industry has consolidated dramatically, and should have strong incentives to act rationally and tightly manage capacity growth, this doesn’t seem to be happening. Revenue performance has disappointed across the U.S. airline industry as capacity creep has outpaced demand. We have decided to exit this position on fundamental deterioration. The U.S. airline industry is seemingly unable to act as a disciplined oligopoly. While the stock was up since our initial investment in late 2013, all of our gains occurred during the first year or so of our ownership.

During the quarter, we initiated a small position in Telsa as an emerging franchise. Tesla has the potential to be a game changer in the automotive and energy industries. We believe its products are compelling, its business model has removed many of the friction points in the car buying experience, and it should enjoy significant demand for its vehicles going forward. The initial response to the unveiling of the Model 3, its first mass market car launch, with over 400,000 orders in the first month (each requiring a $1,000 deposit), highlights the demand for its vehicles and the potential for the company. The biggest risks are around its ability to produce vehicles fast enough to meet this demand. While we believe there will be production issues over time, and Tesla will likely lag its very aggressive deadlines, we would note the firm’s amazing progress in ramping manufacturing to date and believe that its top-tier engineering talent will continue to make significant progress and ultimately meet demand for its vehicles. As Model 3 volume ramps in 2020 and beyond, we believe Telsa could approach and exceed $30 in earnings power per share.

Inflows into passive investment vehicles, including those fashionably described as “smart” or “strategic beta” ETFs, have lifted valuations in whole sectors of stocks, quite indiscriminately. Technical portfolio flows are not, of course, the same thing as fundamental, company-generated cash flows. We believe market distortions will arise when fund flows into factor-screened stocks aren’t well supported by corporate earnings performance. Valuation matters! Unlike portfolios algorithmically screened for a particular factor or two in ever-evolving, dynamic markets, we consistently seek attractively valued stocks of quality businesses with strong earnings prospects, and expect that, over time, they will deliver higher returns with less volatility.

Thank you for investing alongside us in the Thornburg Value Fund.

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