Managers of FPA Capital Fund on Value Investing, Economic Outlook and Western Digital Corporation (WDC)

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Jan 12, 2011
Now that Value Guru Robert Rodriguez should have come back from his Sabbath year, but as he promised he would not come back to the day-to-day management of the FPA Capital Fund. He has decidedly left that responsibility to the two younger lieutenants of his – Dennis Bryan and Rikard Ekstrand to co-manage the banner fund of FPA Advisors.

Dennis and Rikard have written the fund’s letter for the fund’s semi-annual report. The report covers the fund for the 6-month up to September 30, 2010, but the letter was dated on October 18, 2010, so it is more recent. I attached the letter to the end of this article, but if you want to read the report in full, go here.

Allow me to provide a few highlights:

On Performance of the fund

The fund underperformed S&P 500 for the year ended on September 30, 2010 (10.59% vs. 13.96%). Morningstar listed the fund returned 24.25% for the year of 2010 (through Dec. 31, 2010) vs. S&P 500’s 15.06%. Truth is, it is probably meaningless to evaluate a mutual fund based on 1-year performance, so let’s talk about longer term: for the past 10, 15, 20, 25 years and since the fund the inception on June 30, 1984, the fund returned 9.32, 10.68, 16.01, 14.72, and 14.78% respectively, beating the benchmark S&P 500 by a large margin.

On Value Investing – Buy and Sell Principles

Dennis and Rikard summarized their buy-and-sell principles:
Contrarian value investing is by nature a lonesome activity, but one that we relish because of the potential for outsized reward opportunities for those that embrace this enduring philosophy. We do not mean to give short shrift to other viable investment strategies, but merely to reinforce in the minds of our clients and shareholders that we will faithfully continue the practice of buying securities that are, in our opinion, absolutely cheap and have a good margin of safety. Being loyal to a strict valuation discipline also requires us to reduce or liquidate entire positions when security prices reach beyond fair value. Our investment strategy is timeless and one practiced by only a few other highly successful investment professionals; it is in a distinct minority amongst a plethora of strategy options for global investors

More on Value Investing – Patience and Loyalty

In the letter, the two managers counseled patience for value investors and for the investors of their fund:
Patience and loyalty to absolute valuations are the signature virtues of our investment strategy. Investment managers often want to display how smart and knowledgeable they are versus other investors, so they rapidly move in and out of stocks based on the latest tidbit of information. Rather than stop to assess the significance of the information to the long-term valuation of a business, these traders and speculators quickly “pull the trigger” and buy or sell stocks if they believe the news is not yet discounted in the share price. This is why, according the New York Stock Exchange, the average holding period is now just seven months. As your portfolio managers, we do not measure our holding period in months but rather in years. We are fundamentally different than what our industry represents today, and our patience and discipline to absolute valuation has served your portfolio well over the years. We definitely will not out-perform every year, but over longer periods of time we have been able to achieve excess returns due to our adherence to the virtues of long-term value investing.

On the Economic Outlook

Traditionally, Robert Rodriguez integrates his macro-view into his portfolio management. At the time of writing of the letter, FPA Capital Fund has 73.4% in common stocks and 26.6% is in cash and short term investments. 10 months ago on March 31, the fund had 71.4% in stocks and 28.6% in cash and short term investments. So essentially they have not changed the view. Cash has dragged the fund’s performance, but prudence has served the fund and its investor well over the long term.

The fund managers’ macro view was negative, at least it was the case on October 18. I will quote the opening paragraph, which summarizes their views, please read the full text in details:
We continue to believe that the U.S. economy is not on a sustainable growth path. The last twelve months growth is primarily the result of inventory rebuilding, pent-up demand from the recession, and stimulus spending by the Federal government. None of these factors can be upheld indefinitely. We continue to see headwinds for the economy and the stock market, including declining credit generation from the banking system and the structured finance system, a consumer that continues to reduce debt levels despite facing high unemployment and limited real wage growth, and U.S. Treasury debt levels going north of 100% of GDP with higher deficit spending as far as the eye can see. In addition, corporate profit margins are back to 50-year peak levels and are unlikely to expand from here. For these reasons, we have, when the opportunities have presented themselves over the last several years, skewed the portfolio to investments that are exposed to global-demand growth and/or global commodities. We have only done so, however, when the investments have matched our criteria of industry leadership, strong balance sheets, quality management teams, and prices far below their intrinsic values.
It will be interesting to know how the two managers think about QE2. But we have to wait for another six months before they speak to us again.

On Western Digital Corporation (WDC, Financial)

In the letter, the two fund managers presented a rather detailed investment thesis for Western Digital Corporation (WDC). As a illustration on high value investing is being practices at PFA, here we are:
We purchased WDC in the recent period in the low-to-mid $20s. At our recent purchase price, WDC was trading at approximately 6x fully taxed, trailing twelve-month earnings, not including the company’s roughly $10 in net cash per share. Clearly, the market does not believe that WDC’s current earnings are sustainable, and neither do we.

However, we do believe that the company is unlikely to erode its large cash position and that WDC’s earnings might trough around the $2 level during this cycle.

In our opinion, the stock is depressed on investor fear that tablet computer devices such as the Apple iPad, which does not use a disk drive to store information, will cannibalize the computer market of netbooks, which do use disk drives. We have incorporated into our assumption that the netbook market could experience a decline from roughly 35 million units over the last twelve months to around 10 million units in 2012. Each of the HDDs for the netbook market represents $30 of revenue and $6 of gross profit dollars per unit sold. Thus, the HDD industry could experience a $750-million hit to revenues, or 2% of total industry revenues, over the next couple of years should tablets take share from netbooks. Gross profit dollars for the industry might decline $150 million due to fewer netbooks sold, but WDC alone has earned over $2.4 billion of gross profit during the last twelve months. While we do not want to minimize the risk of tablets eating into the share of netbooks, it appears the impact may not be as great as some expect, but we plan to watch this trend closely over the coming quarters.

Interestingly, the tablet market is not all negative for the HDD companies, and the reason is that tablets and other wireless devices, such as smart phones like the iPhone, drive users to download new applications, or apps. These apps reside on the internet web and are being stored on HDDs. Thus, the more wireless devices are sold, the more apps are created, and the more HDDs are required to store all of that information. Many of these apps are storage intensive like video files, which require a substantial amount of storage capacity. We are now hearing that sophisticated users of tablets are purchasing external hard drives to back up files that can no longer be stored on a 64 GB flash chip.

There is also the real concern that Seagate Technology (STX), WDC, and Hitachi are going to cut each other’s throats by slashing prices to either retain or gain market share. In 2004, the industry, led by Maxtor (since acquired by STX), cut prices to capture share, and nearly every disk drive company experienced a decline in profits; some lost a huge amount of money. STX and WDC were the only two companies that stayed reasonably profitable, but even those two saw their operating profits decline 28% and 13%, respectively, from the prior year. While the iPad tablet risk gets much of the headlines, we believe the competitive risks and lower selling prices could potentially do the most damage to WDC’s valuation.

PFA Capital Sept 30Report