July 1, 2020
To Our Fellow Shareholders:
I always thought that writing to you twice a year was often enough for both of us1. But the rapid pace of change lately in every area compresses weeks into days.
The last six months feels like years. The Wall Street Journal recent article “Six Months That Shook The World”2 is aptly titled. In my last letter, I wrote to expect more market and price volatility given markets are now dominated by automated/electronic trading, but recent events dwarfed that warning. While books will be written and classes taught about the economic, societal and public health events of the last six months I’ll avoid the presumption that my thoughts on all topics are needed for the historical record. I will touch on the big picture, while staying focused on discussing our recent portfolio repositioning, results and my views about our holdings and strategy going forward.
First – many people have suffered and died from COVID-19, and it’s not at all over. I hope you and your families have fared ok and I thank those on the front lines – protecting and serving us all.
Recent entrants into the investment business are fortunate – they have had thirty years of experience in six months. While I’m writing to you in July, I’m discussing the recent volatile six month period. Even for those of us who have seen much, and successfully embraced past crisis’ and volatility as opportunities, there was no precedent or playbook for recent events. Beginning in mid-February and hitting a crescendo in late March a decent ho-hum economic pace lurched into a global pandemic, a cessation of worldwide business activity, massive unemployment, problems in the day to day functioning of the banking and credit markets and an immediate recession. The broader stock market (S&P500 Index) experienced a dramatic 34% drop over a mere five week period. Many aspects of the fixed income and credit markets experienced unprecedented levels of illiquidity and selling. This was followed in April by a massive raft of legislative programs to help offset the shutdown. The Federal Reserve then intervened (and continues to do so) into the plumbing of the banking and credit markets on a scale that dwarfs anything seen in the GFC (Global Financial Crisis). The COVID-19 curve flattened domestically and worldwide – with some international areas faring even better. The broader stock markets and credit markets subsequently rebounded dramatically from their March 2020 lows. We are now experiencing a strange combination of continued negative investor sentiment, pockets of speculation and euphoria, much higher stock and bond prices and some material deterioration in the COVID-19 statistics in certain states and the potential for re-introduced stay at home orders.
We entered the crisis with cash and, in our opinion, an attractively priced portfolio that I had begun opportunistically improving after our reorganization in December 2019 when I assumed the role of sole portfolio manager. While mindful of the unknowable epidemiological and economic risks present in February and March, but mindful of Churchill’s maxim to never let a crisis go to waste, we played both offense and defense during the last six months. We invested about 40% of our then available cash into the teeth of the downturn, buying value (and especially quality) amidst the panic. We upgraded our holdings, moved on opportunistically from situations where the facts warranted, accelerated the portfolio repositioning, and then more recently further trimmed some legacy positions, exited others, rebuilt cash levels, added a small hedge, and are ready for whatever may come. We exit this period with an undervalued, higher quality, faster growing and safer group of holdings than we entered it with.
The disappointing results over the last six months, which includes the peak of the crisis, masks some important positives, which have continued lately. On a relative basis we are pleased to have been listed in the Wall Street Journal’s monthly “Category Kings” tables versus our peers for 5 out the last 7 months. While “you can’t eat relative performance”, great long-term records necessitate outshining one’s peers. Also, our calendar second quarter results compared well with the traditional list of indexes we compare against – a strong step in the right direction on the march back to excellence. For the last quarter (3/31/20 through 6/30/20), the Fund was up 20.89% vs S&P 500 Index (with dividends reinvested) of 20.54%.
In investing and business once you wade beyond riskless, or near riskless holdings (such as highly rated bonds) there is always much about the future of companies or assets you invest in that are unknown. This goes for public markets/companies – the pond we fish in – or private companies. A marketplace (either public or private) addresses this by pricing more predictable companies or assets (a 3:2 favorite in horse parlance) with a much lower payoff than a long shot (a 12:1 horse). Opportunistic value investors striving for above average returns awake daily looking for a 3:2 horse going off at 12:1 odds – a mispriced investment with an attractive payoff potential but manageable risk – and then seek to compile a portfolio of such things. One finds such gems via good qualitative and quantitative analysis and insightful decision making. Value investing teaches us that a great purchase price can provide us with downside risk mitigation and increased upside. Of course, every once in while there is a collapse in the normally efficient odds making system for all horses (i.e. companies and assets) and then detailed analysis matters less than liquidity and nerves of steel.
Historically, during normal and even tumultuous times, solid analysis and judgement, a good starting price, and some patience were the keys to generating strong returns. As I’ve said, trying to instead predict the macro – market direction, interest rates, and timing of recessions has proved to be a futile way for almost all to try and compound wealth over time. Those macro measures have historically been unknowable factors that have NOT been critical to long-term performance as long as you got your business analysis and purchase price roughly right.
The recent downturn was different. The unknowns in March, which are still material risks, were of a magnitude and importance that they impacted the ability of many good companies to survive without impairment. Many industries found themselves experiencing dramatic revenue declines without the ability to reduce costs enough to offset them. Even a moderate debt load made many companies even more challenged. The duration of the almost cessation of much business activity worldwide WAS a very critical but unknowable variable that WOULD impact the intermediate term results of many companies.
However, markets and securities are by their nature forward looking. Price weakness usually precedes economic weakness, higher stock and bond prices would likely appear before, and in anticipation of, business normalcy returning. Rather than spend March joining the ranks of the armchair epidemiologists, the facts that I kept focused on as we invested a material amount of our cash and repositioned holdings during the downturn included the following: The health statistics were likely to improve after worsening, quarantine conditions would be gradually relaxed, companies with less leverage would be able to navigate this better, certain products or services are potentially now more essential and desirable than appreciated and would become a lasting part of budgets long after others items are cut. Finally the Federal Reserve, Congress, and the White House had quickly and materially reacted with monetary and fiscal programs and appeared inclined to do more as needed.
In reviewing and managing the portfolio during this period we viewed the underlying business of every company or asset we owned or looked at through five lenses. How will it do if the economy remains as bad as it looked in March? How will it do if things get worse? How will it do if the economy returns to the pace of early 2020? Have recent events negatively or positively impacted its core business and earnings power on a normalized basis? Finally, of course, how disconnected (in either direction) is the stock or bond price from those conclusions about the underlying value and outlook? This last point is what value investors talk about the most, but if your prediction of the future of the business is not roughly right it is unlikely the investment will be a material winner even if purchased cheaply.
The accelerated speed of change and digitization of many areas of our lives lately applies to businesses not just financial markets. Certain trends already in place gathered enormous steam recently. Second and third tier retailers still searching for what makes them special to customers won’t get a chance to find out. New ways to receive and consume goods and services once the domain of early adopters are suddenly commonly used. Finally, your most important vendor might now be your broadband provider and cloud storage/service companies. It was all happening eventually anyway, but now it has happened. However, we won’t forget that the price you pay in relation to underlying value still matters.
In our last letter I touched on how owning good businesses bought opportunistically (and then holding them and not rushing to sell them when they do well) was not only consistent with value investing, but a long part of our early history at GoodHaven and at my prior firms, but that I felt needed more renewed focus. One of Wall Street’s worst maxims is “you can’t go broke taking a profit.” Realizing profits on successful investments VERY prematurely has been one of our biggest (though hardest to see) historic mistakes. For a primer on how value and quality intersect (and some nostalgia for some of you) attached is part of a letter I wrote in 1998 touching on this. Recently I had been gradually steering us back in this direction, when I should have been sprinting. It’s been the cheap stocks of more difficult businesses, run by talented executives that has caused us more trouble than better businesses. Investing for the long-term necessitates a strong view about a company’s future competitive position and earnings power. That is why years ago many of us avoided technology companies and favored consistent growth companies including; advertising agencies, food companies, etc. Technology (including software) was often shunned, despite often having high profitability characteristics, as the rate of change and inability to predict long-term industry winners made it too risky. That has changed lately. First, many technology companies aren’t really only technology companies. Is Alphabet a technology company or an advertising platform(s)? Is Apple a device manufacturer or an operating system/ecosystem paired with devices? Really, artificial intelligence (AI) on a large scale is at the core of many of these companies. Second, the dominance of some of these companies leaves them hard to dislodge (sometimes that attracts regulatory issues). Despite their enormous size and dominance it’s interesting to observe how some of these companies still maintain a healthy paranoid, intense, and inquisitive culture – that’s not how GM functioned when it’s market shares peaked in the early 1960’s. We got the qualitative and quantitative right with Alphabet – though taking some profits along the way was a mistake. After making a great purchase years ago of Microsoft (once a top holding) we sold too early, making some nice money but leaving much more on the table. Don’t expect us to start paying growth P/E multiples for businesses, don’t expect to open one of our Fund reports and see a venture capital looking portfolio. Sometimes we will find attractive not so great businesses with a catalyst or some distressed debt. But when we find those rare growing and predictable companies and buy them well, expect us to water the flowers and cut the weeds – not the opposite.
Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) is now our largest holding after we materially increased its size during the recent market downturn. I’ve always found many portfolio managers too emotional when evaluating Berkshire. Some engage in a form of worship without focusing on analysis, others love to celebrate any Berkshire shortcoming or flaw in an almost “gotcha” type of joy. Finally, others wonder if owning Berkshire or any holding company makes them look less creative or clever in the eyes of clients. I believe these are all flawed ways to think objectively when trying to make logical investment decisions. Berkshire is a large conglomerate – part insurance/reinsurance company, part investment portfolio, part non-insurance operating businesses and part a large pile of cash and very little debt. Let’s forget the historic notoriety and deserved great reputation of Berkshire’s Warren Buffett (Trades, Portfolio) and partner Charlie Munger (Trades, Portfolio) and focus objectively on the businesses and the math. At its recent stock price – and “marking” Berkshire’s large investment portfolio to current market values –Berkshire sells for less than 1.1 times adjusted book value – a valuation level not seen since 2011. Berkshire had operating earnings in 2019 of about $29 billion pre-tax excluding capital gains/losses from investments. One way to view the business is a 15% adjusted return on equity for the holding company – excluding the equity investment, portfolio dividends received, and part of the excess cash. We believe the investment portfolio on its own is attractive. In a broad sense pricing and terms/conditions are improving materially in many property & casualty insurance/reinsurance lines.3 We believe that management talent is deeper than appreciated. The recent stock price strikes us as materially undervalued – and we have purchased additional shares opportunistically at attractive prices.
The Berkshire operating companies and investment portfolio are not immune from today’s business challenges – some holdings more than others. Material near-term declines in operating income for certain divisions will obviously happen. Berkshire has noticeably tapped the bond markets in the last few months given rock bottom interest rates and perhaps a desire to have even more liquidity. However, with $137 billion in aggregate cash holdings as of 3/31/20, we believe Berkshire can withstand any economic downturn and behave opportunistically. Mr. Buffett struck a cautious tone at the May annual meeting and Berkshire has not been an active buyer in public or private markets to date. The reasons include the competition for “rescue finance” deals from large investment firms, Federal Reserve actions creating an ability for troubled borrowers to access traditional financing and Berkshire perhaps contemplating a deeper and prolonged downturn. Amidst a lot of recent criticism of Berkshire, board member and well known investor Meryl Witmer (and family) recently bought about $2 million of Berkshire shares personally in the open market. Critics of Berkshire’s “old economy” focus seem to forget that Apple represents approximately 40% of the equity portfolio, with an estimated unrealized gain of $60 billion. Finally, it appears that the pace of stock buybacks at Berkshire may have accelerated lately. In any event, I like the risk/reward of Berkshire from recent price levels – though I think there is less downside but less upside than I thought in March. As with all things – I remain objective to the facts.4
Alphabet (Google) (GOOG, Financial)(GOOGL, Financial) is now our second largest holding. In our opinion, Alphabet can manage the downturn well with over $150/share in net cash.5 However, the business will be temporarily negatively impacted in the near-term considering that perhaps 15% of paid search is travel and leisure related, in addition to some general weakness in advertising spending in other sectors. In addition, regulatory headwinds continue to increase. The DOJ just outlined a broad overhaul of the legal protection for online platforms and in Europe the Google search feature will be unbundled from Android’s operating system. There are some new positives too – like dramatically increased demand for their cloud services and a rollout of Google Discover (home page feed). All in all, Alphabet continues to be one of the best business models I’ve ever seen – with exceptional returns and still surprisingly robust growth. Given all the above and with the shares currently trading at an undemanding 23x 2021 consensus earnings estimates— after adjusting for the cash holdings—we still see plenty of long-term upside.
Barrick Gold (TSX:ABX, Financial) is close behind as our third largest holding and during the recent difficult period our biggest winner by far. The company is operating well – and has so far avoided material closures of mines due to COVID-19. Its competitors have not been as fortunate. The new management team from Randgold, with their historic experience in navigating things like Ebola, has helped Barrick react well to COVID-19. Gold itself is a bit higher lately and therefore so are Barrick’s likely earnings/free cash flow – which should be currently greater than $2 billion – in excess of $1/share. Barrick’s balance sheet is solid – come what may – and earnings should hold up fine if mines remain open and gold prices continue to be healthy. The company should have more cash than debt in the near-term absent an acquisition. A gold miner – or any mining company for that matter – in the hands of most management teams and in most environments is not normally a good business. However, CEO Mark Bristow and team are not just any management team and the current macro backdrop is anything but normal. I’m suspect of anyone’s (including mine) ability to understand how a worldwide cessation of activities (very deflationary) and an unprecedented Federal Reserve response of money printing and lower short-term interest rates – will play out as it relates to gold and currencies. As I mentioned when quoting Charlie Munger (Trades, Portfolio) in the last letter, it was a mystery to many (who felt with certainty) that the enormous monetary stimulus after the 2008 crisis would lead to material inflation and a weakness in the dollar but instead we had deflation and a strong dollar. We’ll see what happens this time around. One wonders what’s better in an inflationary world —an alternative currency or a portfolio of “good businesses”—or both. In the meantime, I’ll stay “primarily” focused on thinking about Barrick the business and comfortable with the optionality Barrick might provide, which may be material.
Rounding out our top holdings is Jefferies Financial (JEF, Financial). As you know from prior letters, Jefferies is an investment bank run by Rich Handler and Brian Friedman, where Joe Steinberg of Leucadia fame remains a top shareholder. Our insights into the company and the people go back decades. Even before the crisis, Jefferies was executing on a well communicated and prudent path—simplify the business, increase the return on equity and repurchase shares when undervalued. In fiscal 2019 alone they repurchased approximately 8% of their shares. It is easy to begin to see this strategy bearing fruit. The first quarter ending 2/29/20 was much stronger than prior periods – with record revenues and a much improved 16% return on tangible equity. For the fiscal second quarter—which captures the recent downturn—they reported an impressive 11.6% return on tangible equity despite a lack of banking deals for part of the quarter and unprecedented market volatility. Jefferies repurchased an additional 10 million shares in Q2 for $16.42/share. The past few months have seen record levels of trading and activity in fixed income and equity markets. After the Federal Reserve’s recent initiatives, fixed income underwriting has exploded though mergers & acquisitions have been depressed industrywide. The shares appear very undervalued trading around 40% below its tangible book value.
Before discussing some compelling new investments we’ve been able to make recently, let’s discuss where our biggest declines were and what my current thinking is related to these securities.
Energy equities were our biggest dollar decliners recently. Lost in the headlines lately has been the magnitude of the decline in the price of oil in the first quarter – from $63 to $21 (and negative $38 on April 20th), and then a subsequent rebound to $40 – though still significantly below the $61 year-end 2019 price.
WPX Energy (WPX, Financial) was our biggest energy exposure and energy detractor in the period though the price rebounded dramatically in calendar Q2. We know it well and have had historic success as owners. We believe the company is very well managed, over 70% hedged at over $50 oil for 2020, and has no near-term debt maturities. For 2021, WPX now has 31% of oil production hedged at $40 a barrel, and 85% of natural gas hedged at prices significantly higher than today’s price. But as I mentioned in the last letter, this is a tough business and having its key metric drop by 70% in a month or so is a reminder of its vulnerability. Birchcliff Energy (TSX:BIR, Financial) is a smaller holding and more gas focused but also declined materially. Oil prices have lately bounced back dramatically to about $40. While I enjoy being a contrarian, and both WPX and Birchcliff are unusually cheap should energy prices regain their lost ground we have not been adding any material capital to equities in this sector, though we are happy with our current exposures. As mentioned earlier, our focus on new capital commitments lately has been on companies with better business models and balance sheets whose share prices were previously priced too high for us. Hess Midstream is a much different animal than WPX and Birchcliff. It is akin to an infrastructure service business, with more protected earnings stream and material dividend – though hardly riskless. Our recent activity in the debt of WPX was very successful on a small scale – more on that later.
Until a few years ago we had never owned an airline security before. We became impressed with how the massive industry consolidation (domestically) had changed the profit dynamics for owners. We have written about it all previously regarding our holdings in American (AAL, Financial) and Delta (DAL). Full planes, less price discounting, efficient operations, cyclical but no longer boom-bust economics, share repurchases and dividends, oligopolistic tendencies, enormous profitability, clever management teams, and what seemed like cheap stock prices – all the things to warm a capitalist’s heart. We expected periodic severe recessions, low profitability, and were willing to live with the risk of a crash or 9/11 type existential worry and even periodic brief cessations of flying if needed. We did not think that a health crisis would lead to both a fear of flying by travelers and broad-based quarantine policies, while the companies continued flying almost empty planes – leaving the companies burning money at an alarming rate. I missed the opportunity to sell very early in the downturn. The big domestic carriers then received government grants, curtailed flying and created enough liquidity for a while. Mr. Buffett publicly disclosed in early May that he had recently exited Berkshire’s holdings in all the big domestic airlines. Customer traffic had declined to almost nothing, and so we felt the oversold equities were pricing in an extended period of no traffic which we felt was too negative and there was significant upside optionality though the business was impaired. We swapped our American position to United (UAL) (which had lagged in stock price) because of their better execution pre and post-COVID, and decided to be a little patient. Traffic began to improve in May and June, and both United and Delta improved their cash burn rate. The stocks rose dramatically about 144% and 93%, respectively, along with many travel and leisure companies from mid-May to early June. We sold all of our airline equities in June – our gain in United about offset our loss in Delta and the earlier loss in American was just that – a mistake.
We sold legacy holding Macy’s (M) in December and January. We will continue to look for ways to redeploy capital to better/more attractive opportunities throughout the portfolio.
We added some new names to the portfolio – one earlier in the year, but others during the market downturn. Some our household names – some are not. Our size gives us the flexibility to own some smaller companies and we will from time to time.
TerraVest Industries (TSX:TVK) is a small company based in Canada – in their words:
“TerraVest Industries is a market leading manufacturer of home heating products, propane, anhydrous ammonia (“NH3”) and natural gas liquids (“NGL”) transport vehicles and storage vessels, energy processing equipment and fiberglass storage tanks. Our expertise is in manufacturing steel and fiberglass products and we are an industry leader in our respective product categories.”6
TerraVest has a successful history of expanding by buying smaller companies in the above categories at attractive prices, running a tight ship, earning high returns on capital and opportunistically repurchasing shares when they are cheap. Canadian entrepreneur Charles Pellerin owns about 18% of the company, and Dustin Haw runs things day to day. Both seem like good businessmen and fiduciaries. Before the recent crisis I would have said we paid about 8 times near-term free cash flow for this little gem which has a 3% dividend yield (as of the date of this report) and modest organic growth but strong potential to grow through acquisitions and solid internal returns. Like most things – near term earnings will be weaker, but the underlying earnings power and thesis look intact. TerraVest contributed positively during the period.
Progressive Corp. (PGR) is a high-quality company I’ve long had my eye on, purchased during the recent market downturn. It is a well-known brand – summarized in their words:
“The Progressive Group of Insurance Companies, in business since 1937, is one of the country’s largest auto insurance groups, the largest seller of motorcycle policies, the market leader in commercial auto insurance, and one of the top 15 homeowners carriers, based on premiums written. Progressive is committed to becoming consumers’ number one choice and destination for auto and other insurance by providing competitive rates and innovative products and services that meet customers’ needs throughout their lifetimes, including superior mobile, online, and in-person customer service, and best-in-class, 24-hour claims service.”7
A glance at Progressive’s historic results and underlying returns might cause one to forget that they are primarily in the auto insurance industry. Net premiums earned increased by 13%, 14%, 17% and 20% in each of the last four years from 2016 – 2019. A return on equity during those years ranged from 13% – 31%. When analyzing insurance companies be at first wary of growth – it’s easy to put new business on the books – only over time do you find out if it’s really profitable growth. However, at Progressive, the long-term underwriting results are exemplary and they are the industry leader in technology and data analytics. We expected near-term unusually high levels of profitability with the cessation of much driving (and losses) and then, as we are now seeing, more than normal driving (and maybe losses)—both of those are near-term noise around this long-term story. Their investment portfolio recently saw some expected volatility. Unit growth may slow a bit too, and more customer credits may be appropriate. However, with a necessary core product, a market share of around 11% in auto insurance and sensible new lines of business evolving, I think purchases made at around 11X earnings can yield strong long-term results and the position can get bigger opportunistically. Progressive was a positive contributor for the period.
Bank of America (BAC) is a household name and the second largest bank in the United States by asset size. Its activities include commercial banking, consumer banking, investment banking and trading, private banking, and more. What matters though is profitability, risk profile and returns to owners. I’ve long been impressed with how the company has improved in all these key areas and we used the recent downturn to initiate a position – mindful that we also have a look through exposure given Berkshire’s material ownership Bank of America. In the last five years earnings per share have grown from $1.38 to $2.77, return on tangible common equity from 9% to almost 15% and all the while maintaining amongst the lowest cost of deposits of the big banks and respectable levels of loan loss provisioning. The magnitude of potential near-term impacts to their business is wide but our assumptions in March were for: 1) materially higher but manageable credit losses; 2) lower “spreads”; 3) modest loan growth; and 4) continuing dividends and no share repurchases. That is pretty much how things are playing out so far. Recent Federal Reserve 2020 Comprehensive Capital Analysis and Review (CCAR) had no major surprises—Bank of America would be well-capitalized under the stress scenarios and the bank maintained its current dividend. We are well aware that unemployment needs to materially improve over a reasonable timeframe. The Federal Reserve and Treasury appear to recognize that the banks are part of helping the economy recover and are not the cause of systemic worries ala 2008. Bank of America and its brethren have been through frequent stress tests by their regulators – which provide a helpful framework for how to think about the near term. With all that considered I think we paid an attractive price and would consider increasing our exposure to Bank of America and to other banks opportunistically.
A few years ago yours truly attended a group dinner where the head of one of the largest domestic retirement plans was the featured guest. After hearing that all their recent money manager allocations were to either KKR (KKR), Blackstone (BX), or Apollo (APO) it confirmed what strong businesses these firms had become. Finally, during the period as the stock price declined materially, we initiated a new position in KKR & Co., the alternative asset manager that was founded 43 years ago. Under the leadership of Henry Kravis and his team, KKR’s AUM has grown to $207bn, or an annualized growth of 17% since 2005. While not a guarantee of success, KKR employees and management own roughly 40% of the firm and since 2009 through the end of 1Q 2020, KKR has grown book value per share by an annualized rate of 10%. For reference, Berkshire Hathaway grew book value per share at a similar rate during the same period.
Although KKR is historically known for its private equity business, they currently manage a variety of global strategies that include liquid and opportunistic credit, hedge funds, real estate, and infrastructure funds. Approximately 10% of AUM is permanent capital and another 60% of the AUM has an 8 year lock up period. KKR’s private equity funds delivered an overall net return of +19% since inception through 2018, compared to the S&P 500 of +12%.8 In fact, during the Great Financial Crisis, total AUM and management fees increased by 16% and 6%, respectively, as the firm was able to deploy AUM dry powder in attractive investments. Net cash and investments make up ¾ of KKR’s latest book value per share of $16.52. We purchased our KKR shares at approximately 1.1x 2019 book value, which ascribes little value for its franchise and AUM growth potential. Another one of our prior holdings was Oaktree Capital Group, which recently sold a majority stake to Brookfield Asset Management (which we also own currently) in March 2019 at a valuation that was greater than 2.0x book value. As we saw in Q1’s earnings KKR will need to navigate some near-term leverage issues at certain companies they have invested in or control and they are not immune from mark-market impacts on the balance sheet. They have proven adept at navigating such things historically. They also have the ability to invest in the near-term across the capital structure in their different businesses in new opportunities presented by this crisis. In fact so far since late February they have been aggressive – deploying at least $18 billion of capital. KKR was a gainer for the period, after we purchased shares as low as about $16 during the period – they have since rebounded to over $30.9
Rounding out most new holdings initiated during the quarter was a smaller new holding in Exor (MIL:EXO). We’ll have more to say on Exor in future letters, but here are some basic details on the company: Exor is the Dutch based holding company historically controlled by the Italian based Agnelli family, the founders of Fiat. Exor has been run for some time by Agnelli descendant John Elkann and has in its current incarnation compounded NAV by an impressive 19%/year from March 2009 – March 2019, requiring stellar deal-making and investment skills. Exor maintains large public stakes in Fiat, Ferrari, and CNHI and a large investment in PartnerRe (reinsurance). There are formal plans to merge Fiat with PSA Group (Peugeot). A full priced possible deal to sell PartnerRe fell apart when John would not accept a lower price than initially agreed to. I was initially bothered by the failed PartnerRe sale but as I looked at the potential opportunities to deploy capital at good returns in the reinsurance sector in the near-term I decided I’m fine. We paid around 40% below NAV for our initial stake.
Finally, we added materially to STORE Capital (STOR) during the period. STORE Capital is one of the largest and fastest-growing net-lease REITs in the United States. They have almost no near-term debt maturities and STORE has a long-term track record of value creation with a total return of over 19%/year from the Initial Public Offering (IPO) in 2014 through 12/31/19 – dramatically outperforming the 7.7%/year return for the comparative MSCI US REIT index.10 The opportunity to increase the position came as the stock declined dramatically given STORE has an obvious exposure to tenants in hard hit industries including restaurants and movie theaters. STORE has so far navigated through this short-term need to offer some tenants rent deferrals – where they should recapture these deferrals within a short period of time. The thing we worry about are not some deferrals but too many customers shutting down during a difficult economy. However, as they own profit center assets, with 92% of their multi-unit tenant investments bound by master leases, their contracts tend to be senior to other tenant payment obligations. We believe there are now more chances for STORE to deploy fresh capital and with over $600 million in cash on hand there may be opportunities. We purchased shares in the downturn gradually as they declined to the mid-teens. They have since rebounded to the mid-$20’s. We were impressed that they maintained their current dividend this quarter. STORE executives have also bought more stock for themselves during the period. Currently trading at about 13X funds from operations and a 6% dividend yield we see plenty of upside.
As the crisis unfolded we reviewed our material housing related exposure: homebuilder Lennar, distributor Builders FirstSource and to a lesser extent flooring company Mohawk Industries.11 Our initial worries about the cyclical risks to Lennar and Builders were replaced by research driven observations that crisis induced demand declines should be measured against potential positive new trends including lower mortgage rates, de-urbanization and WFH (work from home) habits and home related spending. This was in addition to our historically positive views on the single family home supply/demand backdrop and the quality of our companies. We decided to maintain our positions and allow Lennar and Builders to become bigger percentage holdings as their stock prices increased. Recent earnings results and trends from each company support this decision. We remain well aware that recent levels of unemployment need to improve over time to support these positive views.
CORPORATE DEBT – POTENTIAL OPPORTUNITIES
I wrote above about the importance of focusing on good/high quality businesses, so why am I about to write about potentially investing in distressed bonds? Because there will come moments when such opportunities are compelling. The portfolio will periodically have a modest allocation to true special situations. We have waded into the debt markets for the Fund in the past – but I thought a little discussion of why is warranted.
While a bond is a contractual obligation to pay the owner a certain “coupon” and then return principal at a certain time, equities or equity ownership is really a claim on future company profits where the “earnings coupons” are unknown but potentially much more lucrative depending on how well those “earnings coupons” do over time. Periodic opportunities to buy into the more contractual part of the company’s capital structure at equity like returns is attractive. Along those lines, in March, the domestic bond markets experienced an unprecedented level of turmoil. Dramatic price drops, no liquidity, forced sellers and more. This situation applies to many different pockets of the debt markets. Subsequent unprecedented actions to provide liquidity by the Federal Reserve have for now dramatically improved these markets. Potential opportunities in non-investment grade (junk) corporate debt and fallen angels may resurface. We have successfully waded into these markets in prior market dislocations. We purchased some WPX Energy bonds in March in the low $50’s after they had collapsed from $100, and subsequently sold them in the mid $90’s in May as the sector rallied – one of our bigger dollar gainers in the period. This is a reasonable example of some of the volatility prevalent in parts of the bond market in that period.
Of course, the opportunities may not present themselves as I think they might, but we have a watchlist of potential interesting situations. Our preference is the debt of good businesses with a levered/bad balance sheet. The junk market has experienced an enormous bounce in prices recently and new Federal Reserve actions implemented have created a panacea for weaker borrowers – for now.
IN CLOSING
Neither I nor anyone can predict how quickly the economy will repair itself nor the near term epidemiology. The disease statistics are now worsening in certain large states, forcing them to again curtail certain business activities.12 The world is feverishly searching for a potential vaccine(s) and other remedies. However, we are through the period of maximum fear that the economy and markets might cease to function normally and have entered a phase of “what might different companies actually earn in the next 6-24 months, when will unemployment normalize, and how bad will the consumer credit and commercial debt defaults be in the banking sector?” These are harder questions to answer. Individual stock selection will matter a lot in this type of environment, and I have a feeling will matter a lot more in the next few years than in the past few years – which should bode well for us. We maintain additional firepower and liquidity with cash balances now back over 20% after some recent sales. We have added a small market hedge. By the way, the levels of government/Federal Reserve borrowings and intervention to offset the shutdown(s) are unprecedented, much broader in scope than in 2008, and presents a host of unanswerable but important questions about government debt levels, moral hazards and more.
I’ve spared you more “value vs. growth” discussions – and instead I reiterate my still current thoughts from the last letter in the next paragraph – and for what it is worth – this discrepancy has only gotten wider during the recent market rally. Per the chart below, the gap between the MSCI World Growth Index and the MSCI World Value Index is at an all-time high. The last time such a large gap was evident was right before the 2000 tech bubble, after which investors eventually returned to value stocks.13
“There is no shortage of well documented industry statistics that you’ve previously read here and elsewhere, detailing the extreme discrepancies recently between the stock price performance of “value” and “growth” companies – as imperfect as those categories are. The data is obvious, well documented and likely implies an inflection point in sector performance sooner rather than later. But I’m sure you’re a bit tired of reading about this topic, and I’m a bit tired of penning my name to its discussion – so for this letter, enough said on that topic. By the way, we are always striving for strong long-term performance, whether or not we get help from some mean-reversion in the above trends.”
I have added to my Fund holdings during this period. By design, we have not utilized leverage in the Fund and I never intend to. It has always been, and will always be, important to have the ability to be an opportunistic buyer and not a forced seller during periods of stress. I said it earlier but it’s worth repeating – we exit this period with an undervalued, better quality, faster growing and less cyclical group of holdings than we entered it with. We have a few holdings that are designed to potentially deploy capital opportunistically into a further downturn: Berkshire, Brookfield, Alleghany, KKR and Exor.
The material increase in domestic stock markets very recently has surprised most investors, including some legends. I’ve previously written about the futility of making short-term market predictions as an investment strategy and this period is a wonderful reminder of that.
I thank all shareholders for their continued confidence. As GoodHaven 2.0 unfolds we are eager to add more like-minded new shareholders, keep us in mind. I also thank our Board of Trustees and long-time partner and investor Markel for their support and wise counsel.
Stay healthy and safe.
Larry Pitkowsky
The opinions expressed are those of Larry Pitkowsky and/or Keith Trauner through the end of the period for this report, are subject to change, and are not intended to be a forecast of future events, a guarantee of future results, nor investment advice. This material may include statements that constitute “forward-looking statements” under the U.S. securities laws. Forward-looking statements include, among other things, projections, estimates, and information about possible or future results related to the Fund, market or regulatory developments. The views expressed herein are not guarantees of future performance or economic results and involve certain risks, uncertainties and assumptions that could cause actual outcomes and results to differ materially from the views expressed herein. The views expressed herein are subject to change at any time based upon economic, market, or other conditions and GoodHaven undertakes no obligation to update the views expressed herein. While we have gathered this information from sources believed to be reliable, GoodHaven cannot guarantee the accuracy of the information provided. Any discussions of specific securities or sectors should not be considered a recommendation to buy or sell those securities. The views expressed herein (including any forward-looking statement) may not be relied upon as investment advice or as an indication of the Fund’s trading intent. Information included herein is not an indication of the Fund’s future portfolio composition.
References to other mutual funds should not be interpreted as an offer of these securities.
Must be preceded or accompanied by a prospectus. It is not possible to invest directly in an index.
Passive investing involves the purchase of securities or funds that attempt to mirror the performance of a specific index. Active investing involves the purchase of individual securities or funds whose managers attempt to select securities based on fundamental research, quantitative analysis, or other factors and who actively change the underlying portfolios in response to corporate or macro developments.
