Large-cap, small-cap, mid-cap, domestic, or international, it did not matter in the third quarter where one was invested in equities, all sectors got shellacked. Global stocks declined more than 16%, and domestic large-cap and small-cap stocks dropped nearly 15% and more than 20%, respectively, in the third quarter. Whatever happened to safety through diversification?
We wrote earlier this year, when the market was in positive return territory, that investors seemed to be ignoring the growing fiscal crisis in Europe and paying rich multiples for stocks. What was obvious to us a couple of quarters ago was that the European sovereign debt problems were not going to go away simply because some heads of states said Greece would not default on its debts. As recent as September some world leaders were still denying Europe was facing a financial crisis. Well when a country has €50 billion of cash interest costs and just €46 billion of tax revenue, like Greece, that represents insolvency, in our opinion. As the markets were rising earlier this year, we continued to sell into that strength. This was after we aggressively trimmed back the majority of the positions last year, and even eliminated a couple of stocks.
As stock valuations rapidly declined, we loosened our belt and parted with some of your portfolio’s cash. We purchased more names during the past quarter than at any other time since the fall of 2008. We will discuss some specifics later in the letter, but to give you a sense, we bought shares in a healthcare company, a financial service company, and a technology company, among others. However, we utilized only a portion of the portfolio’s cash and none of the newer positions reached a fully-committed level, typically 3% of the portfolio’s gross value, this due to prices moving away from us once we began allocations.
As portfolio managers, we recognize the large macro-economic risks and also observe that P/E ratios are still too high for many companies, despite the recent market decline. For instance, the Russell 2000 and 2500 had P/E’s at the end of the third quarter of 19.9x and 17.4x, respectively. Your portfolio’s P/E is roughly 11x. Moreover, according to the Bank Credit Analyst, non-financial corporate after-tax profit margins have reached the highest level in over thirty years and near post-World War II highs. Thus, investors are still paying rich multiples for corporate earnings with near peak profit margins. While we will not waver from our valuation discipline, recent volatility did provide us the opportunity to deploy capital.
Over the years, we have often mentioned that liquidity will be used to strategically purchase securities at very attractive values. The third quarter offered up a few such opportunities. While the indices were falling roughly 20% and many stocks declining 30% or more, we deployed capital into that weakness. For instance, we purchased shares of Amerigroup Corp. (AGP) after that stock had plunged nearly 40% in the quarter and roughly 45% from its recent 52-week high.
AGP operates as a multi-state managed healthcare company. It focuses on serving people, who receive healthcare benefits through publicly funded health care programs, including Medicaid, Children’s Health Insurance Program (CHIP), Medicaid expansion programs, and Medicare Advantage. The company currently serves approximately 2 million members in eleven states, including Texas, Georgia, Florida, Tennessee, Maryland, New Jersey, New York, Nevada, Ohio, Virginia, and New Mexico.
At our purchase price, we bought the shares of AGP at roughly 8x trailing-twelve month (TTM) earnings and at a 17% free cash flow yield. The investment thesis is that states are experiencing and will continue to experience difficulty in raising revenues and a greater demand to provide healthcare to needy people, particularly children. One solution for states to deal with these two issues is to outsource their Medicaid programs to managed-care companies like AGP. States save money because AGP has the operational scale, efficiencies, and the processes to drive costs out of the system yet provide equal or better care than government-managed healthcare programs. We expect state budgets to remain tight over the foreseeable future, in turn, providing good growth prospects for AGP.
Besides revenue reimbursement risks, we believe a big short-term risk to AGP, or any other managed care provider, is the medical loss ratio. That is, AGP could be surprised by higher medical costs due to more sick people or the severity of illnesses coming in greater than expected. Nonetheless, AGP should be adequately compensated in future years if those risks persist and the company is able to achieve higher reimbursements from the states.
We initiated a position in Veeco Instruments (VECO) after its shares collapsed nearly 50% in the quarter. The company designs, manufactures, and markets equipment to make high brightness light emitting diodes (HB LEDs), solar panels, hard-disk drives, and other devices. The company’s LED and Solar segment designs and manufactures metal organic chemical vapor deposition (MOCVD) systems that are used to make HB LEDs. Its Data Storage segment designs and manufactures ion beam etch, ion beam deposition, diamond-like carbon, physical vapor deposition, chemical vapor deposition, and dicing and slicing systems, which are primarily used to create thin film magnetic heads that read and write data on hard disk drives.
We purchased VECO at less than 1.5x TTM EBITDA, net of $14 cash per share. VECO is a company that allows shareholders to participate in the rapidly growing market for LED lights, which may soon replace the Edison incandescent light bulb. VECO has approximately 45% market share worldwide for MOCVD tools.
HB LED lighting is in its infancy and the world is moving fairly quickly to LED lighting. For instance, Japan is accelerating their push to LED lighting, particularly after the recent big earthquake in Fukushima. In California, retailers will be banned from selling the Edison incandescent bulb starting in 2012. For the USA, the ban goes into effect in 2014. Europe is in the process of phasing out incandescent bulbs, and in 2016 the EU will even phase out halogen lamps, a viable competitor to LEDs. LEDs consume just 3-33% of the energy other lamps consume, depending on which lamp is being compared, for the same lumen output.
In our opinion, VECO’s valuation is cheap, after considering its net cash position, and we can see the company earning over $3 a share within the next three years. Thus, there is good upside potential in the stock. However, the capital equipment business is quite volatile, with periods of excess capacity and then periods of tight capacity. Today, the market is over supplied with MOCVD tools (mainly in China), as producers have purchased equipment ahead of the LED lighting demand ramp. Excess capacity and the fear of a rapid decline in MOCVD tool orders is why the stock recently declined more than 50%. We currently have approximately a 0.50% position, recognizing that orders will likely get pushed out or even cancelled over the next several quarters, and that the stock could drop further from our recent purchases, at which time we would expect to increase the allocation.
Normally we discuss a couple of stocks that performed well in the quarter, but given the large overall market decline, no stock provided any meaningful positive contribution to the portfolio. However, the portfolio had a number of under-performing stocks, including Newfield Exploration (NFX) and Trinity Industries (TRN). Both of these stocks declined roughly 40% in the quarter, with NFX closing at $39.69 and TRN at $21.41.
NFX is an Oil & Gas Exploration and Production company in which we originally invested back in the fall of 2008. Our average purchase price then was approximately $20, and we subsequently sold more than half of the position as the stock appreciated to more than $70. We believe the NFX management team is an excellent steward of shareholders’ capital and that the company has some assets which should generate good returns for equity owners. NFX declined, along with many other energy stocks, because oil prices declined more than 15% to below $80 a barrel during the quarter. Should NFX decline further, we are likely to buy what we sold earlier and possibly more depending on the prevailing price level.
TRN is an investment that we have owned for a number of years and represents an opportunity for shareholders to take part in the renewed strength of the railroad and railcar industries. Besides making and leasing railcars, TRN also makes barges that are used to move products along various rivers in America, structural wind towers that support the turbines to make electricity from wind, and the company has a concrete and aggregates business. Needless to say, TRN’s sales and profits are highly correlated with industrial economic activity in the U.S. In the third quarter, investors grew more fearful of a recession and, thus, a decline in TRN’s future profitability. Earlier this year, we anticipated a slowdown in our economy and reduced the portfolio’s position in TRN accordingly. The stock price of TRN did not decline far enough in the quarter to entice us to add to the position, however we would add if its price falls within our valuation range.
In times of volatility it is important to remember the philosophy and strategy that guides us, as we manage the portfolio. Before detailing our outlook, we will lay out some of our key investment tenets. We believe that fear and uncertainty, which creates volatility in stock prices, provide us with opportunities. The larger the downside volatility, the bigger the discount from intrinsic value at which we can accumulate shares in a business. In our opinion, the best way to produce superior absolute returns, while protecting capital, is to build a portfolio of companies with the following characteristics:
i) Leadership positions and a history of profitability. Companies with such characteristics have a lower probability of business failure than firms with secondary or tertiary positions, or businesses with unproven operating histories and a lack of profitability. When economic recessions occur, customers and vendors naturally gravitate toward larger and financially solid companies. This is because customers and vendors have greater confidence in market leaders and their ability to remain solvent.
ii) Balance sheets with little leverage. A strong financial position helps to protect against the cyclical changes in profitability that are inherent in business cycles and that can bankrupt firms with too much leverage. Strong balance sheets not only protect a company against bankruptcy, but also allow shrewd managers to buy good assets when there is distress in the economy, enhancing the long-term enterprise value of such entities.
iii) Management teams of high quality. Effective management maximizes business and capital allocation opportunities in both good times and bad. For example, attention to a low cost structure protects margins and cash flows during recessions. A focus on improved volumes, mix and pricing also provides owners with better upside during times of growth. While a successful past is no guarantee of future outperformance, we make investments in companies that have a management team with a proven track record of achievement and an effective capital allocation philosophy and where there is a true alignment of interest with their shareholders.
iv) Potential for profitability improvement. We seek those companies that have the ability to expand margins, for those that do will, in general, have more potential for stock price appreciation. An example would be a company operating under recessionary conditions that we are able to buy at a depressed valuation and where the upside in earnings accrues entirely to us, the shareholders. It also can be companies and industries undergoing a change for the better, but the stock price is not accounting for the prospective improvement. Additionally, we occasionally will find companies that are misunderstood and where we believe the profit potential is substantially greater than the market believes.
v) Prices at least 35% below what we believe the business is worth today. The less we pay, the bigger our margin of safety to provide cushion to any negative changes that can lower the business’ intrinsic value. In other words, if we pay $0.50 for a business we think is worth $1, we still make $0.25 even if the company is really just worth $0.75 – still 50% upside if the business trades to intrinsic value. Price is the great equalizer and we are willing to wait for the right price to come our way. This concept of absolute valuation is what distinguishes us from “relative” value managers, and is among the prime factors for our long-term excess returns. Discipline keeps us from paying too much, a cardinal sin of investing.
These five tenets help protect our investments against both business and market risk, and help guard against a permanent impairment of capital. In addition, we i) focus on the long-term when investing, ii) concentrate our investments in our best and most attractive ideas and sectors, and iii) are aggressive in deploying capital when opportunities are abundant and patient when there is a lack of prospects.
The important factor to remember is that we have been executing this strategy everyday for the past two decades at FPA. We do not expect any changes to this fairly simple investment strategy, but the key is to execute it when the valuations warrant either a buy or sell decision. On our website, www.fpafunds.com, you can find a more detailed review of our philosophy, process and strategy in our Policy Statement.
Volatility has returned to the stock market. We discussed the likely return of volatility earlier this year, and our outlook has not changed much since then. We opined then that “growth in corporate profits will slow considerably…the U.S. economy is not on a healthy growth path with fiscally irresponsible trends which, if they continue, should lead to far greater financial market volatility…the EU is going to have to make a very difficult decision: either they support Greece…or they let Greece default and hope the contagion effects can be contained…the risks to the global economy are high in both cases.” These points still hold true today.
We still advocate that corporate profit growth will slow and could decline, that the issues facing the U.S. and Europe are large, are hard to correct, and are likely to result in subpar real GDP growth of less than 2% for the U.S. and Europe, at best, for the foreseeable future. Considering the economy grew real GDP around 1% in the first half, we could very well dip into a second recession before moving back to slow growth.
We think the leverage in the system that was built up during the last decade, along with the capital destruction from bad loans to, among others, homeowners in the U.S. and governments in Europe, are at the core of the current problems. Unless this debt gets reduced via defaults and restructurings, we don’t see how growth will return in any meaningful way. Excessive indebtedness is a problem for developed countries in general. Aggregate indebtedness, which includes private and government debt, is 450% for the Euro zone, 470% for Japan and 350% for the U.S., according to Hoisington Investment Management. Our thesis is that for growth in developed nations to return in a significant way, we need to see a substantial reduction in these debt ratios, and there is nothing indicating this is happening so far.
The U.S. consumer is in pain. His/her debt went from seven trillion in 2000 to close to fourteen trillion in 2007. This debt load has only slightly been decreased since then. However, decreases in home values severely damaged the consumer’s balance sheet. Weak payroll growth and high unemployment have not helped the situation. Real private hourly earnings are now running negative 2%. This is just above the trough we saw in mid-2008. The duration of unemployment, now over 40 weeks, is double the highest we’ve seen over the last two decades. The U6 unemployment rate at 16.5%, is double what we had in 2007. Nondiscretionary outlays as a percent of total spending has gone from 28.5% to 34% according to MacroMavens, about the level we saw in 1981, at the peak of the inflationary cycle. In summary, the consumer is being adversely impacted on multiple fronts and this is unlikely to change in the short-term.
In light of the above, with the consumer representing 70% of the U.S. economy, we have difficulty envisioning how the situation can improve as things stand. The negative feedback loop resulting from weak consumer spending because of bad balance sheets, high unemployment, and poor payroll growth, led businesses to cut back capital spending and hiring, ultimately resulting in a slow growing economy at best. Data from job openings at small firms is confirming this trend. The percentage of small businesses with one or more job openings has been cut in half from the mid-20s percent in 2007 to the low double digits currently.
The enormous amounts of monetary and fiscal stimulus that has been directed to the U.S. economy are unprecedented, and all it has succeeded in doing is to sustain the economy, as opposed to kick-start it. The amount of federal debt has increased by 30% of GDP in the last few years with record fiscal deficits. This explosion in treasury debt closely follows the household debt explosion we saw the last decade. Gross U.S. Treasury debt is currently $14.9 trillion or 99% of GDP. Public debt increased $1 trillion in FY2008, $1.9 trillion in FY2009 and $1.7 trillion FY2010. Our current ranking as the number twelve highest debt to GDP nation is not encouraging. We continue to believe that this is a serious issue that must be addressed soon, or it will get more difficult to deal with.
The more desperate the U.S. government and Fed get, we fear they will continue to employ these stimulus measures. With the Fed already having tripled the quantity of money over the last several years, the question is whether they will extract all this money when activity in the economy returns. So far the increased money supply has not created much inflation because the velocity of money (the speed at which money changes hands in the economy) has fallen at the same time. This may not last forever. In our opinion, ever increasing amounts of money supply is a very dangerous path to take, even if the intention is to extract it when activity returns. We saw this in the Weimar Republic of Germany in the early 1920s, when increasing amounts of money supply had a minimal impact on business activity but led to rapidly escalating inflation as people lost their faith in the currency and drove the velocity of money ever higher. We don’t think inflation is an issue for the short-term, but we do question what path the Fed and the ECB will take over the long-term. What we’ve seen so far gives us little confidence.
Ludwig Von Mises, the famous Austrian economist, has pointed out the dangers of monetary expansions – “they create a severe misinvestment of capital.” The monetary expansion in the U.S. fueled our housing bubble, creating significant misallocation and destruction of capital, leaving us, as a nation, poorer. Europe is experiencing the same effects from their monetary expansion and poor capital allocation during the decade after the Euro was formed. The large growth of debt in Portugal, Ireland, Italy, Greece and Spain would not have taken place had those countries not been part of the EU with its low interest rates and strong currency. This dismal distribution of capital is likely to significantly constrain Europe’s growth rates in the foreseeable future.
The issues in Europe will take time to work through. The recent announcement by the leaders in Germany and France that they will come up with a comprehensive plan to support their banks is a first step. It will be costly. Egan-Jones Ratings have calculated write-downs associated with holding debt from Greece, Ireland, Portugal, Spain, Belgium and Italy. Using their estimates of 90% for Greece, 70% for Ireland and Portugal, and 65% for Spain, Belgium and Italy, many of the leading banks in Europe have close to zero or negative equity to assets, including Commerzbank, Lloyds, Barclays, Deutsche Bank, Credit Agricole and Societe Generale. Per our own estimate, Portugal, Ireland, Italy, Greece and Spain will need to lower their debt loads by two trillion Euros to be on a sustainable path, or raise their tax revenues to support the excess debt. We arrive at this figure by taking their existing tax revenues and calculating the amount of debt that these revenues will support after deducting all other services that a government needs to perform be it education, police, military, medical, fire, and other services.
With the consumer in difficult straits, the government spending far above what is sustainable to support the economy, and businesses not hiring enough to reduce the unemployment lines, we ask ourselves what this means for corporate profit growth? Nothing positive is our answer. Corporate profits as a percent of GDP for domestic businesses is at record levels. The average level the last sixty years has been 5.0% and we are now at 7.2%. This is higher than the margins achieved in the mid-1960s and 2007. Every time a peak has been reached in the past, margins have come down below the average level within five years. With a mean reversion to lower profit margins most likely coming, and slow GDP growth at best, we expect a lot of profit disappointments coming our way, which we’d welcome with our cash levels currently elevated.
We have skewed the portfolio to companies exposed to global growth because of our negative views on the U.S. and Europe. Of the portfolio’s equity investments, three quarters have a heavy exposure to global-demand growth, as opposed to U.S.-demand growth. This includes our oil service, oil and gas exploration, and technology companies. Our oil and technology investments are backdoor ways to participate in global growth and emerging markets. Developing markets constitute a large share of incremental oil demand and their fortunes can have pronounced impacts on oil demand and prices. Oil also has a severe decline curve that works as a natural balancing mechanism in a weak demand environment. Oil in the ground and equipment used to produce it are real assets that are likely to provide a store of value against potential future monetary inflation. Our technology investments, besides exposure to global growth, also have a built in reduction of supply via obsolescence. On average, technological equipment obsoletes itself over five years, which speeds the path to recovery when excesses build up. We continue to like our investments in the oil service, oil and gas exploration and technology areas for these reasons.
We thank you for your continued support during these challenging times, and will strive to retain the confidence you have expressed in us.
The discussion of Fund investments represents the views of the Fund’s managers at the time of this report and is subject to change without notice. References to individual securities are for informational purposes only and should not be construed as recommendations to purchase or sell individual securities.
FORWARD LOOKING STATEMENT DISCLOSURE
As mutual fund managers, one of our responsibilities is to communicate with shareholders in an open and direct manner. Insofar as some of our opinions and comments in our letters to shareholders are based on current management expectations, they are considered “forward-looking statements” which may or may not be accurate over the long term. While we believe we have a reasonable basis for our comments and we have confidence in our opinions, actual results may differ materially from those we anticipate. You can identify forward-looking statements by words such as “believe,” “expect,” “may,” “anticipate,” and other similar expressions when discussing prospects for particular portfolio holdings and/or the markets, generally. We cannot, however, assure future results and disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. Further, information provided in this report should not be construed as a recommendation to purchase or sell any particular security.