FPA Capital Advisors Anticipating More Value Opportunities in 2012: Q4 Commentary
We announced the reopening of the Small/Mid-Cap Absolute Value Strategy to separately managed accounts effective January 15 this year, with the FPA Capital Fund remaining closed. We closed the strategy in July 2004 because we believed that unrestrained growth would not be in the best interest of our investors. At that time, short-term liquidity had risen and there were very few new investment opportunities that met the strategy’s strict value requirements. This is not the case anymore. We have deployed more than 700 basis points of liquidity in seven new stocks over the past year. It’s a step in the right direction. We are still running with high cash levels and would have liked to have deployed even more capital, but the opportunities did not warrant this. We will wait patiently until more prospects present themselves. While our strategy outperformed its benchmarks (Russell 2000 and Russell 2500) in 2011, it is important to note that this will not always be the case. Our goal is to generate superior returns over a cycle which can mean periods of underperformance. Using the FPA Capital Fund as a proxy for the Small/Mid-Cap Absolute Value Strategy, we have generated a compound annual growth rate of 14.8% since July 1984 versus 9.2% and 11.1% for the Russell 2000 and Russell 2500, respectively.
The top four performers in the quarter were Amerigroup, Reliance Steel & Aluminum, Trinity Industries and Oshkosh Corporation, up 51.4%, 43.1%, 40.4% and 35.8%, respectively. We purchased Amerigroup (AGP) earlier in 2011 when the stock price went from the seventies to the low forties, as investors sold the stock on lower than expected earnings results. We took advantage of this price dislocation to purchase the stock at 3.9x EBITDA, 8.2x earnings, 1.7x book value and 40% of sales. The buying opportunity presented itself due to margin compression that, after extensive research, we thought would be short-lived. Unfortunately, the stock has quickly moved up since our purchase, taking away the opportunity to add more. Reliance Steel & Aluminum (RS) and Trinity Industries (TRN) performed well as investors became less worried about the U.S. economy in the fourth quarter and rewarded more cyclically exposed stocks, like these two. Oshkosh Corporation (OSK) moved up for a number of reasons: the access segment has produced better results and the problematic defense program will reach profitability a quarter earlier than initially thought. In addition, Carl Icahn took a large position in the company and is working to get board representation.
Only four stocks had negative returns in the quarter, Veeco Instruments -14.7%, Federated Investors -13.6%, InterDigital Inc. -6.5%, and Newfield Exploration -4.9%. Veeco (VECO), which makes MOCVD (metal oxide chemical vapor deposition) machines which are used to make LEDs, softened as its customers slowed orders. We had been expecting this and built the position as the share price came down. Federated Investors (FII) fell as investors worried about the impact on profitability from fee waivers that result from continued low interest rates. We have a small position, less than one percent, in Federated. We like the yield we are getting, north of 5%, while we wait for a return to more normal profits as fee waivers in its core money market business subside. This is, however, not an investment with tremendous upside and there are risks to its money market business, so to add to our existing position we would want to be even more generously compensated. InterDigital (IDCC) declined as investors began worrying that the company may not sell itself to a strategic buyer. We added to our position as the stock came under pressure and the price fell far enough below our estimate of instrinsic value. Lastly, Newfield Exploration (NFX) provided us with the opportunity to repurchase some of what we had sold at substantially higher prices in the last twelve months. Newfield reallocated some of its capital dollars to its highly economic Monument Butte field in Utah and reduced its Bakken investments. This will slow the volume growth rate somewhat, but it should improve the returns on capital. That’s a tradeoff we like, higher returns on invested capital versus a little slower volume growth.
Helmerich and Payne Incorporated (HP) was a new addition in the fourth quarter. HP is a leading U.S. land rig oil service company with a fleet of 324 rigs including 38 under construction. HP has the most advanced rig fleet in the U.S. and this allows it to benefit from the switch to horizontal drilling which requires more advanced equipment than traditional vertical drilling. As a result of this, HP commands a higher premium on its equipment versus the competition. The stock came down from the 70s earlier in the year and broke into the 30s at which point we bought into it. We paid 4.4x EBITDA, 10.2x earning, 1.2x book value, and 1.7x sales. HP has a strong balance sheet with only 10% Total Debt to Total Capital.
Our core screen that looks for companies having low ratios of Price to Book, Price to Earnings, Price to Sales, and Price to Cash Flow, and little debt on the balance sheet is signaling a moderation in opportunities. A recent run qualified 128 names. This is below the 150-200 qualifiers that reflect a more normal level.
The valuation of the portfolio is attractive based on historical measures. For instance, the P/E ratio is less than 13x, which is almost half the Russell 2000 P/E of 23.0x. The portfolio companies are performing well with a weighted return on average equity of approximately 13-14% versus 10.7% for the Russell 2000. In addition, these returns are achieved with substantially less financial leverage, with less than 30% Total Debt to Total Capital versus 37.2% for the Russell 2000.
Our investment strategy has always taken the macro-economic environment into consideration, but never as much as today. Over the past couple of decades, we consistently evaluated the prospects for higher or lower inflation and what impact the inflation rate would have on a company’s revenues and profits. We have always considered what the Federal or State government could do to disrupt an industry from a regulatory outlook, which is why, for example, we have stayed clear of the utility industry. The utility industry was a heavily regulated industry until the 1990s and then aspects of the industry were de-regulated. However, when Enron, Calpine, and others abused the system the industry once again became heavily regulated. We have always assessed monetary policy, regulations, fiscal policy and other macro-economic variables, but they played a less important role in our investment decisions than when we appraised a business’s operations, competitive position, return on capital, financial strength, and management’s capabilities. Unfortunately, we cannot say the same today.
Today, we do not have the luxury of just focusing on the bottoms-up fundamentals of a business. In our opinion, the macro-economic risks have increased to the point where the systemic risks are large enough to adversely affect all of our investments. The large macro risks we are particularly worried about, and which we have discussed over the past couple of years, are sovereign debt defaults and the domino-effect those defaults would have on the global economy.
Financial credit and energy are among the most important input factors that sustain our modern economy. Without credit, Boeing does not sell planes to Lufthansa. Without credit, Exxon does not sell oil to a French refinery. Without credit, real estate developers would not have the money to build a new retail complex to house Apple’s newest stores. According to the Bank Credit Analyst, European banks represent one-third of all global finance projects. Unfortunately, there are many European banks that have large exposures to European sovereign debt issued by the likes of Greece, Ireland, Portugal, Italy, Belgium, etc. Should one or more of these countries stop making interest and principal payments, credit from these banks will likely shrink. How much might credit shrink is anyone’s guess, but European banks are already backing away from previously announced deals and yet not one of the aforementioned countries has missed a payment thus far. Moreover, beyond inter-bank loans, European banks have entered into credit default swap (CDS), interest rate swap, and currency swap agreements with U.S.-domiciled banks and other financial institutions. In this game, the dominoes are both numerous and large.
We will try to provide some assumptions that directionally frame the risks posed by over-levered European countries. These assumptions are purely meant to illustrate the enormous amount of capital that may be destroyed should one or more European nation default on its debt obligations. The framework may also be used to calculate Japan’s and America’s potential write-off of debt as well, or any country for that matter. Although it is likely that Japan and the U.S. will eventually inflate away their growing debts.
To start: based on 2011 numbers provided by the International Monetary Fund (IMF) and the ratings company Egan-Jones, Greece’s estimated debt level is €330 billion and its tax revenues are roughly €46 billion. If one assumes Greece’s tax revenues remain unchanged (they are currently falling due to a ~15% contraction in its GDP) and investors require a 6% interest rate to buy and hold Greek debt, what level of debt can Greece support on a go-forward basis? The answer depends on what percent of the tax revenues the politicians would want to allocate to debt service versus paying for education, roads, sewers, police, fire, healthcare, and thousands of other demands for government services. We believe allocating 10% of tax revenues to debt service (interest payments only) seems reasonable, but one could easily argue for either a lower or higher percent. Thus, under our assumptions of a 6% interest rate and an allocation of 10% of tax revenues to interest payments, Greece could support roughly €76 billion in debt. This implies an approximate €250 billion debt write-off from Greece alone.
We have shared these numbers and estimates with our clients since the summer of 2011, when the heads of many European states repeatedly said Greece will not default. As the summer of 2011 dragged into the fall, European leaders tentatively suggested that private financial institutions “voluntarily” accept a 20% haircut on their Greek debt holdings. Then the haircut grew to 50% and today we are hearing that a 70% haircut may be required before another bailout package is offered and accepted.
We as investors see numerous problems in the way European leaders have mishandled this tragic set of circumstances and too many for us to outline in this letter, but we will highlight two issues that we see as very serious. The first is that European leaders seem to only want to focus on Greece and, in our opinion, are ignoring the default risks of Portugal, Ireland, Italy and Spain. If we apply the same logic and assumptions that we used for Greece, these countries combined could add another €1.6 trillion to the debt write-off bucket. Again, much of this debt is held by European banks. Of course, these estimates would be ridiculed by European leaders as outrageous and unreasonable, but we are not even including the potential losses on banks’ books for business or consumer loans should the European economy shrink, as the latest statistics indicate.
The second problem we see, and in some ways even more dangerous than not addressing the magnitude of the entire default risk, is that politicians have failed to recognize that their economic and political systems are no longer sustainable.
The Eurozone’s economic system has clearly benefitted the rich Northern countries in the Euro area that export products and services to the less-rich, less productive countries of the South. But in order to keep their economies growing, the rich export-oriented countries have had to recycle their trade-surplus revenues through their banks and then into the sovereign debt of countries running trade-deficits. Until recently, the effect was to lower interest rates in the Southern countries, thereby stimulating unsustainable real estate development and personal consumption.
At first, this system looks like a virtuous cycle as jobs in the north and south grow and people prosper, but it is really more akin to a Ponzi scheme where the last marginal producer in the north gets rich just as the tower of debt is about to topple over. It is similar to a Ponzi scheme because the debt eventually rises so high that all of the creditors cannot be repaid in full. Much of this increased debt has not only created an illusion of prosperity throughout the region, but also the ingredients for a combustible showdown amongst banks, politicians and the citizens they purportedly represent.
To illustrate the unsustainability of the current situation all one needs to do is look at the uncompetitiveness of the Southern countries versus Germany. According to the OECD and Capital Economics, Greece’s unit labor costs are approximately 40% higher than Germany’s. Italy’s and Spain’s costs are 30% higher, and even France’s are roughly 20% greater than Germany’s.
Instead of issuing more debt or imposing severe fiscal austerity measures, it would be advisable, from our perspective, if the politicians allowed market forces to recalibrate the different productivity levels of the various countries within the Eurozone. Thus, imbalances from issuing too much debt and disparate productivity levels would not be allowed to get out of control and jeopardize normal, sustainable economic activity. Of course, other measures would be required as well and we discussed those in prior letters.
Regrettably, the Eurozone’s political and economic systems do not allow for equilibrium in productivity to be reset periodically. That is wages in the South are not adjusted downward to reflect their lower productivity, and greater incentives are not provided to increase consumption in the North. Obviously, currencies in the North and South are not allowed to rise or fall to adjust for the imbalances because they both use the same currency. Thus, the competitive gap widens further as businesses have no incentive to invest capital in the lesser productive countries, which creates more imbalances.
Sadly, we have now reached a dangerous point where central bankers are facilitating this unsustainable game of musical chairs. The European Central Bank (ECB) is providing very low interest rates to banks so they can help the Southern countries rollover their Euro-debt at rates well below what the market demands. The ECB loans have led to a huge increase in the Central Bank’s balance sheet, which is now roughly €3 trillion. Helping to monetize an over-levered country’s debt is not sound monetary policy.
More puzzling is why Germany’s central bank, the Bundesbank, would lend the ECB nearly €500 billion for the ECB’s Target2 interbank payment system. The recipients have been not only Greece, Ireland, Portugal, Spain and Italy, but also France. Hans-Werner Sinn, President of a Munich-based economic research firm, Ifo Institute for Economic Research, was recently quoted in Bloomberg Businessweek as saying, “if the Euro breaks up then the whole claim [€500 billion] is under risk. This may be the largest threat keeping Germany within the Eurozone.” It is astonishing to us that the Bundesbank would enter into such a risky endeavor after rebuilding their credibility over the last several decades, and considering the history of previous German central bankers who twice destroyed their currencies over the past ninety years.
Currencies are merely a medium of exchange in an economy and investors require that the central bankers do not debauch those currencies. If currencies are diluted to prop up a failed system, investors lose the anchor on which they rely for purposes of valuing a security. Central bankers play a vital role in a well-functioning economy by allocating credit to banks to stimulate a sluggish market and holding reserves from banks to dampen excess lending. While controversial, central bankers may even be the lender of last resort, but only at a price that is fair and at a level which future players would not want to endure. Lending money out to banks at 1% or less does not seem fair to those who hold that currency for savings and investments, nor does it seem appropriately high enough to discourage future reckless behavior.
The above economic commentary plays a significant factor in our outlook for 2012. It is very possible that Greece defaults on its debts this year, which could trigger insolvency among several large European financial institutions that are highly levered and own a lot of Greek debt. What the ripple effects would be on the CDS market and the entire financial industry are difficult to predict, but it is clear to us that banks are going to be fearful of lending to other banks until the risks are better understood. Moreover, in the event of a Greek default, it is entirely possible that several European banks will be nationalized and recapitalized. All of this is a prescription for a substantial decline in credit underwriting by European banks and, thus, lower economic growth worldwide. The only good news is that there has been enough “foot dragging” to allow exposed banks to better prepare their balance sheets should Greece default on its debts.
We believe U.S. economic growth this year will remain sluggish, despite the decent momentum in the latter part of 2011. We also recognize that this year is an election year, so it is possible that politicians could surprise us by implementing a growth policy based on prudent tax reform including extending the Bush tax cuts another two years. However, because of varying political reasons, we believe the odds of Congress and the White House agreeing to a deal in time to boost 2012’s economic growth are very low.
Barring any rational tax and growth policies from Washington, we do not believe the consumer is in a position to ramp up their borrowing or spending. Consumer debt is still very high today at just under 100% of GDP, and many people have expressed a desire to continue to reduce their financial leverage.
Despite the recent encouraging signs that unemployment is declining, the U6 rate is still over 15%. The U6 rate includes the official unemployment rate plus those working part-time that want to work full-time and those who want to work but have given up looking for a job. This high U6 rate, low wage growth, and the ineffective government policy of trying to boost home prices, should encourage the average consumer to remain parsimonious.
The strong likelihood that Europe has entered a recession or will soon experience an economic contraction will have some negative repercussions on our economy, for no other reason than some of our exports to that region will suffer. For example, while the final statistics are not yet available, it appears that our exports to Europe fell roughly 7% in the fourth quarter. The Euro has continued to weaken and is now close to 1.25 to the dollar. The dollar’s strength and a European recession do not bode well for American exports to the Euro region.
If our major trading partners in Europe suffer an economic recession, the U.S. consumer remains sluggish, and the dollar strengthens, we do not see how corporate earnings will surprise on the upside. Unless one believes that Japan, China, and the emerging markets are going to buck the challenging economic conditions in the U.S. and Europe, one should expect continued stock-market volatility in 2012. Your portfolio has substantial liquidity that can and will be used strategically to purchase market-leading companies at attractive valuations should their stock prices exhibit the type of volatility we expect this year.
In summary, we expect the ECB and the Federal Reserve to continue to provide substantial liquidity to their respective banks and economies. The Central bankers hope that this liquidity will provide time for countries to get their fiscal houses in order and jump-start moribund economies. However, we believe we are getting near an inflection point when the music stops and someone is going to be left without a chair. The obvious candidate for such a predicament is Greece. But if Greece defaults, why would Ireland and Portugal want to continue suffering under the draconian austerity measures imposed on them? No European country is immune to the risks posed by the reckless leverage these governments have assumed, and have encouraged their banks to purchase. With today’s global financial system so intertwined, the risks to U.S. equity investors, from a sovereign default, are greater than anytime in the last quarter of a century. Hence, we are expecting more market turbulence this year, but positioned your portfolio accordingly and possess the liquidity required to pursue opportunities that may avail themselves to the patient, absolute-value investor.
Thank you for your continued support and confidence 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.