We have articulated many times over the last couple of decades that cash is a residual of investment opportunity, and we do not target a certain percentage. That is, cash levels are low when there is an abundance of value and high when there is a scarcity of absolute value opportunities. We think of cash as an asset that has no duration, but provides an embedded call option that can be exercised when quality assets are cheap and on sale.
It is often a lonely endeavor to be a true contrarian absolute value manager. Most people feel secure in the knowledge that others like them are nearby, doing similar activities, and generally moving in the same direction. Most people do not want to be alone or feel awkward because they are the only ones on the dance floor. Our Small/Mid-Cap Absolute Value team has established a long-term track record that is predicated on standing away from the crowd, allocating capital when there is fear in the market or when there is a large degree of uncertainty about an individual enterprise.
We have written many times in the past, and will continue to reinforce in the future, that our absolute value investment strategy can lag the stock market indices not only when stocks are rising rapidly, but also when they are richly valued. At over 20x trailing-twelve month earnings and 15x forward earnings, small- and mid-caps stocks are certainly not cheap. This is familiar territory for us; it compares most recently to the 2004-2007 period, although the 1996-1998 was comparably frustrating. In contrast, the Fund has a Price/Earnings ratio of approximately 11x, and the account’s weighted average return on equity is roughly 30% greater than its benchmark’s return while have substantially less leverage than the indices.
We do not mean to convey that we are waiting for the market to crater before we buy stocks. No, our frustration is more akin to the Montana fly fisherman who catches just one prize fish rather than the school of rainbow trout swimming nearby. For instance, despite Q3’s strong performance for all of the major indices and the Fund, we did add a new stock to the portfolio. We have added eight new names to the Fund over the last year or so, evidence that the market does not have to collapse for us to deploy capital.
Alliant Techsystems (ATK) is our newest holding. The company’s Aerospace Systems segment develops and produces rocket motor systems for human and cargo launch vehicles, conventional and strategic missiles, missile defense interceptors, and small and micro-satellites. In addition, it provides composites to military and civil airplane manufacturers. The company’s Defense segment develops and produces military small, medium, and large caliber ammunition. It also provides defense electronics systems, missile subsystems and components, and propulsion and controls systems. Last, in its sporting segment, ATK produces ammunition and sells accessories for local law enforcement departments and the sport hunting/sport enthusiast markets.
We purchased our initial position in ATK below $45, or less than 6x trailing-twelve-months earnings and 55% of revenues to enterprise value. We believe the risk:reward ratio is very attractive at our entry point. At time of writing this commentary, ATK had rallied above $55 or roughly 30% higher than our cost basis.
We added to our Devry (NYSE:DV) position as the stock declined approximately 27% in the third quarter. We maintained our roughly 1.80% position in the stock, despite the material decline in the share price. Many of the schools in the For-Profit education industry have experienced negative enrollment growth recently mainly because potential students have concerns about the job market and their employment prospects after graduation. We believe these are cyclical issues and enrollment will likely stabilize, albeit at a lower level, in 2013. The company continues to experience growth in its medical and nursing schools and is diligently adding to its Brazilian assets. DV’s balance sheet remains strong with nearly $3 in net cash, and the valuation is attractive at less than 4x enterprise value to EBITDA.
As one would expect in a rising market, we reduced several positions in Q3. Notably, we reduced Atwood Oceanics (NYSE:ATW) due to the stock price appreciating 20% in the quarter, reflecting the prospects of stronger profitability due to robust oil prices. We reduced Veeco Instruments (VECO) in the mid-to-high $30s because it approached fair valuation and our channel checks suggested that the metal organic chemical vapor deposition market, used to produce high-brightness LEDs, will remain under pressure for a while longer. We trimmed the position before the stock slid over 20% from its 52-week high. During the quarter we further reduced Foot Locker (FL) and Signet (SIG), which increased over 16% and 10%, respectively. Both of these retailers have been big winners for your portfolio over the last few years with FL up nearly 500% since our last purchase during the fiscal crisis and SIG up over 585% during the same time frame. FL and SIG are among the best managed retailers in their respective retail niches, and they boast the largest market shares as well.
We fully exited Amerigroup (AGP) after the company received an unsolicited takeover offer from Wellpoint (WLP), which was more than double our cost basis. Although we owned AGP for approximately one year and are pleased with the return it generated for the Fund, we believe the stock had more upside potential given the dynamic trends in the market. Nonetheless, on a present value basis, we believe the offer from WLP is fair and that AGP shareholders will approve the deal.
Performing well in the quarter were ATW, FL, SIG, and Oshkosh (NYSE:OSK). OSK appreciated over 30% in Q3 due to in part to investors growing more confident that the company’s earning power over the next few years would be greater than the expectations of just a couple of quarters ago. Additionally, the higher confidence can also be attributed to management’s more focused attention on reducing costs and improving the profitability in their Access Equipment, Commercial, and Fire & Emergency divisions. The stock closed the quarter at $27.43, and we believe the shares may rise further over the next couple of years as the company strives to achieve its target of over $4.00 in earnings per share.
In addition to DV and VECO, Arris Group (NASDAQ:ARRS) also declined in the quarter by roughly 8%, but it is still up over 18% year-to-date. Thus, we attribute the weakness in ARRS more to investors taking some profits off the table rather than anything negative about the operations of the company.
We continue our due diligence efforts in multiple areas. Our pipeline of companies with long histories of profitability, strong industry positions, pristine balance sheets, and solid management teams is robust. The team remains patient for better valuation levels, but is very active in sourcing and researching future companies for your portfolio.
Economic Commentary and Outlook
The resilience of the U.S. consumer, the government’s excessive deficit spending, the Federal Reserve’s loose monetary policy, and investors stretching for returns when corporate profits are at peak levels and valuations already extended – all of these have our attention and concern.
Consumers in the doldrums
The American consumer is not shopping much. Despite what some measures are indicating on employment, we are worse off than five years ago. The U6 unemployment rate, which includes part time employees who would prefer full time jobs, is almost double the 2007 level of 8.0%, and has increased in the last six months from 14.5% to 14.7%. Total nonfarm employment is still 4.5 million below the 2008 level. As a result, the civilian employment-to-population ratio has dropped from over 63% in 2008 to 58.5%. This almost five-point drop is the real hit to employment levels, and it is substantial.
The real median income for U.S. households measured in 2011 dollars has declined by nine percent since 2000 (when it hit $54,932) to $50,054 per household. It is hard to increase your spending if your real income is declining and those around you have difficulty finding jobs. This is why personal consumption expenditure was revised down to 1.5% for the second quarter and continues to be weak. During the last three and a half years real consumption spending has only grown 0.7% per year, less than one fifth the 3.6% rate per year achieved in the decade before.
The U.S. consumer is trying to pay down debt created by the property and credit excesses of the last decade. Household debt at 113% of disposable personal income is down from the peak five years ago, but is still far above the average of 70-80% in the three decades before that. Thus, a continuation of the balance sheet repair mode is more likely than not. With the consumer as the dominant driver of GDP, this augurs continued weak GDP trends going forward.
Can the Fed’s stimulus counteract these trends and what are the risks?
In spite of the Fed’s exceedingly easy monetary policy, the consumer has not responded. The Fed is persisting nonetheless, offering up QE3, after QE1 and QE2 succeeded in growing annual real consumption spending by only 0.7%. In our eyes, further quantitative easing is neither logical nor well thought out, since the upside does not offset the risks. Having already increased the money supply from $850 billion to $2.8 trillion the last five years, the Fed is now embarking on another $500 billion per year expansion, and it will keep expanding until the outlook for the labor market improves substantially. This $500 billion per year equates to a 60% increase in the money supply on the 2008 base, not small potatoes even for an economy the size of the U.S. It is easy to forget where you are when you’ve gone off the road as has the Fed, and the further you drive in the woods, the harder it is to find your way back. Risks related to loose monetary policy include i) price instability should the credibility of the U.S. dollar erode, ii) misallocation of capital, and iii) creation of bubbles that could threaten financial institutions and financial markets.
We agree with the closing arguments of a paper recently issued by the Federal Reserve Bank of Dallas, written by William White, the chairman of Economic Development at the OECD. The paper “Ultra Easy Monetary Policy and the Law of Unintended Consequences,” asserts two premises for current monetary policy to work: i) it must be effectively transmitted to the real economy, and ii) it must lead private sector spending to respond by stimulating the real economy and reducing unemployment. White concludes that the current ultra easy policy is neither likely to be effectively transmitted to the real economy, nor to lead private sector spending to respond and reduce unemployment. White closes by stating that…
“the capacity of such policies to stimulate strong, sustained and balanced growth in the global economy is limited. Moreover, ultra easy monetary policies have a wide variety of undesirable medium term effects – the unintended consequences” and “aggressive monetary easing in economic downturns is not a free lunch.”
We’re of the same mind. The price for current policy mistakes will be paid in the future. The longer current policies remain in place, the further from equilibrium we will be and the larger the readjustment and costs. Said the ancient philosopher Lao-Tzu: “Set about difficult things while they are still easy.” The time to act against the unintended consequences of ultra easy monetary policy is now.
A constrained universe of investment opportunity
Corporate profits are at or close to peak levels and the valuations attached to those profits are rich. The Russell 2000 trailing twelve month Price/Earnings ratio of 25x is more than twice your portfolio’s of around 11x. It is hard to intelligently deploy capital when most people are stretching for yields. We can see the reaching for return effect in our “core value screen” which looks for companies selling below 15x earnings, 7x cash flows, 2.2x book value and 1x sales, and have debt to capital of less than 40%. This screen is qualifying less than one hundred names currently, which is in the bottom third historically. Moreover, equity mutual funds presently have close to record low cash levels, which happen when investors are hungry to put capital to work1. We are content with husbanding our cash and deploying it profitably only when we get attractive opportunities, which has been the case on multiple occasions the last eighteen months. We have also sold aggressively when the valuations have so warranted, selling more than two thirds of our oil and gas exploration investments and half of our oil service assets since 2009.
The present consensus bottom-up forecast is for the S&P 500 net profit margins to increase from 8.9% this year to 9.7% next year2. This translates to an almost 10% increase in the net profit margin which is already extended. We think the more probable scenario over the next several years is a contraction in profit margins, which will likely lead to a retrenchment in valuation multiples and create opportunities to deploy capital.
Combing for small to mid cap value today
We ran a study on the Russell 2000 to see what performed well year-to-date. The result was that of the 219 companies that appreciated by more than 50%, most were marginally profitable at best, highly levered and richly priced. Only half of the companies had a profit. The ones with a profit had an average Price/Earnings of 36x and an average Price/Book of 5.6x. This illustrates one of William White’s unintended consequences: misallocation of capital into highly speculative investments. Since we strive to invest in market leading companies with a history of profitability, strong balance sheets, successful management teams, selling at a deep discount to their underlying absolute values, none of these Russell 2000 “outperformers” passed our screens before their outperformance. Another indicator of investors risk appetite is NYSE margin debt, which is now approaching the level of its prior peak in 2007.
We continue to reduce risk in the portfolio by selling stocks as they reach or exceed their fair values. Despite aggressively selling stocks in our energy and technology sectors over the last few years, these sectors represent almost three quarters of our equity investments. We like our investments in these sectors because of their exposure to global demand growth, as opposed to exclusively relying on U.S. growth, which we, as stated, believe will lag. Our oil exposure is further substantiated by the fact that it is a real asset that should provide a store of value if monetary inflation becomes a problem in the future.
We thank you for your continued support and trust.
The portfolio holdings as of the most recent quarter may be obtained here.
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.
The FPA Funds are distributed by UMB Distribution Services, LLC