FPA Capital Fund Q4 Commentary
Energy, which is broken down into oil service and exploration and production, continues to be the largest area of the portfolio despite us reducing several positions during the year. We have sold the lion’s share of the significant investments made back in late 2008 and early 2009. Since the second quarter of 2009, FPA Capital Fund has taken approximately $400 million in profit on an original $359 million invested. In other words, we have taken around 111% of the original amount invested off the table. Despite this selling, we still retain most of our initial investment in the energy sector. We continue to have conviction in our energy holdings, which are now primarily oil focused. Oil is a global commodity that has a heavy exposure to global-demand growth and in particular that of the developing economies. We believe growth in the developing economies will exceed that of developed ones and oil will be one of the beneficiaries of this. Oil production also has a sharp decline curve, roughly 9% according to the International Energy Agency, which makes it difficult to grow supply. Importantly, this high decline rate not only enhances the upside, but also potentially helps protect the investments in a recessionary environment, since supply and demand get back into equilibrium much faster. Lastly and most imperative, oil in the ground and assets used to produce it, should provide a store of value against potential future monetary inflation.
Industrials and technology companies drove most of our outperformance in the quarter. Our industrials were up approximately 15% and our technology companies 10% versus 10% and 2% for the respective sector constituents in the benchmark. The top five contributors in the quarter were Trinity Industries, Arrow Electronics, Western Digital, ENSCO, and Interdigital.2 The bottom 5 performers, of which four were energy companies as discussed above, were Rowan Companies, Newfield Exploration, Rosetta Resources, Foot Locker and Baker Hughes.
During the year we continued to trim positions as they got close to or exceeded our fair value estimates. We trimmed about half of the portfolio stocks during the year including five energy investments, three technology investments and both our retailers. We also added to five existing positions during the year, Devry (DV), Interdigital (IDI), Newfield Exploration (NFX), Patterson-UTI Energy (PTEN) and Veeco Instruments (VEO). Patterson-UTI, which we had sold at higher prices, came down to 75% of book value3, around 3x trailing cash flow4 and close to half its replacement value of primarily new equipment, at which time we began repurchasing the stock. We also initiated a new position in the defense industry.
During 2012, the following investments went up by more than 15% in value: Amerigroup, Veeco Instruments, Oshkosh, ARRIS Group, Western Digital, Foot Locker, Federated Investors, Cabot Oil & Gas, Reliance Steel & Aluminum, ENSCO, Signet Jewelers, Trinity Industries and Atwood Oceanics. As you can see, our winners included companies from 7 industries. Some of these investments have been a part of the Fund for many years and some were brand new positions initiated in the past two years. Of the above, Veeco was the only addition during the fourth quarter, as it came under pressure following weak order intakes. The below normal order intake provided us with an opportunity to add to this industry leader in the MOCVD equipment market (metal oxide chemical vapor deposition) at an attractive price of less than 3x enterprise value5 to trailing three-year average EBITDA6. Recall that we sold about 30% of this position in the third quarter at higher prices. We trimmed five positions during the quarter in response to appreciated stock prices, these included Atwood Oceanics, ENSCO, Federated Investors, Signet Jewelers and Trinity Industries.
One should keep in mind that our strategy can produce periods of outperformance or underperformance. Using FPA Capital Fund, as a proxy for the overall strategy, against the Russell 2000 Index, we have outperformed in 16 out of the past 28 years and underperformed in twelve.7 The greatest underperformance was 2006 when FPA Capital Fund was up by 5.42% and the Russell 2000 Index was up by 18.37%. 2001 represented the highest outperformance, when FPA Capital Fund returned 38.13% against 2.49% for the Russell 2000. Since inception, despite this volatility, FPA Capital Fund has returned 14.63% annually vs. 9.48% for the Russell 2000. It is important to balance the good years with the bad years, since both are inevitable when investing in a concentrated portfolio that puts zero emphasis on benchmark weightings. With our average holding period of more than five years, this volatility versus the benchmark is simply due to our stocks being either more ‘in accord’ or ‘out of accord’ at any given point.
It is important to remember that we seek investments that are oversold and out of favor. Our investments are generally the “bad stories” on Wall Street and shunned by other investors, with recent examples being Patterson-UTI, Veeco, Interdigital and Devry. This is contrary to the general investment community. They look for good stories and pay the price in higher valuations. A study on the cost of conformity in investing by A. Dasgupta, A. Prat and M. Verado titled “The Price of Conformism” which is discussed in James Montier’s book “The Little Book of Behavioral Investing”, shows that there is a 17 percent difference over a two year period between stocks that are sold the most by institutions and stocks most purchased. The stocks that institutions sold the most outperformed the market by 11 percent, and stocks that were purchased the most underperformed by 6 percent. John Maynard Keynes once said that “The central principle of investment is to go contrary to the general opinion on the grounds that if everyone agreed about its merits, the investment is inevitably too dear and therefore unattractive.” Buying into stocks that are shunned and oversold is never easy, but it is the only way we believe may achieve our stated goal and generate the outperformance over time.
A Wall Street Journal article on January 12, 2013 highlighted FPA Capital Fund as one mutual fund that had a low expense ratio, a portfolio that was differentiated from the index, and a five-year return that was materially ahead of the index. We are pleased to see that we compare favorably in all three areas.
A Barron’s article8 2 days later discussed the topic of portfolio differentiation in more detail. It posed the question of how one differentiates active managers from closet indexers using a measure called “active share”, a measure that evaluates how closely a portfolio tracks an index. If the active share is 30%, then only 30% of the portfolio is invested differently from the index and the remainder tracks the index very closely. The story suggested that funds with an active share of 90% and above had outperformed their benchmarks over the measurement period between 1990 and 2003. Not having paid attention to this measure before, we thought it would be interesting to see what the active share for FPA Capital Fund was. The answer was an active share of 98%, meaning only 2% of the portfolio was mimicking the benchmark.9 Such a high active share is not due to a conscious effort, but the result of building the portfolio from the bottom-up, one stock at a time, and purchasing only stocks that meet the stringent risk reward criteria we continue to seek.
Our divergence from the indices, and the market in general, can be seen in the portfolio metrics. The valuation of the portfolio is very low compared to the indices as well as based on historical measures. The P/E ratio10 is currently 10.8x, which is less than half of the Russell 2000 P/E at 23.8x. We believe that this large valuation gap will shrink over time and help drive the portfolio’s performance. Our investments also carry less financial leverage with 28.8% total debt to total capital vs. 38.8% for the Russell 2000.
We have often stated that we will continue to invest in our team and process, so as to ensure our ability to meet the stated goals within the defined investment philosophy. To this extent we are very pleased to announce a new member of the team. Nile Garritson joined us during the quarter. Nile is a CFA charterholder, has a Bachelor’s degree in Business Administration and an MBA from the University of Southern California. He worked in trading and private wealth management at UBS and held various positions in Treasury and Financial Planning at Edison International. Nile has been investing personally since 1999 and exemplifies the discipline and patience needed to affect our strategy. We look forward to introducing Nile to our clients over the coming year.
Economic Commentary & Outlook
Whew! According to the media and those who make a living as economic pundits, we narrowly avoided going over the so-called fiscal cliff at the beginning of 2013. The stock market11 rejoiced and subsequently rose roughly 5% between December 31, 2012, and January 4, 2013.
Call us skeptics, but we hardly believe that corporate profits will sufficiently increase to justify a weekly gain of 5% just because taxes are going up a lot on high wage earners and the spending sequester was temporarily postponed. More likely, the stock market was concerned about earnings declining had we not avoided the doomsday fiscal cliffhanger and, thus, experienced a relief rally to ring in the New Year on a cheerier note. Unfortunately, Congress and the White House could not amicably discuss the nation’s business in a civil tone. Some reports suggest that members of the Republican leadership and President Obama were not even on speaking terms by year end.
Guessing when the President and the GOP might again converse is like predicting when Lindsay Lohan is going to have her next cocktail. You know it is going to happen, but the outcome is not likely to be pretty, and there ought to be some responsible adult supervision.
The markets rallied at the conclusion of the first round of the fiscal talks. Round two, which includes raising the country’s borrowing ceiling, automatic spending cuts, and funding Federal government spending through the Continuing Resolution process, could see some of that optimism doused.
After reading several recent commentaries from our political leaders in Washington, round two promises to be just as messy as round one. For instance, Speaker of the House John Boehner and Senate Minority leader Mitch McConnell both recently stated that the tax issue has been dealt with and is now off the table for further discussions. Of course, President Obama and House Minority leader Nancy Pelosi both recently said that taxes on the wealthiest corporations and individuals will have to go up to pay their fair share. Hoist the warning flags.
If one lives in California and is fortunate enough to earn over a $1 million annually, the marginal tax rate for this lucky Golden-Stater may now be over 60%, including all income taxes, Medicare taxes, and the new ObamaCare tax of 3.8% on investment income. This does not include taxes for Social Security, property taxes, sales tax, or a host of other taxes. If enough Hollywood bigwigs and Silicon Valley billionaire-geniuses opt to follow French actor Gerard Depardieu to Russia, the Golden State could indeed look a bit more tarnished.
The point is that high marginal tax rates matter and, if they get high enough, people will alter their behavior. Businesses are no different than individuals when it comes to taxes. The U.S. has one of the highest corporate tax rates in the developed world, and companies are not repatriating foreign income back to the U.S to avoid paying them. The Wall Street Journal recently reported that U.S. companies are holding over $1 trillion of foreign cash in international financial institutions to avoid being taxed at considerably higher U.S. rates than where the profits were earned and already taxed.
Hence, we can envision the President recommending lower corporate tax rates and modest spending cuts that would take place near the end of his second term or afterwards. In return, the President would ask that loopholes and deductions for wealthy businesses and individuals be reduced or eliminated. Based on recent interviews, the GOP leadership wants significant changes to entitlement spending –particularly with respect to Medicare, Medicaid, and Social Security- and other programs before agreeing to increase the country’s debt ceiling.
From our perspective, a reasonable outcome for round two includes lowering both corporate and individual tax rates, broadening the tax base, reducing deductions and loopholes, and lowering the growth rates of future entitlement spending. The economy is still fragile and growth is tepid. Lowering tax rates will free up capital and spending by businesses and individuals, which should lead to faster GDP growth and higher profits. Trimming current Federal spending is important, but cutting current spending too much right now could backfire. Nonetheless, we need to lower the cost trajectory of entitlement spending by restructuring these programs so they are more efficient and are received by those truly in need. This will help to keep future interest rates from eventually rising to a point that effectively forces draconian restraints on the government and likely a very deep economic recession.
The problems the U.S. faces are large and daunting. Business people and investors have largely benefitted from restructured and highly efficient corporations that generate abundant earnings and good returns on capital. These people have seen their incomes more than keep up with the cost of living over recent decades. However, a good number of Americans are struggling to maintain a middle-class quality of life. Others hold little prospect of even joining the middle class for a complex set of reasons, among them the breakdown of the so-called traditional American family, or their work skills have grown obsolete or too costly in today’s highly technological and globally-competitive economy.
It is the above-described backdrop, in our opinion, that has led to excessive government intervention in the economy and markets, which in turn inhibits a necessary adjustment of ongoing financial imbalances. Capital allocators must be aware of these structural challenges because government policies or social strife can negatively impact companies’ revenues and profits. Government regulations, such as ObamaCare, have the ability to raise the cost of running a business without any payback to the owners. Likewise, if a large number of people are struggling maintain a middle-class livelihood, future consumption of products and services produced in the economy may diminish.
There are no easy or quick solutions to our problems. The stock market likes the current government deficits and easy monetary policies that help to maintain current consumption and, therefore, corporate revenues and earnings. The dilemma is that we are borrowing today not to make investments that will help build a more efficient and productive economy for the future, but to feed current consumption. According to the Office of Management and Budget, in 2012 the Federal government allocated roughly 62% of the budget to entitlement spending versus just 50% in the early 1990s.
Consider this, while inflation-adjusted Federal spending for Medicare and Medicaid has annually increased 5.5% and 3.9%, respectively, from 2002 to 2012, spending for higher education and agriculture research has declined 2.4% and 1.1%, respectively, over the same time frame. Federal spending for science and technology increased less than 1% after adjusting for inflation over the past decade. With a budget deficit of approximately 7% of GDP, these numbers are neither sustainable nor a sign of future strength of our economy.12
Unless we see material changes to our current fiscal predicament and more growth-oriented policies, we believe our economy will remain sluggish and not reach a sustainable higher level of growth. Slower GDP growth will make it difficult for businesses to grow sales and profits, unless there is a surge in demand from foreign markets. However, our trade partners in Europe are either not growing or mired in structurally weak economies and currently experiencing recessions. Japan’s new Prime Minister, Mr. Abe, is trying to jump start his moribund economy with easier credit and a lower Yen, which bodes ill for U.S. exports to Japan. Thus, to experience a renewal of demand growth from overseas, we need to rely on China and other developing nations to absorb our exports.
In summary, we remain cautious with respect to U.S. economic growth for 2013 and believe stocks in general are not attractively priced to warrant a more aggressive allocation to equities. We continue to believe earnings growth for many companies will be challenged and struggle to meet the high expectations embedded in their current Price-to-earnings multiples. We further believe it is sensible to continue to maintain a high level of liquidity in the Fund, so we will have the ability to quickly deploy cash into attractive investment opportunities when they present themselves.
The easiest response to the Fund’s cash position is to buy more equities and be fully invested, irrespective of valuations. We believe this is what many of our contemporaries are doing today. In the Morningstar fund database there are small cap value managers that own companies with the following characteristics: large positions trading at over 40x trailing-twelve months net income and more than 15x peak earnings and other positions that have generated positive net income only one year (in 2009) over the last decade. Investors should not be surprised that this occurs, given the pressures that managers are under with fully-invested mandates. Some of these “Value” funds should be called “I hope no one discovers what I am doing fund.”
Your manager has not and will not play that game. We will, however, continue to remain vigilant, seeking companies that provide excellent risk-to-reward ratios and meet all of our strict investment criteria in the allocation of your capital. When our due diligence is complete and a stock meets all of our metrics, outlined in our Investment Policy Statement, we will at that point deploy your capital. This approach is what has driven our long-term gains over the past several decades, and we endeavor to maintain our investment discipline, so as to continue to seek to generate similar long-term returns into the future.
We thank you for your continued support and trust.
Portfolio Holding Submission Disclosure
Except for certain publicly available information incorporated herein, the information contained in these materials is our confidential and proprietary information and is being submitted to you for your confidential use with the express understanding that, without our prior written permission, you will not release these materials or discuss the information contained herein or make reproductions of or use these materials for any purpose other than evaluating a potential advisory relationship with First Pacific Advisors.
You should consider the Fund’s investment objectives, risks, and charges and expenses carefully before you invest. The Prospectus details the Fund's objective and policies, sales charges, and other matters of interest to the prospective investor. Please read this Prospectus carefully before investing. The Prospectus may be obtained by visiting the website at www.fpafunds.com, by email at email@example.com, toll-free by calling 1-800-982-4372 or by contacting the Fund in writing.
Investments in mutual funds carry risks and investors may lose principal value. Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. The Fund may purchase foreign securities which are subject to interest rate, currency exchange rate, economic and political risks; this may be enhanced when investing in emerging markets. Small and mid- cap stocks involve greater risks and they can fluctuate in price more than larger company stocks. Groups of stocks, such as value and growth, go in and out of favor which may cause certain funds to underperform other equity funds.
The return of principal in a bond fund is not guaranteed. Bond funds have the same issuer, interest rate, inflation and credit risks that are associated with underlying bonds owned by the fund. Lower rated bonds, convertible securities and other types of debt obligations involve greater risks than higher rated bonds.
Portfolio composition will change due to ongoing management of the fund. References to individual securities are for informational purposes only and should not be construed as recommendations by the Funds, Advisor or Distributor.
The FPA Funds are distributed by UMB Distribution Services, LLC, 803 W. Michigan Street, Milwaukee, WI, 53233.
1 As measured by the S&P 500.
2 For a complete list of the portfolio’s holdings refer to pg. 8 or fpafunds.com.
3 Book value is the value at which an asset is carried on a balance sheet. To calculate, take the cost of an asset minus the accumulated depreciation.
4 A company's free cash flow for the previous 12 months.
5 A measure of a company’s value often used as an alternative to straightforward market capitalization.
6 EBITDA is essentially net income with interest, taxes, depreciation, and amortization added back to it.
7 Historic Annual returns can be found at fpafunds.com.
9 Benchmark is Russell 2500 from Morningstar.
10 Price to Earnings ratio (P/E) is a valuation ratio of a company's current share price compared to its per-share earnings
11 As measured by S&P 500