FPA Capital Fund Q1 2013 Commentary
We are often asked “why not just buy more of what you own and be fully invested?” Our answer is the same today as it was almost thirty years ago. That is we do not target a specific level for cash, rather cash is a residual of investment opportunity. We build the Fund one stock at a time, and each investment achieves a certain weighting based on its risk-to-reward ratio. The higher our confidence in a company executing its business plan, coupled with more upside potential than downside risk, the larger its weighting will be.
We monitor each stock position in the portfolio every day. When a stock meets all of our strict investment criteria and reaches an attractive valuation level, we establish a new holding or add to an existing position. When a stock attains a premium to our estimate of its intrinsic value, we reduce or eliminate the holding depending on how large the premium is to its value. At the end of the process, we generally end up with 20-40 stocks in the Fund. If the number of companies that qualify for a position in the Fund is at the lower end of the range, or our conviction in the existing holdings is not at the highest level, the portfolio will have an elevated level of liquidity. On the other hand, if it is a target-rich environment and our convictions are exceptionally high, the Fund will have very little liquidity.
In our opinion, there is currently a dearth of investment opportunity in the U.S. Small-Mid Cap stock universe. For example, our core valuation screen shows just sixty-four companies passing. We have looked at all these companies. We either own them or deem them not to be investment-worthy. Over the past three decades, this screen has ranged between the low 40s to over 400 companies. Additionally, we have conscientiously reviewed the 52-week new low list for NYSE-listed1 companies over the past few decades to source potential new ideas. At the end of the first quarter, fewer than twenty companies of the more than three thousand listed companies on the Big Board were trading at their 52-week low, excluding ETFs2, ADRs3, and Preferred stocks4.
Moreover, if one were to examine the P/E5 multiples for the broad indices, particularly the Small-Mid Cap universe such as the Russell 2000 and 2500, one should be alarmed at the extraordinarily high valuations investors are paying to own stocks. For instance, at the end of the March quarter, the trailing-twelve month price/earnings ratio6 for the aforementioned indices were 26.3x and 23.2x, respectively. Clearly, current market conditions are not ideal for us value investors.
Growth and momentum investors, and some pension consultants, will so say “so what?” These people will point out that the market and many stocks are tracking higher, and it is not wise not to be fully invested. Yes, the market has been robust and the invested portion of the Fund has performed very well, but we have a couple of questions about the wisdom of allocating capital to very expensive stocks.
The first question is, “What is one’s required growth rate of profits for paying such large multiples for these companies?” The academic texts books and many growth investors will tell you all about the PEG ratio7. This metric is defined as the P/E ratio divided by the expected growth rate in earnings. Generally, these investors want a PEG ratio of 1 or less to commit capital. Thus, with the current P/E for the Russell 2000 at 26.3x these growth investors need earnings to grow faster than 26%, or they will be merely speculating by having to pay a PEG ratio greater than 1x.
If one accepts that paying 1x for the PEG ratio makes reasonable investment sense, and we do not because we believe no investor can predict with 100% confidence what the future holds, then what is the consensus for earnings growth? The latest reports we have read is that the consensus for earnings growth for 2013 is projected to be 4-7%.
Interestingly, earnings for Small-Mid Cap companies are currently growing at about 1.6% per quarter, or less than 7% annualized.8 This a far cry from the 26% required per the widely-held view that a PEG of 1 or less makes eminent sense. It is analogous to that iconic 1984 Wendy’s commercial with the actress Clara Peller, who asks, “Where’s the beef?” If you do not remember the commercial, Peller receives an enormous hamburger bun with a tiny piece of beef inside. Her elderly friends ridicule the bun by saying, “It’s a very big bun. It’s a big fluffy bun. It’s a very big fluffy bun.” If Clara and her friends were around today, we could hear them saying, “It’s a very big P/E. It’s a big fluffy P/E. It’s very big fluffy P/E.” But not enough of beef, ahem, earnings growth.
This brings us to our second question, “What will drive earnings growth higher?” The biggest factors that determine earnings are revenues and profit margins. Generally speaking, the faster revenues and margins are rising the faster earnings will grow. The opposite is also generally true. Of course, aggregate revenue growth is tied to nominal GDP9 growth.
Over the last five years our economy has experienced the slowest nominal GDP growth rate during any other five-year period since the 1930s.10 The two biggest drivers of long-term real GDP growth are primarily a function of population and productivity growth. Both of these statistics have slowed or are slowing currently. If these two statistics remain moribund and the inflation rate does not pick up, it will be a challenge for nominal GDP to grow at a quicker pace.
With corporate revenues tied to weak nominal GDP, it will be difficult to close the huge difference between the P/E ratio and earnings growth. Some might highlight that a fair amount of publicly-traded companies’ revenues are derived from overseas markets. However, given the state of the European economy, the recent decline in the Yen, and the volatility of emerging market economies, we do not believe it is sensible to rely on exports or foreign sales to boost revenues to a level that would materially close the gap between the P/E ratio and the growth rate of EPS11.
The other factor that influences the growth of EPS is after-tax profit margins. Yet, with profit margins dramatically rebounding from low levels of the great recession a few years ago to recent lofty levels not experienced since World War II, the chances of material margin improvement are not high. Frankly, over the past year or so, margins have actually ticked down a bit.
A year ago, there was some hope that a “Grand Bargain” in Washington D.C. would usher in lower corporate tax rates in exchange for the elimination of many tax loopholes. Given the distrust and philosophical differences between the President and many members of Congress, we are not hopeful that a so-called Grand Bargain will materialize any time over the next couple of years. Thus, unless we experience an incredible burst of productivity, corporate margins are not likely to improve enough to close the yawning gap between the P/E ratio and EPS growth.
This brings us to our next question, “If revenues, margins, and earnings do not increase at a pace that would allow the enormous gap between the P/E ratio and growth rate of EPS to substantially diminish, what will keep equity investors from experiencing a massive decline in share prices?” The obvious answer is that global central bankers will have to keep the liquidity floodgates open to prevent an economic and market collapse.
Call it the David Copperfield market. In other words, Bernanke, et al, need to create an illusion of prosperity by providing enough liquidity to the financial system that not only levitates security prices to levels that are not justified by the underlying fundamentals, but also artificially lowers the cost of money (interest rates) so the borrowers find it more affordable to purchase goods in the real economy.
Our concern is this gross manipulation of the capital markets and real economy cannot be sustained over the long term. Nevertheless, investors feel compelled to take on more and more risk by purchasing equities because of the lack of return in less risky assets, but ironically their total return over the full cycle may end up being something less than zero percent should we revert to more normal margins and valuations.
We are routinely reminded how quickly perception can change from everything being OK to a disaster. Think of the Japanese, who relied on nuclear power for a substantial amount of their electricity generation needs, and then in less than one day the illusion of sustainability vanished due to a tsunami. More recently, think of a successful but retired Cypriot couple living off their conservative bank savings, as their golden years are passed with the pleasure of enjoying the warm sun of the Mediterranean region. Then in one weekend 60% of their life-time savings vanish.
Nobody, including us, knows when the perception will change from that Bernanke has everything under control to that of the Federal Reserve has no exit plan from its massive monetization of our country’s debt. Perhaps the perception does not need to change because Congress and the President will do the responsible thing and stop leveraging up our fiscal balance sheet. However, with the Baby-Boomers retiring en masse over the next decade, it is difficult to see how Washington will reign in the inexorably rising spending tied to this cohort.
In light of the above we remain extra vigilant with respect to allocating capital during these challenging times. We trimmed a number of positions during the quarter as stock prices soared and valuations grew richer. We reduced positions in the energy sector, but also in the retail, industrial, and technology sectors. We did not eliminate any of our holdings during the first three months of the year.
Despite our acute concerns about the over valuations for many stocks in our universe, we did initiate two new positions in the quarter: Apollo Group (APOL) and Centene Corp. (CNC). We are very familiar with the industries in which both of these companies operate due to our prior investments in DeVry, which competes against APOL, and Amerigroup, which competes against CNC.
Our investment thesis in APOL is similar but not identical to DeVry. That is, we believe the efficient delivery of quality education to people who did not attend a traditional four-year college is essential for those students and workers to enhance their knowledge and compete in today’s domestic and global economy. People with college degrees experience lower unemployment rate and get paid more than those with just a high school diploma. According to U.S. Census Bureau, there are ~198million people in the U.S. over the age of 25. 31% of these people have high school as their highest educational attainment and another 17% have some college but no degree. Hence, over 95million people might be interested in obtaining a college degree. Many for-profit schools offer online programs, night/weekend classes, and convenient locations. All of which help working adults who seek flexible schedules to earn a degree.
Where the two differ is APOL is almost entirely reliant on its University of Phoenix subsidiary for its earnings, but DeVry has several schools/subsidiaries that contribute profits for shareholders.
The for-profit education industry is currently experiencing substantial declines in enrollment, which is also negatively impacting APOL’s business. The decline in enrollments is largely due to three factors. The first factor is the current employment market is weak and potential students are unsure whether there will be a decent job or promotion available to them after they graduate. The second issue causing lower enrollments is the rising expense of attending college today. Most students do not have the money to pay for their college education out of their own pocket, so they rely on student loans to pay for tuition and books while attending their school of choice. However, many people are reluctant to take on debt to pay for school either because they are uncertain about their prospects to pay off the loans or do not feel a compelling urgency to borrow money now and attend school today. Some students are also exploring Massive Open Online Courses, or MOOCs, which are presently free. The final reason is the recent unfavorable news flow against the industry. The quality of education is being questioned. We believe that DeVry and Apollo provide a high-quality education.
APOL’s earnings peaked a couple of years ago at a shade over $4 per share12. We believe that the company’s EPS could decline to the $1.50-$2.00 over the next year or two, despite the consensus expectations that APOL will earn roughly $3 this year and $2.50 next fiscal year13. We believe APOL’s normalized earnings is approximately $3, which, if the market rewards the company with a normal valuation, implies that the stock could trade to the $40 level after considering its nearly $7 in net cash per share. We purchased the stock in the high teens and the price is currently just a few percentage points below that level.
Centene provides healthcare services in the United States under two segments: Medicaid Managed Care (MMC) and Specialty Services. It is CNC’s Medicaid Manage Care business that competes against Amerigroup, an investment the Fund made in August 2011. If you recall, we purchased Amerigroup when the stock was trading in the low $40s and last year Wellpoint (WLP) acquired Amerigroup for $92 a share.
While we were pleased to generate a very high IRR14 on our investment in Amerigroup, we no longer had exposure to what we believe is very good business. Thus, after we sold our Amerigroup position we refocused our efforts on the other MMC companies that could likely perform well given the consolidation and growth in the industry. As our long-term investors know, we look for market leading companies with a history of profitability, a pristine balance sheet, and good management teams. Centene fits these criteria. They have been very successful in winning new business over the past few years, while keeping a healthy balance sheet and displaying prudent capital allocation but we believe that they are just at the beginning of the growth phase.
We believe CNC is a well-run company that many individual States choose to work with to offer healthcare services to the State’s poorest residents. As Medicaid services expand to more residents due to The Patient Protection and Affordable Care Act (PPACA), commonly referred to as Obamacare, CNC is in a good position to expand its business and meet this new demand for healthcare services.
Beyond the PPACA, CNC is also in a good position to benefit from taking on patients that are known as Dual-eligibles. Dual-eligibles are those patients who qualify for both Medicaid and Medicare services. As the government streamlines its healthcare budget, these Dual-eligibles will either end up being serviced by Medicaid or Medicare service providers, but not both for the majority of members. CNC has the healthcare network in place to absorb a decent number of these Duals, which should lead to further growth in the company’s income over the coming years. We have a small position in the stock, but will look to increase the size of our holdings should the stock weaken and decline to a level that would support a larger allocation of capital.
While the Fund had many individual stocks that performed well, one position, Newfield Exploration (NFX), declined roughly 16% in the quarter. We originally purchased NFX for this fund back in 2008 during the financial crisis and when the stock was trading in the $20s. NFX subsequently rose to mid $70s after oil and natural gas prices recovered from the deep recession. We aggressively trimmed the position as the stock reached its all-time high. Natural gas prices started to decline materially in 2011 and so did NFX.
Fast forward to 2013, NFX has essentially round-tripped its move from the low $20s in late 2008 to the mid $70s in 2011, and now it is trading again in the low $20s. We are encouraged by management’s decision to sell its international assets if they receive an attractive offer. The potential proceeds would reduce net debt and provide resources to drill production wells in several of their important U.S.-based basins. The benefit and cash flow from this drilling activity will likely show up next year, but many investors have sold their shares and depressed the stock price because they do not have the patience to wait for the improvement in the company’s operations. We have the patience and, thus, recently added to our position.
We thank you for continued support and Trust.
1 NYSE is New York Stock Exchange.
2 ETF is exchange traded fund.
3 ADR is American Depository Receipt
4 Preferred stock is an equity security which may have any combination of features not possessed by common stock including properties of both an equity and a debt instruments, and is generally considered a hybrid instrument.
5 P/E is price-to-earnings, or a valuation ratio of a company's current share price compared to its per-share earnings.
6 P/E is price-to-earnings, or a valuation ratio of a company's current share price compared to its per-share earnings.
We hope that investors will find FPA commentaries helpful to understand application of the same investment discipline in various markets, and can refer to particular items that interest them.
7 PEG is price-to-earnings divided by growth. This ratio is the stock's price-to-earnings ratio divided by the growth rate of its earnings for a specified time period. The price/earnings to growth (PEG) ratio is used to determine a stock's value while taking the company's earnings growth into account, and is considered to provide a more complete picture than the P/E ratio.
8 Mellon Analytics.
9 Gross Domestic Product.
10 Bureau of Economic Analysis.
11 Earnings Per Share.
12 Peak occurred in 2011.
13 Thomson Reuters.
14 Internal Rate of Return, or a rate of return used in capital budgeting to measure and compare the profitability of investments.
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The Russell 2000 Index consists of the 2,000 smallest companies in the Russell 3000 total capitalization universe. This index is considered a measure of small capitalization stock performance. The Russell 2500 Index consist of the 2,500 smallest companies in the Russell 3000 total capitalization universe offers investors access to the small to mid-cap segment of the U.S. equity universe, commonly referred to as "smid" cap. These indices do not reflect any commissions or fees which would be incurred by an investor purchasing the stocks they represent. The performance of the Fund and of the Averages is computed on a total return basis which includes reinvestment of all distributions.
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