FPA Capital Q2 2013 Portfolio Commentary and Outlook
The Fed's excessive liquidity program (aka: Quantitative Easing) is analogous to performance-enhancing stimulants for athletes. For those that use or rely on them, performance is markedly better for a period of time. However, when the stimulants are removed performance is assuredly worse, and being caught relying on them is at best embarrassing and at worst disastrous. Witness the fall of former great cyclists and baseball players after being discovered unwisely consuming the enhancements. Many investors today are consuming the Fed's monetary enhancements and performing well, but what happens when injections stop?
We have highlighted several times over the past year-and-a-half that the twin stimulants of enormous fiscal budget deficits and unprecedented Federal Reserve liquidity were not sustainable. It is now clear that the large Federal budget deficits are trending down as higher tax rates raise more revenues and the budget sequestration slows spending. While this combination has reduced the budget deficit, we feel these two factors have adversely impacted growth in sales and profits.
First quarter GDP growth, for example, was recently revised downwards to just 1.8%, and earlier estimates for the second quarter's GDP of as high as 3.0% by some economists now seem highly unlikely. Moreover, applying Generally Accepted Accounting Principles (GAAP)ii, earnings for the S&P 500, in aggregate, did not grow year-over-year through the month of June. Actually, based on U.S. GAAP, earnings for the S&P 500 declined about a half of one percent over the past year. According to Factset, a financial data firm, 87 companies have thus far issued negative EPSiii guidance for Q2 2013 versus 21 that have issued positive EPS guidance. In other words, more than 80% of the recent corporate EPS guidance was negative.
But there is no need to worry about increasing GDP; the bureaucrats in Washington are changing how GDP is measured. Starting in July, 2013, the green eyeshade people will include research & development expenses, rights to entertainment programs, and accrual expenditures for defined benefit pension plans in their new statistics for calculating the size of our economy. These one-time adjustments will, voilà, boost GDP by roughly $500 billion, or 3%, overnight.
Despite weak GDP growth, a slight decline in GAAP earnings, and negative EPS guidance, the S&P 500 and the Russell 2500 appreciated more than 20% and 25% over the past year and more than 13% and 15%, respectively, year-to-date. According to Standard & Poor's and Barron's, the P/E ratioiv for the S&P 500 increased from 15.7x to 18.7x, or roughly 20%, over the past year, while earnings were essentially flat. In other words, 100% of the return for the S&P 500 over the past year was due to P/E multiple expansion as opposed to GAAP earnings growth.
While attending various investment conferences over the past year, we have had the opportunity to ask other investors why they think the stock market is going up if earnings are not growing. The consensus answer is that the market is rising because of the Federal Reserve's monetary policy is facilitating capital flows into the equity markets. Magnus Piene, head of global securities for Norway's largest bank, warned his clients that "all this liquidity is pushing people to do things they should not be doing." In a Wall Street Journal opinion article on June 21, 2013, Romain Hatchuel, who is the Managing Partner for the New York-based asset management firm Square Advisors, wrote an article titled "Central Banks and the Borrowing Addiction." In the editorial, Mr. Hatchuel is quoted, "Few serious money managers will tell you that they see compelling investment opportunities out there. The more optimistic ones usually put forward the same reason: liquidity, liquidity, liquidity." Nonetheless, investment managers are reluctant to reduce their stock weightings, as measured by near record low cash levels for investment funds – and miss out on rising prices – irrespective of valuations.
Based on the recent comments by Fed Chairman Ben Bernanke regarding tapering the Fed's policy of quantitative easing and the market's negative reaction to those comments, it is clear to us that market fundamentals such as earnings growth, returns on invested capital, expanding profit margins, and revenue growth are taking a backseat to speculation about Fed policy. This situation, in our opinion, is risky for investors because valuation metrics are largely being ignored, and history generally is not on the side of those who ignore valuations for too long. Perhaps we are old-school, but we firmly believe profit growth and valuations are the long-term determinants of stock prices.
We reviewed other contemporary periods of time (see the table below) when equity markets were, in our opinion, expensive – similar to the current environment – and then how equity markets performed subsequent to those high valuation periods. For example, in the middle of 2000 the FPA Capital Fund was trading at just 14.7x earnings. However, the Russell 2500 and S&P 500 were both trading above 25x earnings, and the markets then declined over 40% during the following couple of years. In the middle of 2008 the Russell 2500 was trading at 20x earnings while the S&P 500 was trading at over 16x. Again, the equity markets experienced a sharp decline of greater than 40% the following year. We want to be clear, we are not forecasting a decline in the equity markets of the magnitude exhibited during those two prior periods. We are merely pointing out that the equity markets today are rich and being driven principally by Fed policy, in our opinion.
While the Fund has underperformed over the last year-and-a-half, there have been two other periods, consistent with the aforementioned frothy periods above, when the Fund underperformed for roughly three years. For instance, during the period between 1997 and 2000 the FPA Capital Fund underperformed the Russell 2500 by over 600 basis points compounded annually. However, from 2001 through 2005 the Fund outperformed the Russell 2500 by over 1,000 basis points compounded annually. The Fund also underperformed from 2006 through 2008, and then outperformed the benchmarks from 2009 through 2011 by over 600 basis pointsv per year.
The point of looking back over the past couple of decades is to underscore that our strict absolute value philosophy has resulted in 3-year or 4-year periods of time when we underperformed because we did not own or chase expensive stocks. However, when reviewed over a longer period of time, our Fund's returns have exceeded the Russell 2500 by over 300 basis points compounded annually since 1985. While other investors may choose to accept large risks for technology stocks, like in the 1990s, or ignore the huge financial leverage consumers and financial companies were encumbered with six years ago, or play ball with the Fed's current unprecedented monetary policies, we will remain vigilant with respect to valuations.
Our investment philosophy is predicated on deploying an absolute value set of metrics to guide our buy and sell decisions. When stocks are absolutely cheap we buy, and when stocks are rich we sell. The result is that we will end up with excess cash when stocks are expensive, which may lead to periodic underperformance. However, when the tide turns and stocks decline, the cash will help preserve capital and then be used to allocate to what we believe are very cheap, but excellent investment opportunities.
Despite our dogged obsessiveness with value and our current high cash levels, stocks in the fund have performed well year-to-date. Included below is a table that highlights how each individual stock has performed this year.
The best performing stock this year for the Fund is Western Digital (WDC), which appreciated 47.5% and closed at over $62. We have written about WDC in the past, but, as a reminder, the company is the largest manufacturer of hard disk drives (HDDs) used to store information. The Fund initially purchased WDC in 2007 in the mid- teens and then added substantially to the position during the financial crisis when the stock traded as low as $10 a share in 2009.
WDC has been among our largest weightings over the past year, when the stock was trading in the low $30s. The stock was very cheap, trading then at less than 5x earnings, primarily because investors were focused on the company's revenue exposure to the declining desktop and notebook computer sectors, which are being challenged by tablets and other mobile devices. We focused on the entire product spectrum, which included enterprise drives that generate 3x more revenue per unit than PC drives and also have higher profit margins. As businesses and individuals shift more of their computing and storage requirements to cloud-based architectures, the vast majority of that information resides, and will continue to reside, on HDDs. WDC supplies various types of enterprise HDDs, but is very focused on the particularly fast-growing market niche of nearline storage products. We are optimistic about WDC's earnings potential this year. Thus, with currently about $9 per share in net cash per share, we believe WDC has good growth potential. Nonetheless, we have trimmed back our position, given the stock's substantial appreciation, in order to keep the weighting at a desired level and to reflect the new risk-to-reward ratio at these higher prices.
Another stock that has performed well this year is DeVry (DV). DeVry, which appreciated more than 31%, is a For-Profit education company that was established over eighty years ago. Today, most people think of DeVry as a company that offers IT and Accounting degrees. This is true but DV also has a large medical school, a nursing school, a CPA test-preparation business, and a Brazilian operation that includes a couple of schools. DV's medical school, Ross University, produces more medical residents for U.S. hospitals than any medical school in the U.S. The company's Becker Professional Education division is synonymous with CPA review programs. Its Chamberlain College of Nursing is growing to meet the inexorable demand for nurses in the U.S. These latter schools, along with the company's Brazilian schools, are doing very well.
However, the company's core DeVry University division (DVU) is currently experiencing enrollment declines. There are several possible reasons why DVU is seeing negative enrollment numbers, but the leading cause is many young people are questioning the costs of obtaining a college degree and whether there will be a good job waiting for them when they graduate. There have been many stories in the media about students burdened with high student-loan debt and unable to pay off their loans because either the graduate has not found a job or the job they accepted does not pay enough. Interestingly, 86% of DVU's graduates find a job within six months of obtaining a degree within their field of study at an average annual salary of over $42,000.
After reaching the mid $60s in 2010, DV declined to the low $30s in late 2011, when we initiated a very small position. As the stock further declined into the $20s, we added substantially to our position in 2012 and earlier this year because our valuation model showed that, at that valuation, we were purchasing the troubled DVU division for $0 despite the fact it accounted for more than half the company's revenues and still generated low double-digit operating margins.
Our average cost basis for DV is in the mid $20s, and the stock recently closed in the low $30s. We expect DVU's enrollment to stabilize over the next year and the other schools to continue to experience nice enrollment growth. While DV once earned over $4 of EPS, we believe they might earn less this coming year. Of course, only the markets will determine its ultimate value and there are many factors affecting the stock price. However, with over $4 of net cash per share and if the market applies a normal valuation to the company's normalized earnings power, we believe DV's stock price has good appreciation potential.
A couple of the portfolio's stocks have not performed well this year, including Apollo Group (APOL) and Rosetta Resources (ROSE). APOL is a new position in the portfolio that was initiated below $20 share earlier this year in the first quarter and after the stock declined dramatically from over $80 a few years ago. As the stock further declined from the $19 level to close to $16, we added to our position.
As we mentioned in our last letter, our investment thesis in APOL is similar but not identical 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 rates and get paid more than those with just a high school diploma. According to U.S. Census Bureau, there are approximately198 million 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 95 million 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 earn a degree.
APOL's earnings peaked a couple of years ago at a shade over $4 per share. We believe the company's EPS could decline substantially over the next year or two, despite the consensus expectations that APOL will earn roughly $3 this year and $2.50 next fiscal year. We further believe APOL's normalized earnings, once the cost cutting efforts are complete, could be higher than street estimates. Assuming the company achieves that level of earnings and that the markets apply a reasonable earnings valuation to the stock price, we believe that the stock has good growth potential. The company's recently released results for its fiscal third quarter provide evidence that management is rationalizing the company's cost structure to generate good free cash flow for shareholders, despite the current challenging enrollment issues. In addition, the balance sheet remains pristine with more than $7 in net cash per share.
ROSE is a stock the Fund has owned for over six years and has performed exceptionally well. The stock has declined more than 6% this year, primarily because the company issued over eight million new shares, or an increase of over 15% to shares outstanding, to fund the acquisition of Comstock Resources' (CRK) Permian Basin assets. CRK was highly leveraged and did not have the capital to develop its Permian Basin oil reserves and, thus, was forced to sell these very promising reserves. With this purchase, ROSE picked up some of the most sought-after reserves without having to pay a premium. Nonetheless, in the short term, ROSE's stock
took a little bit of a hit due to the dilution of the new share issuance. We believe ROSE has ample opportunity to add value to its new Permian reserves by, for instance, reducing the down spacing of its vertical wells from 40 acres to 30 acres and possibly even 20 acre spacing. Besides the vertical play within the Permian reserves, there are also several horizontal pay zone opportunities that could add substantially to the ultimate recoveries. Other exploration and production companies with acreage in the same vicinity as ROSE's new Permian assets have produced some very promising initial wells. Though it is too early to gauge whether these new assets are as productive and profitable as ROSE's world-class Eagle Ford shale assets, ROSE's management team has a long history of proven success. We look forward to updating you on ROSE as the company ramps up its drilling activity in this region later this year and in 2014.
We thank you for continued support and trust.
Dennis M. Bryan
Chief Executive Officer and Portfolio Manager
P.S. Effective July 29, 2013, shareholders will notice that we have modified the closing language in the Fund's Prospectus. By way of background, the Fund has been closed to new investors since July 2004. Many financial advisors and consultants have existing clients in the Fund and have contacted us to request the ability to allocate FPA Capital to all of their clients, not just clients who owned the Fund prior to the close. After careful consideration, it was determined to allow for such purchases. We believe this strengthens the Fund's long-term investor relationships, and that modest inflows might partially offset the net outflows the Fund currently experiences.