In the classic movie Casablanca, starring Ingrid Bergman and Humphrey Bogart, Bergman’s character Ilsa asks Sam the Café Americain piano player to play it again Sam. Of course, Sam eventually indulges Ilsa and plays “As Time Goes By.” Later that same evening, Rick Blaine, Bogart’s character, also asks Sam to play it again.
In our modern era, Janet Yellen is “Sam” the piano player. Just like Sam in Casablanca, Janet may be reluctant to play her own rendition of “As Time Goes By,” but investors are asking Janet to play it again…for old time sake. Ms. Yellen’s version of “As Time Goes By” is to keep interest rates at rock- bottom lows until she and the Federal Reserve believe we are at maximum employment levels and/or GDP growth is distinctly on the rise.
The result of this beautiful melody (ultra-low cost money) is soaring equity values. For instance, the S&P 500 rose roughly 5% in the second quarter and is now trading at 20x trailing twelve month’s GAAP earnings; and the Russell 2500 appreciated more than 3.5% in the quarter to surge to nearly 29x earnings. Seemingly, the major indices touched record highs every day. Indeed, soothing music to the ears of many investors.
Similar to the first quarter and as mentioned above, the major indices reached new highs in the second quarter. However, unlike the first quarter, we believe the fundamentals for the economy are improving. In our prior letter, we did not express any confidence that the economy was improving because the fundamentals were so weak. As it turns out, the latest report from the government statisticians is that the first quarter GDP declined nearly 3%, even though the January 2014 consensus expectation was for 2.6% “growth.” Thus, the bar has been set relatively low for subsequent quarterly growth for the remainder of 2014, including the second quarter.
This outlook is consistent with our statement last quarter, that we did not expect a recession this year, which is typically defined as two consecutive quarters of negative economic growth. Despite our dour expectation for first quarter economic results, we saw enough evidence that the poor fundamentals were not getting worse and, in fact, were showing some improvements.
For example, new manufacturing orders steadily improved throughout the second quarter, and industrial production also gained momentum. According to the ISM Purchasing Manager’s report, the production index was above 60 for both the months of May and June. An index number greater than 50 indicates that production is growing.
Moreover, in early July the non-farm payroll employment numbers were relatively strong at a positive 288,000 new jobs for the month of June. Large companies are also raising wages at healthy rates. For example, Gap and IKEA recently announced that they are increasing their minimum wages 10% and 17%, respectively. Disney and Anheuser-Busch also recently announced wage increases, and it’s likely we will see other large companies follow suit. Nonetheless, we would not expect consumers to go on a wild spending binge, due to higher energy and healthcare costs that are currently putting a squeeze on the average American’s wallet. We see the proof of this in the earnings releases of many consumer discretionary companies that focus on middle and lower middle class Americans.
The big question is whether earnings will improve with what appears to be better economic factors. Certainly, we do not expect a repeat of the poor first quarter profit results. According to the Bureau of Economic Analysis, total U.S. corporate profits declined 10% quarter-over-quarter and declined 3% year- over-year in the March quarter. These numbers should not be confused with the S&P 500 earnings per share numbers, which take into consideration share buybacks and only include five hundred large, publicly-traded companies. Nevertheless, the EPS growth for the S&P 500 has been very weak over the past year, as discussed in prior letters.
Our assessment is that profit margins are trending back toward more normal levels, after a couple of years of near record highs. If labor wage rates increase at similar levels to what Gap and IKEA recently announced, higher labor costs will likely put further pressure on profit margins. We have discussed in the past that labor wages as a percent of GDP are at post World War II lows, and that investors have benefitted from corporate managements efforts to keep labor costs in check. If this trend is in the process of reversing, revenues would need to accelerate to help corporate earnings meet investor’s optimistic expectations.
Frankly, the average worker can use an increase in wages because their discretionary incomes have been compressed by higher food and energy costs. For instance, based on analysis from MacroMavens, since 2007, 90% of the roughly $500 billion increase in discretionary spending has been a function of higher prices. In other words, while discretionary spending is up $500 billion nominally from the peak in 2007, only 10% of the increase in discretionary spending is tied to higher unit demand.
In summary, we believe the U.S. economy is rebounding from its depressed March level. However, the economy needs to produce real growth of roughly 4% each of the next three quarters in order to achieve a full-year growth of 2%. Despite the low bar set in the first quarter, it still might be too much to expect the economy to grow 4% the last three quarters of the year. This is especially true if energy and food costs continue to rise. Hence, the robust earnings growth expectations embedded in many stock’s valuations may prove to be too optimistic.
The Fund’s portfolio continued to outperform the benchmark for the first half of the year. Some of the largest positions in the portfolio, like InterDigital (IDCC) and Rosetta Resources (ROSE), were among the best performers as well – IDCC and ROSE appreciated more than 44% and 17%, respectively, in the second quarter.
While it is too early to claim victory in IDCC, it is particularly satisfying to us to see the stock perform so well. When we were buying IDCC shares, some investors suggested the company was too risky due to the inherent litigation of the industry. We did not acquiesce to this simple analysis and applied a more rigorous assessment to the business. As it turns out, the company has lost its last two major litigation cases that the International Trade Commission (ITC) has ruled on, but to date, the stock shows no ill- effects of those decisions. The reason why the stock has performed well, despite losing a couple of ITC cases, is that the company has signed multiple licensing agreements with its customers over the last year or so, some of whom were being sued by IDCC.
IDCC has also sold some non-core patents to very large technology companies, like Intel, for hundreds of millions of dollars. As we stated before, we believe IDCC has multiple ways to generate profits for shareholders, and suing its customers and prevailing in court is just one way for investors to win – not the only way.
IDCC is also a good example of how we invest. The greater a stock’s reward to risk ratio, the more aggressively we generally will purchase a company’s shares. InterDigital was the worst performing stock in the portfolio in 2013 and we took advantage of that stock price weakness by substantially increasing our position since December 2013.
Among a few stocks that had negative returns in the quarter, Veeco Instruments (VECO) and Titan International (TWI) are also among the smaller positions in the portfolio. Titan, which declined 11.4% in the quarter and will be discussed later in this letter, is a relatively new stock in the portfolio and one that we added to as the share price declined. VECO declined 11.1% in the June quarter, but not enough for us to add to the position.
For those investors that either attended FPA’s latest Investor Day in early June or are long-term investors in our strategy, the following may ring a bell. During our Investor Day presentation, we discussed our philosophy and process of seeking to invest in market leading companies, with a history of profitability, strong balance sheets, and good management teams - but only when they offer the appropriate risk/reward characteristics.
A key part of our process that is discussed less frequently is our discipline to sell when stocks get over- valued, despite the prevailing levels of liquidity in the portfolio. We believe this is one of the key differentiators of our strategy.
We added to a number of existing positions in the quarter and started one new position, which is too small of a position to talk about at this point. Among the stocks that we added to in the quarter were Atwood Oceanics (ATW) and Titan International (TWI).
Although ATW appreciated roughly 4% in the June quarter, in early April the stock was down 10% from its closing first quarter price. As we mentioned last quarter, when we also added to the position, investors are concerned about the prices the company can charge to rent out its equipment to its customers. Atwood owns off-shore drilling rigs, some of which cost upwards of $600 million apiece to construct today.
These $600 million rigs, typically very sophisticated drill ships, allow ATW’s oil & gas exploration customers to drill in the ultra-deep waters of the Gulf of Mexico, off the coast of western Africa, or in the deep waters of Brazil. These deep water basins, and other basins, hold the potential to extract over a hundred billion barrels of oil over the next few decades. However, these are very expensive and long- term projects, which not every oil company has access to or the capital to risk. Hence, ATW’s drill ships can potentially be rented out to a narrower group of customers than rigs for shallow water drilling (typically four-hundred feet of water depth), where the company’s jack-up drilling rigs operate.
While there are a number of potentially large oil & gas reserves in the ultra-deep waters, generally 7,500 feet of water or deeper, the timing of when these projects get started can be lumpy. Additionally, ATW is not the only drilling rig operator that sees this very large opportunity, so the company’s competitors have also ordered new UDW drill ships. Thus, the market is concerned about a temporary supply and demand imbalance for UDW drill ships.
In our conservative analysis, we think UDW drill ship rental rates may fall from roughly $600,000 a day, which is where day rates were in late 2013, to roughly $500,000 a day. In this downside scenario, we estimate that ATW could earn close to $5.00 a share this year and over $7.00 a share in 2015 and 2016. This also assumes one of the company’s semi-submersible rigs is idled later this year. With ATW trading below $50, we believe the risk-to-reward ratio warranted additional capital being deployed in the stock. Subsequent to our additional purchases in the second quarter, two of ATW’s competitors announced new UDW drill ship contracts at much higher rates than many investors and Wall Street analysts expected. We think these recent higher day rate contracts, which were also higher than our conservative case expectations, bode well for Atwood’s two remaining un-contracted UDW drill ships.
As mentioned above, Titan declined nearly 12% in the quarter and we added to the position as the stock weakened. As you may recall, we initiated the position in TWI in the fourth quarter of 2013 in the mid- teens. Despite our additional TWI purchases, we do not yet own a full position in the stock. However, we have plenty of capacity to take the stock to a normal full position, which is 3%, but this assumes the company earns the right to have more of your capital allocated to the position.
The primary reason why TWI shares sold off recently is that the wheel and tire markets for large construction and mining equipment remain depressed. Investors had hoped that the off-road, large construction equipment and mining business would see some acceleration after the very cold winter season, but that does not appear to be the case. Tire inventory levels for large, off-road equipment were too high for dealers to be aggressive and purchase tires en masse earlier this year. However, there is some recent evidence that much of the excess tire inventory has been reduced to levels that now support some restocking.
Our investment thesis for TWI is not predicated on the wheel and tire market for large, off-road equipment to come roaring back to levels experienced before the financial crisis. Rather we believe the assets TWI has accumulated over the past decade can be managed more efficiently and, therefore, profit margins can improve without a huge increase in revenues. We recently visited one of TWI’s Midwest tire facilities and came away with the impression that simply operating the existing production equipment more efficiently would yield substantial improvements in the plant’s profitability.
Furthermore, we believe most of TWI’s operating plants have ample room for productivity enhancements and, thus, profit improvement. It is encouraging that the company has promoted Paul Reitz as the firm’s President, and that Mr. Reitz has replaced senior plant managers with more capable people. However, more work needs to be done in order to maximize the profit potential the company’s assets are capable of generating for shareholders.
Among the stocks we reduced in the quarter was Cimarex Energy (XEC). XEC is an Oil & Gas Exploration and Production company located in Denver, Colorado. Yet the company’s energy assets are primarily located in Oklahoma and Texas, with some acreage in New Mexico as well. XEC closed at a shade over $143 at the end of June and has appreciated more than 36% year-to-date.
One reason why we have a positive bias toward energy companies is that demand for oil continues to increase but new supplies of oil are getting more difficult and expensive to develop. According to Cambridge Energy Research Associates (CERA), in 2013, the global oil discovery rate of 13 billion barrels was the lowest rate since 1952 and was down 30% versus 2012. To put that into perspective, the global consumption of oil is currently running about 33 billion barrels a year. Moreover, CERA estimates that the number of new field discoveries has fallen 50%, and new field sizes are on a slow, downward trend for both oil & gas. Ominously, the previous success rate of a new well drilled was 25%, but that number has declined to 14% currently.
Over the past few years, most of the successful new oil wells and higher production has come from shale oil projects in the U.S. It is companies like Cimarex that are helping to keep a lid on oil prices from sky- rocketing and potentially preventing another consumer-led recession. Despite our positive view on the long-term prospects for the energy markets, we trimmed backed the XEC position in the quarter to take some risk off the table. The oil & gas business is still a risky and cyclical industry. Given that the stock price has nearly tripled over the last two years and is up roughly eight-fold from early 2009, we believe it is prudent to cash-in on some profits.
In summary, the returns on your invested capital continue to generate good results, but it is still not a target-rich environment for absolute value managers. Equity investors behave as though central bankers will bail them out if stock prices dip too much. However, there are clear warning signs out there that the market is not grounded to the typical fundamentals that drive stocks higher or lower. Recently, the Bank for International Settlements (BIS), the global Central Bankers’ Central Bank based in Switzerland, released a report that warned that “euphoric” financial markets have become detached from the reality of a lingering post financial-crisis disorder. The BIS called on central bankers to scrap their current policies that risk fueling unsustainable asset bubbles. What is notable about the current BIS warning is that it is the same organization that in the mid-2000s warned about the brewing financial crisis at that time.
The BIS assessment resonates with us because they place more weight on balance sheets and the expansion of the credit markets. One of our key investment tenants in evaluating the risk of a company is the strength or weakness of its balance sheet. We rigorously review balance sheets because it often takes just a small negative to turn disastrous for a highly levered enterprise, or economic structure. Yet, investors only want to hear the sweet tunes of Ms. Yellen and the rest of the Fed orchestra, but we hear the BIS singing a different refrain, which may not be good mood music for the market.
On July 11th, we celebrated the 30th anniversary of managing the FPA Capital Fund (Trades, Portfolio), which at $1.4 billion is also the largest portfolio we manage in the Small-Mid-Cap Absolute Value strategy. Why is it that there are not that many strategies that survive 30 years with essentially the same management? We think the main reason is that people do not know when to sell, especially when stocks are rising and excessively over-valued. There are many good bottom-up, fundamental research funds out there that fish in the same waters that we do. Quite a few of them buy the types of companies that we are attracted to. A significant mistake some make is to remember only half of the saying: “buy low and sell high.” We believe that abiding by both sides of this rule has greatly contributed to our tenure.
We remain very enthusiastic about our strategy’s future. Our pipeline of potential investments is very robust. For the past few years, we have been communicating through these letters and webcasts that we do not need the market to come down by 20% or more for us to draw down the portfolio’s liquidity. This was proven true during the first half of this year as we deployed incremental capital.
We thank you for your continued trust and confidence in our strategy.
Chief Executive Officer and Portfolio Manager
Managing Director and Portfolio Manager
July 16, 2014