The GoodHaven Fund recently sent out its fourth-quarter 2017 letter to investors.The letter discusses several of the fund's major positions, like WPX Energy (WPX, Financial), Alphabet (GOOG, Financial)(GOOGL, Financial), Barrick Gold (ABX, Financial) and Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial). Now, those are some names I like.
A piece of the fund's long letter that really jumped out at me is the following observation (emphasis mine):
"Imagine that a genie had appeared from a magic lamp a year ago and told us that by year end oil would rise to nearly $60 per barrel, OECD and U.S. oil inventories would decline meaningfully during the year, that WPX Energy Inc. (currently our largest investment) would grow oil production by almost 50% in 2017, monetize non-core assets, improve its balance sheet, forecast another 40% increase in 2018 oil production, and be less than one year from generating material free cash flow.
With that knowledge, we would have expected the stock price of WPX to be much higher than where the year began rather than its recent quote of a double digit decline for the fiscal year.
Instead, our energy holdings were our worst performers creating the backdrop for what we believe is an opportunity to capitalize on the inefficiency of markets. The two energy companies we own have talented managers with proven capital allocation records. While not depending on material commodity price increases, we expect a material catch-up in WPX’s stock price, which should follow business value over time. Adding to our confidence, oil supplies are down and prices are up. To paraphrase Ben Graham, in the short-run the market is a voting machine; in the long run, a weighing machine."
I have been wondering about the same thing. Oil has had a really good run and has increased by 100% from its bottom. Quite a few energy investments I own aren't really responding. The chart below, which is from the Federal Reserve of St. Louis, shows West Texas Intermediate (WTI) crude:
When reviewing WPX in particular, it is a money-losing exploration company that is investing heavily to grow production. Theoretically, if the company would quit investing so heavily to increase production, its capital expenditures would decrease a lot and free cash flow would improve measurably.
WPX is GoodHaven's largest position. They explain its attractiveness as a function of energy underperformance in general and exchange-traded fund flows specifically:
"The fundamental industry backdrop continues to improve. As a percentage of the S&P 500, energy continues to bounce along forty-year lows, despite its necessity in everyday life. Yet since the oil price decline of 2014 and 2015, overall industry capital spending collapsed by at least $1 trillion and has not recovered. This is likely to constrain overall industry supply growth for years notwithstanding steady but still modest gains in hydrocarbon alternatives. Since February, both OECD and U.S. inventories have fallen sharply while the S&P energy sector underperformed the overall S&P 500 by a wide margin as shown below. In the short-run, this may simply reflect ETF cash flows, which now seem to be the tail wagging the fundamental dog."
The supporting chart from the fund's report illustrates crude inventory changes, WTI price development and the move in the S&P 500 energy sector. There is definitely a strange disconnect going on there:
Earlier I wrote if you want to find value in the S&P 500, look at energy first. Using a different lens, I reached a similar conclusion. I also share the fund's concerns about ETFs and their potential to distort valuations. ETF flows chase funds with good recent performance. Once that's absent, the gathered momentum may be exaggerated because of the new allocation strategy. With capital being withdrawn from active managers, they are losing their ability to arbitrage the inefficiencies away.
With the ETF boom in full swing, new funds get launched every day. There are now funds far in excess of the number of stocks available. Because an ETF with bad recent performance will fail to gather assets, these are generally not launched or stocks with bad recent performance are excluded. You can read more about the subject here.
I find it convincing energy is an undervalued sector and ETF flows could explain why it remains out of sync with the broader market. If WPX isn't exactly your cup of tea, read this article on oil specialist T. Boone Pickens' top positions.
Disclosure: No positions.
