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Sydnee Gatewood
Sydnee Gatewood
Articles (2456) 

FPA Capital Fund's 1st-Quarter Commentary

Discussion of markets and holdings

Introduction

I hope that all of you and your families are healthy and doing well considering all the disheartening news out there.

The last major market decline happened in December 2018, when the S&P 500 index hit 2,351.10.1 In the next 14 months, the S&P 500 index went on a tear and increased 44% (forty-four percent) to 3,386.15 (all time record).2 An unsuspecting consumer of this statistic would have guessed that 2019 was a banner year for the S&P 500 companies. However, total earnings growth of the index was only 0.6%.3

Fast forward a month, and all that gain of the past 14 months was erased.4 The question we asked on that day was the following: do we feel better about the near-term prospects for the stock market today or in December 2018? In late 2018, investors were mainly worrying about the trade war between the US and China. Both countries announced a number of tariffs. Yet, in March 2020, we had two other things to worry about: COVID-19 and the oil price war’s impact on U.S. employment. We would argue that we believe one should be more worried today than in December 2018. We have to fight an economic war in more theaters today. On top of it, the deficit is larger today and the rates are lower. So, we believe the war is worse and the country’s ammunition is lower

How bad can things get? A recent JP Morgan report makes the following forecast for real GDP growth rates for the first quarter of 2020: China down 40%, US down 4% (followed by down 14% in the second quarter), and Euro area down 15% (and down 22% in the second quarter). Their global projection for GDP is down 2% this quarter, followed by 13% next quarter.5 The March 26, 2020 unemployment report showed that a record 3.3 million Americans applied for unemployment benefits the week before – the previous record was 695,000 in 1982.6 Unfortunately, that record lasted only a week and doubled to 6.6 million the next week. Globally, the prospects of employment are not much better. Just the global travel industry, which came to a stop, provides a living to 319 million people – 10% of global employment!7

Needless to say, the first quarter of 2020 was a very bad one for stock market performance. At the end of first quarter of 2020, the S&P 500 index stood at 2584.59 – a 20.00% decline for the year (and a 23.67% decline from its all-time high). Small and mid-cap companies fared even worse. The Fund’s benchmark, the Russell 2500, declined -29.72% in the first quarter of 2020.8 The FPA Capital Fund (Trades, Portfolio) (“Fund”) declined by - 19.57% for the first quarter of 2020, and -17.23% for the 1-year period ending 3/31/20, but was able to protect your capital better than most in its Morningstar Mid-Cap Value category on a total return basis across both time periods. The primary drivers of performance during the quarter were consistent with the drivers of performance during the year.

The Fund finished in the 2nd percentile year-to-date through 3/31/2020 out of 433 funds and finished in the top 7th percentile for the one-year period through 3/31/2020 out of 426 funds in the category.9 We are not surprised by the Fund’s outperformance. We wrote extensively about the importance of fundamental research and warned about some of the issues we worried about with index funds and ETFs in many of our letters – particularly in our first quarter 2017 letter in a section titled: Are ETFs the new weapons of mass destruction?10

Some of you may wonder and ask whether this decline happened simply because of the coronavirus pandemic. Make no mistake: the decline did not happen because of the virus. It happened because the market was very expensive. The virus, as bad as it is, was just the catalyst. The market participants have been pouring gas on the floor for years and the virus was the match that lit it.

We have been writing quarter after quarter about how we found the stock market valuations extremely high. It has been very hard to find good companies at attractive valuations. We also wrote about how with the lack of opportunities we would not chase these high multiples and, therefore, simply accumulate cash.

We already had a large cash balance due to high company valuations. As we started reading about what China and then South Korea were experiencing with COVID-19, we quickly appreciated the seriousness of the situation. We took several steps to protect our clients’ (and our) money. For example, during the quarter:11



  • We started selling our airline investments in January. We were out of our Allegiant Travel Company (NASDAQ:ALGT) and Spirit Airlines (NYSE:SAVE) investments completely before any major travel restrictions were implemented.
  • We sold out of our only restaurant investment before any restaurant restrictions.
  • We sold two of our three banks.
  • We sold out of a relatively-new investment in a company that provides RFIDs12 with the goal of connecting goods to internet (think of luggage, apparel, food, auto parts, etc.). Even though we like this business a lot, we did not feel it belonged in the portfolio when movement of products and people would be severely curtailed.


Clearly, it would have been best had we sold everything and just quarantined ourselves.

Long-term shareholders might also recall that, over the past ten years, we have had a large allocation to energy. Do not fret, we have been decreasing that exposure over the past three years and our exposure at the end of first quarter 2020 was approximately 5.0%. It remains to be seen whether it will be Russia or Saudi Arabia that will win the recent oil price war. We believe that the US employment rate will be the loser. There are many estimates on how many jobs are supported by the American oil and gas industry - ranging from a couple million directly to more than ten million in the whole ecosystem.13 The head of International Energy Agency suggested as much as 20 million barrels per day decline in oil consumption.14 We expect many high-cost US oil and gas companies to file for bankruptcy with such a steep price decline in the price of oil and worsening refinancing environment. The survivors have significant potential to do quite well going forward.

Company discussions:15

Energy

Energy-related companies performed very poorly during the quarter as the pandemic’s effects on demand were exacerbated by the oil price war. We believe that over the last few years worldwide oil has seen reduced investment and at some point in the future that underinvestment should lead to favorable fundamentals, thus making an energy allocation an important part of a long term portfolio. We have two investments in the sector, Noble Energy (NASDAQ:NBL) and Viper Minerals (NASDAQ:VNOM).

Noble Energy’s business is diversified between US shale assets, Eastern Mediterranean gas and West African operations. The company demonstrated strong operational performance in the US and, prior to the oil price war, we believe was on the brink of a significant cash flow inflection point coming in 2020 as a large Middle Eastern gas asset, Leviathan, went into production. The company also has a substantial hedge position for 2020. While we believe the company’s goal of $500mm in 2020 FCF has been postponed, we believe the company has the ability to further reduce its capital expenditures in US Onshore operations, far more so than companies whose cash flows come purely from these assets. We think the prospects look much better for 2021 though. US onshore capital expenditures should be managed to a number that makes sense at the existing oil price. We believe Leviathan should be operating at full capacity with contracts with likely $5+/mmcf16 floors. Finally, the company is expected to finish its West African natural gas monetization project in early 2021 resulting in $200mm+ in FCF change vs 2020.17 Adding any recovery in oil prices and we think the risk/reward seems very favorable. The trick is to survive to that point, yet NBL has $4.4bn of liquidity,18 no substantial debt maturities until 2024 and 62% of its debt is not due until after 2041.19 We believe we will see this company on the other side of the oil price war and it will be in a much stronger position.

Viper Minerals (NASDAQ:VNOM) is facing declining production in the area of its mineral rights, but it is substantially hedged for 2020 and 2021 on oil prices which we expect to result in meaningful free cash flows even at very dire oil price scenarios. We believe that gives them enough runway to emerge on the other side of the price war and, based on our analysis, the risk/reward of that emergence could be attractive.

Longer term, if we are to experience high inflation due to all the money printing and increased deficits, commodities might prove to be a good hedge. That said, one needs to be careful to only in invest in companies with balance sheets that can withstand the difficulties of the current environment.

Banks

We entered the quarter with three regional bank investments. All three have strong management teams, conservative lending practices, strong records and solid capitalization. One was a highly undervalued bank with a leading position in a very stable economy, but a high sensitivity to interest rates. Another had a stable and substantial dividend yield and some sensitivity to interest rates. Third and our favorite was a member of the minority of banks that are liability sensitive and gain a multi-quarter tailwind on Fed rate cuts. It was also trading on the lower end of bank valuations based on book value and earnings, which we believe was due to factors that depressed the bank’s past ROIC20 but were no longer in effect. As the Western world was entering the coronavirus crisis, we sold the first bank both because of its sensitivity to interest rates and the local economy that it operates in sensitivity to domestic and international tourism. More recently, we sold the second bank due to less lucrative risk/reward, as its stock held up much better than the sector while overall sectoral risks have increased.

We kept the third bank, Investors Bancorp (NASDAQ:ISBC), and added to the position as the bank gained a multi-quarter tailwind from ZIRP21 and traded down to 70-80% of book value due to its exposure to the New York/New Jersey area, making it one of our top 5 losers for the quarter. The vast majority of the bank’s book consists of single and multi-family mortgages. The bank’s commercial and industrial (“C&I”) loan portfolio is relatively small and generally avoids sectors most sensitive to coronavirus. ISBC just completed an acquisition that should further reduce its capital costs and help it increase its C&I business at a time when, if done conservatively, it could be quite advantageous. We also believe that their geographic area has the resiliency and depth of resources to quickly rebound after the pandemic and their loss experience should not be differentiated from peers trading at higher valuations.

Conclusion:

These are hard times with not much visibility. First, we are yet to hear from corporations about their first quarter 2020 earnings and (perhaps more importantly) their second quarter 2020 earnings guidance, keeping in mind that the guidance visibility may not come as companies themselves are in the dark and may choose to not provide 2020 guidance. The GDP decline during the Great Financial Crisis was 4.3% and the unemployment rate went from 5% to 10%. This time around the Fed is warning that the GDP might decline by 50% with a 30% unemployment rate next quarter.22 Second, we do not know how the global economy will react when, after an almost complete stop, it is ready to come back to life. We also do not know what the new normal will be once we beat this pandemic: deficit spending is unleashed, supply chains will need to be rethought, stock buybacks will be curtailed (corporations have been the largest equity demand as we discussed in our 2019 second quarter letter23 and already an amount equal to 25% of all that was bought up in 2019 has been “postponed”24), monetary inflation ahead of us, and many more.

Our thoughts and prayers are with those who have contracted COVID-19 and our sincere gratitude and appreciation to all, who have been fighting or helping us during the pandemic.

Thank you for your support and the continued trust you placed in us.

Sincerely,

Arik Ahitov



  1. December 24, 2018
  2. February 19, 2020
  3. Source: Factset; February 28, 2020; Earnings Insight; https://www.factset.com/hubfs/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_022820.pdf
  4. March 18, 2020
  5. Source: Economic Research Note (The day the earth stood still) – 03/18/2020
  6. Source: The Washington Post; March 26, 2020; A record 3.3 million Americans filed for unemployment benefits as the coronavirus slams economy; https://www.washingtonpost.com/business/2020/03/26/unemployment-claims-coronavirus-3-million/
  7. Source: World Travel & Tourism Council; March 2019; Economic Impact 2019 World; https://www.wttc.org/-/media/files/reports/economic-impact-research/regions-2019/world2019.pdf
  8. Comparison to an index is for illustrative purposes only. The Fund does not include outperformance of any index in its investment objectives.
  9. Source: Morningstar. https://www.morningstar.com/funds/xnas/fpptx/performance. Morningstar Percentile Rankings are based on the total return percentile rank within each Morningstar Category and do not account for a fund’s sales charge (if applicable). The highest (or most favorable) percentile rank is 1 and the lowest (or least favorable) percentile rank is 100. Historical percentile ranks are based on a snapshot of the funds as they were at the time of the calculation. Percentile ranks within categories are most useful in those groups that have a large number of funds. For small universes, funds will be ranked at the highest percentage possible. For instance, if there are only two specialty-utility funds with 10-year average total returns, Morningstar will assign a percentile rank of 1 to the top-performing fund, and the second fund will earn a percentile rank of 51 (indicating the fund underperformed 50% of the sample). FPA Capital Fund (Trades, Portfolio) had a 5-year percentile ranking = 88 (out of 345 funds) and 10-year percentile ranking = 100 (out of 241 funds) through 3/31/2020.


  10. Source: FPA; https://fpa.com/docs/default-source/funds/fpa-capital-fund/literature/quarterly-commentaries/fpa-capital-fund-commentary-2017-q1.pdf?sfvrsn=2




  11. The information provided does not reflect all positions purchased, sold or recommended by FPA during the quarter. It should not be assumed that an investment in the securities listed was or will be profitable.


  12. RFID is radio-frequency identification (https://en.wikipedia.org/wiki/Radio-frequency_identification)


  13. Source: Independent Petroleum Association of America (“IPAA”), May 29, 2019, New Study: ‘Independent’ Oil, Gas Operators Drive American Energy Development By Wide Margin, https://www.ipaa.org/new-study-independent-oil-gas-operators-drive-american-energy-development-by-wide-margin/




  14. Source: Bloomberg; March 25, 2020, Updated on March 26, 2020; Oil Resumes Plunge After IEA Warns That Demand Is in ‘Free Fall’; https://www.bloomberg.com/news/articles/2020-03-25/oil-stabilizes-as-traders-seek-to-assess-stimulus-impact




  15. In this Company Discussions section, references to individual securities are for informational purposes only and should not be construed as recommendations by the Fund, the portfolio manager, the Adviser, or the distributor. It should not be assumed that future investments will be profitable or will equal the performance of the security examples discussed. The portfolio holdings as of the most recent quarter-end may be obtained at www.fpa.com. Past performance is no guarantee, nor is it indicative, of future results. Please see important disclosures at the end of this Commentary.




  16. Based on FPA estimates. MMCF = one million cubic feet; https://www.investopedia.com/terms/m/mcf.asp




  17. Source: Company guidance during earnings call on February 12, 2020 and FPA estimates




  18. Source: Per company press release on March 12, 2020




  19. Source: 10K filed on February 12, 2020; Note that NBL owns a majority stake in NBLX whose debt is consolidated on NBL’s balance sheet, yet it is non-recourse to NBL.


  20. ROIC is return on invested capital. (https://www.investopedia.com/terms/r/returnoninvestmentcapital.asp)
  21. ZIRP is zero interest rate policy and is when a central bank sets its target short-term interest rate at or close to 0%. The Federal Reserve cut the Fed Funds rate to nearly zero on March 15, 2020 as a result of the ongoing coronavirus pandemic and weakening economy.


  22. Source: Bloomberg, March 22, 2020; U.S. Jobless Rate May Soar to 30%, Fed’s Bullard Says; https://www.bloomberg.com/news/articles/2020-03-22/fed-s-bullard-says-u-s-jobless-rate-may-soar-to-30-in-2q?sref=zNDOdQGc




  23. Source: FPA; https://fpa.com/docs/default-source/funds/fpa-capital-fund/literature/quarterly-commentaries/fpa-capital-fund-commentary-2019-06_final.pdf?sfvrsn=4


  24. Source: Bloomberg, March 30, 2020; A Quarter of Annual Buyback Volume Has Been Yanked, Goldman Says; https://www.bloomberg.com/news/articles/2020-03-30/a-quarter-of-annual-buyback-volume-was-yanked-by-goldman-clients?sref=zNDOdQGc


Important Disclosures

This update is for informational and discussion purposes only and does not constitute, and should not be construed as, an offer or solicitation for the purchase or sale with respect to any securities, products or services discussed, and neither does it provide investment advice. Any such offer or solicitation shall only be made pursuant to the Fund’s Prospectus, which supersedes the information contained herein in its entirety.

The views expressed herein and any forward-looking statements are as of the date of the publication and are those of the portfolio management team. Future events or results may vary significantly from those expressed and are subject to change at any time in response to changing circumstances and industry developments. This information and data has been prepared from sources believed reliable, but the accuracy and completeness of the information cannot be guaranteed and is not a complete summary or statement of all available data.

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 Fund, the portfolio manager, the Adviser, or the distributor. It should not be assumed that future investments will be profitable or will equal the performance of the security examples discussed. The portfolio holdings as of the most recent quarter-end may be obtained at www.fpa.com.

Investments, including investments in mutual funds, carry risks and investors may lose principal value. Capital markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. The Fund may purchase foreign securities, including American Depository Receipts (ADRs) and other depository receipts, which are subject to interest rate, currency exchange rate, economic and political risks; this may be enhanced when investing in emerging markets. Foreign investments, especially those of companies in emerging markets, can be riskier, less liquid, harder to value, and more volatile than investments in the United States. Adverse political and economic developments or changes in the value of foreign currency can make it more difficult for the Fund to value the securities. Differences in tax and accounting standards, difficulties in obtaining information about foreign companies, restrictions on receiving investment proceeds from a foreign country, confiscatory foreign tax laws, and potential difficulties in enforcing contractual obligations, can all add to the risk and volatility of foreign investments.

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.

Value stocks, including those selected by the Fund’s portfolio manager, are subject to the risk that their intrinsic value may never be realized by the market and that their prices may go down. Securities selected by the portfolio manager using a value strategy may never reach their intrinsic value because the market fails to recognize what the portfolio manager considers to be the true business value or because the portfolio manager has misjudged those values. In addition, value style investing may fall out of favor and underperform growth or other styles of investing during given periods.

About the author:

Sydnee Gatewood
I am the editorial director at GuruFocus. I have a BA in journalism and a MA in mass communications from Texas Tech University. I have lived in Texas most of my life, but also have roots in New Mexico and Colorado. Follow me on Twitter! @gurusydneerg

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