Dear Shareholders:
We hope everyone reading this letter as well as their families are healthy and doing well in these interesting times. We would like to thank our shareholders for your trust in managing the Fund.
The stock market continued its robust run in the third quarter of 2020. The S&P 500 Index ("S&P 500") gained 8.93% in the quarter, which brought its year-to-date performance to +5.57% and +15.15% for the last 12 months. The S&P 500 now stands over 47% higher than its March lows. The Russell 2500 Index ("R2500") was up 5.88% during the third quarter, performing -5.82% year to date and +2.22% for the last 12 months. The R2500 now stands 52% higher than its March lows. On the value side of the spectrum, the Russell 2000 Value index gained 2.56% in the quarter, and lost -21.54% year-to-date and -14.88% year-over-year. The index stands 37% higher than its March lows. The Fund's performance was 1.26% and -8.53% in the quarter and year-to-date, respectively.
We take a bottoms-up approach in our research and look at each company individually, seeking to purchase good companies at low valuations. As the year-to-date performance of the Russell 2000 Value index illustrates, it should come as no surprise that we have been able to find some bargains in 2020. This is despite the fact the indices noted above stand well above their March lows and the overall market valuation is at levels not seen since the original tech bubble in early 2000. For the third quarter, we were small net buyers as the Fund's cash position declined by almost 2 percentage points, but the Fund is still less than 60% invested. The underinvestment hurt the Fund's performance versus the market.
As we write the letter, the market went on in the beginning of October to further gains largely based on new stimulus expectations, optimism for Q3 results and the Federal Reserve's ("Fed") commitment to continue its near zero interest rate policy. We have to ask though which of these factors were a surprise? Surely few, if anyone, expected that Q3 should look worse than Q2 as companies negatively affected by COVID-19 learned to better cope with the virus and the economy reopened beyond April levels. Surely, a new stimulus was expected. There was uncertainty about timing and size, yet neither of these have been resolved. Surely the Fed's stance is not a surprise either. We would admit that Q3 consensus looks better now than it looked in Q2, but given that the market is now above the pre-COVID levels, the real comparison should be to pre-COVID expectations.
The official unemployment rate improved to 7.9% in September compared to the 14.7% high in April. Yet it is still more than double what it was in February and the rate of improvement slowed down in September. Even that improvement was more due to a drop in the labor participation rate than job gains as the net employment gain was only 275,000 vs 800,000 expected. 1 We have also seen new and significant announcements of layoffs (Walt Disney, Allstate) and furloughs morphing into layoffs.2
The market also appears to be rewarding businesses that have cut capital expenditures and are using cash flows to reduce leverage. Yet, longer term, capital expenditures typically lead to growth and employment while lack of capital expenditures has the opposite effect. Even companies with soaring stock prices are still being frugal on new hires and we have seen some companies asking their employees to relocate and take a pay cut.3
While we see the layoffs from large businesses, there is some evidence that small businesses have been hit even harder. According to online marketing firm Womply, 1 in 5 small businesses in the U.S. that were open in January have stopped operating entirely as of mid-September. And in a survey by small business social-networking company Alignable, 42% of their 6,325 respondents were at risk of going out of business in the fourth quarter. Further, according to the Fed, 70% of banks have tightened standards for small business loans in response to the pandemic.4 Anecdotally, we have heard that it has become more difficult to raise venture and private capital as well. In 2018, small businesses employed a third of the U.S. workforce and have traditionally been an engine of U.S. job growth. Yet now that engine is in danger of going in reverse. Notably, the pandemic is still ongoing and the effectiveness and timing of medical solutions as well as the pandemic trajectory continue to provide a plethora of risks to the shape of economic recovery.
In addition to the pandemic, there is also the usual election-related political risk. There is tax policy risk from one party. There is increased trade war risk from another. There are different opinions on the shape and size of the new stimulus bill. The political environment seems to have become rather radicalized on both sides, potentially increasing the risks to the economy.
Where does it leave us? We generally focus on undervalued companies that we believe are good businesses with organic growth and strong free cash flow prospects. The cash flows should provide a valuation cushion. We look for good management teams that can manage the cash effectively. At the same time, given the overall valuation level of the market, we currently find few companies that trade near our entry price targets. As a result, the Fund has many relatively smaller positions that are waiting to be scaled up when the companies reach our valuation targets. In addition, we have a pipeline of potential investments that can be acted on when valuation levels improve.
FPA and Queens Road Funds Strategic Partnership
On July 30, 2020, FPA issued a press release that it had entered into a strategic partnership with Bragg Financial Advisors, Inc. ("Bragg"), advisor to the Queens Road Small Cap Value Fund and the Queens Road Value Fund (the "Queens Road Funds"). Please see the press release for details at fpa.com. Per the agreement, FPA will oversee and market the Queens Road Funds and Bragg will continue to manage the portfolios. On October 23, 2020, shareholders of the Queens Road Funds approved FPA as adviser and Bragg as sub-adviser. The Queens Road Funds moved to the FPA Funds platform effective November 1, 2020, and were renamed the FPA Queens Road Small Cap Value Fund and the FPA Queens Road Value Fund. In early November, it is expected that the Board of the Fund will recommend to shareholders that the Fund reorganize into the FPA Queens Road Small Cap Value institutional class and, if approved, the reorganization would be targeted to close in mid-December.
Portfolio Review
The following comments focus directly on the Fund's portfolio companies.
NCR Corporation (NCR, Financial):
NCR was the Fund's best performer for the quarter. The company sells ATM, POS (point-of-sale) and self-checkout hardware, software and services. It is in the process of shifting further away from its historical hardware focus to higher margin recurring software-as-a-service products. We believe the company's stock declined disproportionately during the pandemic partly due to relatively elevated leverage and the impact of the pandemic on its customer base. We believe the leverage is sustainable due to an increasing level of recurring revenues. While some of its customers experienced greater impact from COVID-19, the pandemic created opportunities with other customers.
AGCO Corporation (AGCO, Financial):
AGCO was the Fund's second best performer during the quarter. The company produces agricultural equipment. This market is cyclical and the last agricultural equipment boom occurred in 2013/2014. The type of equipment they sell is typically replaced on a 7-year cycle, creating a tailwind for the company for 2020/2021. The stock appreciated in the quarter on indications that the agricultural equipment market is improving.
Viper Energy Partners (VNOM, Financial):
VNOM was the Fund's worst individual performer for the quarter. The company owns mineral rights to oil fields (we discussed the company in greater detail in prior commentaries). Interestingly, both spot and long term oil contracts did not change much from June 30th to September 30th. VNOM's largest oil field operator, Diamondback Energy (Ticker: FANG), owns a large stake in the company. The relationship incentivizes FANG to develop acreage where mineral rights are owned by VNOM as it receives a higher percentage of the profits due to its ownership in VNOM. The stock declined during the quarter as: 1) FANG was having its own issues with high leverage; 2) VNOM hedged its 2020 production at low levels; and 3) VNOM has signaled a more gradual approach to returning to normalized levels of shareholder distributions, which have been cut due to the pandemic. We believe all of these are transitory factors and the selloff is overdone.
Centene Corporation (CNC, Financial):
CNC was the Fund's 2nd worst performer for the quarter. The company is a managed care organization (discussed in more detail in prior commentaries). The stock declined on election uncertainty and on the increased likelihood that the Supreme Court might strike down the Affordable Care Act due to the death of Supreme Court Justice Ginsburg. CNC does have the headline risk, but the stock is trading at 10x 2021 price to earnings multiple versus its long term historical average of 16x.6 Its COVID-19 costs appear to be in line with expectations and the worst long term effect from a repeal of the Affordable Care Act is estimated to be a 10% hit to earnings.7 We believe that any likely political scenarios would not cause a major long-term disruption to the company while its valuation appears to price in a much more dire scenario.
Conclusion:
We believe the market has outpaced the economy. It has grown more expensive during the quarter while there is growing evidence that recovery will take longer and will not be smooth. We remain cautious with an elevated cash position, ready to invest if the fundamentals come into alignment with valuations.
Thank you for you for your support and trust.
Sincerely,
Dan Kaplan
- Source: Wall Street Journal, October 2, 2020; The U.S. Jobs Recovery is Sputtering. https://www.wsj.com/articles/the-u-s-jobs-recovery-is-sputtering-11601656955
- Source: Wall Street Journal, October 2, 2020; U.S. Job Gains Slow as More Layoffs Become Permanent. https://www.wsj.com/articles/september-jobs-report-unemployment-rate-2020-11601593020
- Source Wall Street Journal; October 11, 2020; Silicon Valley Pay Cuts Ignite Tech-Industry Covid-19 Tensions. https://www.wsj.com/articles/silicon-valley-pay-cuts-ignite-tech-industry-covid-19-tensions-11602435601
- Source Wall Street Journal; October 9, 2020; Covid is Crushing Small Businesses. That's Bad News for American Innovation. https://www.wsj.com/articles/covid-is-crushing-small-businesses-thats-bad-news-for-american-innovation-11602235804
- Reflects the top five contributors and detractors to the Fund's performance based on contribution to return for the quarter.
- Based on S&P Capital IQ consensus estimates as of 9/30/20
- Based on Sanford Bernstein estimates
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. You should not construe the contents of this document as legal, tax, accounting, investment or other advice or recommendations.
