Further indications of an improving U.S. economy and a sudden decline in oil prices affected the Fund’s fourth-quarter performance and prompted mixed results.
While we were surprised by the sharp drop in oil prices, we had already begun reducing exposure in Energy holdings, fully exiting two underperformers. Our stocks in this area were hit harder than those in benchmark, on average, primarily because the Russell 3000® Value Index includes a pair of behemoths in the energy space: Exxon Mobil Corporation (XOM, Financial) and Chevron Corporation (CVX, Financial). These highly diversified companies are arguably more immune to downside volatility than the smaller names we hold, but may not represent the upside potential we seek. Many smaller companies were down sharply. Meanwhile, however, the “smart” money in the industry is acting on opportunities. For example, early in the quarter, it was announced Baker Hughes Incorporated (BHI, Financial), one of our portfolio holdings, was going to be acquired at a premium by the much larger Halliburton Company (HAL, Financial) as part an effort to build scale during a period of lower oil prices. This pattern is especially relevant in the pressure pumping space, an area we expect to hold up better than others in Energy Equipment and Services.
Attribution
Our stock picking in Industrials and Information Technology –Â two other areas benefiting from our thesis for continued economic growth –Â solidly beat the benchmark. The top-performing company in the portfolio this quarter (and one of our top ten holdings), JetBlue Airways Corporation (JBLU, Financial) profited as oil prices fell, reducing operational costs, and the company announced several initiatives at their November analyst day that should drive improved profitability.
Our allocation to and stock selection within financials detracted. Given current global macro uncertainties, we are avoiding market weight exposure to large-caps in the Banks, Real Estate Investment Trusts (REITs) and Insurance Industries, which we deem as unattractive due to foreign currency and fixed income risks. We have also steered clear of Diversified Financial Services. This area is overvalued in our opinion, trading at 20.9x forward two-year earnings compared to a long-term average of 12.8x. Underweights to defensive areas Consumer Staples and Utilities also held us back. We fundamentally disagree with the premise in which stocks in these sectors have performed as we see a wide range of catalysts for economic progress that should reward more cyclical investments. In Materials, despite mixed results between allocation and stock selection effects, an overall strong relative result was achieved.
Portfolio Activity
No significant adjustments were made within the portfolio outside of trimming within Energy. We believe lower energy prices coupled with improving jobs data make our bias toward economic growth even more compelling.
Strong promise in a beaten-up energy industry. Tidewater Inc. (TDW, Financial) is among the Energy stocks that weighed down returns this quarter. Tidewater is the world’s largest provider of service vessels and marine support services to the global offshore energy industry. We feel it is well positioned to sustain reasonable utilization and day rates even in a weak rig environment. Tidewater’s strong safety record and technically advanced equipment are valuable assets.
Like its peers, Tidewater is under day rate price pressure due to perceived excess capacity in the industry and collapsing oil prices. The company currently trades at just 60% of book value and less than 10 times estimated earnings for the current fiscal year ending in March. At those prices, we see Tidewater as a bargain. Furthermore, it is executing an aggressive stock repurchase program, having purchased $100 million shares or approximately 5.7% of the company between mid November and early December 2014. The CEO has also put more skin in the game, buying an additional 5,000 shares. The corporate buyback activity could increase in future years as capital spending for fleet renewal diminishes. We expect stabilizing energy prices and economical day rates to lead to strong cash flows in the future that can be directed to debt reduction and shareholder returns.
In addition to these signs of future promise, Tidewater also pays a dividend of over 3%. We believe it is an excellent example of a strong company in a beaten-up sector.
An underappreciated wholesaler. United Stationers Inc. (USTR, Financial) is a leading wholesale distributor of business essentials, including office products as well as janitorial and industrial supplies. Unlike competitors, it has no retail storefronts and is not subject to the same retail rationalization pressures facing other companies in the space. USTR has a network of distribution centers that allows it to ship products to approximately 25,000 reseller customers, with next day delivery to more than 90% of the U.S. Given these fulfillment capabilities, we see the company as well positioned to benefit from the shift to online buying. USTR’s goal is to become the premier supplier of digitally sourced business essentials. Many analysts group it with other office supply retailers, causing them to miss the key points of its strong distribution network and diversifying revenue.
Currently, USTR trades at approximately 11x forward one-year earnings estimates, which is a considerable discount to the companies we consider its most relevant publicly traded competition. As USTR continues to move into faster growing and higher margin non-office categories, we believe earnings will grow and the company will be rewarded with a higher multiple. Additionally, a possible rebranding may help the market better understand the company and its strategic initiatives.
Outlook
Our outlook is squarely centered on improving consumer and industrial fundamentals as part of a broad, if slow moving, economic expansion.
Catalysts dependent upon a reviving U.S. economy are prevalent in the portfolio, and the much discussed “tax break” associated with cheap energy may benefit moderate income households disproportionately. The following graphic shows consumer confidence over time broken out by income bracket. Confidence among consumers in the $35,000 to $49,999 bracket has lagged that of higher earners—a gap that the decline in oil prices may help to lessen.
Consumer Confidence by Income Bracket
Source: Evercore ISI, January 1990 to December 2014, seasonally adjusted Conference Board Consumer Confidence Index. Past performance does not guarantee future results.
Consumer credit recovery. We continue to like Capital One Financial Corp. (COF, Financial), a leading credit card provider. The sluggish economic recovery and low levels of consumer confidence have dampened the use of credit cards and the growth of consumer loan balances. We see Capital One as underpriced, trading at 1.1x book value (compared to generally above 2x prior to the credit crisis). At this point in the economic recovery, revolving consumer credit remains well below pre-crisis levels but is steadily increasing. Capital One is poised to benefit from a wide interest rate spread between credit card yields in the low teens and deposit funding costs of less than 1%. Any additional strength in consumer driven spending could be directly beneficial to Capital One’s top line growth.
Invested in housing starts. New household formations, associated housing starts, and first time home buyers seem to be ticking up. Universal Forest Products, Inc. (UFPI, Financial) is well positioned to participate in this growth and is a long-time holding dating back to a highly contrarian purchase in 2010. It was a strong contributor during the quarter, particularly as this economic strength became more clear later in the period.
We have commented on UFPI in the past and our optimism for the company’s prospects remains steadfast. Housing related activity remains a key driver of UFPI’s results, and we are encouraged by two recent packaging related acquisitions that will compliment their existing Industrial segment. We think more mergers and acquisitions are likely and UFPI has the balance sheet to fund future purchases. In our view, the outlook for Industrials rivals the construction side of the business as companies begin to replace equipment that has now reached an average not seen since the early 1990s. Despite the appreciation in the quarter, the stock remains attractively valued at 1.6x stated book value and 7.1x 2015 estimated earnings before interest, taxes, depreciation and amortization (EBITDA).
Emerging opportunities in Information Technology. One sector we continue to find interesting is Information Technology, in which several existing holdings, such as Cisco Systems, Inc. (CSCO, Financial) and Fabrinet (FN, Financial), rebounded this quarter from prior lows we thought were overdone. We are maintaining a moderate overweight to IT given catalysts such as businesses’ needs to invest in IT infrastructure to replace aging systems. Mobile devices, cloud computing, and bandwidth infrastructure are additional major drivers in the industry. More importantly to us as value investors, valuations are compelling in the space, with decades-low multiples to earnings and cash flow, and often robust balance sheets.
We continue to apply our disciplines, centered on the 10 Principles of Value Investing™, for each buy and sell decision. While these are difficult and frustrating times for us and doubtless you too, we are certain the right course of action is maintaining the time-tested and fundamental methods of analysis that have proven their value over the long term.
Thank you for the opportunity to manage your capital.
