Quarterly Commentary and Outlook
In the third quarter of 2015, Fund of America delivered a negative return behind the S&P 500 Index.
All year the US equity markets had been buffeted by a myriad of macro headwinds and despite numerous challenges, our portfolio was ahead of the broader market (S&P 500 Index) until the third week of September. On September 21, political concern around pharmaceutical pricing emerged, which led to a 7 day selloff that hit all of our health care investments.
While we were disappointed that our portfolio did not perform better during this isolated period, we would note that we have suffered through health care scares in the past. Most recently in the summer of 2011, all of our health care stocks were hit following the “Sequester” budget agreement. Once the initial shock of the “Sequester” was absorbed by the market, health care stocks recov-ered. We believe the same type of recovery could potentially take hold now.
While the political spotlight and market pullback have adversely affected all of our health care holdings, we believe it is important to share with you our views on Valeant Pharmaceuticals International (VRX, Financial). Valeant has been the subject of numerous articles/ rumors over the last month regarding its business practices. What initially began as an investigation into the aggressive manner in which Valeant had raised prices on two drugs that it had acquired in early 2015 has grown into a full-scale firestorm of controversy over its entire business model. Two US District Attorneys have issued subpoenas requesting information on Valeant’s pricing as well as its patient assistance programs. As we write today on October 21, the company is now under suspicion over the utilization of a network of specialty pharmacies that it uses to distribute and fulfill a portion of the demand for its products.
We continue to remain focused on the facts: that Valeant has been quite successful pursuing an acquisition program, growing adjusted free cash flow from $182 million in 2008 to over $2.1 billion over the last twelve months. We acknowledge Valeant has accumulated significant debt as part of its acquisition strategy and while manageable, its balance sheet has left it vulnerable to short sellers. In our view, the debt is fully manageable and debt-to-EBITDA may decline.
With regard to Valeant’s business practices, we have studied the issues at play. In our dealings with the company over the last eight years, we have been consistently impressed with the thoroughness and diligence of the management team.
We clearly recognize that political pressures have grown on the pharmaceutical industry, yet we believe Valeant management is fully cognizant of this new reality, and should adapt its strategy swiftly and appropriately. In our view, much of the rhetoric is based on misinformation or misunderstanding and this noise should eventually diminish. We believe the current stock price is trading at a significant discount to the value that underlying business fundamentals should warrant.
Our core investment philosophy that has served us well over the years is predicated on an ability to look through short term uncer-tainty, and to focus on the intrinsic value of a business over the longer term. From a broader perspective, the portfolio valuation looks attractive to us. Although the recent weeks and months have been volatile and painful, our experience has taught us to remain true to our philosophy and discipline through all market conditions.
Top 5 Contributors
For the quarter, the top 5 contributors to performance were Delta Air Lines, Motorola Solutions, AutoZone, Masco Corporation and Lowe’s Companies. Delta (DAL, Financial) reported strong quarterly results and reiterated their plans to keep system capacity flattish for the fourth quarter. The company also increased its dividends by 50% and authorized a new $5 billion share buyback through the end of 2017. Motorola Solutions (MSI, Financial) received a $1 billion investment from private-equity firm Silver Lake. The company plans to use part of this investment to buy back up to $2 billion of its stock through a modified Dutch Auction tender offer and to also build out its software and services business through strategic partnerships and acquisitions. Masco Corporation (MAS, Financial) announced stronger than expected earnings in the 2nd quarter driven by strong sales in its cabinet segment. The company also completed the spinoff of its insulation business, TopBuild. Lowe (LOW, Financial)’s corporation reacted to better than expected earnings and the continued positive outlook for housing.
Top 5 Detractors
The main detractors to performance over the quarter were Valeant Pharmaceuticals International, Halozyme Therapeutics, Eastman Chemical Company, Lexmark International and LyondellBasell Industries. Eastman Chemical (EMN, Financial) traded down on concerns over the general economic outlook and commodity prices. Despite the sensitivity of Eastman’s stock price to commodity price fluctuations, we believe Eastman is undervalued.
We appreciate your confidence and thank you for your support.
Sincerely,
First Eagle Investment (Trades, Portfolio) Management, LLC
