FPA Capital Fund 3rd Quarter 2017 Commentary

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Oct 09, 2017
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Introduction

Dear Shareholders,

On August 22, 2017, FPA announced that I would become the sole Portfolio Manager of the FPA Capital Fund (Trades, Portfolio) as of the beginning of the fourth quarter of 2017. I appreciate the trust that the FPA Managing Partners and the FPA Capital Fund (Trades, Portfolio) Board have placed in me, and I will work hard to earn the trust of all our stakeholders.

I have already started repositioning the portfolio. I chose to eliminate five companies and add three new names amounting to 21% of invested capital. Our first full month of performance since the announcement against our benchmark was 6.51% vs. 4.54%. But as many of you know, we – here at FPA – do not focus on the short-term results. As we have stated on our website, one of our firm values is “the value of the long view,” which we described as market cycles rather than a short period.1 Our team’s overarching goal is to generate strong returns over a market cycle and we urge everyone to judge our team the same way.

The primary objective of the FPA Capital Fund (Trades, Portfolio) is long-term growth of capital. The Fund’s performance relative to its targeted objective has been disappointing over the last five years. As we continue to evolve, and as we strive for continuous improvement, there will be a number of changes. However, let me start with what will not change. We do not plan to change our mandate or our values. You can continue to expect the same level of commitment, focus, and integrity that you have always expected from us.

As a refresher, the FPA Capital Fund (Trades, Portfolio) is a long-only, absolute-value fund that is benchmark indifferent. We look for market leading companies with a history of profitability, strong balance sheets, and good management teams. Once we identify and research these companies, we will buy when there is a compelling reward-to-risk ratio and we will sell when we believe the ratio is unfavorable. The resulting portfolio tends to be concentrated. I eat my own cooking. I am (and will continue to be) invested in the Fund alongside you.

We put all of our investment candidates through rigorous analyses. The process starts with reading publicly available filings and studying the financial statements. Our goal here is to develop a thorough understanding of how a company makes money and what major challenges it could face. Then we expand our knowledge by talking to anyone who can shed more light on the company or industry. For example, we talk to management teams, competitors, suppliers, clients, and industry experts. We prepare in-depth investment memos that summarize all of our learnings. We then decide whether we want to invest in the company, and if so, at what price and at what weighting. Once a company becomes a portfolio holding, we continuously monitor it and its competitors.

“An organization’s ability to learn, and translate that learning into action rapidly, is the ultimate competitive business advantage.” - Jack Welch

The core of our investment process and our investment philosophy is not changing, but we have learned some lessons from the past, and we intend to incorporate those lessons into our process going forward. Our analysis of the Fund showed that since the beginning of 2011, the vast majority of our shortfall against our benchmark was caused by our investments in energy and carrying significant amounts of cash. The steps outlined below should help minimize both of those issues going forward.

We will diligently avoid position inertia - We will seek to act quickly to adjust position sizing when there are changes in our analysis of facts and the risk/reward profile. We will guard against the natural tendency to remain attached to positions we like even when information and prices change. If we observe a shift in the underlying fundamentals of a position, or find it expensive, we will look to trim/exit that position as aggressively as possible (market conditions permitting). We will not make small adjustments when we believe bigger changes are warranted.

We will differentiate between long-term and opportunistic investments - We expect our long-term holdings will be in high quality businesses. High quality can come in a variety of forms, such as a strong market position, pricing power, or a unique business model that translates into a high return on capital over a cycle. We will be more vigilant and disciplined about exiting lower quality businesses once valuations are no longer extreme. As such, you can expect us to trim our lower quality energy holdings once prices normalize (again, market conditions permitting). That does not mean that we will not occasionally take positions in lower quality businesses when valuations are at extreme levels (e.g. some energy names following the great recession, or where they are trading today).

We will be more nimble – Our research process is very robust, and it takes at least a month to fully research a company. Before we decide whether to embark on a full analysis, we need to make sure that we are spending our time wisely. To that end, we initiated an interim step of generally spending just two days looking at an idea and preparing a short memo to assess whether an idea warrants further research. This way we should be able to look at more companies and spend our time on those that are more likely to become portfolio positions. I expect our faster process to allow us to convert more of our ideas into new investments. Moreover, having just one portfolio manager making the final decision should accelerate investment decisions.

Despite our lackluster performance in the past few years, not all was bad for the Fund. Let’s quickly review what has worked:

We stayed true to our process and our mandate - Value investing has been out of favor for the last five years, and that has hurt our results, but we have never strayed from our process or our mandate. We continued to search for the same types of opportunities we always have with the same level of diligence, and an unwavering insistence on an attractive absolute valuation. And going forward, you can expect the same unwavering commitment to our mandate and process.

Our research process, apart from a few tweaks, remains unchanged - A continuing source of pride for the Capital Team is our internal research process. When researching investment ideas, we hope to understand and quantify potential sources of upside and risk and to understand the key drivers of a business and industry at a fundamental level. This deep understanding helps us build the confidence required to weather the many rainy days that inevitably come with value investing. Our research process remains as thorough and as committed to objectivity as ever.

Our new positions added value - We continued to insist that new positions must be thoroughly vetted prior to adding them to the portfolio. This includes a detailed memo and model as a result of our research process. The good news is our new positions (positions added since the beginning of 2011) have performed well, with the majority of them profitable and with gains handily outstripping losses.

“When the facts change, I change my mind. What do you do, sir?” -- Attributed to John Maynard Keynes

Portfolio alterations since the announcement of Portfolio Manager change:

Since I was announced as the sole Portfolio Manager of the FPA Capital Fund (Trades, Portfolio), there have been a number of changes in the portfolio. As value investors, we recognize there are often opportunities hidden in plain sight that allow us to invest in businesses at attractive valuations, such as when a thematic view impacts an entire sector and ignores company-specific details. For this reason, we tend to spend a reasonable amount of time picking through stocks in sectors that have underperformed. Two sectors that fit the bill today are retail and energy. The overarching negative theme in each sector is easy enough to understand. In energy, the theme is that there’s just too much oil and prices will be lower forever. In retail, it’s that Amazon is taking over the world, and the store-based model is dead. There’s certainly at least a kernel of truth to both of these thematic ideas, but value can be found in either disagreeing with the consensus (as we do with energy) or in finding the baby that’s been thrown out with the bathwater.

Retail:

Finding the baby is what we’ve been trying to do in retail. We recently dusted off a memo we had originally written in 2014. The stock in question had been sucked into the retail sector’s downdraft and was trading at 10x free cashflow. As the stock price fell, we did a full refresh of our memo and sharpened our pencils on our valuation work. A key question we asked ourselves was whether the company was susceptible to disruption from Amazon (the key theme dragging down the sector). Our research led us to conclude that close to half of the business is insulated from this risk and the other half, while not immune, is much less impacted than many other retailers. We also recognized that unlike many retailers, this business was not cyclical and not seasonal, meaning that we think the firm should continue to generate steady free cash flow year in and year out regardless of what the broader economy is doing. Finally, we met with management in their headquarters to confirm that these cash flows would in our view be deployed wisely. Satisfied with their answer, we have begun building a position in this baby (thrown out with the bathwater).

We have also used this time to review our other retail holdings and reassess whether we have appropriately evaluated this looming threat. We evaluated each position’s risk/reward ratio from its current level, taking into account the changing retail landscape. As we reviewed some of the holdings, we decided to eliminate Hibbett Sports, Signet Jewelers & Vista Outdoor, and to reduce our holdings in Foot Locker. We determined that these businesses would be facing increasing secular headwinds over the coming years. We made those changes despite their relatively undemanding valuations because we have learned that management teams faced with a declining business often take inappropriate risks that can destroy value (e.g. buying unfamiliar businesses, doubling down on a shrinking business).

Energy:

We have discussed our objective to dedicate more capital to well-run companies in higher quality industries earlier in this letter, so how does our current oil & gas sector allocation fit in as our portfolio evolves?

Ultimately, our high-level conclusion is that, barring extreme cyclical troughs where the market is clearly under-supplied and prices appear unsustainable, oil & gas investments do not currently fit our process and philosophy. Before discussing why we believe today is one of those rare times to own a significant position, there are three central reasons why energy investments currently conflict with our process.

First, this is a fractured market with limited barriers to entry, so it is destined to operate irrationally to the detriment of shareholders. Second, it is a global industry that is largely controlled by state entities (meaning that government interests will conflict with economic ones) or run by management teams that are highly paid regardless of the returns they produce. As Evercore ISI recently pointed out, Big Oil and E&P (exploration and production) entities earned 113% and 106% of target annual bonus compensation during the past three years despite one of the industry’s worst periods of financial performance.2 For E&Ps specifically, resource growth outweighs earnings and return on capital employed in the pay packages of CEO’s by a 12:1 margin. Finally, as a whole, the capital markets turn a blind eye and continue to fund the vast majority of operators that do not earn their cost of capital over a full market cycle.3 This perpetuates the cycle of value destruction.

This is an earned insight. We select what we believe to be the highest quality energy companies, demonstrated by a strong track record of value creation across cycles, and balance sheets that can withstand a prolonged trough in commodity prices. However, based on the facts mentioned above, it is currently imprudent to hold even well managed energy companies beyond the point of market normalization.

Today, like just after the financial crisis, is one of those situations where the market appears so favorably imbalanced that we are willing to stay meaningfully invested in the sector. To put this into perspective:

· Global crude inventories – the intersection of supply and demand – declined 10 out of the last 12 months. In a typical year, inventories build seven out of 12 months and draw at much lower magnitudes.4

· Oil bears primarily focus on three things. I list these concerns below along with what the data actually show:

o U.S. production growth. Calendar year 2018 YoY growth estimates range from 600k barrels per day to 1.4mm b/d.5

§ The latest Energy Information Administration (EIA) monthly data through June 2017 show that U.S. onshore production grew just 295k b/d over the last 12 months, with the oil rig count up 122% (it has since flattened).6 This production growth is literally a quarter of what many believe the growth rate to have been and roughly 200k b/d below the less reliable EIA weekly estimates.

  • OPEC rational guardianship in CY2018 (i.e. will they release spare capacity?)
    • This is a reasonable concern, but it’s important to understand that:

· The majority of cuts are from Saudi Arabia, a country that 1) is burning FX reserves and needs $70+ Brent to balance the fiscal budget;7 2) is preparing to IPO a portion of the state oil company in order to help finance a multi-decade restructuring of the national economy; 3) has recently supported the idea of extending cuts beyond March 2018;8 and

  1. is widely believed to already be operating near capacity, all while the probability of supply disruptions in Libya, Nigeria, Venezuela, and Iraq is higher than last year.
  • A downturn in global demand

§ The IEA – which has a long history of underestimating demand – continues to revise demand higher. The agency has increased 2Q’17 estimates by 800k b/d over the last three months, and CY2017 demand growth is now projected to be +1.6mm b/d versus an estimate of +1.3mm b/d back in January.

With supply growth more constrained than the market realizes, inventory draws are set to accelerate as global oil consumption on average runs higher in the back half of each year. As inventories approach normal levels, we expect to see much higher oil prices. Further, once our stocks reflect what we believe to be a more reasonable (yet still conservative) global marginal cost of production, we are prepared to fully exit the sector. We have already exited one of our energy investments.

Even though my goal in this letter is to focus your attention on the future, I will address the elephant in the room: Babcock & Wilcox Enterprises, Inc. (BW, Financial). We wrote about BW extensively in our Q1’2017 letter. At the time, we mentioned that the company took a charge due to some project mishaps in one of their three businesses. Subsequently, when BW reported its first quarter 2017 earnings it announced that the issues were contained and that they did not expect any additional charges. One quarter later, in their second quarter 2017 earnings call, BW changed its tune again and substantially increased the amount of money needed to resolve the issues. BW has been in business for over a hundred years and has not, to our knowledge, experienced any charges similar to what the company has incurred over the past few quarters. However, this management team found a way to take over $250mm of charges for a potential gross margin amount of $500mm from six projects. This outcome was not in our downside case scenario. Judging from the stock price movement of the day of the announcement, it caught a lot of people by surprise, including us. Needless to say, we exited the position because it no longer fit our criteria and we lost confidence in BW’s management.

Conclusion

This is the longest stretch of time that value has underperformed growth for Russell 2500.9

Since the Great Financial Crisis, the valuation gap of growth companies over value companies in Russell 2500 has been widening.10

We cannot predict when (or if) this situation will reverse itself. However, following the previous five cycles when growth outperformed value, value stocks have delivered very robust performance (although there can be no guarantee this pattern will be repeated in the future).11

We remain committed to our absolute value roots. We realize that the Fund has performed poorly since the second half 2014 (notwithstanding our robust performance of 2016). However, my duty is to think about the future. And I think that the future is bright: Our portfolio is trading at a significant discount to our estimate of our companies’ intrinsic values. Moreover, our pipeline of investment ideas has never been stronger. We expect to deploy capital into good companies in a very swift manner should the valuations permit.

I am a true believer in transparency and open communication. I thank all of you who have reached out since the announcement of this transition. Please continue to do so. As always, we appreciate the trust you have placed in us – and know that it is not taken for granted. I can be reached at [email protected].

Respectfully submitted,

Arik Ahitov

Portfolio Manager

September 2017