FPA Capital Fund's 3rd-Quarter Commentary

Agreement vs. Truth

I just read a beautifully-written book by Richard Powers called "The Overstory." It is, by no means, a book about finance or investing. It is about trees, activism, and resistance. One partial sentence from the book has stayed with me: “[The] Overwhelming tendency to mistake agreement with truth.” One such agreement is around how low rates will reignite economic growth. But is that the truth?

As I write this letter, more than $17 trillion dollars of global debt has negative yields.1 What does that mean? My economics-related academic training is limited to a Bachelor’s degree in economics and a couple economics classes in graduate school. Maybe that is the reason I am having a very difficult time making sense of what negative rates actually mean. In my view, negative rates force many investors to go further out on the risk curve, but I have not seen the evidence that they drive any meaningful economic growth. How do banks survive in a low/negative rate environment? Economic growth is somewhat predicated on banks being willing to extend credit, but does a bank want to lend at negative rates when they continue to carry all their fixed costs? I can envision a scenario where central banks continue (or rather are forced to continue) their aggressive monetary policies. And while stock market investors might relish these actions in the short term, unless these actions result in economic growth, their efforts will be fruitless.

There was a time when investors worried about an inverted yield curve and sub-50 ISM readings.2 I do not know whether we are already in a recession or about to be in a recession, but we are in the longest postwar expansion cycle and we are in the middle of a trade war, so should investors not prepare for this risk? In case some of our readers were not investors during previous recessions, here is a summary of what has happened historically during the past 9 recessions:

S&P 500 Declines Around Recessions:3

Note: Declines represent peak-to-trough price contraction most closely associated with each recession.

A Quick Update to Last Quarter’s Letter

In our second quarter letter we posed the following question: what if corporations prioritize debt payment over stock buybacks? The quarterly share buyback activity is still well-above its 20-year average but it seems like there was a steep decline in the second quarter.

The decrease in the buyback activity matches with the declining confidence from the leaders of these firms– the fourth lowest level since mid-1970s. And just to hammer the point home, at these levels historically, we’ve either been in a recession or about to enter one.

Q3 2019 Update5

Value stocks have been performing very poorly on a relative basis since the beginning of 2017. The cumulative return of Russell 2500 Index, since the beginning of 2017 is 23.76%. However, Russell 2500 Growth was up 38.16% during that period vs. Russell 2500 Values’ paltry performance of only 11.63%. That is a major divergence of performance between value and growth. It has not been easy to be a value investor to say the least.

The Fund was down 1.58% in the third quarter of 2019 vs. down 1.28% for Russell 2500. Also importantly, the invested part of the portfolio performed well at around 20.11% (net) year to date compared to 17.72% for the Russell 2500.6

Ambarella, Inc. (AMBA, Financial)

Ambarella develops high-end image signal processing and computer vision (CV) chips. These chips are used in security cameras, drones, sport cams, and a growing array of automobile applications (e.g. dash cams, driver monitoring systems). The company has been shifting its business strategy to focus on CV applications primarily for security cameras, Advanced Driver Assistance Systems (ADAS), and Autonomous Vehicles (AV) and has been deemphasizing the consumer end-market.

Our investment thesis for Ambarella is that the stock is overlooked as the firm’s legacy consumer business (e.g., GoPro, Drones) has been in decline while the firm’s CV business has been driving expenses higher, with limited revenue to date. Our view is that the consumer business is now sufficiently small that further declines don’t matter as much and that the CV opportunity, if successfully executed, could add billions of dollar to the firm’s valuation. It is our view that this management team has a history of success in the video chip space and we think they are well positioned to be a major competitor in this space.

During 3Q19, we saw early signs that momentum is building for the firm’s CV business. They announced that 40 customers across multiple end-markets are currently testing their latest CV chips and on the earnings call management expressed a high level of confidence in their future opportunity set. We expect this momentum to continue and have raised our internal valuation estimates.

Noble Energy (NBL, Financial)

Noble Energy is an exploration and production company with diversified operations: onshore in the US (DJ, Eagle Ford and Delaware basins) and offshore in Eastern Mediterranean and West Africa. The company just delivered positive second quarter results with production ahead of and costs lower than expectations, and also lowered capital expenditures for the full year due to US well cost improvements while raising mid-point of the production guidance.8

Our Core Thesis:

• Free cash flow inflection in 2020 with the completion of a major gas project, Leviathan, and further acceleration in 2021 as it reaches full capacity.
• Lower total production decline rates expected to result in lower-than-industry capital expenditure needs to maintain production levels.10
• Gas operations in Israel (which were designed for easy expansion) and low cost discoveries near Cyprus and West Africa.
• Strong management team operationally with appropriate hedging policies and investor friendly capital allocation plans.
• Strong balance sheet with LTM EBITDAX leverage of 2.3x.11

Dana Incorporated (DAN, Financial)

Dana is a global auto part supplier primarily focused on driveline components (e.g., axles & drive shafts). The company serves three different end-markets: light vehicles, commercial vehicles, and off-highway vehicles. This is a name we know very well and have traded in and out of since 2015. However, the stock performed poorly in 3Q19. We used this period of weakness to add to our position and continue to believe our core thesis (discussed below) remains intact.

Our Core Thesis:

• Better business today than it was historically given the firm’s new focus on profitability over market share and less concentrated end-market and geographic exposures.
• Management has improved operational focus by consolidating suppliers, closing plants, and moving up the value chain in terms of technological sophistication.
• Firm is becoming more powertrain agnostic with recent acquisitions increasing their exposure to Electric Vehicle (EV) components.
• A backlog of orders over the past few years have required upfront investments, depressing Free Cash Flow (FCF), but we believe these orders are poised to become meaningful contributors to FCF over the next several years and we expect both FCF and earnings to grind higher.

Following a slight earnings miss in 2Q19, the stock sold off materially and continued to drift lower over the next few weeks as macro risks appeared elevated and the herd stampeded out of cyclical stocks. We took a longer-term view and added to our position on the way down. We felt the sell-off was overdone and the stock was reflecting the near-certainty of a recession. We think the stock is inexpensive.

Interdigital, Inc. (IDCC, Financial)

InterDigital monetizes intellectual property in the wireless tech space. The Company is not a basic patent portfolio manager or a patent troll, but rather is an inventor of patents with 340 engineers worldwide. IDCC spends significant sums on research & development and files patents on technology that is considered essential for the wireless device industry and in turn, demands licensing revenues. We like this business because:

Our Core Thesis:

• There has been tremendous growth in wireless communication and we expect that to continue. We see an investment in InterDigital like selling pickaxes to goldminers in that you don’t have to pick a winner, just identify the general growth trend.
• They have contracts with the big two – Apple and Samsung (and many more).
• We see future growth opportunities from 5G and Internet of Things, two trends still in their infancy.
• Strong operating leverage: recurring revenue has been increasing at a greater pace than operating expenses.
• Solid balance sheet and a history of wise capital allocation.

IDCC already has 90% of non- Chinese wireless market under contract. Trade discussions between the US and China have created some short-term struggles, but based on IDCC management input, we believe that IDCC will have long- term success signing up Chinese clients. The market is worried about delays with any new contracts being signed by Chinese clients when the US is in the middle of a trade war, but we see this as an opportunity to add to our position at an attractive price, while we wait for what we believe to be the inevitable.

Conclusion

The FPA Capital Fund (Trades, Portfolio) had another busy quarter. We initiated three new positions and eliminated three. Similar to what we communicated in our last letter, we still believe that the overall market is overpriced. We continue to invest in only our highest conviction ideas and strive for higher quality in our portfolio. To that end, our quality score for the portfolio increased by more than 35% in the past two years.12

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

Sincerely,

Arik Ahitov

1. https://www.bloomberg.com/graphics/negative-yield-bonds/
2. https://www.instituteforsupplymanagement.org/ismreport/mfgrob.cfm?SSO=1; ISM = Institute for Supply Management
3. Source: Standard & Poor’s, Haver Analytics, Credit Suisse U.S. Equity Strategy – 09/11/2019
4. S&P Dow Jones Indices as depicted in Financial Times – 08/23/2019 - https://www.ft.com/content/8cb379a0-c509-11e9-a8e9-296ca66511c9
5. In this Q3 2019 Update 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.
6. Calculated as net performance/ (1 – average cash balance). Past performance is no guarantee of future returns. Comparison to an index is for illustrative purposes only. The Fund does not include outperformance of any index in its investment objectives.
7. Reflects the top five contributors and detractors to the Fund’s performance based on contribution to return for the quarter. Contribution is presented gross of investment management fees, transactions costs, and Fund operating expenses, which if included, would reduce the returns presented. The weights of the top 5 / bottom 5 contributors within the portfolio for the last three months as of September 30, 2019 were: Ambarella (2.3%), Western Digital (2.7%), MKS Instruments (2.7%), Valmont Industries (1.8%), Allegiant Travel (4.7%), Cimarex Energy (2.0%), InterDigital (4.6%), Dana (2.9%), Cision (1.3%), and Ryder System (1.9%). The information provided does not reflect all positions purchased, sold or recommended by FPA during the quarter. A copy of the methodology used and a list of every holding’s contribution to the overall Fund’s performance during the quarter is available by contacting FPA Client Service at [email protected]. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities listed. Past performance is no guarantee, nor is it indicative, of future results. Please see important disclosures at the end of this commentary.
8. Based on Q2’2019 earnings call on August 2, 2019.
9. Based on SEC filings and FPA estimates.
10. ‘Decline rate’ is the annual reduction in the rate of production after a peak in production.
11. LTM = Last twelve months; ‘EBITDAX’ is earnings before interest, taxes, depreciation, depletion, amortization and exploration expenses. ‘EBITDAX Leverage’ is Debt / EBITDAX.
12. The FPA Capital team scores the Fund’s portfolio holdings on a quality ranking on a scale of 0 (lowest quality) to 10 (highest quality). A company’s quality score reflects the FPA Capital team’s historic investment framework (e.g., market leadership, history of profitability, solid balance sheets, and strong management teams) as well as including industry-related aspects such as competitive strengths and weaknesses based on an internal attribution process. The protfolio quality score does not guarantee the Fund’s future performance or success.

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, polit developments. The Fund may purchase foreign securities including American Depository Receipts (ADRs) and other depository receipts, which are subject to interest rate, cu political risks; this may be enhanced when investing in emerging markets. Securities of smaller, less well-known companies involve greater risks and they can fluctuate securities. Groups of stocks, such as value and growth, go in and out of favor which may cause certain funds to underperform other equity funds. You risk paying more for a security than you received from its sale.

Value style investing presents the risk that the holdings or securities may never reach their full market value because the market fails to recognize what the portfolio managem value or because the portfolio management team has misjudged those values. In addition, value style investing may fall out of favor and underperform growth or other styl Small and mid-cap stocks involve greater risks and they can fluctuate in price more than larger company stocks.

The return of principal in a bond investment is not guaranteed. Bonds have issuer, interest rate, inflation and credit risks. Lower rated bonds, callable bonds and other type risks. Interest rate risk is when interest rates go up, the value of fixed income securities, such as bonds, typically go down and investors may lose principal value. Credit risk is issuer's failure to repay a loan. Generally, the lower the quality rating of a security, the greater the risk that the issuer will fail to pay interest fully and return principal in a tim security may lose some or all its value.

Portfolio composition will change due to ongoing management of the fund. References to individual securities are for informational purposes only and should not be construe the portfolio manager, FPA, or the distributor.