FPA Capital Q3 Commentary: Russell 2000 'Nose-Bleeding' ValuationHFA Staff
From FPA Capital Q3 letter to investors, also see FPA 2013 Q3 Fund Fact Sheets
Portfolio Commentary & Outlook
The all too often heard phrase of “don’t fight the Fed” continues to be proven true, as evidenced by protracted appreciation across equity markets. During the third quarter, the market for both large-cap and small-cap stocks experienced healthy gains between mid-single digit to high-single digit returns. The Fund returned 8.28% for the quarter. The Russell 2500 appreciated 9.08% in Q3, while the Russell 2500 Value and S&P 500 gained 6.43% and 5.24%, respectively. Despite the portfolio’s large cash position, your portfolio achieved superior returns compared to the Russell 2500 Value and the S&P 500, but could not quite match the Russell 2500.
Your portfolio’s return on invested capital has matched or exceeded the major indices’ returns this year, depending on which index one observes. Nearly 40% of the stocks in the portfolio appreciated more than 30% year-to- date through the end of the third quarter, and roughly 85% of the stocks achieved double-digit returns over the same time frame. The good news is that the portfolio companies are performing well, the management teams for these companies are executing on their business plans, and the stocks in the portfolio still provide investors with good value. The bad news is that small/mid-cap stocks are, in general, about as expensive as we can recall over the past few decades and the pickings remain slim. For instance, the Russell 2500 is now trading at 26.5x trailing twelve-month earnings, and the Russell 2000’s P/E1 is at the nose-bleeding level of 31.2x.
Despite the “overvalued” asset class, we were still able to add three new names to the portfolio this year, including one in the third quarter. Each of these three companies operates in different industries (Education, Healthcare, and Retail) and has their own set of reasons why they are attractive to us as absolute value investors. In a normal year, and clearly this is not a normal year, we would expect to add four or five new companies to the portfolio. Hence, our antenna remains acutely tuned to capture any signal that alerts us to highly attractive investment opportunities, but our equipment is mostly picking up the noise of bull hoofs rampaging wildly as Ben Bernanke pours endless liquidity into the capital markets.
Speaking of Mr. Bernanke and the Federal Re serve, we would immensely appreciate it if he and his cohorts would explain to the American people what would happen if the Fed stopped buying $85 billion worth of Treasury and mortgage securities every month. Does the Fed believe the U.S. economy would collapse sending all of us into the poorhouse? Do they think the stock market would nosedive and wipeout trillions of dollars of wealth? Do they think interest rates will rise substantially and by enough to snuff out the recovering residential real estate market? If the answer is yes to any or all of the above, then our economic foundation is shakier than many might believe.
Recently, the International Monetary Fund’s (IMF) Global Financial Stability Report (GFSR) estimated that scaling back the Fed’s asset purchases could lead to bond market losses of up to $2.3 trillion. José Viñals, financial counselor to the IMF, says the U.S. needs to control its systemic risk. However, the IMF notes that containing longer-term interest rates and market volatility has already proven to be a substantial challenge, and that is before there has been any change in short-term interest rates.
We know the Fed has mentioned, ad nauseam, their concerns about unemployment rates in the country being too high and the lack of decent job growth, and we share their concerns about people not finding jobs. However, isn’t it logical to think that if a new job is created because of the Fed’s “quantitative easing (QE)” that that job will disappear once the easing ends? If it were as easy as printing money to create jobs, why not print tens of trillions of dollars and solve the problem? The answer is that, in our opinion, jobs are not created because the Fed prints a bunch of money. Rather jobs are created when businesses want to expand their operations. Businesses generally expand their operations when they are producing rising profits, unless you are Twitter and have access to Wall Street’s brightest minds and capital.
If we assume that businesses add employees to the payrolls when profits are increasing, or at least steady, and the Fed understands this relationship, then the Fed must hope that their QE policy will increase the aggregate level of demand and, therefore, profits in the U.S. However, the Fed cannot just give the money to individuals and force them to spend it. Nor can the Fed give money to companies and the companies then, voila, report to shareholders the “new found” profits.
So how does QE affect demand? The answer likely lies in something called the Wealth Effect. That is, the Fed believes that business and consumer spending increases when businesses and consumers are wealthier. Higher stock prices certainly increase the wealth for those who own shares. But this theory makes sense as long as businesses and individuals believe their “new” wealth is sustainable.
When businesses and individuals believe their larger wealth is temporary, the much sought after increased spending is not nearly as much if the increased wealth was expected to be permanent or long lasting.
Intuitively, we know if two people each get a job paying $75,000 annually, but one is expected to be a permanent job with a solid company and the other is with a temp agency that could end at any time, the individual with the permanent job is likely to spend more money, especially on bigger ticket items such as housing or an automobile. This is not true in all cases, but in an economy with tens of millions of participants the monetary velocity and aggregate spending should be higher when people believe their incomes are sustainable rather than on tenuous footing.
Investors are no different than our simple illustration above. If the stock market’s rise is not due entirely to sound fundamentals, investors will question the sustainability of those returns. So why won’t smart investors sell over-priced securities and cash in their chips and buy a yacht or beach house? Clearly, some investors are doing just that today.
However, many investors, especially large pension plans and other institutional investors, are being forced to remain in the stock market because the alternative investment choices are just as bad, or worse, as owning stocks. Ominously, if too many investors run for the exits at the same time, share prices are likely to materially decline and upset the Fed’s goals. Thus, the Fed has to be careful with all of this taper talk, lest they upset the proverbial apple cart.
In any case, the Fed’s policy of increasing aggregate wealth, facilitated by the stock market’s rising share prices, will likely benefit only a relatively few investors. The so-called 1%ers will indeed buy fancy cars, build more McMansions, and acquire other luxury goods, which will help the economy grow. However, the policy is unlikely to unleash a torrent of spending from the vast majority of Americans. The reason why is that the middle class and those less fortunate have very little or no investments in publicly-traded equities. Moreover, a recent Sentier Research study shows that the inflation-adjusted median household income is $2,380 below where it stood four years ago.
Obviously, the Fed has not been trying to create a stock market bubble with its QE policy. And we are sure there are some Federal Reserve officials who are concerned about a rapidly rising stock market, given the anemic earnings growth. Yet the Fed’s objective of stimulating the economy so more jobs are created is not gaining the desired traction. This brings us to the so-called tapering program many economists and investors had thought the Fed would embark on at the end of September.
For several months during this summer, assorted Federal Reserve officials gave speeches around the country hinting at a possible reduction in the Fed’s monthly purchases of $85 billion worth of Treasury and mortgage securities. There were various reasons given why the Fed could taper their QE program. Some officials discussed the improving housing market, some talked about fewer new unemployment claims being filed, some hinted at the improving fiscal budget deficit in D.C., and some talked about the expectations for faster GDP growth later this year and in 2014. Nonetheless, Mr. Bernanke and the Fed decided to stand firm and make no changes to their QE policy.
Investors reacted positively to the Fed’s taper caper. At the end of the day, most investors primarily yearn for higher stock prices, and secondarily they may want to know why equities are rising. Over the last few years, the Fed has conditioned investors to believe that the Fed will not allow the stock market to decline too much, and potentially set in motion another economic recession. Just like Pavlov’s dogs salivating when the bell rung, the market rises when the Fed sings its tune a bout more QE.
With the recent announcement that Janet Yellen has been nominated by President Obama to lead the Federal Reserve after Mr. Bernanke’s term expires, investors should expect more easy-money policies from the Fed. Under Ms. Yellen’s leadership, the Fed is likely to weigh more heavily on trying to maximize both nominal GDP and employment growth.
Should a Yellen-led Fed engage in a more reflationary stance than Chairman Bernanke has to this point, we would expect financial assets to react positively, at least initially, and until price stability is jeopardized. Nonetheless, we will remain zealous in our pursuit of finding value stocks in a rising and richly-priced market. During these times, it is very easy to drop one’s guard and buy or hold over-priced securities, because of the pressures to keep up with the indices. Yet, if one were to shun downside protection or maintaining a “margin of safety2”, one would relinquish among the most important characteristics of value investing.
Turning to your portfolio, stocks in the portfolio have performed well year-to-date. Included below is a table that highlights how each individual stock has performed this year.
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We initiated one new position in the third quarter, Aarons (AAN), and purchased shares in several existing investments, including small amounts in Apollo Group (APOL) and Devry (DV) and a larger increase in Arris Group (ARRS). We have written about the for-profit education companies in previous letters, so please refer to those letters should you want to familiarize yourself with APOL or DV.
Let us share some thoughts about ARRS. Our team has followed ARRS since 2005 and purchased the first share for the portfolios we manage in October 2010. Arris provides communication hardware products to cable operators. Every day, we demand faster speeds and more bandwidth from our intern et providers in order to achieve a higher satisfaction with our internet experience. We also ask for more High-definition (HD) channels from our TV/video providers. We want to stream movies and upload our own movies or videos to the internet. All these desires require large capital investments by cable operators.
In order to meet this demand, cable operators need to continuously update their infrastructure and this is where Arris comes in. ARRS manufactures and sells a wide range of technology products so all of the above wishes can be realized. ARRS has been gaining market share in many of its product niches because of the quality of its offerings and its leading technology innovations, which many of its customers and industry experts view as the “gold standard”.
We initially invested in Arris at an attractive valuation at close to 12% free cash flow yield and under four times total enterprise value to EBITDA3. At the time of our investment, the company’s net cash position made up approximately 35% of its market capitalization. The management team, which we hold in high regard and which has demonstrated a strong operational track record, has been taking advantage of this low valuation by gradually buying back their outstanding convertible debt and reducing their outstanding shares.
However, in December 2012, a major development occurred when ARRS acquired Motorola Home from Google for $2.5b. An industry analyst described the acquisition quite correctly as “minnow eats whale.” We believe ARRS got a good deal by buying from a motivated seller. As mentioned earlier, we have been following ARRS for nearly a decade and think this management team is very disciplined. That said, as with any major acquisition, we worry about the integration/execution issues, but we have confidence ARRS’s management team will optimize the operations. After the initial cost savings and synergies are accomplished in approximately a year, we believe the Company can generate substantially higher owner earnings and, therefore, good returns on our invested capital.
We continued to take advantage of strong upward momentum in the market place and trimmed a number of positions. When the market is trading at rich multiples, we trim or sell our positions. Currently, the market is expensive so we have more cash than usual. We are absolute value managers so we will stay on the sidelines as long as it takes and husband our cash until excellent investment opportunities become available. On the other hand, we will quickly deploy capital into investments if they are attractive–like we have done on three separate occasions this year.
We have done just that over the last 29 years for the strategy. Our portfolio is very defensive right now and has a great valuation advantage over our benchmark. Our P/E ratio is roughly 13 multiple points lower than Russell 2500’s nearly 27x multiple at the end of the quarter.
During the quarter, we also fully exited a position– Alliant Techsystems (ATK). Our long-term clients know that our average holding period is over 6 years. Alliant Techsystems was in the portfolio for only approximately one year, and appreciated more than 115% from our cost basis. Our long-term clients also know that we start trimming our positions when we believe our required margin of safety diminishes. We also sell the position outright if our investment thesis has worked out and/or the investment thesis has changed. All these criteria were met with Alliant Techsystems.
Alliant Techsystems is an armament and aerospace company. The company has three segments. Aerospace is the first one. In this segment, the company provides mainly two products. The first one is what is called a Solid Rocket Motor. Each time NASA sends a cargo into the space, they need one of ATK’s propulsion systems. Another product line for the Aerospace segment is aircraft components such as wing skins, fuselage skins, and other composites. The Company’s products can be found on F-35s and Airbus A350s.
The second segment is Defense. The Company is the overwhelming majority provider of small caliber ammunition to the U.S. Army. In this segment, they also offer medium and large caliber ammunition and missiles.
The last segment is called Sporting. They sell sporting and law enforcement ammunition, accessories, and tactical gear. These are sold to police departments, Department of Homeland Security, FBI, and U.S. Secret Service on the law enforcement side. On the commercial side, the largest customers are Wal-Mart, Cabela’s, Gander Mountain, and large distributors. Our team started looking at defense companies when many investors were worried about defense budget cuts, sequestration, and the end of wars. Alliant’s stock price peaked at around $120 in late 2007 and gradually decreased to $90 in 2010 and then started decreasing more rapidly and hit $43 in Q3’12. That’s when we started buying and built a small position with an average price of approximately $43.50.
By September 2013, our investment thesis played out – investors who were worried about lower armament sales and NASA contract losses were proved wrong. In 2012, we believed that the selling was overdone, as the uses of armament were mainly for military training, and the rest of the aerospace business was doing well. The stock price subsequently increased to over $95 per share, which is in the range where we exited the position.
As you know, we endeavor to find and invest your capital in more stocks like ATK. Unfortunately, it is currently not a target-rich environment for dedicated Small/Mid-Cap Value investors. We have experienced these droughts several times over the past few decades. Our patience has ultimately been rewarded as we have subsequently been able to put capital to work when the tide changes. We remain optimistic. If we can discover three new stocks for your portfolio in a year like 2013, we are confident that we will be able to put more capital to work when the market experiences greater volatility.
We thank you for continued support and trust.
1Price/Earnings ratio (P/E) is the price of a stock divided by its earnings per share.
2 Buying with a “margin of safety,” a phrase popularized by Benjamin Graham and Warren Buffet, is when a security is purchased for less than its estimated value. This helps protect against permanent capital loss in the case of an unexpected event or analytical mistake. A purchase made with a margin of safety does not guarantee the security will not decline in price.
3 EBITDA (Earnings before Interest Tax Depreciation and Amortization ) is essentially net income with interest, taxes, depreciation, and amortization added back to it, and can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions.