Larry Pitkowsky's 2nd Quarter GoodHaven Fund Commentary
To Our Fellow Shareholders:
Sometimes performance stats tell you a lot about a portfolio, a manager, or the underlying businesses - sometimes the message is misleading (in either direction). Regardless of reported results, we try to tell it straight as we see it at the time, try to call out true mistakes when we make them, and try to give you our thoughts and insights about our investments and where the puck may be headed rather than where it's been.
Results since last year have indeed been a jumble, for both the Fund and various indexes. For example, although fiscal 2018 was disappointing to us after a decent prior twenty-four months, we outperformed both the S&P 500 Index ("S&P") and the Wilshire 5000 Total Market Index ("Wilshire") indexes by a fair margin in the horrible month of December 2018 and in the fourth calendar quarter of 2018. Since then, markets have rallied and until May 31, our rebound was well behind the S&P. However, since the end of the Semi-Annual Period ending May 31, we have gained an additional 8.65% (as letter is being finalized on July 14th) - and it may represent the beginning of a truly positive trend. Last year we established some new investments that are doing well, we have started to see a rebound in some commodity markets, and we believe our positioning - which is very different than most large equity indexes - is starting to be a positive rather than a negative. Markel Corporation, a minority partner in the Advisor, recently added $15 million to its investment in the Fund, an action for which we are grateful and which indicates their confidence in our long-term approach.
In recent years, we and a considerable number of our "value investing" peers have struggled compared to large-cap equity indexes which have experienced massive cash inflows (despite strong returns in the first few years of the Fund and both a solid absolute and relative 2016 for the Fund). What has appeared to be deeply out of favor has generally stayed that way, growing companies generating losses or modest profits have become highly prized with huge market capitalizations (usually a temporary condition - and one we have seen before), and a cash reserve has proven to be a drag rather than a truly opportunistic asset. Despite a strong tendency for financial markets to "regress to the mean" over time, current trends have persisted longer than is comfortable. CBS Marketwatch recently ran a story entitled Value Stocks Are Trading at the Steepest Discount in History, proclaiming that "there has never been a worse time to be a value investor." Such pronouncements are historically associated with a turn for the better and we believe a "snapback" is coming.
Our investing approach defines value as the worth of a business to a rational and well-informed buyer and our success depends on our ability to reasonably value businesses and for the market to recognize that value over time. While we prefer growing businesses, we rarely own high growth companies generating losses or that have reasonable profits with very high valuations. Many of the latter have been some of the strongest gainers in recent years. Yet the history of markets is that undervalued securities with responsible managers have tended to rise in price and overvalued securities have tended to fall, and that the natural forces of capitalism restore balance when economic trends have gone too far.
Since the "great recession" of 2008-9, markets have gradually seen excesses build in that have not reverted - low to near zero interest rates around the world, "cheap" commodity input prices for most businesses, excessive value placed on growth stocks irrespective of profit, and, until recently, unfettered globalization of supply chains. For example, there are now roughly $13 trillion of government bonds around the world with negative yields (a form of "Bizarro World" for investors1), the Goldman Sachs commodity index, a broad measure of many different commodities now sells at the biggest discount to the S&P financial sector in more than 70 years, and we have now seen the longest period of expansion without a recession in modern memory. Global businesses who depended on cheap manufacturing in China are now seeing cost structures threatened by tarriffs.
Negative yielding bonds are a historic anomaly: we believe this trend should change or eventually there is likely to be a currency crisis somewhere. Further, either commodities generally are cheap to other assets or something critical has changed in the world economy. But people still need food, energy, and shelter and desire even more products and services as the world grows wealthier and people live longer - all of which require commodity inputs. We doubt the world economy has changed that much. Lastly, much of what we own trades at valuations that seem to be already reflecting the chance of a recession coming soon. Almost all of what we own is demonstrably less expensive than the market as a whole when comparing balance sheets, cash flows, and overall valuation. In the past, this has generally indicated a good chance of sharply improved results.
But let's look at some examples of why the Fund has struggled on a relative basis since our last semi-annual report.2 Six securities accounted for virtually all of the dollar decline in the portfolio from a year ago - these were: American Airlines, WPX Energy, Birchcliff Energy, Jefferies Financial Group, Spectrum Brands, and Systemax. We believe all remain attractive investments, and given our view that value has not been impaired, a lower price today should mean even better upside potential looking forward.
To preface the discussion, a brief word about insider purchases and share buybacks: we have been skeptical of most companies that borrow heavily to repurchase stock, even if borrowing rates are low. Once the cash has left the company and the shares are bought, the debt remains - and is often subject to refinance risk or creates other liquidity constraints. We are more intrigued when companies use discretionary free cash flow or excess balance sheet cash to repurchase shares at a low multiple of earnings or book value. The latter types of transactions are often an indication that management believes their company's shares to be materially undervalued and in those situations, investors should be happy that the stock does not appreciate rapidly - because otherwise the company cannot buy enough to really move the needle on value. We also like it when multiple insiders/executives buy stock in a short time-frame. After all, management can sell shares for any number of reasons - diversification, appreciation, a desire to purchase a new house or other assets, etc. But when they buy - which usually means an inability to sell in a short-time frame, it almost always indicates a belief that the shares are cheap to business value.
In late May and early June of this year, American Airlines (NASDAQ:AAL) traded below $30 per share. During the last twelve-month trailing period, the company has earned nearly $6 before corporate income taxes (which is roughly equivalent to after-tax earnings due to a significant tax-loss carryforward position), paid $0.40 in dividends, and has repurchased almost twenty-five million shares (more than 5% of average shares outstanding) - yet the stock price is roughly 37% lower than a year ago. The industry has consolidated in recent years, load factors are greatly improved, credit operations have added a material source of profit, and there are few signs of aggressive price competition.
At American, bookings continue to be strong, the company is focused on improving margins to raise profitability, and a number of insiders personally bought an aggregate of 110,000 shares for roughly $3 million in late May and early June of 2019. American has allocated the majority of its capacity growth this year to its largest hub Dallas-Fort Worth ("DFW"). DFW is the world's 2nd largest hub by peak day departures and American's margins here are approximately 75% higher than their systemwide average. This strategy of concentrated growth in the largest high margin hubs has been executed successfully by other industry peers. Recent data points from DFW have been positive and encouraging. Further, while the industry as a whole has been able to pass through higher fuel prices in recent years, softer oil prices this year should be a tailwind. In our opinion, the business of American Airlines could be worth nearly double recent quotes.3
Jefferies Financial Group (NYSE:JEF) was another large decliner over the last twelve months despite a steadily increasing tangible book value and a profitable business. Jefferies Financial was the result of a merger between Leucadia National (Trades, Portfolio) and Jefferies Group and now consists of the largest middle-market investment bank/broker-dealer and a variety of legacy businesses from Leucadia that are either wholly or partly owned. Some of these investments are required to be "marked to market" - resulting in significant volatility in financial income reports. However, Jefferies remains profitable and has been aggressively repurchasing stock in the last eighteen months (with the proceeds from asset sales) at a meaningful discount to tangible book value (around $26 per share based on Jefferies financial statement of May 31, 2019) - resulting in an increase in value for each remaining share outstanding. During the last eighteen months or so, the company repurchased nearly 60 million shares at an average price of a little over $22 per share.
We note that in a broker/dealer with a relatively "clean" balance sheet, tangible book value is a strong guide to liquidating value - in other words, and although the business should be worth far more as an ongoing entity, shareholders should be able to significantly profit if the business was closed and the net assets distributed. Both Jefferies and its predecessor Leucadia had and continue to have management teams skilled at capital allocation. We estimate that Jefferies entire business is currently worth at least $30 - $35 per share after evaluating all of the pieces and the extensive loss carryforwards, and perhaps more.
Our two growing energy holdings - WPX and Birchcliff - both declined during the period despite solid operating results and cash flows (full disclosure: we sold a material portion of our WPX in September 2018 for a sizeable gain as it approached our estimate of intrinsic value near annual highs). As of the end of the fiscal period, both are selling at or below the low points of December 2018 despite oil prices that are roughly $10 per barrel higher today than in December - and which were as much as $20 per barrel higher earlier this year. In recent years, there has been much volatility in commodity prices and a material decline from the highs. Yet, while these companies have to live with oil and gas prices that they do not control, they can control costs, midstream and processing assets, and capital allocation - and both have performed very well on those metrics. In the case of WPX, we believe the company will be cash flow positive in 2019 and should be able to return capital to shareholders in 2020. We believe the company's overall business is worth more than $20 per share and is based on our evaluation of expected cash flows, assets, and comparable transactions. We note that Occidental recently won a bidding war with Chevron for Anadarko, which has extensive assets in the Permian basin (as does WPX). We expect further consolidation in that area as companies continue to try to drive unit costs lower.
Deeply out of favor due to low commodity prices and transportation constraints, Western Canadian energy companies may be among the most hated in world markets. Weak natural gas pricing and large oil price discounts to world markets have occurred because pipeline capacity is limited and government policy has prevented building new projects to expand capacity or further export oil and gas. We believe this is going to change over the next two-three years as a number of major projects have recently been approved or commenced. One is a new pipeline for natural gas out of the Montney formation in Alberta, where Birchcliff has its large holdings. Another is the Shell project to build a pipeline to the west coast of Canada to export natural gas to Asia - also from the area near Birchcliff's assets. Another potential project is the Trans-Mountain oil pipeline expansion, now owned by the Canadian government. Discounted prices relative to world markets should decline rapidly as projects near completion.
In the case of Birchcliff, the company is a low-cost producer where about 80% of its production is natural gas and 20% is liquids, including oil and natural gas liquids. While levered, the company has generated significant cash flow and earnings even at low gas prices in recent years. The company has no short-dated maturities or material covenants and currently pays a material quarterly dividend to shareholders.4 In addition to its extensive reserves and land position, the company owns most of its processing capacity, which we believe is worth hundreds of millions of dollars. In addition, the company has increased per share production and reserves by double digit rates over the last decade or so - despite seeing a stock price that today sells at a fraction of where it sold previously.5 If we are correct about capacity plans and even without materially higher world prices for energy, we believe Birchcliff is worth far more than recent quotes and could become an acquisition target. Recently, insiders personally bought about half a million dollars of stock in the open market.
Spectrum Brands (SPBR) was up for the period after a material decline when we wrote to you last. We believe their prior operational issues are now behind the company, and most of its businesses are back on track with the exception of the small appliance business, which is facing challenges from tariffs and competition. Nevertheless, the company completed the sale of its battery and auto care businesses in early 2019, greatly improved its balance sheet by using a significant amount of the proceeds to pay down debt, and still generates material free cash flow. Subsequent to the sale, the company repurchased about $250 million of stock at approximately $53 per share and has been trading with a dividend rate of about 3%. We note that Jefferies owns about 15% of Spectrum, has representatives on the Board of Directors, and has a strong interest in seeing the company return to growth and strong cash generation. As a large owner, we expect them to continue to offer both guidance and pressure on Spectrum management.
Systemax (NYSE:SYX) was down modestly despite continued growth in revenue and profit, a large extraordinary dividend payout, and a streamlining of the business to focus on industrial supplies. We believe the company's stock price simply got ahead of itself after an extended period of good news and may have reacted to tariff threats as it sources a number of its products from overseas. However, we do not believe sourcing is a permanent threat and are happy to remain owners as we expect revenue and earnings to continue to grow at a decent clip in the next several years.
Despite a very unusual macro backdrop it's important that we continue to source potential new ideas that fit our parameters. Here the news is good. Some of our more recent investments have seen good business and price performance. Fannie Mae's core business continued to perform well. Importantly, it appears that some concerted efforts are underway to craft a plan of recapitalization of the government's complex control of Fannie Mae which may materially benefit the junior preferred stock issues that we own. Prices approximately doubled during the period. This situation is volatile, fluid, and we expect some material twists/turns along the way to a resolution. We also opportunistically bought Mohawk Industries in the latter part of 2018 after it had tumbled more than 50% from its 52-week high. It has since had a decent bounce back on a price basis. Oaktree Capital announced a takeover offer from Brookfield Asset Management and we saw solid results at Lennar and Federated Investors. We also continue to own sizeable investments in Barrick Gold, Alphabet, Berkshire Hathaway, Delta Air Lines, HP Inc. and Verizon.
Barrick's merger with Randgold appears to be benefitting shareholders. While the price of gold remains volatile, since the merger, new CEO Mark Bristow has created an accretive joint venture with Newmont, has moved quickly to further reduce costs, and is ramping up exploration activity. Further, backdrop conditions seem to be improving - with real interest rates back to recent lows, gold prices rallying, and central banks around the world once more suggesting dovish policy. Notably, Barrick has performed better in a host of currencies other than the US Dollar given interest rate differentials and relative dollar strength. Any move to weaken the dollar should be yet another tailwind.
While facing increasing regulatory headwinds and additional competition in advertising, Alphabet continued to dominate most of its core product segments, generated lots of free cash flow, and continued to grow at double-digit rates. We are well aware that the pricing of Google (NASDAQ:GOOGL)'s ads is largely a function of economic strength, so the company is not immune to weaker business conditions or slower growth. Yet Alphabet has many levers to pull, a host of growth initiatives that we believe should continue to add to shareholder value, and a stock price that is not excessively valued. Berkshire recently was selling at a discount to the valuation at which CEO Warren Buffett (Trades, Portfolio) indicated that repurchases could increase, suggesting that intrinsic value should be materially higher than the recent price. Over the last twelve months, Berkshire repurchased about $3 billion of shares below $310,000 per Class "A" share. Delta is the most profitable of the major airlines and shares many of the industry qualities that we believe make these businesses much more attractive than in prior years, not the least of which is large profits and material dividends in relation to the recent stock price. Like American, Delta is also repurchasing its own shares out of free cash flow.
HP's lucrative printer supplies business stumbled in the first quarter but performed reasonably well in the second and its overall free cash flow remains large compared to the company's stock market value, with both dividends and repurchases benefitting shareholders. Over the last eighteen months, HP Inc. (NYSE:HPQ) has repurchased nearly $4 billion of stock using a portion of its free cash flow at a little more than $22 per share, or close to ten times currently expected earnings. We believe Verizon should benefit from lower industry churn, the upcoming roll-out of 5G service with its much faster speeds, and the potential merger of T-Mobile and Sprint. Notably, Delta, HP, and Verizon all pay significant dividends to shareholders that seem quite attractive given current bond yields.
There is no question that aggressive central bank interventions, the rise of indexation as a force in stock markets, the number of "quant" managers, and the shift by institutions to private equity have changed the general investing environment.
Over roughly forty years, we have seen many such shifts and written about their impact. Yet we believe there has been one constant over time - public companies usually trade somewhere near intrinsic value if one is patient enough. In our experience, overvalued companies generally tend to return to earth, while undervalued ones generally rise. The right value is usually found in near the mean rather than the extremes.
Much of the world's recent growth has been in large tech companies. Yet investment returns are not just a function of growth - what an investor earns depends on both corporate results and the valuation at which an investment is purchased. Even the best business is likely to prove a poor investment if acquired at too high a price. And paying too much for what appears attractive may be the single biggest risk facing most investors today.
For example, index funds are full of very highly valued securities, many of which are not obvious. Microsoft - a company we once owned - now is valued at more than 30 times earnings with a market cap of roughly a trillion dollars. The management has done a great job but the company no longer appears undervalued. Indexes are adding recently issued Initial Public Offerings ("IPO"s), most of which (about 80% by least count) show operating losses. It was just announced that Beyond Meat - a recent IPO of a company selling vegan burgers and generating about $200 million in revenues with a $12 billion market valuation - will be added to the Russell 1000 Index. We think the company is likely to grow materially in the near-term. But at $12 billion, a large dose of optimism is clearly already reflected in the market price and such an index inclusion forces index funds to buy the security at extremely high valuation metrics. There have been plenty of other examples.
Many investors continue to pin their hopes on central banks lowering interest rates back to zero. Yet experience suggests that low rates are not a panacea for solving the world's economic imbalances and preventing recession and may be doing more harm than good. As one investor recently said, "If excessively low rates, even below zero, and QE were magic elixirs, the economies of Japan and the Euro region would be booming. They're not."6 Despite exceptionally low interest rates financed by hugely increased government debt over decades, the Japanese stock market has not recovered to anywhere near the highs that were achieved in 1989 (thirty years ago) - and this even after that central bank has been buying equities in the form of ETFs. A better conclusion is that interest rates alone are not sufficient to prevent either a recession or a decline in excessively high valuations and may act as a tax on investment income, reducing economic activity from those with greater resources. Moreover, broadly diversifying into major index funds or related products when many of the components trade at high valuations may also be toxic to long-term portfolios.
Value investing is not the same as writing about value investing. It's about trying to earn attractive risk adjusted returns over the long-term, which, by definition, means foregoing some of the speculative strategies that have worked well in recent years, such as buying momentum, or buying high to sell higher. We have often cited Eugene Shahan's seminal article "Are Short Term Performance and Value Investing Mutually Exclusive: The Hare and the Tortoise Revisited," which sets forth how even a group of the best value investors tended to underperform nearly 1/3 of the time over a multi-decade period, strongly suggesting that periodic underperformance is a feature, not a flaw, of the strategy. Yet even with such large variances, we believe value investing has historically generated satisfactory returns over time. Yet, it can be immensely difficult and frustrating when you employ a strategy that has tended to work well over extended time periods but occasionally makes you look like a fool - or worse - for an extended period.
As has been the case in previous periods when value was out of favor (such as during the tech bubble of the late 1990s), we have been engaged in a "lasting contest" where we believe conditions will change but cannot be precise about when. Given the recent deep skepticism about the validity of value investing generally, we appear to be much closer to an inflection point where the strategy could start to produce improved returns. We believe our portfolio is positioned to potentially benefit from such a shift, continue to believe the strategy is valuable, own solid businesses trading at modest valuations, and continue to have a material percentage of our personal net worth invested alongside your funds. We appreciate both your patience and your confidence and look forward to the prospect of improved results.
Sincerely,
Larry Keith
The opinions expressed are those of Larry Pitkowsky and/or Keith Trauner through the end of the period for this report, are subject to change, and are not intended to be a forecast of future events, a guarantee of future results, nor investment advice. This material may include statements that constitute "forward-looking statements" under the U.S. securities laws. Forward-looking statements include, among other things, projections, estimates, and information about possible or future results related to the Fund, market or regulatory developments. The views expressed herein are not guarantees of future performance or economic results and involve certain risks, uncertainties and assumptions that could cause actual outcomes and results to differ materially from the views expressed herein. The views expressed herein are subject to change at any time based upon economic, market, or other conditions and GoodHaven undertakes no obligation to update the views expressed herein. While we have gathered this information from sources believed to be reliable, GoodHaven cannot guarantee the accuracy of the information provided. Any discussions of specific securities or sectors should not be considered a recommendation to buy or sell those securities. The views expressed herein (including any forward-looking statement) may not be relied upon as investment advice or as an indication of the Fund's trading intent. Information included herein is not an indication of the Fund's future portfolio composition.
References to other mutual funds should not be interpreted as an offer of these securities.
Must be preceded or accompanied by a prospectus. It is not possible to invest directly in an index.
Passive investing involves the purchase of securities or funds that attempt to mirror the performance of a specific index. Active investing involves the purchase of individual securities or funds whose managers attempt to select securities based on fundamental research, quantitative analysis, or other factors and who actively change the underlying portfolios in response to corporate or macro developments.
This article first appeared on GuruFocus.
