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FPA Capital Fund 2Q17 Slides – Passive Investors Own ~15% Of AMZN

By VW Staff. Originally published at ValueWalk.

FPA Capital Fund commentary and webcast slides for the second quarter ended June 30, 2017.

FPA Capital Fund 2Q17 Commentary

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Introduction

The second quarter of 2017, compared to the prior couple of quarters, experienced relatively few events that the equity markets were not anticipating. One of the more notable surprises was the election of Emmanuel Macron as the President of France. Macron’s La République en Marche! party also won a decisive majority in the French Parliamentary elections. While one should not underestimate the power of French civil servants and employee unions to defend their short workweek and generous benefits, President Macron has the necessary votes to materially reform French labor laws and the tax regime that has held back the growth potential of the French economy for too many years. German Chancellor Angela Merkel hinted at cooperating with the new French president to reduce European Union (EU) austerity measures that have retarded economic growth in Europe. Should President Macron be successful in fulfilling his campaign initiatives, and Chancellor Merkel relaxes her strict austerity plans for the continent, we believe European GDP growth over the near-term horizon could accelerate and help push global growth higher.

Europe provided another notable event in the second quarter: The poor election results for the United Kingdom’s (UK) Prime Minister Theresa May and her Conservative party in the early June snap elections. At this time, it appears Prime Minister May will retain power in a coalition government, but the conservatives will hold a very slim majority in the UK Parliament. While it is difficult to predict what all of this means for the UK, we would not be surprised if the hard Brexit rhetoric takes a backseat to a softer Brexit. A softer exit stance by the UK may trigger a more moderate response from its EU partners. Thus, we believe that the dire economic forecasts for the UK, which were predicated on a hard Brexit, may be avoided, assuming all of the partners in the EU sandbox play nicely.

In the United States, the Federal Reserve again raised short-term interest rates by 0.25%, or 25 basis points. However, the Federal Reserve telegraphed its most recent interest rate increase well in advance of the actual day in June when the new rate took effect. The domestic equity market shrugged off the latest interest rate increase and marched to new heights, much like it did when rates rose earlier this year. Apparently, there is no kryptonite to weaken the current equity-market Superman.

Portfolio Commentary

FPA Capital Fund 2Q17 Commentary

We are disappointed by the Fund’s performance in the quarter. It underperformed the Russell 2500 by 345 basis points. Value stocks in general continue to underperform growth stocks. For example, the Russell 2500 Growth Index increased 4.13% in the second quarter and 10.63% year-to-date, while the Russell 2500 Value Index increased only 0.32% in the second quarter, and 1.95% year-to-date.

Several of Fund’s stocks that performed poorly in the first quarter rebounded in the second quarter, but those gains were not enough to offset the declines in the portfolio’s energy companies. Oil prices fluctuated wildly in the second quarter, but on June 30th oil closed a shade above $46 a barrel, down less than 10% for the quarter. Even so, the equity market was merciless with individual oil company stocks. For instance, 22 energy companies in the Russell 2500 Index2 declined over 30% in the second quarter, and 12 declined more than 40% in the June quarter. In many cases, energy stock prices approached the depths they hit when oil was $26 a barrel. Yet, the June 30th oil price was roughly 75% higher than the bottom reached 18 months ago.

With such a sharp selloff, one would think the fundamentals of our energy companies had deteriorated commensurably. However, that is not necessarily the case with the Fund’s energy investments. For instance, Cimarex’s (XEC) most recently reported quarterly results showed its revenues increased 17% sequentially from the prior quarter, and its adjusted operating profit improved to $222 million, up 147% from $90 million in the prior quarter. More importantly, consensus analyst revenue and profit estimates for the remainder of the year show higher expectations for the subsequent quarters.

Analysts’ consensus revenue and profit estimates for the Fund’s other energy investments show that they expect three of the Fund’s energy investments to improve throughout the year, one company to exhibit flat to minimal growth, and one company to experience declining sales and profits. Thus, five out of our six energy investments are expected to produce flat to materially better results this year versus last year. Notably, as of early July 2017, those five companies had already reported better results for their most recently reported quarter.

Notwithstanding the above comments, the two stocks that detracted the most from the Fund’s performance were Rowan Companies (RDC) and Cimarex (XEC). RDC is an offshore drilling rig owner that until very recently produced excellent earnings and free cash flow. The protracted energy downturn has caused RDC’s customers to cut back on offshore drilling projects, which has negatively affected the company’s backlog. While Rowan has been able to retain its strong position with Saudi Aramco in the Middle East market, it has not been as successful retaining its lucrative deep-water drilling contracts. The company’s rig fleet remains one of the youngest and most technologically advanced in the industry, so we believe that RDC is in a good position to win new contracts when the market turns around.

We understand the market’s bearishness on RDC since the offshore drilling market’s recovery has lagged the U.S. shale oil recovery, but Cimarex’s second quarter stock performance strikes us as an over-reaction to oil’s roughly 10% price decline. As we noted above, XEC can produce excellent profits when oil is around $50 a barrel. The reason is that its oil reserves are among the lowest cost and highest productivity of all U.S. oil shale companies. Let’s look at the numbers. In the first quarter of this year, XEC generated a remarkable 50% adjusted operating profit margin, compared to 9.5% for ExxonMobil and 11.5% for EOG, the self-proclaimed low-cost producer. While most E&P oil companies struggled to make little or no money in the first quarter, XEC crushed the ball out of the stadium.

Moreover, we estimate that XEC’s net asset value (NAV) is over $207 per share using $70 as the price of oil. However, at $60 oil, XEC’s NAV is roughly $162 per share. Thus, at the above range for oil prices, XEC is trading at nearly a 40% to 55% discount to our estimate of its NAV, and that assumes no improvement in any of the company’s outstanding oil shale reserves and projects. Even we accept the oil bear’s long-term price of oil at $50 a barrel, XEC is trading at a 13% discount to our estimate of its NAV. Again, this assumes no enhancement to the company’s best-in-class assets.

Let’s now review a couple of stocks that performed well in the quarter. The top positive contributor this quarter was Aaron’s Inc. (AAN). Aaron’s has been in the portfolio for several years, and it’s a holding we have described in the past. In short, Aaron’s is categorized as a “Rent-to-Own” (RTO) business. There

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