By VW Staff. Originally published at ValueWalk.
FPA Capital Fund commentary for the first quarter ended March 31, 2017.
Deja vu
One of the side effects of running a highly focused portfolio is volatility. We do not mind that volatility because, paraphrasing Warren Buffett, we prefer a higher return that is lumpy over a lower return that is smooth. This is especially true if that volatility allows us to add to our positions at a low price and trim our positions at elevated prices. At one point during last year’s first quarter, our portfolio returned -13.26%. We ended the year up 22.86%. This quarter was another one of those where a number of positions worked against us and our portfolio returned -3.73%. For the fiscal year ending March 31, 2017, the portfolio was up by 18.09%. Our energy investments, collectively, detracted -2.02% from our performance for the first quarter of the year; however they contributed 6.95% to performance for the trailing twelve month period. Large detractors for the fiscal year were Babcock & Wilcox Enterprises (-2.45%) and Vista Outdoor Inc. (-0.82%). We will highlight them later in this letter. Last year, we mentioned that despite some of the “hits” the portfolio had taken, there were catalysts that could lift many portfolio companies up substantially. Our objective has been to construct our portfolio similarly for this year.
Market commentary
There is a new sheriff in town. On Election Day 2016, your Portfolio Managers talked late into the night discussing which stocks we would buy the next morning. We had a list of 11 (including many existing portfolio holdings). The futures market was down about 10% with the news that the next president of the United States would be Donald Trump. Early the next morning, we had to draw up a different list. What are we selling into this strength? As of the end of the first quarter 2017, the Russell 2500 index is up 14.78% since the Nov. 8, 2016 presidential election. Investors decided President Trump’s programs would stimulate the economy. It is hard to disagree with the market’s conclusion when we consider each component of his platform independently: tax reform, defense spending, infrastructure spending, fewer regulations, etc. We believe that any one of those, in a vacuum, could be very beneficial to the U.S. economy, and hence, to stock prices.
In reality, however, no clear progress has been made in any of those areas. Cabinet appointment confirmations have been taking longer than expected, and a number of them have been very contentious. Additionally, President Trump’s tweets continue to divide an already divided country, so why should we expect any bipartisanship today? How will the president’s legislative agenda move forward without bipartisan agreement? The market is pricing in success, but what about failure or a substantial delay? Despite control of both houses of the United States Congress, the Republican Party failed to repeal the Affordable Care Act. We would not call this a good start.
Then there are the inconsistencies. For example, President Trump pledged to make blue-collar workers relevant again, but he is talking about tariffs, which could result in a stronger dollar. The higher dollar may make U.S. manufacturing less competitive and endanger blue-collar jobs. In our opinion, a Border Adjustment Tax would likely result in higher consumer prices, which would hurt financially strapped blue-collar workers. Cutting taxes helps companies, but how would the government plug that hole in revenue and increase defense and infrastructure spending at the same time? Chair Janet Yellen’s Federal Reserve raised interest rates at the March 15 meeting and we believe more interest rate hikes are expected. Higher interest rates mean higher outlays by the government for interest expense on its debt (further widening the budget gap).
The same is true for companies. The total debt outstanding for Russell 2500 companies is $2.1 trillion (vs. a market capitalization of around $4.8 trillion). Every one percent rate increase would translate to over $20 billion of additional interest expense over a period of time (assuming a parallel shift up in the yield curve). Even if all the efforts to stimulate the economy work without a hitch, we would most probably end up with higher inflation (do people still remember what inflation means?).
Are ETFs the new weapons of mass destruction?
Notwithstanding any of the concerns mentioned above, investors appear excited about the future as they continue to pour money into the stock market. They express this excitement by allocating a tremendous amount of capital into index funds and Exchange-Traded Funds (ETFs). Last year, passive funds had $563 billion of inflows, while active funds experienced $326 billion of outflows, according to Morningstar. Active U.S. equity funds manage $3.6 trillion and passive instruments are about to catch them at $3.1 trillion.1 When we add the $124 billion poured into ETFs in the first two months of 2017,2 active and passive investments are almost at parity. This does not even include the so-called active managers that tend to hug an index. The long-term trend is very pronounced. Since 2007, $1.2 trillion dollars disappeared from actively managed U.S. domestic equity funds and $1.4 trillion dollars were added to passive strategies. As the number of corporate listings continues to dwindle, more and more ETFs are brought to the marketplace. This leads to more ETFs (financial vehicles), some of which use leverage, chasing fewer and fewer actual companies. Financial vehicles using leverage to purchase a shrinking pool of real assets—sound familiar? 3
The consequence of unrelenting inflows into passive funds is that stocks that are included in a major index receive ongoing support by the indiscriminate purchases made by these funds regardless of a company’s fundamentals. The benefits are amplified for companies that are owned by dozens of ETFs and index funds. On the flip side, those unfortunate stocks that are not included in a major index receive the reverse treatment, as active managers that tend to be fully invested are forced to sell shares to meet the onslaught of redemptions they are facing. But the worst fate is saved for those orphan securities that are removed from an index. These stocks face both indiscriminate selling from index funds on their removal date and continued redemption-related selling from actively managed funds. Unfortunately, these buy and sell decisions are entirely disconnected from a company’s fundamentals. This potentially sets the stage, should the tables turn, for an exceptionally compelling investment environment where companies with strong fundamentals are available for purchase at cheap valuations for those searching outside of the indices (as we often are).
Moreover, as more investors move from active to passive investments, the market for many individual stocks becomes less liquid. With reduced liquidity, we expect increasing volatility in the marketplace. Last month Kopin Tan wrote in Barron’s, “For weeks, the stretch from 3 p.m. to 4 p.m. became known as the market’s happiest hour, since a surge in late-day buying often nudged indexes from the red into the green. This happened because ETFs and passive index funds, unlike actively managed ones, must rebalance by the end of the day to match the benchmarks they track. According to JP Morgan, a whopping 37% of daily New York
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