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FPA Capital 3Q17: One of Those Rare Times to Own a Significant Position in Oil & Gas

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FPA Capital Fund 3Q17 Commentary, September 2017

Portfolio Alterations

  • As value investors, we recognize there are opportunities hidden in plain sight that allow us to invest in businesses at attractive valuations, such as when a thematic view impacts an entire sector and ignores company-specific details
  • For this reason, tend to spend a reasonable amount of time picking through stocks in sectors that have underperformed
  • Two sectors that fit the bill today are retail and energy. Overarching negative theme in each sector is easy enough to understand. In energy, the theme is that there’s just too much oil and prices will be lower forever. In retail, it’s that Amazon is taking over the world, and the store-based model is dead
  • Certainly at least a kernel of truth to both of these thematic ideas, but value can be found in either disagreeing with the consensus or in finding the baby that’s been thrown out with the bathwater

Energy

  • High-level conclusion is that, barring extreme cyclical troughs where the market is clearly undersupplied and prices appear unsustainable, oil & gas investments do not currently fit our process and philosophy
  • Before discussing why we believe today IS one of those rare times to own a significant position, there are 3 central reasons why energy investments currently conflict with our process
    • This is a fractured market with limited barriers to entry, so it is destined to operate irrationally to the detriment of shareholders
    • It is a global industry that is largely controlled by state entities or run by management teams that are highly paid regardless of the returns they produce; as Evercore recently pointed out, Big Oil and E&P entities earned 113% and 106% of target annual bonus compensation during the past 3 years despite one of the industry’s worst periods of financial performance (resource growth outweighs earnings and ROCE in the pay packages of CEO’s by a 12:1 margin)
    • As a whole, capital markets turn a blind eye and continue to fund the vast majority of operators that do not earn their cost of capital over a full market cycle. This perpetuates the cycle of value destruction
  • Today, like just after the financial crisis, is one of those situations where the market appears so favorably imbalanced that we are willing to stay meaningfully invested in the sector. To put this into perspective:
    • Global crude inventories declined 10 out of the last 12 months. In a typical year, inventories build 7 out of 12 months and draw at much lower magnitudes
    • Oil bears primarily focus on 3 things:
      • 1) US production growth. Calendar year 2018 y-o-y growth estimates range from 600k bpd to 1.4mm bpd: latest EIA data through June 2017 show that onshore production grew just 295k bpd over the last 12 months with the rig count up 122%; this production growth is a quarter of what many believe the growth rate to have been and roughly 200k bpd below the less reliable EIA weekly estimates
      • 2) OPEC rational guardianship in CY2018: this is a reasonable concern but it’s important to understand that the majority of cuts are from Saudi Arabia, a country that is burning FX reserves and needs to $70+ Brent to balance the fiscal budget; is preparing to IPO a portion of the state oil company in order to help finance a multi-decade restructuring of national economy; has recently supported the idea of extending cuts beyond March 2018; and is widely believed to already be operating near capacity while the probability of supply disruptions in Libya, Nigeria, Venezuela, and Iraq is higher than last year
      • 3) A downward in global demand: IEA, which has a long history of underestimating demand, continues to revise demand higher; agency has increased 2Q17 estimates by 800k bpd over the last 3 months, and CY2017 demand growth is now projected to be +1.6mmbpd vs. an estimate of +1.3mmbpd back in January
    • With supply growth more constrained than the market realizes, inventory draws are set to accelerate as global oil consumption on average runs higher in the back half of each year. As inventories approach normal levels, expect to see much higher oil prices
    • Once our stocks reflect what we believe to be a more reasonable global marginal cost of production, we are prepared to fully exit the sector

Retail

  • Stock in question had been sucked into the retail sector’s downdraft and was trading at 10x FCF. As stock price fell, did a full refresh of our memo and sharpened our pencils on valuation work
  • Key question was whether the company was susceptible to disruption from Amazon
  • Research led us to conclude that close to half of the business is insulated from this risk and the other half, while not immune, is much less impacted than many other retailers
  • Also, unlike many retailers, this business was not cyclical and not seasonal, meaning that we think the firm should continue to generate steady FCF year in and year out regardless of what the broader economy is doing
  • Satisfied with our management meeting, have begun building a position on this name
  • Also reviewed other retail holdings and reassess whether we have appropriately evaluated this looming threat. Evaluated each position’s risk/reward ratio from its current level, taking into account the changing retail landscape
    • Decided to eliminate Hibbett Sports, Signet Jewelers, and Vista Outdoor, and to reduce holdings in Foot Locker

Conclusion

  • Longest stretch of time that value has underperformed growth for Russell 2500
  • Since the GFC, valuation gap of growth companies over value companies in Russell 2500 has been widening
  • Cannot predict when or if this situation will reverse itself but following the previous 5 cycles when growth outperformed value, value stocks have delivered very robust performance

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