To Our Fellow Shareholders of the GoodHaven Fund (the “Fund”):
Measured by either a calendar year or fiscal year basis, 2016 was a good year for the Fund. For the calendar year ended December 31, 2016, the Fund gained 20.13% compared to a gain of 11.96% for the S&P 500 Index. For the fiscal year ended November 30, 2016 (and after a rough first month of December), the Fund gained 13.89% compared to 8.06% for the S&P 500 Index.1
As discussed in prior letters, outlier declines in oil, gas, and metals in 2015 overshadowed some positives and led to unusual portfolio weakness throughout 2015 and early 2016, which affected our historical and relative results. This weakness appeared to end in February of 2016 and has been followed by a sharp recovery in some key investments. Most of the factors that resulted in the weak results of 2015 appear to have been attenuated or reversed.2 Throughout this unusual volatility, we did our best to behave consistently, did not overreact, and bought under pressure when our research told us that values were intact.
We continue to own a portfolio that we believe is materially less expensive than the S&P 500 as measured by some common historical valuation markers and remain disciplined when looking at potential new investments. The Fund also continues to hold cash, reflective of generally high valuations, which allows us to behave opportunistically. We try to invest to the extent that we find sensible things to do and remind our fellow shareholders that our personal stakes in the Fund are material. We are not willing to do something for you that we are unwilling to do for ourselves.
Perhaps more importantly, we are increasingly confident that some of our headwinds are turning into tailwinds as we enter 2017. The overall environment seems to be friendlier to our approach despite stretched index valuations. While we do not pretend to have a crystal ball that predicts future economic conditions or commodity prices, most market trends regress toward the mean over time. In other words, very expensive securities tend to become less expensive given time, while bargain securities tend to become less of a bargain, barring some permanent change in demand.3
In addition, many industries tend to have cycles. However, it usually pays to hang on to a good business through cyclical moves unless that business becomes materially overvalued. Here’s why: a good business run by smart people has the opportunity to significantly outperform its direct competition over an extended time period. In other words, you don’t want to overweight cyclical influences, especially when good capital allocators are running an enterprise.
In that vein, we note that several of our investee companies improved costs and operations in significant ways or re-allocated capital in a shareholder friendly manner. For example, Alphabet (formerly Google) adopted new financial discipline in pursuing its non-advertising “moonshot” venture investments (which currently cost shareholders about $3 billion annually, or a penalty of nearly $5 per share pre-tax). Barrick Gold has reduced its “all-in-sustaining-costs” per ounce of gold from over $1,000 four years ago to just above $750 today while also reducing debt by over $4 billion in the last two years. WPX Energy reduced the cost to drill a well in the Bakken formation from $11 million a few years ago to about $5.5 million today and made a major acquisition in the Permian basin in 2015 that now appears to have been a huge bargain. White Mountains Insurance sold some subsidiaries and used a portion of the proceeds to repurchase shares at or near tangible book value. And Birchcliff Energy, already a low-cost operator, recently upgraded its asset base through a major acquisition of overlapping properties, which should improve efficiencies and reduce risk going forward.
These types of changes, when sensibly implemented, make these companies more valuable, irrespective of cyclical influences. Improving cost structures, reducing leverage, and making sensible capital allocation decisions all add to value. While volatility may result from changing economic conditions or commodity prices, we think the medium-term demand for products and services offered by these businesses will remain robust and that intrinsic values will grow. Generally speaking, these businesses have tremendous optionality.
In past letters we have cautioned that while we could not predict when, the likelihood of interest rates rising from at or below zero was a virtual certainty. Although a recent increase in the federal funds rate was indeed small, subsequent bond market losses exceeded a trillion dollars.4 While we cannot predict the timing, further increases seem likely over time, particularly if inflation starts to heat up. In addition to the recovery in energy and metals this year, higher interest rates should help some of our other investments going forward, like Leucadia National, Federated Investors, White Mountains Insurance, and Berkshire Hathaway.5
Over time, we prefer to invest in companies that not only appear to offer business value well in excess of recent market values, but which also have strong balance sheets and shareholder friendly management. We are continually looking to upgrade what we own – but only if we can buy at an advantageous price. We have identified a number of companies meeting these criteria that await prices offering potential returns higher than what exists today.
GoodHaven Fund – Portfolio Review
Currently our largest holdings are WPX Energy, Barrick Gold, Alphabet, Birchcliff Energy, White Mountains, and Leucadia. Somewhat smaller positions include Hewlett Packard Enterprise, Spectrum Brands, Federated Investors, Staples, and Verizon. While we feel good about all of these companies we must continue to ensure that we are sizing the investments commensurate with their risks.
WPX had a good year, and began to reap the benefits of its extensive reorganization, its purchase of very valuable RKI in the Permian Basin, and a material recovery in the prices of oil and natural gas. While the investment community seems split as to whether prices will rise further or decline, our expectation is for limited downside and reasonable upside due to: a deep and pervasive decline in capital spending across the oil and gas industry over the last two years; the lowest rate of new oil discoveries in seventy years (according to consultant Wood McKenzie); producer nations whose economies are deeply stressed at lower price levels; a recent OPEC agreement to limit production; and domestic inventories that, while still high, appear to have peaked.
WPX weathered the staggeringly large decline in oil prices (from over $100 per barrel in mid-2014 to less than $30 per barrel in early-2016) with some dings, but emerging as a much better business. In early 2014, natural gas dominated the business and it had holdings in the eastern and western United States and Argentina, which included a bloated overhead structure, large and fixed natural gas
transportation agreements, and other onerous expenses. After consummating a number of tough dispositions at reasonable prices during a difficult period, the company acquired a sizeable position in the Permian basin in mid-2015 – a deal our research suggests has added billions of dollars of value to the company.6
As a result, WPX has streamlined its holdings into three main areas – the Permian, the Bakken, and the San Juan – focused primarily on oil rather than gas. All of these properties are among the most productive and lowest cost within these basins. Under the leadership of Rick Muncrief, the company has cleverly reallocated capital and sharply reduced its overhead and drilling costs. With oil prices now above $50 per barrel and a decent hedge book for 2017 and part of 2018, the company is well positioned to take advantage of the opportunities it has created in recent years. According to a recent corporate presentation, WPX is projecting that its oil output will almost double in the next two years.
The Fund’s second largest investment, Barrick Gold, was similar in a number of ways to our previously successful investment in pre-split Hewlett-Packard (HP) where a low-cost producer and asset rich company generating significant cash flows became over-leveraged after overpaying for a large acquisition and borrowing to finance the deal. HP overpaid for a software company and Barrick for a copper miner. In both cases, the fall-out from bad deal-making resulted in major governance changes, with new management teams and significant board turnover.
In the case of Barrick, we became aggressive buyers due to several factors: new management and governance was focused on rapidly improving the balance sheet and per share free cash flow as primary objectives; the company’s low cost operations appear to have opportunities to drive costs even lower; there were noncore assets that could be used to reduce and restructure borrowings; per share cash flows could easily justify a much higher price; gold prices were far off the highs of just a few years earlier; and central bank reserves had exploded since 2008, suggesting that depreciation of fiat currencies was more likely down the road.
Since John Thornton took over as Chairman of the Board, the company has eliminated roughly $4.5 billion in debt, built significant liquidity, eliminated nearterm debt repayments, and reduced “all-in-sustaining costs.” Just as impactful, it has also announced several important capital allocation decisions designed to rationalize its holdings and improve growth prospects – all of which were accomplished without touching the core mines owned by the company that are among the lowest cost operations in the world.7
As a commodity company that produces gold, silver, and copper, Barrick’s short-term results are clearly dependent on metals prices. On that subject, we are somewhat agnostic, believing that gold represents an alternate currency that is relatively rare and hard to depreciate through increased supply. Its main paper alternatives – dollars, yen, euro, renminbi – have seen supply multiply sharply since 2008. In 2011, the price of gold peaked at just over $1,900 per ounce, followed by a decline to below $1,100 per ounce in early 2016. During 2016, the price rose during the year to about $1,400 per ounce and then declined to a bit below $1,150 per ounce in recent days.8 We sold some shares near August highs to manage concentration risk that we recently began to repurchase.
In the last few weeks, headlines as well as Barrick’s stock price appear to be reflecting fears that an incipient chain of interest rate increases will crush gold prices. These fears appear overdone and are only espoused by those whose study of markets does not go back to the 1970s, when interest rates and metals prices both rose sharply in response to rising inflation. Although deflationary forces have abounded in recent years, we suspect, though we are not betting the farm, that the greater possibility today is that governments around the world continue to try to devalue their currencies in response to debt levels that are simply too high. If gold behaves as it has historically – as a hedge against currency depreciation – a significant price increase could occur. Alternatively, more monetary ease may
reappear at the first sign of real economic weakness. Either way, with a talented management team, a better balance sheet, and a much lower cost structure, Barrick appears poised to prosper over time.
While hardly unknown, Alphabet continues to grow at a rapid rate for such a large company. Alphabet’s scale is staggering, with at least five applications used regularly by more than a billion people and the largest digital ad platform in the world. It also owns YouTube, which as a standalone business would be larger than most television networks, and Android, the most widely used operating system on smartphones and increasingly on other devices.
On an annual basis, the company is expected to generate close to $40 per share in earnings, despite still losing about $4 per share after-tax in its corporate venture capital investments. The stock is no longer cheap, but neither is it overpriced given its valuation, prospects for growth, and generation of free cash flow. Recently, for the first time, the company approved a significant share repurchase. With nearly $120 per share in cash and almost no debt, the company is in a unique position to be able to spend heavily to improve its business and benefit its shareholders at the same time. Its biggest threat would appear to be regulation rather than direct competition.
Among other holdings, Leucadia National appears to have seen its fortunes turn up after a tough period of softness at its largest subsidiaries. Both Jefferies and National Beef have seen large and positive swings in earnings in recent quarters and the company just announced the sale of a long-held subsidiary at a very attractive price (we added to our investment well below tangible book value during 2016). Federated Investors is currently somewhat out of favor as investors reacted negatively to recently implemented changes in regulatory rules governing its core moneymarket fund business, though we do not believe such changes are a major threat. Nevertheless, in a rising rate environment, we would expect assets to migrate back into money funds, increasing earnings power.
Staples was forced to call off its merger with rival Office Depot due to anti-trust issues, but still retains a significant scale advantage in its core business. The company has struggled in recent years in response to changes in technology and retail trends, but appears to be approaching an inflection point where growth may begin to resume – something we are watching carefully. Hewlett Packard Enterprise successfully completed one divestiture and announced two others – all have helped to move shares higher in 2016. During the year, we bought shares of Verizon when its stock price weakened in response to a forecast of flat growth for a year or two. Over time, we expect the wireless business will remain incredibly stable, wireless spectrum will be a valuable asset, and the company will have significant embedded pricing power.
While the personal computer business at HP Inc. has improved, the company continues to struggle with the effects of a higher dollar and soft printer supplies revenue, though the overall business still generates large cash flows while trading at a low valuation. Spectrum Brands continues to offer price conscious consumers and retailers a value proposition that seems to resonate in today’s business climate. We admire the management and board of Spectrum in their ability to continue to identify and successfully integrate several acquisitions in recent years (as a reminder, we first bought Spectrum nearly five years ago at roughly one-fifth its current price).
Nevertheless, as in most sports, even good investment managers cannot avoid unforced errors. While renewing efforts to minimize process mistakes, we do own a few securities where the underlying businesses or management teams were unable to prove out our thesis in the last year. Some decisions on these must be made soon. Among these investments are Walter Investment Management, Dundee Corp., and Sears Holdings, which total less than 5% of the overall portfolio as we write.9 There is sometimes a small upside to mistakes – during the year and despite a significant overall economic gain, we were able to realize sufficient tax loss to avoid taxable distributions in 2016. While tax does not drive our investment decisions, we are aware that it does impact many of our shareholders. We try to manage these liabilities to benefit shareholders when such actions are not disruptive to the portfolio.
In today’s world, it’s worth reflecting a few thoughts on money flows in mutual funds (both specific to the GoodHaven Fund and to the industry generally). Most investors are emotional and a good number of the decisions they make turn out to be counterproductive. For example, in our first two to three years, our performance was solid and money poured into the Fund. In hindsight, it seems that many of these new shareholders represented “hot money” chasing recent performance. These investors did not think much (if at all) about business values or how we try to select businesses that have the potential to offer a competitive return on our capital going forward.
Following that period, we went through a roughly eighteen month performance lag, after which a cascade of money exited the Fund (the former hot money shareholders, mostly) with the crescendo of outflows occurring in late 2015 and early 2016 – just in time to miss a double digit performance rebound that handily exceeded the performance of many broad equity and debt indexes notwithstanding a healthy cash position that moderated risk.
Through these periods, we believe we have behaved consistently and overall turnover in the portfolio has been fairly low (our shareholders were trading us more than we were trading the portfolio). In effect, we went through a tough period where we were out of sync with markets – something that happens to all value investors from time to time – yet many decided that the short-term result was somehow a fatal flaw.
So why the large influx and outflow of shareholder money – which of course makes it more difficult to manage a portfolio? The answer is relatively simple – it’s human nature. Most people are not wired to behave in a way that really benefits from the volatility of markets. As Ben Graham once said, markets exist to serve you, not to educate you. It seems to us that a longer-term view and a tolerance for some volatility is becoming an increasingly valuable competitive advantage in the world of investing. Accordingly, we want to thank our like-minded shareholders for sticking with us and benefitting from our rebound this past year. Onwards!
Lastly on this subject of seemingly ill-timed cash flows, we want to draw your attention to the cascade of money that has poured out of actively managed funds and into passive vehicles, such as index funds. While the trend from active to passive has been in place for a while, the recent acceleration has been astonishing, with nearly half a trillion dollars moving in the last two years. In September 2016, the Illinois State Pension Board fired all active managers and switched roughly two-thirds of its total assets to passive equity index funds. In October 2016, the Wall Street Journal ran an article entitled “The Dying Business of Picking Stocks,” essentially arguing that passive investing had become institutionalized, a preferred strategy of institutional investors, and that active investing was going the way of the dodo.10
Our views on indexation are probably not controversial, but they are pointed. Indexation may make sense for a good number of investors when markets are moderately valued or cheap and when people have no time or inclination to seek out sensible managers or research for undervalued securities. We believe however, when broad indexes sell at or near record high valuation levels, you do not want your portfolio to closely resemble the index (ours does not!)
As writer Samuel Clemens (also known as Mark Twain) once was reputed to have said, “History does not repeat, but it does rhyme.” The decade following the end of the technology bubble that ended in March 2000 was a fruitful and productive period for value investors who had refused to buy overpriced merchandise from late 1998 through early 2000. Yet these same investors had to have been willing to suffer relative weakness during the last eighteen months of the bubble even as the speculative trading profits from money-losing businesses seemed endless.
In the near-term, we suspect that money-flows from active to passive have been driving recent index returns and that such flows may be topping out. Historically, owning indexes at current valuation levels is correlated to poor forward ten-year returns. We suspect today is little different. As one of our shareholders recently wrote to us, why in the world would anyone want to own a piece of every business in the S&P 500 when most of these businesses seem fully valued or worse? Put simply, we don’t. A good investor should be willing to trade the comfort of the index crowd for the prospect of better returns, so long as they can tolerate the volatility of sometimes standing alone.
Today, there are still plenty of reasons for caution. Worldwide debt levels are materially higher than when the 2008 financial crisis began. Recovery has been tepid. Bond yields may have bottomed but remain at very low levels even as stock indexes hit all-time highs. As one commentator joked, the definition of a looming economic black hole is when the stock market is near record highs, bond yields are near record lows, and nobody is happy.
But amid all the noise and while not easy, investing boils down to trying to do a few simple things well. First, we want to own securities priced to offer reasonable prospects for returns relative to their market prices, not when they are priced to perfection. Second, we need to constantly test our assumptions and adjust holdings when new developments are hostile to our thesis or valuation, based on in-depth fundamental research. Third, we want to have the courage of our convictions and not be easily swayed by external events, market volatility, political developments, or investment fads. Lastly, we believe it is important that we invest personally in the fund and have significant “skin in the game.”
Thank you for your patience – we are confident this past year represents a return to better days.