Performance – Semi-annual Review
During the first six months of 2013 our Equity accounts advanced approximately 14.5% and our Balanced accounts increased approximately 10.5%. This compares to a total return of 13.8% for the S&P 500 and -2.4% for the Barclays Aggregate Bond index. Despite generating positive overall returns, our performance continues to be hampered by large cash balances. This is evidenced by the fact that our individual equity positions advanced 18.5% during the first two quarters of the year – meaningfully outperforming the S&P 500.
The strong market returns in the first half of the year impacted our results in a manner consistent with expectations: almost all of our positions advanced substantially with 21 out of 22 positions producing gains.
Below is a chart which lists, in order, the top 5 and bottom 5 contributors to performance so far in 2013:
The largest contributor to performance was our position in Best Buy – which advanced 131% during the first six months of the year (representing the single best performing stock in the S&P 500 year-to-date). We discussed at length our opinion of Best Buy in the first quarter Letter and the fact that the company’s underlying fundamentals over the past 12 months have not fluctuated nearly as much as the company’s stock price. With the stock recently trading near $30/share (up from a low of $11/share in December) our viewpoint is that the current market value more closely reflects the company’s true net worth.
The one negative performer during the first two quarters was Level 3, which despite modestly improving fundamentals, continues to trade at a deep discount to our calculation of intrinsic value. The company recently appointed a new CEO, Jeff Storey, who is instilling more operating and capital discipline throughout the organization. Storey has a strong track record in the telecom industry – most recently highlighted by the excellent turnaround he engineered while at Wil-Tel, a former Level 3 competitor. Despite only holding the CEO title for a short while, the roadmap and strategy he has presented gives us confidence he’s the right person to drive significant shareholder value. Over the course of our multi-year involvement with Level 3 (as both debt and equity owners) we have taken advantage of temporary price declines to increase our weighting in the anticipation of a much brighter future. We are optimistic that a new culture of financial discipline, when coupled with an improving top-line, will translate into enhanced results for shareholders.
Interest Rates & Forced Selling
At the risk of sounding like a broken record over the past two years, both in these Letters and in meetings with clients, we consistently communicated that a rise in interest rates was inevitable. The question was not “if”, but rather “when” and “to what extent”. This viewpoint was based on the premise that the Federal Reserve’s artificial suppression of interest rates through Quantitative Easing (QE) would not last forever. The first warning shot was fired in May when Fed Chairman Bernanke hinted that the Fed’s massive monthly bond purchases could wind down by the end of the year. Since that time the 10-year Treasury rate climbed from a low of 1.6% to a high of 2.7% in less than three months.
The companies we own will experience limited, if any, direct impact from rising interest rates. Almost all of our holdings operate with little financial leverage, and those that do have opportunistically refinanced their debt at lower rates and extended maturities over the past year. Less certain is the impact to the overall economy as the Fed pulls back on its historic money printing exercise. Monetary policy over the past three years has simply been unprecedented, which therefore makes its long-term impact very difficult to predict.
One unintended consequence from the recent spike in rates was the emergence of sizeable redemptions from bond mutual funds as investors raced for the exit. Forced to satisfy investors’ redemption requests, bond fund managers sold down positions irrespective of valuation or attractiveness. In fact, this forced selling probably exacerbated the speed with which rates increased.
We have often talked about the concept of “forced selling” and the corresponding benefit to patient, long-term investors. Forced selling can occur for a variety of reasons which have nothing to do with the underlying fundamentals of the asset being sold. For example, in our experience we have opportunistically invested in companies, like Chesapeake Energy, after senior executives were forced to sell large quantities of stock in order to meet a margin call due to personal financial reasons. These types of inefficiencies in the marketplace create mispricings which we try to exploit to our advantage.
For accounts with a fixed income allocation, we used the recent sell-off to add one new bond position as well as increase the overall allocation for clients who were underweight. Given our previous expectation of rising interest rates and the meager returns available, we entered this period with ample amounts of cash plus a relatively short duration portfolio. This shielded us from some of the carnage taking place. While most bond funds are experiencing negative performance this year (the Barclays Bond Index is down 2.4%) our corporate bonds have delivered a positive 2.1% return. If rates continue to rise you should expect us to add incremental capital to new and existing positions.
Genworth Financial (GNW)
During the quarter we added the newest position to the portfolio with our investment in Genworth Financial (GNW). The company, which was owned by General Electric until its IPO in 2004, is one of the largest providers of long-term care and mortgage insurance in the country. These two areas of the insurance market have performed terribly since the onset of the Great Recession and Genworth’s stock price reflects that: after peaking at $36/share in 2007 the stock subsequently sank below $2/share in 2009. We purchased our position in June at $11/share.
The company’s largest business segment, long-term care insurance, provides benefits to policy holders against the escalating costs of long-term care services like assisted living and nursing homes. Despite having invented the product in the 1970’s, Genworth was not immune to the industry-wide problem of poor underwriting standards and insufficient premium pricing – in particular, overestimating the amount of policies that would lapse and underestimating the increase in health care costs. This double-whammy of poor underwriting and faulty pricing resulted in consistently meager returns.
In addition, the company’s second largest business line, mortgage insurance, suffered greatly when the housing market collapsed and mortgage delinquencies increased. As an insurer of mortgages, the company realized considerable losses due to foreclosures and declining home prices. To compound the matter, most private mortgage insurers like Genworth were effectively squeezed out of the market starting in 2008 as the government run Federal Housing Administration (FHA) increased its market share.
After surviving this difficult period we believe the worst is now over and that the company, under a new leadership team appointed this past December, has a credible plan to turnaround the business and improve profitability. At the heart of this strategy is an effort to raise premiums on existing long-term care policies by approximately $200-300 million per year. This will be a multi-year effort and require approval by each state insurance commission, but once completed will improve earnings by at least $70 million per year or $0.14/share.
With respect to the mortgage insurance business, the company is a direct beneficiary of the improving housing sector which results in fewer delinquencies, increased mortgage originations, and rising home prices. All of these factors will dramatically improve the profitability of the U.S. mortgage business which lost $140 million in 2012. By 2016 we calculate the earnings contribution from this division to be more than $200 million which represents an improvement in earnings of $0.74/share.
At our initial purchase price of $11/share in June, the stock was trading at just 46% of tangible book value ($27/share) and 9.7x earnings ($1.08/share). These depressed multiples are a result of investors valuing the company based on its historical earnings power and consistently weak return-on-equity (ROE). As long-term investors there is an opportunity to participate in a company turnaround over the next three years where earnings can climb to over $2/share and ROE can increase to the high single-digits – all of which can occur irrespective of the economic environment or the health of the overall stock market. This would likely yield a stock price in excess of $20/share by 2016 and an IRR in the high 20% range.
Lastly, there exists two other opportunities for Genworth to enhance value beyond what we have already described. First, the new management team has articulated a plan to sell non-core assets (like its Wealth Management Group) in order to generate cash, improve the balance sheet, and ultimately return capital to shareholders. If they are able to use the capital to repurchase stock at today’s depressed value this ultimately could increase the long-term value of the company by approximately 10%. Second, like all insurance companies, Genworth maintains a large investment portfolio of premiums not yet paid out (or float). At a current value of $74 billion, the company’s float would allow it to increase earnings by more than $0.50/share for every 1% increase in interest rates, all else being equal. In a world of rising rates this dynamic could propel the company’s profitability and valuation significantly higher.
Calpine (CPN)
We previously discussed Calpine in our Q1 2010 Letter and again recently at our investor meeting in March. On both occasions we highlighted the company’s excellent competitive position in its three core markets: California, Texas and the North East (NY / NJ /PA). The company warrants further discussion not only because it’s our single largest weighting but it also operates in a fairly complex industry with many moving parts.
As a reminder, Calpine is a wholesale (or unregulated) power provider. Essentially, the company generates and sells power to regulated utilities that in turn sell to the end user. While there are numerous elements to the Calpine thesis the two key pillars are: a favorable regulatory landscape and structurally lower natural gas prices. We will address each below:
The Regulatory Landscape
Current environmental regulations, in an effort to reduce carbon emissions, continue to support the use of natural gas and renewables. A combination of existing and new laws (at both the Federal and State level) have effectively tilted the scale in favor of natural gas-fired generation and renewables at the expense of coal. The slow and steady march, starting with the Bush administration and continuing with the current administration, resulted in a regulatory framework that mandates lower emission of harmful gasses from power plants.
The cost to comply with the new rules is very high for “dirtier” power plants that lack the necessary equipment to reduce these toxins. As costs rise, power generators seek to recover their capital investment and must raise prices. This dynamic creates an advantage for cleaner burning gas plants which already comply with the rules. Plants that are unable to meet the clean air standards and require too much capital reinvestment are being retired. The result is market share gains for gas powered generating firms like Calpine. In particular, we are seeing this coal retirement phenomenon occur with great frequency in the North East.
Much like the Federal mandates, many States (like California) recently enacted a host of rules which leaves Calpine well positioned to capture generating capacity in the coming years. Specifically, the legislative body in Sacramento mandated an aggressive roadmap for renewable power use in California over the next 5 years. In order to meet these goals the state is increasing its reliance on wind and solar. There is one small problem – the wind does not always blow and the sun does not always shine. In those circumstances the integrity of the power grid must be maintained and that’s where Calpine has a role to play. The company receives capacity payments or “rent” to offer standby capacity for those occasions when the weather forecaster is wrong (insert your own joke here). Calpine’s utility customers face large fines if they do not deliver the amount of power promised. Keeping Calpine on standby to provide power acts as a form of insurance. This is a very lucrative and growing portion of Calpine’s business in California.
Low Natural Gas Prices
The shale gas revolution over the past five years blessed the U.S. with natural gas for many decades to come. As a result of this ample supply, the low price of natural gas positions gas-fired power plants like Calpine very favorably compared to coal-fired plants. In addition, the recent stability in natural gas prices compared to previous periods of wild fluctuations makes gas a much more reliable base load fuel.
Finally, the management team, led by Jack Fusco, continues to impress us with a masterful job building shareholder value by allocating capital between building new plants and repurchasing stock in the open market at a discount to fair value. We continue to see a bright future for Calpine and expect the company to benefit from the above mentioned trends for the foreseeable future.