During the first six months of 2015 our Equity accounts generated negative returns of -3.69% compared to a 1.23% return for the S&P 500 and our Balanced accounts returned -1.56% compared to a 0.68% return for the benchmark (which is weighted 50% S&P 500 and 50% Barclays Aggregate Bond Index).
Performance in the first half of 2015 was again negatively impacted by the portfolio’s energy exposure. At quarter end, the cumulative energy weighting was approximately 12% and is overshadowing other positive contributors in the portfolio. In particular, our investment in Chesapeake Energy (CHK) accounted for most of the total performance decline in the first six months of the year. The company is facing significant challenges with depressed oil and NGL prices, as well as, punitive contractual obligations; however, we believe it has sufficient liquidity to withstand a prolonged period of low commodity prices and ultimately monetize the tremendous economic value of its resource base.
Despite the continued weakness and volatility in oil prices, the underlying fundamentals over the past six months do point to higher prices in the future: rig counts remain depressed (currently 638 vs. 1,482 to start the year), capital expenditures have been curtailed (most industry estimates expect at least a 20% decline compared to 2014), and demand remains relatively stable (the EIA estimates global consumption growth of 1-2% over the next two years). We encourage you to read our first quarter letter where we discussed our energy holdings and future expectations in more detail.
Excluding energy investments, results in the first six months were essentially flat. Strong gains in several positions, including Wesco Aircraft (WAIR) and Lab Corp (LH), were largely offset by losses in non-energy related positions like Calpine (CPN) and Rent-a-Center (RCII).
Below is a chart which lists, in order, the top 5 and bottom 5 contributors to performance so far in 2015:
Stretching back to last summer our relative performance compared to the S&P 500 is as much a result of what we own (i.e. energy) as what we don’t own. During this period the single best performing industry group in the S&P 500 was healthcare, driven mostly by gains in managed health care and biotech. Moreover, four of the top ten best performing individual stocks during this period were biotech companies. Another top ten performer was Netflix. While the market is certainly rewarding these stocks in the short-run, we find it troubling that investors are willing to place increasingly higher values on businesses that are marginally profitable or heavily regulated. It seems like nothing else matters except rapid revenue growth or, even worse, pie-in-the-sky projections of future revenue growth.
It is inevitable that an investor will experience periods of underperformance either due to self-inflicted mistakes or an irrational market. In this case, both factors have influenced our recent results and, admittedly, the experience has been frustrating and below our high expectations. Yet, we are optimistic about the current portfolio of companies we own and their future investment potential. This not only includes our energy investments but also the remaining 88% of the portfolio represented by high-quality business trading at attractive prices. This situation is not too dissimilar from 2007 when our performance lagged the market by 1,500 basis points (-9.5% vs. 5.5%). Over the next three years most of our investments rebounded and we outperformed the market by 1,100 basis points (3.0% vs. -8.3%).
In previous letters we have explained in detail some of the forces at play driving the irrational behavior mentioned above. The lack of overall volatility and distress, combined with historically low interest rates, creates the conditions for relatively high asset prices and few bargains. Consequently, activity levels during the first half of the year were negligible. We added one new long position to the portfolio, Apollo Global Management, which is discussed in more detail below.
New Position: Apollo Global Management (APO)
In June we purchased a new, albeit somewhat small, position in Apollo Global Management (APO). We started our research late last year after the stock had fallen from a high of $36 to the low $20s. Apollo is a large investment management firm focused on alternative assets like private equity and distressed credit. Founded in 1990, Apollo is led by a troika of highly-skilled and experienced investment virtuosos – Leon Black, Joshua Harris, and Marc Rowan. Over the past 25 years the Apollo team has implemented a distressed, value-oriented investment philosophy and generated one of the best long-term track records in the private equity business (39% gross IRRs). Today, the company manages approximately $160 billion in total assets on behalf of pension funds, endowments, and individuals.
We are attracted to the combination of a top-tier alternative investment firm, managed by world class investors (who also own 50% of the company), with significant opportunities to increase assets under management (AUM). There is a growing trend among large institutional clients to allocate more money to areas such as private equity and distressed credit and only a handful of firms can compete with Apollo on a global scale. We are modeling AUMs to reach approximately $300 billion by 2020, but that might prove conservative.
The decline in the stock price highlights why we think the company is misunderstood and potentially mispriced. Most investors are fixated on two issues which the company is undeniably struggling with at this time: the ability to deploy large amounts of capital and the likelihood of any realizations from its current portfolio to help generate incentive fees. In our opinion, these two problems are cyclical and, if history is any guide, there will be opportunities in the future to both deploy capital and realize capital. Short-term results might look weak, but long-term oriented investors can take advantage of this myopia.
We estimate the fair value of the company around $35 per share based on normalized earnings of approximately $2 per share. At a current price of $21, we are paying slightly more than 10x earnings for a world-class investment firm with very attractive growth prospects.
As always, please feel free to contact us with any questions or comments.