Thornburg Value On The "Coin Flippers" Of Graham & DoddsvilleVW Staff
Thornburg Value Fund Q4 2014 letter to investors
Two quarters ago, we wrote about how boring a time it was in U.S. equity markets. Last quarter, things grew a little more interesting. In the most recent quarter, markets turned much more exciting – and volatile.
Crude prices continued their decline from $98 earlier in the year to $54 late in the quarter. Foreign exchange markets suffered tremendous volatility, with the dollar strengthening against almost every major global currency. Russia suffered dire geopolitical consequences for its intervention in Ukraine, and was quickly hit with a plummeting ruble – a reflection of that economy’s overdependence upon oil-export revenues and thus crude prices. Combine all this with mixed messages from the Fed about the rate at which it will remove monetary stimulus. The recent October market bottom, for example, seems to have coincided with unexpected comments from St. Louis Fed President James Bullard on delaying the end of quantitative easing.
No wonder the quarter was volatile.
Thornburg Value Fund: Performance for the quarter
The Thornburg Value Fund rose 4.28% (for the A shares without sales charge), modestly trailing the benchmark S&P 500 Index’s return of 4.93%. For the year, the fund rose 11.50% (A shares without sales charge), versus the index’s 13.69% climb.
We remain excited about our overall progress since mid-2012, when we began to bolster the consistent earning characteristics of the portfolio. Since the end of June 2012 we’ve annualized at 23.92% versus the S&P 500 at 20.49% with improved risk and downside capture characteristics.
That said, the lag in performance for the quarter and the year brings us to a debate that rages periodically within the investment world: the merits of active versus passive management styles. Active managers, such as Thornburg, favor individual stock picking and tend to care little about emulating performance benchmarks. Passive “management” is essentially investing in the benchmark itself (or some proxy thereof). After we touch on the active/passive debate, we’ll look at performance drivers for the fund.
Thornburg Value Fund: Time for a turn? Active management takes a beating
On the first Monday back following the New Year’s holiday, the Wall Street Journal seemed to say to active portfolio managers, “I hope you had a nice holiday because your industry is dying!” After noting Vanguard Group’s massive inflows during 2014, the article observed: “Through Dec. 29, about 74% of active stock funds in the U.S. were underperforming their category benchmarks, according to Morningstar.”
The last several years have been quite tough for active managers, not just 2014. No wonder passive styles have been garnering huge flows of investor dollars and the financial press are reading the last rites over individual stock pickers.
This debate is not new. Thirty years ago, Warren Buffett gave a speech at Columbia University focused on what he called “The Superinvestors of Graham-and-Doddsville.” He was responding to the preponderance of academics who, at the time, were certain that their efficient market hypothesis (EMH) was correct and that all information that is knowable about publicly traded securities is always reflected in their prices. The EMH leaves little room for active managers to outperform over time in aggregate and suggests that those who have are simply lucky coin flippers. Buffett steered attention towards “an extraordinary concentration of success” in this purported coin-tossing contest made up of a group of pre-identified investors that came from a common “intellectual village,” in this case, disciples of Ben Graham. There seem to be too many successful investors in this village for it all to be just chance, Buffett argued.
A quick caveat: keep in mind that we are active managers whose livelihood depends on our ability to outperform over time. We would ask you to focus on two further intellectual villages. First, high active-share managers. Those managers who run diversified portfolios with high active share, or difference from their index, have, on average, outperformed over time, according to “Active Share and Mutual Fund Performance,” by Antti Pettajisto.1 There aren’t many of us left that don’t “closet benchmark,” but those of us that remain have shown a much higher rate of outperformance, net of fees, relative to our benchmarks.
Finally, take a look at one even smaller “intellectual village,” this one even corresponding with a particular geography: Santa Fe, New Mexico, of all places. All seven of the equity funds launched by Thornburg Investment Management, beginning with the Thornburg Value Fund in early October 1995, have performed competitively compared to their respective benchmarks, net of fees, since inception.
Either we are a group of incredibly talented coin flippers, or there is something to our philosophy and approach, our culture, and our location, that has allowed each strategy to prevail over the long term in a contest that some believe is impossible.
We haven’t outperformed every year in every strategy. And high-active-share managers can provide return streams that are lumpy at times relative to their benchmarks. But our philosophy and approach to active management has worked in the long run.
Further, we have attempted to position the portfolio today so that it performs better in a difficult equity environment. It will be interesting to follow whether active managers broadly can provide more protection when we get the inevitable downturn in U.S. equities.
With regard to fund flows, the move from active to passive may continue for some time. This could further impact relative performance of securities in the markets in which we invest. But, the worm has turned in the past, and active managers have often started to outperform just as the multitudes of articles declaring their death reached their peak.
Following this period of significant flows into passive strategies, we like our odds. Back to Buffett: “In any sort of a contest – financial, mental or physical – it’s an enormous advantage to have opponents who have been taught it’s useless to even try.”2
Thornburg Value Fund: The best house in a bad neighborhood
U.S. large-cap active managers have more exposure, on average, to mid- and small-cap companies than does the S&P 500 Index. Large-cap performance walloped small-cap performance in 2014. But interestingly, if we think critically about the current economic environment, the United States looks very good right now, relative to everywhere else in the world. Europe is a mess. Russia is a mess. Emerging markets are weak. China may suffer a severe downturn. Relatively speaking, the United States seems in great shape.
Which U.S. companies have the most business exposure to the United States? Small and mid-cap firms. Which U.S. companies have the most exposure to markets outside the United States? The large-cap multinationals. So, what’s going on? We think the rush of flows into passive index funds in the United States has pushed up valuations of many large-caps.
In the Value Fund, we are finding compelling value in mid- and small-cap stocks in the United States. We’re being mindful about how much exposure we carry to them, but over the course of the year, we’ve grown our exposure to small and mid-caps somewhat. In an environment in which the U.S. economic backdrop looks much better than anywhere else in the world, we’ve increased our exposure to firms that do more business here. Granted, this exposure dragged on our relative performance in 2014.
Thornburg Value Fund: Delving into performance
For the quarter, the fund trailed a bit in a strong U.S. stock market. Positioning weighed on fund performance with our high average cash balance (8.1%) not doing much for us. Other than our cash position, sector positioning contributed slightly positively, with our overweights in consumer discretionary and health care both helping, and our underweights in consumer staples and utilities both hurting.
Stock selection was about neutral for the quarter overall, though we saw material variances versus the benchmark in two sectors in particular, telecommunication services and energy. Within telecom, new holding Zayo Group Holdings was a big winner. Zayo, a Colorado-based global provider of internet bandwidth services, had its initial public offering (IPO) in October. We felt at the time that Zayo’s higher exposure to dark fiber (a more predictable business) and lower valuation than Level Three Communications made it a good swap candidate. Strong performance of this holding helped lift the performance of our telecom exposure 22% versus a negative 4% total return for the S&P’s exposure. Zayo is too new to be included yet in the S&P 500; the 61% total return that we captured in Zayo shares during the quarter wasn’t available to passive S&P 500 investors. The index was stuck mostly with AT&T and Verizon, which both traded lower.
Within the energy sector, we used our flexibility to do some harm, unfortunately. While our average energy exposure (7.9%) was lower than the index (8.9%), because we have a mix of riskier investments within the space, our performance was much worse. Our energy holdings were down just over 20% versus the index’s energy exposure (with a big weight in Exxon) down only half as much. After the crash in oil prices, we’ve been investigating the carcasses, but so far have added only to current holding Weatherford. Weatherford is a compelling self-help storyâ€”management has divested noncore assets and is focusing on operating their key businesses better. We like their oligopoly position in tubular services. While business might slow, given much lower oil prices, this is a good business with a strong competitive position.
Leading individual contributors included Phibro Animal Health, Zayo Group, Express Scripts, Target and Alibaba. Phibro was what we would call a “cold IPO.” It is a family-run, N.J.-headquartered animal-health business. When Phibro shares came to market in early 2014, investors were not interested. Phibro’s largest competitor, Zoetis, started the year on a down note, disappointing the street with slower-than-expected revenue and earnings growth. In a busy IPO market at the time, Phibro, a small cap, was overlooked. We participated in the deal (at a lower-than-anticipated price, mind you) and bought additional shares close to deal price once it began trading. Since then, Phibro management has done a good job of executing and growing their business, and the space has garnered more interest from investors (not in the least due to Pershing Square’s activist stake in Zoetis) and both stocks have appreciated materially. Though Phibro shares are higher, we see further upside, especially if a strategic buyer shows interest.
Express Scripts asserted its role as a force for cost containment in the U.S. healthcare distribution chain at the end of the quarter. Unfortunately, it did so at the expense of another holding in the fund, Gilead Sciences. Express announced that it would exclusively cover a new drug from Abbvie for the treatment of hepatitis C for a portion of its covered lives. This caused some weakness into year-end in Gilead shares, though we continue to believe Gilead will get more than its fair share of this large market. We’d prefer that the kids play nicer with each other in the sandbox, but that said, if there is a risk to pharma/biotech pricing over the long term (which would be bad for Gilead), some of the savings should accrue to the Pharmacy Benefit Managers (good for Express).
Target’s turnaround seems to be progressing. During the quarter we visited a Canadian Target store in Calgary and collected many on the ground accounts that support the idea that this holiday season in Canada was likely to be much better than last year’s disaster. For example, in Calgary it starts snowing as early as September each year. For the 2013 holiday season, Target’s Canadian inventory management system was only able to deliver snow shovels to the stores in late November. This past holiday season, the store manager in Calgary had more of what he needed when he needed it.
We’ve written much in the past about Alibaba Group. Alibaba stock strength continued into the fourth quarter after the company’s successful third-quarter IPO. We continue to like the opportunity for the company, though we sold our direct ownership at price target during the quarter and remain exposed through our Yahoo holding. While promise remains, the discount was much greater when Alibaba was misunderstood and hidden as a private company owned mainly by Yahoo and Softbank.
Top detractors were Weatherford International, Inpex, MasTec, Gilead Sciences, and Netflix. Weatherford and Inpex have direct exposure to the price of oil. If oil prices stay at or below current levels forever, these will likely be poor investments for us. We find that scenario unlikely. MasTec, while less directly exposed to the crude oil price, performs installation services for energy infrastructure projects in the United States, which may be weaker than anticipated. MasTec also does cellular-tower installation work for AT&T, who has recently lowered their capital expenditure expectations in the United States. We think some of this may be bluster, given FCC threats to regulate broadband more aggressively. We like MasTec’s competitive position in a relatively fragmented market. They are market share gainers, both organically and through acquisition. Generally speaking, a healthy U.S. economy should be good for MasTec business levels.
Netflix performed well following our initial investment in May of 2014, though following a disappointing third quarter earnings report, retraced its gains and sits today at about the price where we initially invested. We think the recent results are a bump in the road and believe Netflix is strongly positioned in a world where internet TV is likely to grow at the expense of a fraying cable/satellite bundle.
Thank you for investing alongside us in the Thornburg Value Fund.