Oakmark Select Fund 2Q15 Letter: Chesapeake Energy HurtsVW Staff
Oakmark Select Fund’s letter to investors for the second quarter ended June 30, 2015.
The Oakmark Select Fund was essentially flat for the quarter, as was the S&P 500 Index. Three quarters into our fiscal 2015, the Oakmark Select Fund has returned 2%, compared to 6% for the S&P 500 Index. Our best performers in the quarter were Amazon, up 17%, and a number of our financials, including AIG, which increased by more than 10%. Our worst performing names were Calpine and Chesapeake Energy, both of which declined by more than 20%. From a sector-weight standpoint, our large position in financials had a meaningfully positive impact on returns, offset by our underweight in health care.
Oakmark Select Fund - Chesapeake Energy's poor performance
Chesapeake Energy has been a notably poor performer in 2015, down 42% since the start of the calendar year, and deserves further discussion. Every oil and gas producer has been hurt by the decline in commodity prices, but it has been particularly painful for Chesapeake. This is because Chesapeake has an unusually large fixed-cost base, which magnifies the impact falling revenue has on earnings. The outsized costs stem from onerous transportation contracts that require Chesapeake to pay a fixed-dollar amount to suppliers regardless of the volume of energy the company produces. Since a portion of these agreements cover assets that are not economical at today’s prices, Chesapeake’s high-return assets must now shoulder the full burden of these legacy costs as well as their own costs. At current commodity prices Chesapeake is losing money, and investors have become worried about the company’s liquidity.
We believe these issues are manageable, and we remain confident in the company’s ability to improve its earnings and liquidity. We believe Chesapeake’s huge scale will allow the company to sell a relatively small percentage of its future production in exchange for cash making up a relatively large percentage of the company’s current enterprise value. Such divestitures may take various forms (providing immediate cash, third party drilling capital, or simply reducing transportation burdens), but all would help resolve liquidity issues while also highlighting what we believe is the large disconnect between Chesapeake’s intrinsic value and its market price. Considering that Chesapeake’s Board of Directors looks at such decisions with the goal of maximizing value per share, we are comfortable that our investment is in good hands.
Oakmark Select Fund: Portfolio Changes
During the quarter we added two new positions to the Fund, Monsanto and Fiat Chrysler, and eliminated Medtronic because its share price appreciated towards our estimate of intrinsic value. This brings our number of stock holdings to 21; we would expect the Fund generally to own around twenty positions.
We believe Monsanto is a very high quality company with above average growth prospects and an exceptionally strong competitive position in a large and consolidated industry. Low corn prices, challenges in valuing the company’s biotech pipeline, and the difficulty of quantifying upside from precision agriculture have caused Monsanto to sell for materially less than our estimate of its intrinsic business value. Management has been smart about capital allocation, both by repurchasing shares using cheap fixed-cost long-term debt and by attempting to purchase Syngenta at a price that should produce a strong return for shareholders, and in our view both Monsanto’s technological advantages and end markets are likely to grow.
The investment merits of Fiat Chrysler, which we consider a very inexpensive company led by an outstanding CEO, are discussed at length in this quarter’s Oakmark Fund commentary. In addition to buying Fiat common stock, we also purchased convertible bonds. The bonds convert to more shares of stock if the stock declines below a certain level, thus effectively providing some downside protection, yet they were trading at a price we believe represented the value of the stock price plus the bond coupons. Stated another way, by purchasing these bonds we essentially received the downside protection for free. While we never hope such insurance will be necessary, we are always happy to acquire it at no cost.
William C. Nygren, CFA
Anthony P. Coniaris, CFA