FPA Capital Fund is a Los Angeles-based deep value mid-cap investment fund. Its investment philosophy is to exploit market inefficiencies among stocks of small- to mid-cap companies. Their selection process is designed to minimize risk by selecting companies with market leadership, long-term histories of profitability, financially strong balance sheets and high quality management. The fund holds its investments for a long time (5 years) and has a low turnover ratio. In its fourth-quarter commentary, FPA Capital Fund talked about its performance last year. FPA Capital Fund returned 22.86% in 2016, outperforming the benchmark Russell 2500 index which gained 17.59%. The fund thinks that the stock market valuation is quite high as the Russell 2500 started 2016 trading at nearly 27.7x earnings and ended the year trading at nearly 31x earnings. The fund returned 9.42% during the fourth quarter, despite a cash level equal to almost 30% of the portfolio. Roughly 85% of the FPA’s positions appreciated during the quarter, and all industries made positive contributions to the performance.
Regarding the economic outlook in 2017, the fund does not belong to the doom-and-gloom camp and it is also not in the camp that expects a huge acceleration in economic growth for the year. It thinks that a stronger dollar could be a headwind for companies with large foreign earnings, and rising interest rates would increase borrowing costs and interest expenses. FPA Capital also believes that higher interest rates and potentially large swings in currencies could lead to increased volatility. In the article below, we will discuss some of the fund’s top performing positions presented in the letter.
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Aaron’s, Inc. (NYSE:AAN) was the biggest contributor to the FPA Capital’s performance accounting for 1.17% to the fund’s quarterly return, as the stock price appreciated by nearly 26% in the last quarter of the year. Aaron’s, Inc. (NYSE:AAN) is a specialty retailer of furniture, consumer electronics, and household accessories. It has approximately 2,040 store in approximately 30 states. Despite brick and mortar retailers facing a tepid quarter, the company’s Progressive Finance unit continued to post excellent growth in profits as it expanded its services to more retailers in the US.
Veeco Instruments Inc. (NASDAQ:VECO) was another top contributor as it accounted for 1.16% of the total return in the fourth quarter. Veeco Instruments Inc. (NASDAQ:VECO)’s stock advanced by over 48% during the fourth quarter due to an acceleration of orders for its key MOCVD tools. These tools are the main manufacturing equipment used to produce LEDs, whether they are for display screens or, increasingly, for lighting products. FPA Capital estimates that Veeco Instruments Inc. (NASDAQ:VECO) currently a roughly 80% global market share for MOCVD tools used to make LEDs.
Houghton Mifflin Harcourt Co. (NASDAQ:HMHC) was FPA’s biggest retractor, as it led to a 0.47% loss during the fourth quarter. Houghton Mifflin Harcourt Co. (NASDAQ:HMHC) has not performed well because the company missed quarterly earnings expectations and its Board of Directors recently has decided to terminate the CEO. The fund’s managers like the company’s core business of publishing K-12 textbooks in the U.S., but the former CEO, chose to expand the business into the Educational Technology industry by purchasing a division from Scholastic Corp. (NASDAQ:SCHL). This acquisition took management’s eye off the core business and the former CEO paid a substantial premium to acquire the business. The fund thinks that the board now understands it needs to find an operator who can manage the core business and generate high levels of free cash flow, given the concentrated competitive landscape and barriers to entry. FPA Capital Fund has materially increased its position in Houghton Mifflin Harcourt Co. (NASDAQ:HMHC) since their initial purchase as the stock declined closer to its downside-case scenario level.
SM Energy Co. (NYSE:SM) was another retractor causing a decline of 14 basis points during the December quarter. SM Energy Co. (NYSE:SM)’s stock fell because the company issued a large secondary offering of stock to help pay for a couple of large properties it acquired in the Permian Basin. FPA Capital agrees with the management’s view that the Permian Basin offers very attractive oil and gas properties. However, these properties will take a couple of years to develop and start generating cash flow for shareholders. FPA Capital Fund had already reduced its position in the stock by over 60% before September in anticipation of a large equity offering. The fund had earned substantial gains from the stock in the earlier quarters as SM Energy Co. (NYSE:SM)’s shares surged by 75% during 2016, even including an 11% drop in the fourth quarter.
In Apollo Education Group Inc. (NASDAQ:APOL), FPA Capital reduced its position buy 80% during the last quarter of 2016. The reason for cutting down the holding was that Apollo Education Group Inc. (NASDAQ:APOL)’s stock appreciated by nearly 25% and was close to the buyout price the board and shareholders had agreed to earlier in the year. The Department of Education has approved the acquisition of Apollo Education Group Inc. (NASDAQ:APOL) by a private equity group with several conditions.