FPA Capital Urges Extreme Caution, Talks Arrow Electronics (ARW), Avnet (AVT), Others

While the equity markets are currently trading at their multi-year highs and most market participants expect them to soar even higher, the fund managers at FPA Capital Fund, Inc. (FPPTX) think that this rally is overdone and are advising extreme caution to their clients. In their recently published market commentary for the third quarter, the fund managers noted that the equity market as a whole has become expensive, citing the multiples at which the fund’s benchmark, the Russell 2500 Index, is currently trading at. Rather than simply stating the high P/E ratio of the Russell 2500 Index, the managers tried to prove their point by comparing the enterprise value-to-EBITDA multiple (EV/EBITDA) of the Index over the last few years. At the end of the third quarter, the Russell 2500 Index was trading at an EV/EBITDA multiple of 19.3, which was significantly higher than the 11.9 average multiple at which it has traded for more than a decade. Furthermore, they also highlighted the fact that “Since the market bottomed on March 8, 2009, the Russell 2500 has increased by 277%, the cumulative EBITDA increased by 57%, and the EBITDA multiple increased by 142%.”

The FPA Capital Fund, Inc. (FPPTX) is a mutual fund managed by Los Angeles-based institutional money management firm FPA. At the end of September, FPA managed approximately $29 billion across multiple strategies, while the FPA Capital Fund, Inc. (FPPTX) currently manages total assets worth $788.3 million. Since August 1, 1984, the FPA Capital Fund, Inc. has generated average annual returns of 13.39%, compared to the Russell 2500’s average return of 11.65%. However, in recent years the fund has been underperforming its benchmark by a wide margin. In the last ten years, the fund’s average annual return has been 4.96%, whereas the benchmark has delivered an average return of 7.95%. Below, we’ll take a look at five major holdings of FPA Capital Fund at the end of September and will discuss what the fund’s managers think about these companies.

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Helmerich & Payne, Inc. (NYSE:HP)

– Shares Held By FPA Capital Fund (as of September 30): 395,818

Although FPA Capital Fund reduced its holding in Helmerich & Payne, Inc. (NYSE:HP) by nearly 13% during the third quarter, the fund’s managers remained optimistic about the company’s future, mostly due to the large size of Tier 1 AC rig fleets it operates. Since alternating current (AC) rigs are more efficient than mechanical rigs and siliconcontrolled rectifiers (SCR), the managers believe that “AC rigs should continue to take market share as upstream producers demand higher rig specifications in order to meet increasingly complex horizontal drilling criteria (i.e. longer laterals) and productivity requirements (i.e. pad drilling, automated pipe handling, and increased mobility).” Moreover, they also think that because Helmerich & Payne, Inc. (NYSE:HP) has cash positions of $524 million, it has more flexibility to fund rig upgrades when compared to its peers. Helmerich & Payne’s stock has appreciated by 31.15% so far in 2016, but despite this rally, still sports an attractive forward yield of 4%.

Noble Energy, Inc. (NYSE:NBL)

– Shares Held By FPA Capital Fund (as of September 30): 919,610

Noble Energy, Inc. (NYSE:NBL) was FPA Capital Fund’s fourth-largest equity holding in terms of value at the end of third quarter, with the fund making no changes to its stake in the company during that period. In their commentary, the fund’s manager wrote that their thesis on oil remains the same, “with both demand and supply moving in the right direction.” They had reasoned in their previous commentaries that oil production will decline if oil prices remain low, hence bringing down the supply, and this is exactly what has been happening. After peaking at 9.6 million barrels of crude oil per day in June 2015, the US crude oil supply has fallen by 1.1 million barrels per day since then. Moreover, OPEC has also cut its production heavily in the past few quarters, with the most recent cut announced on September 28, when it agreed to further reduce production by 700,000 barrels per day. Noble Energy, Inc. (NYSE:NBL)’s stock has been trading in a narrow range for more than six months now and most analysts expect it to continue being range-bound going forward unless oil prices recover significantly.

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We’ll check out three more of the fund’s stock picks on the next page and see what it has to say about them.

Rowan Companies PLC (NYSE:RDC)

– Shares Held By FPA Capital Fund (as of September 30): 1.43 Million

Rowan Companies PLC (NYSE:RDC) was a major detractor to The FPA Capital Fund’s performance during the third quarter, with its stock falling by over 14%. However, the fund showed its conviction in the stock during that time by purchasing an extra 222,480 shares of the company. Rowan Companies PLC (NYSE:RDC)’s stock has performed well this month following Donald Trump’s Presidential victory and is now trading down by only 2.6% year-to-date. On November 21, the company announced that it is forming a 50-50 joint venture with with Saudi Aramco to own, operate and manage offshore drilling rigs in Saudi Arabia. Analysts see this as a positive development for the company and expect the stock do well in the long-term.

Arrow Electronics, Inc. (NYSE:ARW)

– Shares Held By FPA Capital Fund (as of September 30): 305,293

Arrow Electronics, Inc. (NYSE:ARW) has been a part of FPA Capital Fund’s equity portfolio for almost 22 years now. Although the fund kept its stake in the company unchanged during the third quarter, it remains extremely optimistic about the company’s future prospects. One of the major reason for the fund’s bullishness on the stock is Arrow Electronics, Inc. (NYSE:ARW)’s business, which FPA thinks is extremely hard to disrupt.

“Arrow continues to execute well and is making changes to improve its business. For example, Arrow’s Enterprise Computing Solutions business has become more software driven, and this could lead to margin expansion. In addition, as the components business begins to take on more design work and offer more service-based solutions, we believe that margins in this business could also expand.”

Arrow’s stock has appreciated by over 25% so far in 2016 and recently made its lifetime high at $68.07.

Avnet, Inc. (NYSE:AVT)

– Shares Held By FPA Capital Fund (as of September 30): 767,480

Avnet, Inc. (NYSE:AVT) is also one of the oldest equity holdings of FPA Capital Fund, having made its debut in the fund’s portfolio during the first quarter of 2000. During the latest quarter, the fund increased its stake in the company by 83,430 shares. Since Arrow Electronics and Avnet, Inc. (NYSE:AVT) operate in the same space – distribution arm for component and computer equipment manufacturers – FPA Capital Fund’s thesis on both companies is the same. In its commentary, the fund mentioned that it sees recent changes at Avnet (replacing the CEO, selling its underperforming technology solutions business for $2.6 billion, and the acquisition of Premier Farnell for around $1 billion), as positive developments. The fund’s managers wrote, “we have confidence these changes have improved the overall business quality and increased Avnet’s optionality via a de-levered balance sheet.” On November 14, Avnet revealed that it has acquired a majority stake in Hackster, Inc. for an undisclosed amount and said that it will acquire the rest of the company by January 2017.

Disclosure: None