Quarterly Reports

I've been thinking about this lately as I've watched the Federal Reserve try to rekindle our economic fire amid the COVID-19 pandemic. In campfire cookery terms, the virus has been like a once in a hundred year downpour that soaked the woodpile -- wet wood doesn’t burn well. Fortunately, the Fed has trillions of dollars of industrial strength lighter fluid. When combined with the dry kindling that is the U.S. Congress’s fiscal stimulus, the economy could soon be cooking again. With our portfolio trading at less than 14x depressed 2020 estimated earnings, we feel very well positioned for recovery.

I’ve been investing for almost 40 years now, so I’ve lived through many booms and busts, however, I’ve never seen anything quite like the COVID Crash. It took just 20 days for the S&P 500 to fall the 20% required to put us in a bear market. For the first time since 1997, stock market circuit breakers, designed to slow selloffs, were triggered three times in six days. We’ve experienced unprecedented day-to-day volatility: in March, the S&P 500 moved up or down by at least 4% in eight consecutive sessions, eclipsing the old record of six days in 1929. The pace of change is unprecedented.

At roughly 11x estimated earnings, the companies we own continue to be priced at attractive absolute levels and at historically wide discounts to the market despite offering market-like earnings growth prospects. Whether we compare ourselves to broad market indices (S&P at 18x, Russell Value at 15x) or to other value managers (Peer average 15x), we offer differentiated portfolios of what we believe are incredibly compelling investment opportunities.

As Mike Tyson famously observed: “Everybody has a plan until they get punched in the mouth.” For the last few years, Value investing has felt like being in the ring with the former champ. Successful long-term investors know they will have to take a few punches along the way because there is simply no way to get every stock pick right. The issue is not about getting punched: it’s about how one responds to the blow.

The key to investment success this year has been simple: buy the most expensive stocks and avoid the cheapest ones. That’s not what we do at Poplar Forest and our investment results reflect our continued commitment to a value-based investment process. While we’re concentrating on stock prices relative to long-term normalized earnings and free cash flow at the company level, investors currently seem to be focusing on short-term macroeconomic factors. The pre-occupation with recession and risk is understandable, but I believe it has been taken to an unreasonable extreme.

In the midst of the panic last December, and as described in my last letter, we got a visit from a hysterical Chicken Little and his friends. As you know, Chicken Little is chronically bearish – always looking at the glass as cracked and half empty. Henny Penny goes with the flow and tends to get caught up in the emotional tide of markets – selling when her friends are worried and buying when they’re optimistic. Ducky Lucky is able to keep his emotions in check – he sticks to a long-term plan and re-balances his portfolio when allocations drift away from targeted levels. Ducky Lucky best embodies the Warren Buffett maxim to “be fearful when others are greedy and greedy when others are fearful.” After such a strong move in the first quarter, the threesome stopped by our office again in late March to get our current take on the market.

Most of us are familiar with the idiom taken from the old folktale of Chicken Little: “the sky is falling.” This central phrase from the folktale has been adapted for modern times to describe an unreasonable fear—and today is used to describe the irrational behavior driving the current “risk off” market environment. In this quarter’s letter, J. Dale Harvey, Poplar Forest Capital’s Chief Investment Officer, discusses how macroeconomic fears are creating distortions between good business fundamentals and valuation multiples. We believe many of the current overriding fears in the market today are unwarranted, thus creating a great buying opportunity.

"At Poplar Forest, we approach investing the way I shop at Oliver’s – by focusing on what’s on sale. We don’t buy every special (some things are on sale for worrisome reasons), but when we see a good deal on a great stock, we jump on it. I think this bottom up approach is better than preparing a list at home (equivalent to a top-down forecast), then simply buying everything on that list. And can you imagine the index fund approach to grocery shopping – simply buying a little of everything in the store?" - J. Dale Harvey

While it may be difficult to believe after having won three of the last four NBA championships, in the not so distant past, the Golden State Warriors looked like a value investment. At an estimated current market value of $3.1 billion, they are anything but a value investment today, and are certainly a far cry from the $450 million price tag when they were an unloved and underappreciated team just eight years ago. In this month’s quarterly letter, Dale discusses the importance of imagination, conviction and patience in value investing, especially when value investing is out of favor. Just as Joe Lacob and Peter Guber applied these traits when purchasing the downtrodden Warriors in 2010, we continue to apply them every day in our investment process while sticking to our game plan of seeking market-beating, long-term results for our investors.

“We want to understand the volatility of each underlying business, how much leverage is being deployed, the downside in a recession and the price we are paying relative to the underlying value of the company. We invest in companies for the long run when we see a favorable tradeoff between these risks and expected returns in a normal/mid-cycle time frame. We think a recession is likely sometime in the next few years and we want to be comfortable that we will survive a spill in the financial halfpipe without a trip to the intensive care unit. We believe that judgement, hard work and discipline are keys to our investment survival.” - J. Dale Harvey