FPA Capital has managed to outperform the Russell 2000 since its inception during the 1980s. Today, it's still finding value in the small-cap space. Its biggest contributors for the first part of the year were Patterson-UTI Energy (NASDAQ:PTEN) and InterDigital (NASDAQ:IDCC).
FRA Capital has been a slight underperformer of late, but it's been putting the fund to work, as the market for small-caps have sold off and other funds were selling off their energy stocks at "fire-sale" prices.
It remains heavily invested in energy, but also technology, with the two making up nearly half the fund's assets. In the tech space, FPA has built large positions in InterDigital and Western Digital (NYSE:WDC).
Western Digital is a little outside the small-cap space, but a maker of hard disk drives (HDDs) and solid-state drives (SSDs). In truth, it's changing the storage space game. The company got approval from the Ministry of Commerce of the People's Republic of China (MOFCOM) to fully integrate the Chinese assets from its acquisition of Hitachi's (OTCPK:HTHIY) disk drive business. WDC also announced a deal to acquire SanDisk (SNDK) for approximately $19 billion in cash and stock, catapulting the company into a leadership position in SSDs. Western Digital has been in our portfolio since early 2007. The investment is a good example of how we scale up and down our position size over time.
But now onto some smaller-caps: Arris Group (NASDAQ:ARRS), which is a provider of cable operators with communication systems that make it possible for users to consume bandwidth. FPA initially invested in Arris in November 2010, and more than doubled its investment in 2013 after acquiring Motorola Home from Google (GOOG, GOOGL).
Now the thesis has largely played out, and the stock price tripled from November 2010 to March 2014, yet FPA's started buying again at a time when four of the company's five largest customers - Time Warner (NYSE:TWX), Comcast (NASDAQ:CMCSA), Charter (NASDAQ:CHTR) and AT&T (NYSE:T) - got involved in M&A talks.
Arris' largest customers are running out of network capacity, so their CapEx plans should remain elevated. In April 2015, Arris announced another big acquisition - Pace PLC. The thesis is for when these synergies start kicking in, the company could generate as much as $700-800 million of owner earnings. Arris is trading at about 6 times owner earnings to pro forma Enterprise Value.
Even smaller-cap stocks
InterDigital is a $2 billion market cap play on wireless growth. Nokia (NYSE:NOK) and Ericsson (OTC:ERIAF) were the major mobile phone players 15-20 years ago. Today, their phones are industry footnotes, and Apple (NASDAQ:AAPL) and Samsung (OTC:SSNLF) dominate. InterDigital makes critical technology across the wireless industry. To be sure, its technology maintains a vital place inside networks and devices. In summary, we believe that the world will use more smartphones and tablets going forward, but we don't know who the top sellers will be.
FPA has been a big believer in for-profit educators, owning both Apollo Education Group (NASDAQ:APOL) and DeVry Education (DV), which continue to trade at a substantial discount to intrinsic value.
Still, FPA has been adjusting its position, i.e., selling off stakes, to reflect the risk/reward. In October 2014, an inter-agency task force was formed to share information about investigations into for-profit education. It appears that the fervor for prosecuting for-profit schools has increased meaningfully. While it continues to believe there is substantial value trapped in the Apollo organization, it may be more difficult to extract that value than we originally forecast.
FPA believes it's almost a "mathematical certainty" that U.S. production will decline significantly from its peak. But the picture outside of the U.S. is also concerning. 2016 marks the first time since 1986 that global E&P spending has fallen two years in a row.
OPEC's spare production capacity is now at the lowest it has been since the oil shocks of the 1970s. On the demand side, growth continues to be supportive. The United States is not much different. Putting it all together, FPA believes the market should come back into balance during 2016, absent a shock to demand.
FPA's energy-related names have done well during the volatility. It has a preference for onshore drilling, and still owns Rowan Companies (NYSE:RDC). In part because of its highly differentiated liquidity and free cash flow position, and in part because of its opportunity to drive costs out of the business.
Then there's Noble Energy (NYSE:NBL), which had $1 billion of cash and $5 billion of total liquidity at the end of 2015. Yet, it still holds its lowest cash level in 12 years, at approximately 20%. To take advantage of the market swings, it's been deploying cash early during the downturn.