Q2 20 letter to shareholders
The Frank Value Fund Institutional Class returned 7.44% YTD as of 6/30/2020 compared to -3.22% for the S&P 500 TR Index and -18.09% for the Russell Midcap Value Index. The fund is delivering superior returns with significantly less volatility. Please see the end of this letter for more performance information.
Early in the second quarter the Frank Value Fund established new positions in six companies. Though broader market prices were still elevated on a historical basis, our bottom-up process yielded compelling opportunities in individual names – music to a stock picker’s ears. For a great example on how our research process can uncover and purchase a superior long-term investment, we present you with our investment case for eBay in early April.
In the first quarter of 2020 eBay’s stock price declined about 30%. At the time, the latest financials, which were available to humans and algorithms alike, showed $7 billion of debt and only $4 billion of cash. Market participants knew millions of people were losing their jobs and the US was careening into its steepest recession in history. To put it mildly, these are unfavorable factors for a consumer discretionary company like eBay. Beneath the surface though, eBay told a different story, one with savvy management moves, strong financials, and long-term cash flows in-tact.
What may go down as one of the most spectacularly timed asset sales of all-time, eBay sold its entire interest in StubHub, a secondary marketplace for sporting events tickets, in early February 2020. Less than a month later, the coronavirus pandemic canceled all professional sports indefinitely. Buyer beware! Concurrent with the sale, management issued guidance for the remaining revenue at eBay, as well as boosting its 2020 share repurchases from $1.5 billion to $4.5 billion. At $28 per share in late March, this repurchase authorization equated to over 20% of the company! Adding the post-tax cash from StubHub to the balance sheet, eBay could easily contend with the 2020 recession with over $7 billion of cash to manage debt and repurchase shares. This cash materially changed the valuation because the Frank Value Fund’s process is centered on the balance sheet. Cash flow and income are examined through the lens of enterprise value, which penalizes companies for excessive debt. Longer-term, eBay also has a new management team in place, is focusing on its internal, high-margin payment processing opportunity, and management also has the pressure of a large technology focused activist fund pushing for positive change.
What happened in the rest of the second quarter? Stocks rampaged upwards in one of the most furious 50-day rallies of all-time! Yet, continuing jobless claims exceeded 18 million people at the end of June. To put this in perspective, at the height of the previous recession in 2008, continuing jobless claims were under 7 million, and this number did not return to the pre-recession 2.6 million until six years later. The current extreme level of joblessness is a painful detriment to economic growth, and even if a coronavirus vaccine were developed tomorrow, job creation is slow and will cause US GDP to remain below peak for years. But price-action builds the commentary, and several financial pundits are justifying a “V-shaped” recovery in stocks by believing the US economy and jobs are also on a steep rebound. Instead, we believe the signs of life in the US economy are coming off a full-stop from shelter-in-place. If the annualized US GDP were 100 in February, and then declined 40% to 60 in Q2, a return to growth could be as high as 30%, but that means GDP is now only 80. That is a 20% decline from the peak and would still make this the worst US recession of all-time. Employment creates economic growth and corporate profits, and there are too many companies eliminating jobs now, with more to come after some of the government programs expire in July. Stocks are priced on a GDP that does not exist and most are set up for negative long-term returns. Most investors are passive and/or apathetic to fundamentals and that is clear in today’s valuations.
Under the surface of the rally, most stocks are weak. The below chart from Bloomberg shows the top five stocks in the S&P 500 – Apple, Amazon, Facebook, Microsoft, and Google (Alphabet) are bounding to new highs as the rest of the index components trail. This behavior supports our research on passive investing – when you buy an indexed product like an S&P 500 mutual fund or ETF, your money is distributed unevenly. A much higher percentage of your money is going into the liquid mega-cap stocks like Apple than the smaller companies that comprise most of the S&P 500. More flow into these top five names means their stocks outperform, which increases their relative weight in the index. Higher weighting means even more of each marginal dollar going to the top five. This is price momentum and a positive feedback loop that has created monstrosities such as Google and Apple’s 30x trialing price to earnings ratios.
We updated our passive research paper Slaughterhouse Five (Hundred)for first quarter numbers, and we will update again as institutional ownership is released for the second quarter. The trend is still in-tact, but every slight gain in market share the large passive firms make adds instability to stock market structure. The above examples of clustering are results of instability, and we believe when passive investors become net-sellers of stocks, declines worse than Q1 2020 will ensue. As we have observed with the last few instances of stock market declines, volatility has been extreme and correlations high. For strategies like indexing and fully-invested active management, it is impossible to add bargain-priced stocks in a bear market without selling existing holdings. This is where the Frank Value Fund differs. Our strategy still has significant holdings in cash, long-dated bonds, and physical gold. In the first two quarters of 2020 we used our cash to purchase over 10% of the Fund’s net asset value in equities. We have remaining firepower and plan on taking additional long-term positions when passive suffers net-outflows for the first time in its history.
Frank Value Fund Lead Portfolio Manager