Q2 22 Letter to Frank Value Fund Shareholders
Second Quarter 2022
The Frank Value Fund Institutional Class returned -4.30% YTD 2022 compared to a loss of -19.96% for the S&P 500 TR Index and -16.23% for the Russell Midcap Value Index. Please see the end of this letter for more performance information.
Flow, Flow, Flows, and Windfalls
Three trends influenced Frank Value Fund and US equity performance in the second quarter. First, as always, is the large and growing passive component, around 50% of all professionally managed money. These participants refrained from panic and continued to shovel money into the broader market with their weekly 401(k) contributions. While often overwhelmed by the two other trends in Q2: energy shortage and active manager liquidation, passive reasserted its dominance towards the end of June. With equities vastly underperforming bonds in June, the stock component of target-date funds (many are the only holdings in 401(k) accounts) required major rebalancing and purchased equities. Stock market indices rallied violently higher in the third week of June, while investors fled energy stocks on recession fears. It is painful to end the quarter on a down note in an otherwise successful year for the fund. Flows or no flows, we are confident the energy stocks in the Frank Value Fund have the tools to combat price irrationality by generating windfall cashflows.
The energy companies behind the stock prices strengthened significantly, albeit experiencing pullbacks in price towards the end of the second quarter. Our Midwest refiner CVR Energy reimplemented its dividend, (at a 6% rate!) produced 10% of its market value in operating cashflow in three months, and traded at 8x 2022 earnings (which we believe analysts are underestimating). The company can use windfall earnings to further increase its dividend, repurchase stock, and reward shareholders without the need for passive flows. Adding to the upside potential, CVR finished converting one of its refining units to renewable diesel production. Management announced a potential spinoff or sale of its renewable assets, and comparable deals in 2022 indicating they are likely worth 2x the current trading price. As you may have experienced pain at the pump from tight gasoline supplies, the market is even more restricted for diesel, as you can see in the below chart from the EIA.
Demand for distillates is somewhat inelastic, which means prices and conditions have less influence on demand than other goods. This is because diesel is used in essential services like farm equipment and factory production. In fact, according to the EIA, in 2020 during lockdowns and COVID demand only declined 6%. The Frank Value Fund increased its holdings in renewable diesel companies to 10% in Q2, which is roughly 10% more exposure than any index. The entire energy sector is about 4% of the S&P 500, with nearly zero exposure renewable diesel (RD). The Frank Value Fund has three RD companies in size in the portfolio today.
Renewable diesel sits at the fulcrum of energy opportunity for several reasons. Unlike biodiesel, which is difficult to produce, freezes at low temperatures, and must be blended with conventional diesel, RD can be used for 100% of an existing diesel engine’s fuel, and conventional refiners can convert existing equipment to become producers. RD is environmentally friendly, reducing carbon emissions by 50-90%. Of all the renewable energy replacements, RD is one of the fastest to market, most economical, and environmentally friendly. At roughly 5% of all current diesel supply, RD has a large runway for growth, and the current US administration should embrace supporting this expansion. The US lacks refining capacity in general, with far less total capacity today than in 2019. This gives us confidence to hold these positions through a recession. Even without government and bank support, larger energy companies looking to reduce carbon footprints and offset RIN costs have already paid significant premiums (2-4x higher) to acquire similar RD assets than where Frank Value Fund RD holdings currently trade. What if none of that occurs? We will collect the strong profits. Our latest RD purchase has guided $432 million of free cash flow from now until the end of 2023, and we paid around $1.2 billion for the entire company.
Recession and Rates
You may have heard the rumblings of an oncoming US recession. According to the Atlanta Fed’s GDP Now tool, Q2 2022 GDP declined over 2%. That, with the first quarter posting around negative 1.5% would result in two consecutive quarters of declining growth. When GDP is trending down, the Federal Reserve is usually cutting rates to spur investment and growth. Instead, here in 2022, the Fed is terrified of persistent inflation and raised rates from 0% in December 2021 to over 1.5% today. Futures contracts indicate another 75bps raise in July to 2.25% and to 3.25% by the end of the year. Equity and bond markets are gyrating wildly, trying to balance pockets of growth in service companies vs. hangover declines in goods producers, as well as when the Fed will capitulate to declining financial markets (and potentially higher unemployment) and reverse course towards interest rate cuts. We are confident in our positioning because numerous companies we own like H&R Block and Cardinal Health are recession-resistant, and the cyclical companies we own are incredibly cheap as previously mentioned. Whichever way the economy goes or the Fed bumbles, it is clear the old-world order of unprofitable companies and speculation will remain a past relic.
It is doubtful the Fed and its unelected, unaccountable members will learn anything from the latest iteration of the bubble/bust cycle, but the various supply constraints we have detailed in energy and residual inflation pain should keep a world of 0% interest rates, fiscal stimulus, and reckless Quantitative Easing at bay. Unprofitable, unviable companies appreciated 10x or more during the 2020-21 coordinated Fed balance sheet expansion and fiscal stimulus. Over the past 9 months these companies have declined upwards of 80% and few have generated any profits whatsoever. Bonds are once again an asset-class, meaning there is an opportunity cost to waiting for profits in the above unviable issues. We believe companies with actual profits will generate returns in the future, and pure speculations will continue to underperform. However, this painful transition will still enact more suffering, as some of the largest asset flows YTD in 2022 have gone to “famous” hedge funds and ETF providers down over 40% as their believers throw good money after bad. This latest bubble will be remembered as one where the emperor had no clothes and legions of naked followers.
Indices are Still Expensive and the Stock Picking Opportunity
Unlike the worst speculative areas, most companies in the S&P 500 index are profitable. However, this does not mean they will generate superior returns in the next ten years. Even after a 20% decline in the first six months of 2022, the broader US stock market is still extremely expensive. The chart on the right shows Total Market Cap / GDP as 155.8%. At the bear-market lows of 2002 and 2008, this number decreased to 50-75%, indicating another 50-67% potential downside in US stocks.
If you can avoid index-investing, it appears history is on your side. Investors justified these extreme valuations because interest rates were at 0%, inflation was non-existent, and there were no alternatives. None of those reasons make sense today. We have been adamant that high valuations persist because of the dominance of passive investing strategies.
Eventually, passive will lose control. This could come from less contributions to 401(k) plans due to unemployment, investors panicking and reducing their allocations to passive because of losses, or individuals borrowing from their retirement plans (and thus selling passive strategies) to make ends meet. As volatile as stocks have been in 2022, markets have not seen the largest player, passive investors, reduce allocations. Should this occur, serious, permanent losses to indices like the S&P 500 could result, obliterating long-term goals for investors. Why not just avoid the whole mess? The opportunity we see as benchmark-agnostic stock-pickers is bright.
Since passive investing firms do not employ analysts focused on company fundamentals, opportunities are easier to come by in the small and mid-cap space. The Frank Value Fund has capitalized on this lack of competition in 2022, concentrating investments in companies with little to no analyst coverage but with steady and growing profits at much lower valuations than available to passive index investors. Additionally, the fund has invested in larger companies likely to be included in the S&P 500 in the future, ensuring a wall of money will purchase our holdings quickly and at any price merely because the company is now included on a list. This is the focus of Frank Value Fund, to offer active management concentrating on best-ideas outside of the passive investing world. Other active managers engaged in benchmarking cannot beat passive at its own game. Instead, we understand the weaknesses of passive’s algorithmic approach and have honed our strategy to continuously take advantage and add value. In 2022 we are just beginning see these benefits.
|Performance as of 6/30/22||Total Return||Average Annualized Total Returns|
|YTD||1 Yr. %||3 Yr. %||5 Yr. %||10 Yr. %||Since 7/21/04 %|
|Frank Value Fund||-4.30||-5.60||6.01||3.13||5.44||5.90*|
|Russell Midcap Value||-16.23||-10.00||6.70||6.27||10.62||8.99|
|S&P 500 Total Return||-19.96||-10.62||10.60||11.31||12.96||9.27|
Please see our website for distribution information. Performance data quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. You may obtain performance data current to the most recent month-end by calling the Fund at 1-888-217-5426 or visiting our website at www.frankfunds.com. Returns include reinvestment of any dividends and capital gain distributions.
Non-FDIC insured. May lose value. No bank guarantee. The Fund’s investment objectives, risks, charges and expenses must be considered carefully before investing. The prospectus contains this and other important information about the Fund, and it may be obtained by calling 1-888-217-5426. Please read it carefully before you invest or send money.
This publication does not constitute an offer or solicitation of any transaction in any securities. Any recommendation contained herein may not be suitable for all investors. Information contained in this publication has been obtained from sources we believe to be reliable, but cannot be guaranteed.
The information in this portfolio manager letter represents the opinions of the individual portfolio managers and is not intended to be a forecast of future events, a guarantee of future results or investment advice. Also, please note that any discussion of the Fund’s holdings, the Fund’s performance, and the portfolio managers’ views are as of July 6, 2022 and are subject to change without notice.