TOWLE & CO.
DEEP VALUE
INVESTING
(314) 822-0204
April 8, 2014
To: Investors
Steady & stable! First quarter stock prices held firm for the Towle portfolio. Putin’s takeover of Crimea, unsettled
concerns regarding China’s growth outlook, dastardly winter weather in the U.S., and prospects for higher Federal
Reserve-directed interest rates couldn’t tilt pricing to the downside. Stable pricing for the S&P 500 Stock Index since
October 31st signals a calm, benign U.S. equities market. While prospects for global and U.S. economic growth persist,
stock market prices and valuations remain high, deflating expectations for outsized gains in coming quarters.
The following chart provides short and long term performance with results longer than one year annualized. We remain
grateful for these good gains and continue to deeply appreciate the support of our investors.
Periods ending
3/31/14
3 months
1 year
3 years
5 years
10 years
20 years
Inception (1982)
Towle Composite
(Gross of fees)
1.52%
38.33
14.41
35.07
11.82
14.37
17.30
Towle Composite
(Net of fees)
1.33%
37.40
13.63
34.13
10.97
13.55
16.47
Russell 2000
Value
1.78%
22.65
12.74
23.33
8.07
10.81
12.70
S&P 500
Total Return
1.81%
21.86
14.66
21.16
7.42
9.53
11.71
The first quarter letter segments as follows: Investment Environment, Portfolio Review, and Howard Marks.
Investment Environment
The Towle portfolio advanced sharply in 2012 & 2013, up 89.2% net. Will the investment environment support
additional gains to the portfolio? At current prices, is the portfolio at risk of decline? The following thoughts and
concepts guide us in our decision making:
Economic Overview
Global economic progress continues. Production and consumption advance. The International Monetary Fund forecasts
world output expansion of 3.7% in 2014. Economic excess, a likely predictor of recession, seems muted. Following the
Great Recession, pent-up demand remains. For example, progress finally appears at hand for U.S. housing, as
construction and prices are up substantially. Global deliveries of business jets increased by 1% in 2013 but still remain
50% below peak sales of 2008. (Wall Street Journal, March 2014) Well below historic highs, consumer confidence
finally returns to pre-Great Recession levels. (Wells Capital Management, March 2014) Now in its sixth year, this
modest but consistent recovery from the Financial Panic continues to provide a solid backdrop for the U.S. equity
market. In summary, business is satisfactory with no indication that recessionary conditions are upon us.
ACME Analysis
Developed many years ago by Towle & Co. and refined in 2013, our ACME Investment Monitor gauges the current
“desirability” of investing in the U.S. stock market. ACME speaks to “friend or foe” characteristics that are subdivided
into Asset Valuation, Cost of Capital, Market Dynamics and Economic Conditions. While we claim no forecasting skill,
ACME’s 15 indicators provide a framework for our investment process and set the stage for our weekly, Tuesday
morning investment team meetings.
For illustrative purposes, listed below are four current readings representative of the fifteen total indicators:
Component
Asset Valuation
Cost of Capital
Market Dynamics
Indicator
Rule of 20
TED Spread
Investor Sentiment
Definition
(P/E + inflation)
(LIBOR less T-bill)
(Avg. of 4 surveys)
Normal Range
17 to 21
0.25 to 0.75
45 to 60
Economic Conditions
Leading Econ Indicators
(Conference Board)
0% to 5%
Current Reading
19.6
Normal
0.21
Positive
55.4
Normal
4.7%
Normal
Overall, ACME continues to demonstrate a “friendly” investment environment. However, ACME alerts us to the
prospect of extended Asset Valuation. Please note in the previous table how the Rule of 20 pushes toward the upper limit
of its Normal Range. From our perspective, valuations remain particularly high for hundreds of stocks. (See our investor
letter dated January 10, 2014 for examples.) Looking short term, sharp price advances from current levels would draw a
red flag to valuation logic. Earnings need to catch up. Conversely, the three other ACME components, Cost of Capital,
Market Dynamics, and Economic Conditions, signal a more supportive stance.
Immediate Concern
Our 2013 year-end letter, dated January 10, 2014, stated that, “Certainly, the ups and downs of a politically sensitive,
developing global economy will bring downward pressure to stock prices at some point in the year.” First quarter results
bypassed that threat, but stocks in general stay fully priced. And the dreaded, “Sell in May and Go Away” season is upon
us. As a short-term trading tactic, the reduction of equity exposure in the spring to be followed by reinvestment in the fall
has worked well at times. Columnist Ben Levisohn also leans toward the overvalued view, “Stocks are trending at a
median valuation of 18.9 times the last 12 months of earnings, above its historical average of 16.6.” (Barrons’ March 12,
2014) With stocks fully priced, a correction is likely at some point this year. The Towle investment team stands ready to
capitalize on any pullback to reposition the portfolio for maximum long term gain.
Longer Term Issue
Mr. Levisohn also states, “…the rocket-fuel behind the S&P 500’s 172% rally since its financial-crisis low looks
increasingly spent. The Federal Reserve’s shock and awe - otherwise known as quantitative easing - is slowly being
removed…” (Barron’s, March 12, 2014) The overriding concern at Towle & Co. is the eventual impact of advancing
interest rates. This concern is compounded by the unusually long duration and particularly low level of short term rates.
When will the increases begin? How high will rates go? Will P/E ratios decline? At what level of rates will economic
headwinds emerge? We do not have answers to these interest rate questions, but, historically, rising interest rates from a
low base, like we have now, are initially positive for stocks as it signals an improving economy. Eventually, though, an
extended rise in interest rates may tilt equity valuations and economic activity to the downside.
Carry On
The purpose at Towle & Co. is to provide a product that compounds capital at a rate in excess of the U.S. stock market.
The current portfolio contains equity positions that possess, in our view, more than satisfactory three year upside
potential. Looking out many years, the concerns and issues of today will be overpowered by the economic progress of
tomorrow. Faith in the human spirit, political freedom, technological innovation, and free enterprise will generate untold
wealth and opportunity for mankind in the coming decades. Recognizing the long term nature of our investment strategy,
we push on gratefully acknowledging the economic progress that is at hand.
Portfolio Review
Following a modest decline in late January, the quarter ended with no appreciable change in asset values. Rarely are
economic and valuation conditions just right, leading to strong price appreciation similar to 2012 and 2013. Unlike the
robust first quarter gains of recent years, the markets failed to drive Towle portfolio prices higher in 2014.
First Quarter
Gains (%)
2010
11.6
2011
7.2
2012
12.7
2013
15.9
2014
1.3
On balance, portfolio activity was quiet with moderate trading. Thus, portfolio sector composition remained in line with
year-end 2013.
For the quarter, the largest contributors and detractors to performance are noted below:
Company
1. Hawaiian (HA)
2. Meritor (MTOR)
3. Ingram Micro (IM)
4. Flextronics (FLEX)
5. Goodyear Tire (GT)
Return %
45.0
17.5
26.0
18.9
9.8
Contribution %
1.74
0.78
0.75
0.66
0.54
Company
1. Atlas Air (AAWW)
2. Tesoro (TSO)
3. PBF Energy (PBF)
4. Peabody (BTU)
5. Swift Energy (SFY)
Return %
(14.3)
(13.1)
(17.0)
(15.9)
(20.3)
Contribution %
(0.72)
(0.62)
(0.57)
(0.55)
(0.54)
While the overall portfolio experienced minor change, underlying stocks did experience meaningful price movement.
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Addition/Deletion: HERO
Hercules Offshore Inc. (HERO) was purchased and sold during the quarter. The company primarily provides shallow-water
drilling and marine services to the oil and natural gas industry worldwide with a leading market position in the Gulf of Mexico.
We thought the current soft patch in drilling activity and a delay in securing long term contracts for HERO’s ultra-deep water
assets created a window of opportunity to purchase the stock below book value. Upon further review, we became
uncomfortable with the industry’s order book for newly-constructed offshore rigs in 2014-15. We were unable to resolve how
expected demand will absorb this new supply, roughly 1/3 of the existing fleet, without threatening the pricing power for all
industry participants. Consequently, we sold HERO at a modest loss of roughly (3.2%).
Deletion: PTEN
Patterson-UTI Energy Inc (PTEN), the second largest oil/gas land driller in the U.S., posted profitability but failed to show
marked progress toward our operating profit target. For 2013, earnings fell and now stand at roughly 50% of our three year
earnings forecast. Despite this lack of improved profitability, the stock closed in on our sell target. We sold PTEN posting a
gain of 71.4% during almost 20 months of ownership.
First Quarter Adds:
Atlas Air Worldwide (AAWW), General Cable (BGC), Peabody Energy (BTU), Renewable
Energy Group (REGI), SUPERVALU (SVU), and Swift Energy (SFY)
In all cases, these add-on positions represented stocks that experienced noteworthy price declines from their 52 week highs. A
favorite portfolio management tactic is the addition of capital at a time of price decline, increasing the weighting of a position
and enhancing total portfolio upside potential.
First Quarter Trims:
Arkansas Best Corp. (ABFS), Meritor Inc. (MTOR), and PHH Corp. (PHH)
In the last 15 months, Arkansas Best and Meritor experienced dramatic stock market gains with ABFS up 286.9% and MTOR
advancing 159.0%. Prior to their trims, each company represented more than 4% of the portfolio, an over-weighted position.
While profitability progress continues, both firms have yet to approach targeted profit margins. In light of the current earnings
shortfall, a reduction in exposure reduced short term downside risk and bolstered cash. Long term prospects favor retention of
both companies.
In other news, Chiquita Brands International (CQB) executed a definitive agreement to merge with Fyffes Plc forming the
world’s largest banana marketer. Financial details of the proposed combination are yet to be released. To be headquartered in
Ireland, the primary operating officers will be from Fyffes. Most unfortunately, the transaction will be taxable to U.S. Chiquita
shareholders. While the combined company’s balance sheet will show substantial improvement, the key ingredient for
investment success, in our view, is not the banana business but the need to improve the poorly performing U.S. salad operation,
Fresh Express. We continue to monitor the proposal, awaiting the S-4 filing for more financial details.
As mentioned in our January 10th letter, Jones Group (JNY) has signed a definitive agreement to be acquired by private equity
firm Sycamore Partners at $15 a share. A pushback from existing shareholders, to include Towle & Co, regarding the
perceived, low-ball purchase price has not been effective in improving the deal’s proposed price. Likely, the transaction will
close shortly providing a return of 21.8% on our 3.4 year investment.
Owning 6.0% of PHH, Orange Capital, a corporate activist, has pushed PHH to split up or sell the company. Management has
complied, and the company currently seeks a strategic transaction to enhance shareholder value. We await the outcome.
In the 1980s and 1990s, merger & acquisition activity within the Towle portfolio seemed commonplace. The movement to
larger capitalization stocks in the portfolio and the reduction in merger & acquisition activity in many industries has slowed the
Towle M&A participation rate. Nevertheless, the “deals” keep coming. Assuming the Jones Group (JNY) transaction closes,
the total number of companies acquired in 32+ years will be 87, further validating our deep value investment process.
Fourth quarter 2013 earnings reports, made public during the first quarter 2014, met our overall expectations. However, two
companies posted adjusted operating losses for the entire year of 2013. Cal Dive (DVR) and Navistar (NAV) are expected to
reverse results and move to profitability by 2015. Based on current valuation metrics, we retain both positions.
At quarter-end the portfolio held 34 positions with 4.4% in cash. Based on Capital IQ, the portfolio’s median P/E for 2014 is
12.8x versus 15.9x for the S&P 500.
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Howard Marks
The co-founder of Oaktree Capital Management is highly regarded for his decades-long analysis and written commentary about
value investing. When Howard Marks writes, thousands read. Mr. Buffett confirms it, “When I see memos from Howard
Marks in my mail, they’re the first thing I open and read.”
The following excerpts are from Howard’s book, The Most Important Thing. We highlight eight references, just a sampling of
the wisdom from Howard Marks.
1.
There’s no surefire recipe for investment success. No step-by-step instructions. No valuation formulas
containing mathematical constants or fixed ratios—in fact, very few numbers. Just a way to think that might
help you make good decisions and, perhaps more important, avoid the pitfalls that ensnare so many. Pg. x
2.
Investing, like economics, is more art than science. And that means it can get a little messy…In fact, one of
the things I most want to emphasize is how essential it is that one’s investment approach be intuitive and
adaptive rather than be fixed and mechanistic. Pg. 2
3.
Since other investors may be smart, well-informed and highly computerized, you must find an edge they don’t
have. You must think of something they haven’t thought of, see things they miss or bring insight they don’t
possess. You have to react differently and behave differently. Pg. 3
4.
Only if your behavior is unconventional is your performance likely to be unconventional, and only if your
judgments are superior is your performance likely to be above average. Pg. 5 & 6
5.
Risk exists only in the future, and it’s impossible to know for sure what the future holds…No ambiguity is
evident when we view the past. Only the things that happened, happened…Projections tend to cluster around
historic norms and call for only small changes…The point is, people usually expect the future to be like the
past and underestimate the potential for change. Pg. 44
6.
Risk arises as investor behavior alters the market. Investors bid up assets, accelerating into the present
appreciation that otherwise would have occurred in the future, and thus lowering prospective returns. And as
their psychology strengthens and they become bolder and less worried, investors cease to demand adequate
risk premiums. The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more
people move to take it. Pg. 55
7.
When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point
where it’s not risky at all. Broadly negative opinion can make it the least risky thing, since all optimism has
been driven out of its price. Pg. 55
8.
Very few things move in a straight line. There’s progress and then there’s deterioration. Things go well for a
while and then poorly. Progress may be swift and then slow down. Deterioration may creep up gradually and
then turn climactic. But the underlying principle is that things will wax and wane, grow and decline. The
same is true for economies, markets and companies: they rise and fall. Pg. 67-68
Mr. Marks, we endorse your commentary!
Once again, we thank you for your support. Please do not hesitate to contact us with your questions and comments.
J. Ellwood Towle
Christopher D. Towle
Peter J. Lewis, CFA
James M. Shields, CFA
Wesley R. Tibbetts, CFA
DISCLOSURES
Past performance is no guarantee of future outcome. The Deep Value composite results are time-weighted total returns, dollar weighted for the size of
each account, including cash reserves and reinvestment of income. Performance figures are calculated after the deduction of all transaction costs,
commissions, and other portfolio expenses. Returns are subject to adjustment at any time, and the Deep Value Composite is not audited. Although
Towle & Co. makes no attempt to manage against the composition of a specific benchmark, the Firm provides the Russell 2000 Value Index as a
readily accessible indicator of comparative performance as well as the S&P 500 Index as a general indicator of the market at large. Investments made
by Towle & Co. differ in comparison to the Russell 2000 Value Index in terms of security holdings and industry weightings. Towle & Co. invests in
considerably fewer companies than the index with lower average multiples to book value, sales, earnings, and cash flow, and as a result, the volatility
and returns of the benchmark index may be materially different from the individual performance attained by a Towle & Co. investor. We urge
investors to carefully compare the enclosed appraisal reports from Towle & Co. with your account statement received directly from the custodian, in
the case of separate accounts, or from the third-party administrator, in the case of the two limited partnerships. Results for specific holdings
highlighted in this communication represent the gross returns of those positions in Towle & Co.’s model portfolio and may not be indicative of an
individual investor’s actual experience.
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