Source Capital, Inc. (SOR) Q4 2022 Earnings Call Transcript

Source Capital, Inc. (NYSE:SOR) Q4 2022 Earnings Conference Call February 8, 2023 4:00 PM ET

Company Participants

Courtney Reardon – Relationship Manager

Steve Scruggs – Portfolio Manager, Strategy

Conference Call Participants

Operator

Hello. And welcome to today’s webcast. My name is Sarah, and I will be your event specialist. Please note that today’s webcast is being recorded. During the presentation, we will have a question-and-answer session. You can ask text questions at any time by locating the Q&A box on the left side of your screen, type your question and click new questions to submit. If you are experiencing any technical issues as a best practice, we suggest you first refresh a browser.

It is now my pleasure to turn today’s program over to Courtney Reardon. Courtney, the floor is yours.

Courtney Reardon

Thank you, Operator. Good afternoon, everyone, and thank you for joining us today. We would like to welcome you to FPA Queens Road Small Cap Value Fund Second Half 2022 Webcast. Again, my name is Courtney Reardon, and I am the Relationship Manager for the Fund.

In just a moment, you will hear from Steve Scruggs, the Portfolio Manager of the Strategy. Steve has managed the Fund since its inception in 2002. Over those 20 years, the Fund has delivered benchmark beating returns with less risk over the long-term and protected capital during every large drawdown.

Steve’s disciplined value approach is predicated on investing in attractively priced small-cap companies that are in sound financial condition led by strong management teams and operating in growing industries. As of December 31st, the AUM of the strategy was about $500 million.

In terms of our agenda today, there are a few things we will cover. First, we often get questions regarding availability of our Small Cap Value Fund on various platforms and we want to update you on our progress. The Fund is currently available on most major platforms, including Fidelity, Schwab, LPL, TD Ameritrade, Ameriprise, Commonwealth, Wells Fargo, RBC, Raymond James and Vanguard. If you have any trouble transacting in the Fund, please feel free to reach out to crm@fpa.com and we will be happy to assist.

And finally, Steve and I have collected questions from investors and turned it into a little Q&A, which will allow Steve to provide his views on the small-cap market, review the strategy and walk through an investment example. We will then open it up to additional Q&A. If at any time during this webcast, you have questions, please submit those through the device on your screen and we will get to them at the end of the presentation.

The audio, transcript, slides and a visual replay of today’s webcast will be made available on our website, fpa.com and that typically takes about a week to two weeks.

Question-and-Answer Session

A – Courtney Reardon

All right. Let’s get to it. Steve, let’s talk about the objective of the Fund. I’d also love to hear how you think the Fund results — how you think about Fund results lately with the current drawdown over the current cycle and since inception? Steve, I think, you are still on mute.

Steve Scruggs

Thank you. Thank you, Courtney, and thank you all for joining us today. Our objective is straightforward. It’s to outperform the Russell 2000 Value over full market cycles. We expect to do so with less risk. And we define a full market cycle as either from a peak to a peak or a trough to a trough.

And what we are trying to do is to compound money steadily over long periods. The recent period shows that making a lot of money in a frothy speculative market, it doesn’t really matter if you are going to give it all back when stock prices fall.

So everything we do, we do with a bottom-up view. It’s based on classic Benjamin Graham principles, we always focus on fundamentals is regardless of what the market happens to be focused on.

We are confident that in the long run, it always gets back to fundamentals. This causes us to miss out on some of the speculative excesses that frequently happen in the market. But we tend to make up — more than make up for that in down markets when the markets come back to the fundamentals.

Because we participate enough in the up markets and we hold up better in down markets, our investments compound better over time. And since inception and over the most recent cycle, we have met our objective and we have done it with considerably less risk, measured either by standard deviation or market drawdown. Over the last year is a good example. We outperformed in 2022 and we held up really strong during the worst of the COVID panic in the first quarter of 2020. You might be on mute.

Courtney Reardon

Thanks, Steve. Can you please speak to how your specific investment process has been reflected in the overall portfolio return recently and especially over time?

Steve Scruggs

Sure. Our process doesn’t change in different types of markets. We are very consistent. And we talk about the investment process having four pillars is versus balance sheet and we see companies with strong balance sheets. And by that we want companies that have staying power, ones that aren’t reliant on capital markets. These are ones that are going to get through any unforeseen crisis that would happen, whether it’s an economic or financial crisis or pandemic, ones that aren’t going to get an unpatched and ones that are going to have staying power. So balance sheet strength is a foundation of our process.

The next thing we look at is valuation and we are — we demand a margin of safety. We are — primarily we are using free cash flow discount valuation models with a long-term view that normalizes economic earnings over the company’s cycle. We discount those back at a rate that we think compensates us for the amount of the risk that we see in the company and then we demand a margin of safety.

We look at management, just management that can lay out a strategy and execute to that. If they do that, it’s going to show up in the financials. We would love to see management take calculated risks, try new things as long as they are open and honest about it, and we don’t like to see what to see management take — make wholesale bets on changing the direction of the company.

And then the last thing is sector and industry analysis. We want to make sure that we are investing in companies that are in growing industries that have stable competitive dynamics. We will typically are going to avoid commodity industries, overly competitive industries and make sure that the companies are competing in industries that have attractive long-term growth expectations.

And so as we go through this process, it leads us to a portfolio of high-quality companies. And most are mature companies, they are consistently profitable and they show a slow but steady growth and this process is what helps us with downside protection. These higher quality companies with strong balance sheets tend to hold up better in down markets.

Courtney Reardon

When you look at the four pillars, is there one that’s dominant across the portfolio and is there one that you are more lenient on?

Steve Scruggs

No. I wouldn’t say that one pillar is any more important than another. They are all equally important. But it’s not as though we just go through the four-pillar process and check the box for each pillar. There’s a trade-off and it’s more of an art than a science.

Each pillar has a baseline hurdle that must be achieved. But some of the pillars will be stronger than others in any individual company. It’s really rare to find a company. It’s going to have a rock solid balance sheet, a great management in an attractive industry that’s trading at a 12% free cash flow yield.

So when we go through the pillars, balance sheet, that’s one of the things that helps us provide us with downside protection. These are companies that we don’t think are going to get in a pinch. And it also allows us to take a long-term view, because we have confidence that these companies can make it through any type of short-term disruption.

The valuation is very key to what we do, demanding a margin of safety. That helps on the down side. But we also — we model every — when we are coming up with an estimate of intrinsic value, they are all modeled with expected rate of return that we think we need to get based on the riskiness of the company.

And then when we look at management, we are not just looking at the management of the company, but also the culture of the company, what their business model looks like and what are the things that they are focused on. And management, that certainly can’t be minimized.

And lastly, the industry analysis, over the last 20 years, the mistakes that we have learned from, the most common one was buying a really cheap company in an industry that was in secular decline. So this, on one hand, helps us avoid value traps, but it also leads us to companies that have the wind at their back with regard to the industries they are competing in.

Courtney Reardon

Let’s talk about investor expectations. You and I both really like this chart, because it shows how the Fund has performed during various market types and the Fund is again very consistent. Please walk us through how you read this and what investors should expect during different markets?

Steve Scruggs

Yeah. This is a great chart. During times of market weakness, we protected capital better than our benchmark and our peer group. And our outperformance during this — the most recent downturn, it’s in line with what our expectations are. As I say, we are going to outperform — we tend to outperform in down markets and we are going to trail somewhat in robust markets.

But what this chart really shows is, when you look at it on a rolling five-year return basis, since the Fund’s inception, this correlation is very strong. When the benchmark is down, the Fund has outperformed in 23 out of the 23 instances when there was a five-year rolling return period that the Russell 2000 Value was down. And also point out that the average return for the Russell 2000 Value during those periods was negative just under 2% and we actually had a positive — average positive return of over 2%. I think that speaks to our downside protection.

When markets return between zero and 10% on a five-year period, the Fund outperformed roughly 70% of the time. So we are in a — what we would call a normal market, not that there is anything such as a normal market. But in a market like that, we outperformed 70% of the time.

But when the market average return is greater than 10%, we have only outperformed 7% of the time. But if you do — if you see, our performance during those periods was about 12% versus roughly 14% for the index.

So we are participating, but just not as much. So when we look at that on a full market cycle basis, by taking this long-term view, we have achieved our objective and it’s our long-term view that allows us to do this.

Courtney Reardon

Can you walk through what worked last year and what did it?

Steve Scruggs

Yeah. A brief recap of last year. In 2022, the Russell 2000 broad small-cap, it fell over 20%. Russell 2000 Value fell about 15% and our Fund fell 9%. So we held up better. We were down but not nearly as much.

In performance, our performance, it was negatively impacted a couple of things. One, by not holding energy stocks. Small-cap energy stocks, if you look at measured by a broad-based small-cap energy ETF, they were up about 50% last year and that was after being up almost 60% the previous year.

And as I said earlier, we typically are going to avoid energy in the portfolio, because the long-term track record is not an impressive one. It is — I mean, if you think you can predict the price of oil, you can trade in and out of those companies and be profitable, but we are not going to try to predict short-term movements in oil prices. It’s just — it’s not something that we do.

And incidentally, the ETF that I just mentioned, the one that was up 60% last year — 50% last year and 60% the year before, over the last decade, that Fund is down over 80% and that is a broad-based small-cap energy ETF. But our lack of energy for 2022, that’s one of the things that hurt our relative performance and we are okay with that.

We also had a couple of individual holdings that did poorly, one in particular is Synaptics. It’s a long-term core holding and it was down 67% and it had been on quite a run over the previous several years. We think it got a little ahead of itself. We sold a good portion of our holdings due to valuation during 2021 and then we sold a little bit more in early 2022, but we still had it as an equal weight.

And in spite of the recent price decline, when we look at the fundamentals, they look great. We feel good about the company, and in fact, late last year, we started adding back to our position. And I think that’s a good example of our discipline. Selling on valuation as we did in 2021 and then buying back when the opportunity presents itself.

And as far as portfolio positioning, there were no fundamental changes to the portfolio during the year. We trimmed some companies. We added to some others. We initiated six new positions, companies that were really beaten up and we also had four portfolio holdings were bought out during the year.

Courtney Reardon

What’s your largest out-of-consensus view and how is that expressed in the Fund?

Steve Scruggs

I would say it’s our technology holdings is currently 23% of our portfolio and that’s compared to roughly 7% in the Russell 2000 Value and 14% in the Russell 2000. And we get asked about this a lot, because tech stocks aren’t what you really think of when you think of small-cap value stocks.

But the companies we are invested in aren’t the speculative type of companies that grab the headlines. They are process companies, distributors, component manufacturers, and all of them are consistently profitable with very strong balance sheets, and right now, a lot of them are trading at really attractive valuations.

Another out-of-consensus is, we have no direct energy exposure. We think that small-cap energy companies are generally poor asset allocators. It’s entirely cyclical. When they make money, they make a lot of money when they lose money, they lose a lot of money. And unless you are going to be able to predict short-term movements in oil prices, you are not going to be able to know when to buy or sell, and we think that’s for gamblers and it’s not what we do.

Courtney Reardon

Let’s transition to the current setup for small-caps. Is small-cap value still extremely attractive in aggregate in your view from a quality and valuation perspective?

Steve Scruggs

This chart shows the relative historical valuations comparing small-cap to large-cap. And you can see, broadly speaking, small-cap companies are cheap. They have only been this cheap four times in the last 40 years. But as often is the case, a broad measure like this can be deceiving.

When we look within small-caps, what we are seeing is that, the lower quality companies were clearly hit the hardest last year, and many of those look statistically cheap. But when we look at the higher quality companies within small-cap, the ones that we are seeking to buy, they held up better last year. They are cheaper than they were. The valuations are more attractive. But we don’t see them as screaming bargains kind of like the ones we saw in early 2009.

But, overall, I will say the opportunity set, it’s much more attractive. We started last year with over 15% cash in the portfolio, and today, we are just under 10%. So things look more attractive, but we are not seeing broad-based screaming bargains like we have during some softs [ph].

Courtney Reardon

Can you talk about a recent addition to the portfolio?

Steve Scruggs

Yeah. I will talk about — I see and there are a lot of moving parts to this one. It’s a very unique company. Control by Barry Diller, who has a very long successful track record going back decades. And he started out buying QVC in the early ‘90s, did really well with that. He has an interesting — a unique way that he runs businesses.

He doesn’t run the companies to be profitable. And that may sound like something that Kathy Wood would say, but there’s a difference. He runs in a breakeven or slightly cash flow positive, so that he’s not reliant on capital markets or outside funding.

But what he’s focusing on is building long-term businesses and he doesn’t care about hitting a quarterly profit target. It’s really rare and we really like it and it fits in with our philosophy and we wish more managers would operate like this.

But we started buying IAC after the stock was — had fallen over 65% and there are several reasons for the price decline. One is that they own a significant stakes in two different public companies and those stock prices fell dramatically. Another they bought a company called Meredith, which they merged into their Dotdash unit and it was a large merger or a large acquisition and integration did not go to smoothes plan. It was more expensive and it took longer than they had hoped. But the company did announce last quarter that the integration was complete and they have all of their media properties on a unified platform now.

The two companies that they own significant stakes in one is Angi, which used to be known as Angi’s List and it matches home repair contractors with homeowners. And the other company is MGM Resorts International. And between the two of those, they own about $1.2 billion worth of Angi and they own about $2.5 billion worth of MGM and this is for a company who has got a market cap of $5 billion.

If you net out the stakes in those companies and the net debt, the remaining company is trading for about $1.7 billion. And we think that the Dotdash Meredith unit is worth considerably more than that. They are expected to do about $250 million in pro forma or not pro forma, in EBITDA this year.

And so when you look at the two major holdings and publicly traded companies, you look at what we think Dotdash Meredith is worth, the company looks undervalued, somewhat undervalue. But then they have a collection of other companies that they are working on doing similar to what they have done in the past and that’s running them not for quarterly profits, but building the business.

And again, I’d say not for quarterly profits. They run them profitably. They want to make sure that the companies are self-funding, but they put profits back into R&D and marketing, et cetera. And these companies is kind of across the Board they are all Internet related. One is Care.com, which matches family care providers with individuals, it could be either a babysitter or someone for eldercare, does $350 million a year in business, revenue growing rapidly.

Turo, which is kind of an Uber for rental cars. They own about a third of that company is growing quickly. And then the on something called the Mosaic Group, which is a mobile app platform that has over 3.5 million paying subscribers.

So when you — when we look at the core holdings of the business, we can get to a market valuation that’s greater than $5 billion and then when we look at these other companies that aren’t as profitable but are growing quickly, we see a lot of optionality there. So this is — IAC is a company that we think highly and I think it’s a very attractive investment right now.

So if we go through the four pillars, if brief — you briefly go to the four pillars and the way we would look at that, balance sheet strength with regard to their marketable securities and cash on the balance sheet. We don’t have any concerns there. Valuation as a sum of the parts, we have ready valuations for their public equity holdings. And when we model out what we think the Dotdash Meredith is worth, again, we get to something above the $5 billion market cap of the entire company.

And then the remaining companies, we view as options. Companies like that are not our specialty to come up with levels of intrinsic value, because they aren’t throwing off lots of free cash flow, which is one of the key things we like to see in our core investments.

But as I say, they are profitable and they are growing, and it’s because of Diller’s track record over many decades of running companies this way and doing so to the benefit of shareholders, we have confidence in that.

And then lastly, if we look at the industry, the industries these companies in are all growing. One, the Dotdash Meredith online advertising had a rough year last year and it looks like it’s going to be another rough year this year, broadly speaking.

But as the company has gotten this integration finished, they have made some changes in some things. They quite publishing six of their print brand, finished publishing five or six of their print brands. We think we are going to see some margin improvement there, even though it took a little bit of revenue out.

So we like to see a company that’s willing to do that, sacrifice revenue for profitability when it makes sense and it clearly makes sense here to us. So, again, it’s an equal weight holding right now, but we are slowly adding to it and expect to continue to do that.

Courtney Reardon

Thanks, Steve. Let’s shift a little bit to talk about the outlook. You often talk about looking three years to five years out when making an investment decision. How do you incorporate the near-term economic environment? What if there’s a recession?

Steve Scruggs

Yeah. When we say we take a long-term view and long until, say, we are looking three year to five years out and it’s not as though we think we know what the world will look like in five years. We don’t even know what it’s going to look like next quarter. But what it does, it helps us approach investing with a long-term view and it helps us overlook some of the noise today and I will give some examples that may be helpful.

For instance, right now, in Property Casualty business. We have some investments in property and casualty insurers. Inflation has eaten into underwriting profits. The rates companies sold insurance for was not enough to pay the claims because of inflation. We know this and companies are saying out loud.

And we have property casualty, underwriting profits are going to be under pressure in the near-term. And our companies are pushing through rate increases and they will get them. But there’s going to be some hits in the near-term. And so what should we do? Should we sell because of this and then buy back later when things look rosy. Most investors try to do that and it’s impossible to execute.

When we look at a situation with a long-term view, we accept that we factored into our estimates of intrinsic value. We make sure the companies that we are invested in have the balance sheet strength that’s going to get them through it and then we are confident that our experienced management will manage through it. And that’s an example at the company level, but the same holds true at a macro level.

Right now, everyone is predicting a recession and it does seem kind of inevitable. But if we are going to trade on that prediction, we would have to predict how deep the recession is? What type of recession is it? How long will it last? What areas of the economy will be most affected? And then we would have to position the portfolio in light of that prediction.

And so then in six months, our prediction will be tested and we can see what we got right, what we got wrong, and then we would have to make another prediction and position the portfolio accordingly to that prediction. And it’s a common way money is managed and we think it’s based on a false precision. So having that long-term three-year to five-year view outlook, it keeps us from engaging in that fatal [ph] task. At all times, we are bottom up with a long-term focus.

Courtney Reardon

Should we still own Queens Road Small Value today and has the reason for owning it changed at all over the last two decades. How should we think about future expectations for the Fund?

Steve Scruggs

We have seen a lot of change over the last 20 years. And in some ways, markets have become more efficient with regulation fair disclosure, kind of evening the playing field with regard to what management can say and win in. And also technology — the technology available to analyze companies efficiently, I think, has made more markets more efficient.

But I also think in other ways, it’s gotten much less efficient. And most notably, it’s from shortsightedness and I think that’s from both investment managers and management. You just — you can see what happens if a company hits or misses a quarterly number and what the price action in the stock does.

And while we think there is some value in that information that came out with that number, very often, the market overreacts to it and it provides us with an attractive opportunity a lot of the times.

And back to shortsightedness, as an aside, within the last year, I have spoken with two friends and they are both C-level employees. And I had — these are two completely separate conversations. And they got — these are two guys that went from private companies to public companies and then had recently gone back to private companies and they are in two completely different industries.

And they both said independently and they were adamant about it that they would never work for a public company again, because of the shortsightedness. Everything was focused primarily on this quarter or maybe this year and they weren’t allowed to take a long-term view and really work on growing the business over long-term. And this is something that I think it seems to be getting worse and it’s one of the main lenses we use to look at management and a company’s culture and we try to seek out management that are really playing the long game and so that will get paid off in the long run.

And while we have learned a lot over 20 years, our framework remains the same, and we think a consistent process will lead to consistent outcomes. And as we showed the correlation of our performance in different market types is consistently strong and we don’t see any reason why that would change.

We focus on the diligence, discipline in patients and taking a long-term view is core to what we do and we are sure that that’s not no change. And as I started this, our goal remains the same and has to outperform the Russell 2000 Value over full market cycles and we think we can continue to do that.

Courtney Reardon

Thank you, Steve. And with that, we are happy to answer any questions you all may have. I will pause for a moment to see if there are any live questions from the audience. I will also add that we had a few pre-submitted questions that Steve and I tried to address in the prepared Q&A. But if we didn’t answer your questions thoroughly enough, please do reach out to me. And we had one question come through towards the end that we did not address. So I will ask that now while we are gathering listener questions.

Steve, what has happened for small — what, sorry, what has to happen for small-cap to outperform large-cap companies over a sustained period of time?

Steve Scruggs

One thing we are starting with better valuations and that always helps performance. The valuations that you are starting at, look, 10 years ahead, you are going to have better returns if you are starting from a lower valuation than a higher valuation. That’s pretty well documented.

So the fact that small-caps on a relative basis are price cheaper than large-caps is one of the things that we think plays to small-caps advantage. Historically, rising rates have helped small-cap stocks versus large-cap stocks. And then also a recession — coming out of recession, small-caps and small-cap value in particular, have led the way out of eight of the last 10 recessions.

So we are starting with better valuations than large-cap. We don’t know what interest rates are going to do, but higher interest rates have historically helped small-caps, again, that’s just relative to large.

And if we should go into a recession, which we think is very possible, although, we have no idea what the depth of it, we think that a lot of the worries of a recession are priced in. Coming out of that, small-caps 80% of the time over the last 40 years have led the way out. So I think those are three pretty solid reasons why you should feel good about small-caps.

Courtney Reardon

Great. I will pause for one more second to see if there are any other live questions. That appears to be our final question for today. Thank you to those for listening to the FPA Queens Road Small Cap Value Fund second half 2022 webcast. I will turn it over to the system moderator for closing comments and disclosure. Over to you, operator.

Operator

Thank you for your participation in today’s webcast. We invite you, your colleagues and shareholders to listen to the playback of this recording and view the presentation slides that will be available on our website within a few weeks at fpa.com.

We urge you to visit the website for additional information about the Funds, such as complete portfolio holdings, historical returns and after-tax returns. Following today’s webcast, you will have the opportunity to provide your feedback and submit any comments or suggestions. We encourage you to complete this portion of the webcast. We know your time is valuable and we do appreciate and review all of your comments.

Please visit fpa.com for future webcast information, including replays. We post the date and time of upcoming webcast towards the end of each current quarter and webcasts are typically held three weeks to four weeks following each quarter end. If you did not receive an invitation via e-mail for today’s webcast and would like to receive them, please e-mail us at crm@fpa.com.

We hope that our quarterly commentaries, webcasts and special commentaries will continue to keep you appropriately informed on the strategies discussed today. We do want to make sure you understand that the views expressed on this call are as of today and are subject to change without notice based on market and other conditions. These views may differ from other portfolio managers and analysts at the firm as a whole and are not intended to be a forecast of future events, a guarantee of future results or investment advice.

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This concludes today’s call. Thank you and enjoy the rest of your day.