One of the nice aspects of Randall and Herbert Abramson’s fund is that it discloses its most important trades in quarterly letters to investors, the latest of which we’ve been lucky enough to get our hands on. Written in mid-November, Trapeze’s Q3 letter gives a succinct look at the fund’s contrarian ideals, likening value investing to a “Lonely Hearts Club.”
On this strategy, the Abramsons discuss how “staying lonely and avoiding crowds” is the best way to trade undervalued assets with promising firm or industry-specific growth prospects. On the subject of equities, the letter cites a point made by San Diego-based Brandes Investment Partners (via Barron‘s), that mentions the spread between overvalued and undervalued stocks is wider than historical averages, making now a superb time to buy cheap. It discusses that “‘In the past, when the spread between pricey stocks and cheap ones has been wide it has tended to be an excellent time to buy the latter.”‘
While Trapeze does mention some of its top picks trading on the Toronto Stock Exchange, we’re going to take a look at the fund’s investments that do most of their trading within U.S. borders. We’ll start with two NYSE-listed stocks that were included in Trapeze’s “Top Holdings—Beautiful Wallflowers” section: OfficeMax Incorporated (NYSE:OMX) and Metlife Inc (NYSE:MET).
Looking at OfficeMax first, we can see a stock that has hurt long-term investors (down 26.9% over the past three years), but those who have bought in more recently have been rewarded. Shares of the office supply store have nearly doubled since June 1st, and Trapeze thinks more gains could be in store. Here’s what co-founders Randall and Herb had to say about the company:
“OfficeMax, although known to consumers and with sizeable sales, has been overlooked by investors because of the negative sentiment toward anything smaller cap and also perceived as being under threat from the Internet providers […] the company is employing its own levers to advance earnings, including operating efficiencies and cost cutting. And it’s working. The company just reported a stellar quarter with slightly lower top line but about a 40% profit lift. The company’s market cap is now about $700 million. Non-operating assets, on and off balance sheet items, are at least $180 million […] including net cash of $125 million. We are essentially paying just $520 million for the current free-cash-stream of $60 million annually, or about 8.5x free cash flow.”
In addition to OfficeMax’s attractive FCF valuation, shares also trade at a meager price-to-earnings growth ratio of 0.44 based on the sell-side’s consensus EPS growth estimates, which expect 4-5% annual growth over the next half-decade. Driven by the company’s cost-cutting initiative to close underperforming stores, these positive expectations are a far cry from the double-digit earnings compression it has experienced over the past five years. Other hedge fund managers that were quite bullish on OfficeMax’s prospects last quarter include: Steven Cohen (+9,821%), Ken Griffin (+383%), and Cliff Asness (+44%). Check out other big bets made by Cliff Asness recently, and Ken Griffin’s top picks can be seen here.
Getting to Trapeze’s other U.S.-traded “wallflower” pick Metlife, we can see a decidedly different picture. Shares of this multi-national insurance provider have lost around 12% over the past three months, but its size alone – Metlife is America’s largest life insurer in terms of total assets – warrants investors’ consideration. Here’s what Trapeze had to say about MET:
“MetLife, like most insurance companies today, is out of favour because the prospect of higher interest rates from fixed income holdings, a key source of earnings, appears dim and the prospect of more government regulation appears likely. So this dominant international life insurance company trades at less than 6x earnings and well below book value. Our FMV estimate is over 50% higher than the share price, and growing. The company has excess capital which it and key shareholders would like returned to shareholders via dividends or share buybacks. However, the sale of its small banking operation, which is overseen by the Fed, has been holding up the process for months. While frustrating, this should be resolved shortly. Like our other large-cap holdings we are looking for a potential return to fair value in excess of 25% per year over the next 2 years.”
It’s important that Randall and Herb mentioned Metlife’s sale of its online banking business to GE Capital, which was just approved by federal regulators on December 14th. According to MarketWatch, a “GE spokesman said the deal is on track to close before year end.”
While Metlife’s current dividend yield of 2.3% is below competitors like Prudential Financial (3.1%) and Principal Financial (3.0%), the conclusion of its transaction with GE will likely be followed by a payout boost sometime in 2013, assuming that the Dodd-Frank doesn’t regulate MetLife as a nonbank systemically important financial institution. A nonbank SIFI designation would require it to maintain more stringent capital requirements, as Barron’s has discussed recently.
In the “Additions And Deletions” segment of Trapeze’s latest letter, three bullish plays are mentioned in particular: American International Group, Inc. (NYSE:AIG), Southwest Airlines Co. (NYSE:LUV), and Owens-Illinois, Inc. (NYSE:OI).
Regarding AIG, it’s important to note that the insurer was a favorite of the hedge fund industry at large in the third quarter. Of the 400 funds we track, 110 had long positions vs. 61 at the end of the second quarter, good for an 80% increase. Steven Cohen and SAC Capital Advisors were some of the biggest bulls in AIG; see Cohen’s entire portfolio here.
The federal government officially closed its bailout of AIG early last week, selling the remainder of its 15.9% stake in the company. With the completion of its deal, investors can buy an insurer that’s expected to make close to $36 billion in revenue next year at only 0.7 times sales. Wall Street expects AIG to average 14-15% annual EPS growth over the next five years, but the markets are valuing this potential at a mere PEG of 0.16. Clearly, there’s still a bit of “All Investments Gone” sentiment tied to this stock, but a negative bias won’t hang over AIG forever.
Shares of Southwest Airlines, meanwhile, have been hurt by “high jet fuel prices and an anemic economy” according to Trapeze’s letter. Much like AIG, Southwest is undervalued on a sales, cash and earnings basis, and concerning the latter, this is true even though bottom line growth is expected to pick up significantly over the next few years.
On average, sell-side analysts are predicting an annual EPS growth rate of about 18% through 2017, a significant improvement from the negative growth Southwest experienced last year. A below-average cost base and its ongoing conversion of newly acquired AirTran assets are other key growth drivers. Jet fuel prices also look to be stabilizing as we head into the new year.
Last but certainly not least, Randall and Herb mention that their fund increased its position in Owens-Illinois. The duo discusses that OI’s “overly aggressive growth plans to meet incremental demand caus[ed] self-inflicted bloated costs as it had to ship its glass products from plants farther from customers.” As these costs normalize, the Street expects earnings to rise by 8% in 2013, with slightly higher annual growth predicted over the longer term.
OI’s forecast is slightly below what’s expected of peers like Ball Corp (10.6%) and Crown Holdings (10.2%), but investors aren’t valuing this differential properly. Its shares trade at a price-to-earnings growth multiple of 0.9, while Ball and Crown are around 30% more expensive.
On the whole, Randall and Herbert Abramson of Trapeze Asset Management discuss a fine group of value opportunities, each with their own growth initiatives that can push shares higher over the long haul. OfficeMax is in the midst of an effective cost cutting program and Metlife is in a great position to boost its dividend, while AIG has just been freed of government ownership. Southwest and Owens Illinois, meanwhile, are both seeing their respective cost structures improve heading into 2013.
The best advice that Randall and Herb give their readers is that “[i]t’s indeed frustrating to wait until what’s undervalued is discovered and generally embraced,” but “[v]alue investors need to be patient and stay the course,” adding that it is “[w]orth the wait.”
