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FPA Capital Best Small-Caps Today

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FPA Capital has managed to outperform the Russell 2000 since inception during the 1980s. Today, it’s still finding value in the small-cap space. Its biggest contributors for the first part of the year were Patterson-UTI Energy (NASDAQ: PTEN) and Interdigital (NASDAQ: IDCC).

The fund has been a slight underperformer of late, but it’s been putting its fund to work as the market for small-caps have sold off and other funds were selling off their energy stocks at “fire-sale” prices.

The fund remains heavily invested in energy, but also technology, with the two making up nearly half the fund’s assets. In the tech space, FPA has built a large position in Interdigital and Western Digital (NASDAQ: WDC).

Western Digital is a little outside the small-cap space, but a maker of hard disk drives (HDDs) and solid-state drives (SSDs). In truth, it’s changing the storage space game. It got approval from the Ministry of Commerce of the People’s Republic of China (MOFCOM) to fully integrate the Chinese assets from its acquisition of Hitachi’s disk drive business. WDC also announced a deal to acquire SanDisk (NASDAQ: SNDK) for approximately $19 billion in cash and stock, catapulting the company into a leadership position in SSDs. Western Digital has been in our portfolio since early 2007. The investment is a good example of how we scale up and down our position size over time.

But now onto some smaller-caps, ARRIS (NASDAQ: ARRS), which is a provider of cable operators with communication systems that make it possible for users to consume bandwidth. FPA initially invested in Arris in November 2010, and more than doubled its investment in 2013 after acquiring Motorola Home from Google.

Now, the thesis has largely played out, and the stock price tripled from November 2010 to March 2014, yet they’ve started buying again at a time when four of the company’s five largest customers — Time Warner, Comcast, Charter and AT&T — got involved in M&A talks.

Arris’ largest customers are running out of network capacity, so their CapEx plans should remain elevated. In April 2015, Arris announced another big acquisition — Pace PLC. The thesis is fro when these synergies start kicking in, the company could generate as much as $700 million to $800 million of owner earnings. Arris is trading at about 6 times owner earnings to proforma enterprise value.

Even smaller-cap stocks

InterDigital is a $2 billion market cap is a play on wireless growth. Nokia and Ericsson were the major mobile phone players 15 to 20 years ago. Today, their phones are industry footnotes, and Apple and Samsung dominate. InterDigital makes critical technology across the wireless industry. To make sure its technology maintains a vital place inside networks and devices. In summary, we believe that the world will use more smartphones and tablets going forward, but we don’t know who the top sellers will be.

For-profit education

FPA has been a big believer in for-profit educators, owning both Apollo Education Group (NASDAQ: APOL) and DeVry Education (NYSE: DV), which continue to trade at a substantial discount to intrinsic value.

Still, FPA has been adjusting its position, i.e. selling off stakes, to reflect the risk/reward. In October 2014, an inter-agency task force was formed to share information about investigations into for-profit education. It appears that the fervor for prosecuting for-profit schools has increased meaningfully. While they continue to believe there is substantial value trapped in the Apollo organization, it may be more difficult to extract that value than we originally forecast.

Energy talk

FBA believes it’s almost a “mathematical certainty” that U.S. production will decline significantly from its peak. But the picture outside of the U.S. is also concerning. 2016 marks the first time since 1986 that global E&P spending has fallen two years in a row.

OPEC’s spare production capacity is now at the lowest it has been since the oil shocks of the 1970s. On the demand side, growth continues to be supportive. The United States is not much different. Putting it all together, they believe that the market should come back into balance during 2016, absent a shock to demand.

FPA’s energy-related names have done well during the volatility. They have a preference for onshore drilling, and still owns Rowan Companies (NYSE: RDC). In part because of its highly differentiated liquidity and free cash flow position, and in part because of its opportunity to drive costs out of the business.

Then there’s Noble Energy (NYSE: NBL) had $1 billion of cash and $5 billion of total liquidity at the end of 2015. Yet, it still holds its lowest cash level in 12 years, at approximately 20%. To take advantage of the market swings, it’s been deploying cash during the downturn early.

P.S. We’ve worked up a new way to find great underrated stocks and underfollowed hedge funds. One of our latest issues of Underrated Small-Cap Stocks profiles a fund that’s up 12.5% in the first half of 2016. Learn more about what we’re doing with small-caps here.

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