July 15, 2008
SouthernSun 2Q08 Commentary
The news, on multiple fronts, does not seem to be very bright these days. The second quarter ended with a bit of a thud beginning on or about the 5th of June. And while it may seem comforting to blame the news media for the current financial market woes, we are afraid such a notion is not very rational. However, that they have exploited certain issues over others, thus creating a more lopsided view of the global business environment, is defensible and frankly not surprising.
The month of June produced losses for the Russell 2000, 2000 Value, 2500, Mid Cap, S&P 500 and the MSCI All Country All World indices of about -7.7%, -9.6%, -8.2%, -8.0%, -8.4% and -8.3% respectively. Oil hit a record $145 per barrel, housing foreclosures jumped by about 53%, many soft commodities continue to climb ever higher, and many equity markets are well into double digit losses for the year. Broadly speaking, corporate profit margins are being squeezed by higher input costs and some slowing of demand. Pass-through pricing in many businesses cannot keep pace with underlying cost increases as commodities like steel are re-priced multiple times during the day. There are calls by many to more tightly regulate certain futures markets, particularly with regard to energy. A growing sense that speculators have seized hold of some commodities, resulting in a frenzy of cash chasing cash and therefore altering the original intent of these markets, makes some investors very uncomfortable at best. As evidence of this concern, take for example the open letter recently released by airline executives. It suggests that speculators in the energy futures markets have gone from 21% of the contracts to 66% of the contracts over the past twenty years and that the futures contract on a barrel of oil is traded as much as twenty times before it is delivered and used – and whether the facts bare out this claim, the number is surely higher than in the past. All said, there are, as always, a host of concerns. However, despite what many would have you believe, all the news is not bad.
Amid all of these concerns, many of our businesses continue to perform admirably while others have been impacted by near-term reactions that, we believe, will not last. For example, construction equipment sales for May dropped by 8.6% year over year, “but” rose 4.6% from the previous month. Agriculture equipment sales continue to be impressive, “but” only in certain categories (with June and YTD over 100HP 2 Wheel, Total 4 Wheel tractors and Combines up 14.5%, 35.0%, 8.2% and 23.7%, 10.1%, and 12.9% respectively) and in certain parts of the world. Coal prices have dropped by up to $15 per short ton in recent weeks, “but” inventories remain very tight in many parts of the globe.
With the aforementioned as a backdrop, we would again, as we have over the past several decades, hope to communicate the importance of two overarching principles:
1) It is indeed rare, even in science, that a paradigm immediately crumbles the moment some inconsistent evidence is found. Remember that many of those who are suggesting that there are no other possibilities other than those contained in today’s news bites are the same ones who supported an opposing hypothesis not too long ago – beware of the enticing error of false alternatives. For example, a bit more than twelve months ago the consensus view was that near record coal inventories would persist for years due to the global shift away from fossil fuels as we were ushering in a new era of low carbon base-load power. Today, new coal fired plants continue to be built, although many are now clean coal facilities, and the stress on coal stockpiles has taken Central Appalachian Coal prices from $40 per short ton to $130 per short ton in about twelve months time. To further illustrate, twelve months ago analysts, government leaders, and the media all touted ethanol as the transportation alternative of the future – today, twelve months later, ethanol is evil. Many of the same now assert that it drives up food costs – remember two years ago when we suggested that the battle between food and energy would escalate to unimaginable levels but food would win the day – and may not have the benefits once thought by “experts.” False alternatives – this is very likely not an either/or proposition. We could go on - but you probably get the point.
2) There is a tension between proof and knowing that is a constant challenge. It is indeed useful to examine what has occurred in different periods and different times. However useful, it offers little in the way of proof. As my dear friend and Fellow of Mathematics and Philosophy of Science at Green College, Oxford University, Dr. John Lennox, has said, “empirical certainty is reserved for his field alone, pure mathematics, and that is of interest to very few.” We believe that one can best utilize the data and lessons from the past when coupled with the evidence before us as signposts or markers, if you will. Therefore, while our investment process has not changed over the almost two decades of our existence, it has always been a working - living hypothesis. To illustrate, whether analyzing particular observations related to our current portfolio businesses and their leadership over a variety of business/marketplace conditions or more broadly from the oil spike of ‘90-’91 and the U.K. market collapse of ‘73-’741, our process demands that we utilize these observations in context, recognizing that no two scenarios are “exactly” the same. We must recall that investing does not take place in a controlled laboratory but rather amidst a literal world of seemingly unrestrained influences. It is for this reason that we spend a significant portion of our time in the plants and facilities of our portfolio companies – where you would of course expect us to be. This approach, without question, allows us to, at least in part, avoid the siren song of the marketplace and center our attention on the strategic planning of our businesses. Further, as a side bar, our Investment Team is paying particular attention to the potential impact of equity markets on balance sheets, corporate benefit plans, and executive stock option plans.
We, in general, are quite encouraged with the determination, focus, and actions of our companies’ management teams. As we have asserted for years now, intentionality of regional diversification and measured but aggressive competitiveness within a niche has been a hallmark of our portfolio businesses. This remains true today. Although we continue to see many basic cost components on the rise, in many ways these have, at least for the moment, overshadowed much of the solid long term progress across our portfolio business units. The benefit being that not only have some of our portfolio companies become more attractive for fresh cash, but a number of businesses we have been evaluating for some time now, yet waiting for an opportunity to buy at lower prices, are much more attractive.
We have referenced our views about the growing influence of hedge funds on the small and mid cap space, and in the past year, more in the global markets than ever before. For the most part, our intermediate term results would indicate that influence is transient, whether for the better or worse. Of some interest over the short term is the potential influence that hedge fund trading may indeed sway over the broker-dealers, who rely on the higher volume of transactions they afford, versus the low activity of a longer term investor. As evidence, we have seen more than one instance in the past one and a half years where the timing of an analyst report is curiously associated with a quarterly reporting period.
Finally, we are so excited about the addition of two new SouthernSun Investment Team members. Michael S. Cross and S. Elliot Cunningham joined us in the month of June as Analysts.
Mike, 46, earned his B.S. in Business, with a minor in chemistry, from Vanderbilt University and his MBA from the Owen School of Business at Vanderbilt. Mike began his career with Cummins Engine immediately after graduate school. He started and built business units for Cummins with extensive international experience in finance, accounting, distribution, sales, marketing, and product development, manufacturing and government and investor relations. Mike joined SouthernSun after having designed, developed and launched Cummins Emissions Solutions business.
Elliot, 25, earned his B.S. in Business Administration, magna cum laude, from Auburn University in Auburn, Alabama. His responsibilities include the research and analysis of investment opportunities and monitoring of existing portfolio companies. Prior to joining SouthernSun, Mr. Cunningham served as an Equity Analyst for RMK Funds at Morgan Asset Management. Elliot is a Level II CFA candidate.
Should you have the opportunity, please join us in welcoming them. We are very blessed to have them as part of the SouthernSun Investment Team. We have already identified unique benefits each has brought to the firm in just over a month’s time. For the next three months, Mike will be working directly with Phillip Cook and Elliot directly with Peter Matthews. In addition, Mike will be spending a portion of his time getting to know our clients and examining how the Investment Team might better interface with them. Mike will also pick up coverage of all news related to our business interests in Africa and the Middle East. Elliot, on the other hand, will spend a portion of his time with Dave Stevens, thoroughly understanding our trading process and procedures in an effort to identify opportunities for improved efficiencies between trading/operations and the Investment Team. Elliot will also be responsible for daily news and information flow from North America and Western Europe.
In summary, our view remains that current market/business conditions, today as in the past, provide many of our portfolio businesses unique opportunities – many in consolidating niches – to increase their competitive advantage long-term. We are particularly keen on the long term prospects of some niche financial, global infrastructure, agricultural, and industrial businesses.
As always we appreciate your confidence in SouthernSun over the past eighteen and one half years. We are here because of you. You may rest assured we will continue to vigorously apply our discipline.
Michael W. Cook, Sr.
CEO & Chief Investment Officer
SouthernSun Asset Management
1According to Patrick Hosking at “The Times” of London, when the turning point finally arrives many investors will miss it. After two years of utter despondency throughout ’73-’74, during which shares lost four fifths of their value, the U.K. market in January 1975 posted weekly gains of 9.4%, 9.7%, 23.9%, and 9.4%. To quote from a market report at that time by Rowe and Pitman, “Most investors were wrong-footed by the sudden change and remained imprisoned by the seemingly irrefutable logic of their gloom.”
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