January 18, 2009
SouthernSun 4Q08 and 2008 Year End Commentary
As I have been traveling in Asia and the UK the past several weeks, I must admit that I sincerely hoped I would find just the right words to open this letter, given the events of the past year. I feel certain that many of our colleagues in the industry are producing powerful and memorable images in their communication, images that succinctly describe and clarify the year’s key events. The good news is, now having asserted the aforementioned, I am “off the hook”, as it were, for such an introduction.
While discussing the current state of global economic affairs with a high ranking Asian figure, he submitted to me that it seems odd that we are already attempting to contextualize these events when those who are intimate with the details remain uncertain about the relevant questions we need to ask. We tend to agree – and maybe this is part of the reason why I had difficulty crafting a catchy synopsis at the outset.
We have mentioned in the past that we would gladly let others catalogue the events of any given year and we again take that position. In a time where forecasters of doom and gloom captivate the headlines, it seems tempting to forget that a prophet is not only one who may foretell the future but may more likely be one who rightly characterizes the present (note Aristotle, The Art of Rhetoric). With this in mind, and possibly above all else, surely we must agree that our current circumstances have produced a loss of trust in financial systems that would rival in magnitude any in world history. A middle-eastern acquaintance, who has spent a good deal of his time negotiating with world leaders over the past several years, said that he looked into their eyes for oceans and found only puddles. We would suggest that, in the end, currency (capital) is no more or no less than trust – thus, as what were thought to be the stable pillars of our financial systems faltered, even fail, trust evaporates. Some have coined this “a crisis of confidence”, but we think that comes up rather short. In fact, we have consistently suggested that there has been a systematic dismantling of the “notion” of trust in favor of a type of blind empiricism - potentially leaving us with some very unsavory consequences. So, in the end, consistent transparency and accountability from the management of our portfolio businesses mattered little to the marketplace as they succumbed to what one might characterize as a category error.
The harsh reality is that a very long streak of positive performance years in our small cap composite came to an end due to the market contraction and de-leveraging that occurred in the September to December period. On the other hand, we are so grateful that even during this period we continued to see net cash inflows from our clients with few meaningful departures. We believe our traditional, hands on approach will continue to preserve and grow the funds our clients entrust with us. There is never a time when we are encouraged by losing money. This time is no different in that respect. We do believe that as a result of the events of the past year there may well be a recalibrating of risk and reward in the minds of many ( at least for a time) and that our approach to evaluating and valuing companies may well emerge a more sought after strategy. Irrespective of how the other side of this looks, we remain committed to understanding what our businesses are doing, why they are doing it, and what that may be worth to our clients one day.
Our businesses, in general, continue to press forward, albeit in very difficult conditions for the most. We have multiple reasons to remain constructive with our current portfolio companies, as many are seeing unprecedented opportunities to expand their global footprint, even amid the admittedly anemic credit environment. In general, we believe that our portfolio companies’ capital budgets will come down in 2009 with an emphasis toward generating cash and focusing their long term strategic positioning. Further, from a portfolio perspective, we are intrigued by some of the interesting new ideas and opportunities provided by the market sell-off.
We can say without hesitation that our due diligence process has proved worthwhile through the tough conditions of this past year as we have learned more about the strengths and weaknesses of our companies’ capital base as well as their management. We continue to believe that the same will be the case going forward. In 2008 and now into 2009, we continue to log significant time on the ground at our companies’ plants and facilities in order to closely monitor the pulse of operations including bookings, orders, and flow through. For example, we believe our companies, for the most part, will plan and operate as if 2009 and at least half of 2010 will continue to be very challenging on a macro scale; however, by-in-large, they have right sized overhead and personnel while maintaining flexibility to adjust should their specific business environment offer opportunity. One other point that might be worth mentioning is that many of our businesses have taken advantage of favorable operating conditions over the past few years to improve productivity and reduce long term cost. You may recall how we emphasized in previous commentaries the importance of our businesses investing in technology and leading edge mechanization for times much like these.
Although we cannot go over all of the details of our findings these past few months, we think it may be helpful to simply take you around the world (from East to West) with some observations that are country specific followed by a few words on food and fuel.
We have meaningful business interests in China, India and Malaysia. China, in the Year of the Ox, will encounter several important anniversaries, not the least of which will be the 20th anniversary of Tiananmen Square in June. The revealed slowing growth is important for various reasons but we are keen to watch its impact, particularly with respect to employment, on the new permanent urbanites and more specifically the graduate unemployed. As evidenced in the news reports I observed on my latest visit (I am scheduled to be back again in March), the government reports are predictably unreliable. History suggests that the communist party understates the growth figures in good times and overstates them in bad – we would not expect any departure from that tendency in 2009. The need to have the people “feel” secure may never have been as important as today, given the impressive population shift and concentrated numbers of highly educated individuals – suppression may indeed become more difficult to manage than before. That said, we believe that infrastructure growth – roads, bridges, railways, power generation – will remain a priority of the government. When coupled with increasingly entrenched urban consumerism and the progress made by indigenous suppliers to support non-Chinese corporate manufacturing, the picture for China is, for the time, brighter than many others. We also continue to watch China’s natural resource activity in Africa – some of our current portfolio businesses are tapping into the opportunities being created by this long term investment.
We have renewed concerns about military action by India, post-Mumbai, against Pakistan; however, we are cautiously optimistic about the focus of the government on its commitment to providing power and water. What occurs in India and China, with respect to power generation build out, we believe will have a significant impact on the direction of steam coal prices over the coming 12-24 months. Further, banks in India, we believe, maintain a conservative lending approach. The good news is obvious - the bad news is the growing divide between rich and poor. Our portfolio companies’ interests in India are primarily manufacturing and power generation and not IT - although several of our businesses achieve cost benefits from IT outsourcing.
At this point we have limited direct exposure to Russia, Eastern Europe, Africa, and the Middle-East but we do have some. We have broad indirect exposure in all of these regions, particularly in relation to commodity pricing both food and fuel. Briefly, agriculture is the primary exposure for our portfolio in Russia and Eastern Europe. We maintain joint ventures in Russia and Ukraine, as well as livestock operations in Romania and Poland. With energy and grain prices low, Russia and Eastern Europe may struggle economically for some time, what with lack of supportive infrastructure and a relatively immature banking system and when coupled with repatriating populations. We would not be surprised to see some sovereign debt issues emerge from these countries – of particular near term concern would be Hungary. We will be traveling to South Africa in February and expect to have more to report on this region at first quarter’s end.
We have concerns about sovereign debt defaults in Ireland, Portugal, Italy, and Greece. We have great and growing concern about the UK housing sector and spreading unemployment - our various facilities based there along with specific engineering projects, are at some point not insulated from the broader weakness. Our companies have diverse operations, from manufacturing to distribution and sales across much of Western Europe and the UK. We see continued strength in our energy related assets and services in these regions but softness is increasing in most other segments. While Europe is an export economy and therefore depends greatly on emerging economies, most of our facilities are geared toward internal demand. We are and will continue to monitor the specific products and services offered by our businesses, as this may vary from product to product and country to country.
With respect to South America and the United States, as with all the other regions previously discussed, we have many more questions than answers. We currently have meaningful portfolio interests in South America, including manufacturing, distribution and sales. Although our portfolio businesses are primarily located in Brazil, we do have facilities in Argentina, where we believe that sovereign debt default is quite possible. If this were to occur, we believe – even though the government is suggesting otherwise - that it would negatively impact farm programs in the near to intermediate term and subsequently our farm equipment operations. The questions about our United States assets – much like looking at Europe – will range depending upon state and product or service. In general, we believe our portfolio businesses have been proactive both defensively and offensively over the past twelve to eighteen months. We continue to closely monitor a host of metrics with each of our companies as well as keep a regular presence in their facilities around the country.
We are not going to begin to guess what will happen with commodity prices over 2009. As many should have learned, there is no telling when an inflection might occur or what might be its cause. What we will say is that we believe that there are sound reasons for our previous assertions that, though down significantly from all too lofty levels, many commodities both food and energy related should find higher floors as demand and supply becomes fundamentally driven – with lower levels of highly leveraged speculators – where real commercial transactions are genuinely supported. Even though the cost side of the livestock equation has come down, we believe that the size of the hog herd must, and will, come down over 2009 before meaningful profitability can be established. We continue to monitor a forming La Nina, the potential of lower yields in South America due to lower agrichemical use, slowing consolidation and survivability in the United States ethanol sector, policy target changes with respect to alternative fuels in the United States and Europe, nuclear permits globally, and sovereign sponsored power generation and water infrastructure projects as a few of the many clues for opportunity. The United States has on its side a great history of diversity and innovation – we believe that, as in the past, these core qualities will lead the United States going forward.
Finally, we wish to thank you, as always, for your confidence in our firm. We, like you, felt the direct impact of our decisions this past year as we stood alongside you as shareholders in the SouthernSun Small Cap Fund. We do not know what 2009 holds – we do know that we will continue to faithfully implement the same rigorous investment process based on the same philosophy that has produced solid results for the past twenty years.
Best wishes,
Michael W. Cook, Sr.
CEO & Chief Investment Officer
SouthernSun Asset Management
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