Steven Romick: Finite Limit To Passive Inflows And Central Bank Actions – ValueWalk Premium
FPA Crescent Fund

Steven Romick: Finite Limit To Passive Inflows And Central Bank Actions

FPA Crescent Fund commentary for the year ended December 31, 2016.

2016 Hedge Fund Letters

H/T Dataroma

Dear Shareholders:

FPA Crescent Fund – Performance

The markets continued to move higher in the fourth quarter after overcoming the initial misgivings surrounding the results of the U.S. election. The FPA Crescent Fund (“the Fund”) returned 4.51% in the period and 10.25% for the full year. This compares to the 3.82% and 11.96%, respectively, for the S&P 500 and 1.19% and 7.86%, respectively, for the MSCI ACWI index.

FPA Crescent Fund

As has been the case since the Fund’s inception, Crescent outperformed its exposure in the quarter and full year.1 The alpha generated by our equity security selection, as shown in the table below, has helped the Fund meet its two-pronged goal of lower risk and equity-like returns despite maintaining large cash balances for extended periods.

FPA Crescent Fund

One of Crescent’s secondary benchmarks, a balanced stock/bond blend (60% S&P 500/40% Barclays Aggregate Bond), has had a huge tailwind thanks to interest rates that steadily declined starting in 1982, through the Fund’s inception in 1993 and up until 2016.

FPA Crescent Fund

The Barclays Aggregate Bond Index has compounded at 5.42%, far better than the return on our greater than 30% average cash balance since Crescent’s inception thanks to this generational bond bull market. Despite what is a comparative headwind for the Fund, we have beaten the balanced benchmark from inception by 2.45%, although the Fund has lagged in the last five years by 0.54%.

We saw a reversal of this trend in Q4 with interest rates turning up, thereby causing bond prices to fall. The yield on the 10-year U.S. Treasury note increased from 1.60% at the end of Q3 to 2.45% at the end of Q4. A 0.85% increase in rates may not seem like much in basis points but a 53% increase in just three months wreaks havoc on a 10-year bond, causing a 7.3% decline in the value of its principal. As a result, the Barclays Aggregate Bond Index declined 2.98% in Q4 after having increased 5.80% for the first nine months of 2016.

FPA Crescent Fund

We don’t know if the bull market in bonds has ended but given how low rates continue to be, it’s hard to imagine the next decade will feature the same drop in interest rates (and rise in bond prices) that the last decade had. If, in fact, rates continue to rise from here – causing further losses in the bond market – Crescent’s perpetual eschewing of interest rate risk should accrue to the benefit of our shareholders.

Morningstar nominated our team for 2016’s U.S. Allocation/Alternatives Manager of the Year. Both longtime shareholders and Morningstar understand, though, that we judge our performance over full market cycles of which 2016 was just one calendar year. We appreciate their interim recognition nonetheless.

Portfolio

Our exposure to financial firms along with our investment in high-yield bonds both benefited 2016‘s performance as exhibited in the tables below.3 All but one of the winners were financials in the Q4 and full-year periods, the opposite of what we saw in Q1. The losers lacked a theme but it should be noted that our Naspers/Tencent arbitrage continued to suffer (see Q3 2014 commentary).

FPA Crescent Fund

FPA Crescent Fund

As lower-grade corporate bonds declined in price in late 2015 and early 2016, we quintupled our exposure. That sounds like a lot but, in truth, we took it from just ~1% to ~5%. The broader high-yield opportunity we hoped for didn’t come to pass. Index yields traded above 10% for just one day in February 2016, and have subsequently declined to just 6.19% today.4 Our corporate bond investments outperformed the index, returning 41.87% in 2016 vs 17.49% for the BofA Merrill Lynch U.S. High Yield Index, and contributing 2.22% to Crescent’s full year return.5

Our equity book was led by our overweight position in financials. The tale of our fluctuating financial exposure is emblematic of our approach to investing: Buy good businesses when others don’t want to own them and avoid them when they’re popular. Owning the unloved can be trying at times as these companies may be suffering from general economic weakness, industry malaise or internal missteps. Since we lack any ability to discern the bottom in a company’s earnings or stock price, our initial purchases are generally early. That can be uncomfortable for the holder – or worse, the holder of the holder, like shareholders of a mutual fund, for example. The more removed one is from primary research, the less comfort understandably exists in observing a manager maintain a position while it’s declining in price. Worse, if in that instance the manager were to increase its stake, a fund investor’s discomfort may compound. We don’t let our judgment become unduly influenced by stock price, preferring to focus instead on fundamentals.

Going back to the Fund’s inception, we have had an on/off affair with lenders (e.g., banks and thrifts). Using the S&P 500 Bank Industry Price/Book as a proxy for valuation, you can see that Crescent’s exposure to financials has vacillated inversely. As lenders get cheaper (lower Price/Book), we buy. When they become more expensive (higher Price/Book), we sell. Therefore, when the bank index was at a high valuation in the late 1990s and early 2000s, Crescent’s exposure was negligible but we reengaged when valuations were bottoming earlier this decade and our exposure has now increased to an all-time high.

FPA Crescent Fund

We lacked the foresight to build an entire position once the bottom had been reached in the financials or any other sector or asset class for that matter. As a result, we regularly endure periods of underperformance while waiting for our thesis to play out but our buying program generally continues as long as our opinion remains constant.

Lenders declined in price in 2015. We bought. They declined further. We bought some more. Early 2016 brought more of the same. Our investment in financials contributed to Crescent’s performance lagging its exposure for a period of time. We had plenty of phone calls from shareholders questioning the wisdom of these investments. Those calls reached a crescendo in Q1 2016 when four of the five losers in the period were the same financials that round out the winners list in Q4. No surprise that Q1 was a bottom for the sector (and the market). Since we are closer to the investments than our shareholders, we can appreciate their discomfort. And yet discomfort is a kind of petri dish that cultures opportunity. Anxiety creates selling pressure and lower prices, which allows us to invest with a margin of safety.6 The comfort of going it alone is, for us, preferable to that of running with the crowd. In periods of such solitude, we hope we succeed in providing you a modicum of reassurance as we tried to do when we articulated our rationale for financials in our commentaries (particularly, Q1 and Q2 2016) and our conference calls.

Buying at a discount to a business’s intrinsic value (as we did with the banks) offers downside protection but that doesn’t mean we’ll always make money. We can justify an investment if the upside case is much higher than the downside. Sometimes, though, the downside case materializes and we take a loss. We wouldn’t characterize that as a mistake (though we can point to our share of blunders). Our long-formed habit of leaning into the wind will continue and Crescent’s performance will disconnect from its benchmarks at times as a result.

What happens over short time frames should be entirely irrelevant. We instead maintain our focus on the longer term goal of achieving equity rates of return with less risk than the market and avoiding permanent impairment of capital. We appreciate that investment risk, like beauty, is in the eye of the beholder. We define it as losing money. For others, volatility, the institutionally accepted definition of risk, may be more appropriate. If we have $1,000 today and it drops to $750 next year, but then is worth $2,000 five yearsWe lacked the foresight to build an entire position once the bottom had been reached in the financials or any other sector or asset class for that matter. As a result, we regularly endure periods of underperformance while waiting for our thesis to play out but our buying program generally continues as long as our opinion remains constant.

Lenders declined in price in 2015. We bought. They declined further. We bought some more. Early 2016 brought more of the same. Our investment in financials contributed to Crescent’s performance lagging its exposure for a period of time. We had plenty of phone calls from shareholders questioning the wisdom of these investments. Those calls reached a crescendo in Q1 2016 when four of the five losers in the period were the same financials that round out the winners list in Q4. No surprise that Q1 was a bottom for the sector (and the market). Since we are closer to the investments than our shareholders, we can appreciate their discomfort. And yet discomfort is a kind of petri dish that cultures opportunity. Anxiety creates selling pressure and lower prices, which allows us to invest with a margin of safety.6 The comfort of going it alone is, for us, preferable to that of running with the crowd. In periods of such solitude, we hope we succeed in providing you a modicum of reassurance as we tried to do when we articulated our rationale for financials in our commentaries (particularly, Q1 and Q2 2016) and our conference calls.

Buying at a discount to a business’s intrinsic value (as we did with the banks) offers downside protection but that doesn’t mean we’ll always make money. We can justify an investment if the upside case is much higher than the downside. Sometimes, though, the downside case materializes and we take a loss. We wouldn’t characterize that as a mistake (though we can point to our share of blunders). Our long-formed habit of leaning into the wind will continue and Crescent’s performance will disconnect from its benchmarks at times as a result.

What happens over short time frames should be entirely irrelevant. We instead maintain our focus on the longer term goal of achieving equity rates of return with less risk than the market and avoiding permanent impairment of capital. We appreciate that investment risk, like beauty, is in the eye of the beholder. We define it as losing money. For others, volatility, the institutionally accepted definition of risk, may be more appropriate. If we have $1,000 today and it drops to $750 next year, but then is worth $2,000 five years from now, we’ve compounded our capital at almost 15%. If, on the other hand, the 25% drop to $750 causes someone to sell, then they’ve unfortunately let price rather than value be their guide.

If volatility is your definition of risk, then we’d recommend not investing in stocks as there will invariably be a point in time that the markets will conspire against you and, in a meaningful correction, take prices down 20% or 30%…or more. We endeavor to create a portfolio that shouldn’t bear the worst of such a downdraft. Market moves of smaller magnitudes, say 5%-10% up or down, are nothing more than noise. Crescent will do better or worse in these smaller moves over shorter time frames, consistent with its non-index hugging history.

Although there really isn’t much wind to lean into at the moment, healthcare has underperformed, one of the few sectors to decline last year.

FPA Crescent Fund

As you should have come to expect, we’ve spent a fair amount of time recently looking at various companies across the different subsectors (e.g., pharma, distributors, hospitals, medical equipment, insurance, etc.). Though the portfolio had negligible exposure to the healthcare industry at large over the past year, we are familiar with many of the participants and actually had in excess of 14% of the Fund invested in the sector as recently as 2014. Thus far, we have made a few purchases but they’ve been small and we’d prefer not to discuss them further at this time. However, the activity is yet another illustration of how the Fund opportunistically allocates capital across industries.

We’re always on the hunt for those businesses that other investors have placed in the penalty box. We are finding that today, however, there are numerous companies that we’d expect to be unloved or underappreciated but aren’t. We’d love to be more invested. The reason that we aren’t is that stocks aren’t generally cheap – as we’ve regularly discussed these past few years. The reason half the book wasn’t in financials is that Crescent doesn’t seek to take such risks that are disproportionate to being able to achieve our risk-adjusted return objective. The reason that we haven’t found more to do is a function of price, not diligence.

Take Deere, for example. A superior company long known for its wide range of high-quality agricultural equipment and leading U.S. market share, Deere has, nevertheless, not been immune to weaker farm economics. The U.S. has been challenged. Brazil has been horrible. What Deere hoped to accomplish in Eastern Europe changed when Putin’s troops marched into Crimea. Success in the low horsepower Indian market has been slow coming. Deere’s sales worldwide have declined almost 30% from their 2013 peak while earnings per share have plunged almost 50%. A chart of its stock price and earnings per share suggests something entirely different however. Its stock has hit a new, all-time high while earnings are back at 2010 levels. Where’s the margin of safety in the purchase of shares now trading at 21.8x trailing twelve month earnings?7 Deere’s mid-cycle earnings should be higher, which would make the normalized valuation not quite as dear but we miss when such companies would trade as if the bad times would last forever. We aren’t picking on Deere. There’s lots of stuff that crosses our desks that hasn’t made much sense.

FPA Crescent Fund

For a spell, the stock prices of some companies will defy logic but that won’t last forever. Eventually, fundamentals should prevail. In the interim, stock prices can trade anywhere. We hope to populate the Fund with quality companies whose current earnings fail to appropriately reflect longer-term prospects. Sadly, we’re finding a lot of Deeres out there, which explains that for as long as we can remember, we went an entire quarter (Q3 2016) without initiating a new position.

Just because the market isn’t rife with opportunity doesn’t mean that stocks can’t go higher. Some investors feel the need to “keep up”, which can lead to certain sacrifices like rationalizing a lower business quality, accepting a weaker balance sheet, tolerating weak management with poor corporate governance or justifying a more expensive valuation. We won’t, at least not intentionally. Despite the natural tension between doing something versus doing nothing at all, we will remain the same principled investors who have guided this Fund since its inception more than 23 years ago. We won’t likely capture all of the upside in rising markets but we do hope to avoid all of the downside in declining ones.

Economy/Markets

The general consensus appears to be that President-elect Trump will revive the animal spirits that will lift our economy and our stock market. His proposed lower corporate tax rates would make a pricey market less so. U.S. companies might also be able to repatriate foreign-domiciled cash at a low tax rate. There is an expectation that the additional cash from tax savings will be recycled back through the U.S. economy through higher or special dividends, share repurchases, capital investment and/or acquisitions.8

Moreover, there’s talk of as much as a $1 trillion infrastructure spending program for the necessary rebuilding of U.S. roads, bridges, ports and other projects. All of these measures should be a stimulus but we don’t know what the long-term effect will be on the already near $20 trillion in national debt.

On the other side of the ledger as a risk to the U.S. economy, Trump has spoken aggressively about protecting U.S. jobs. Subsequent action could start a trade war. We don’t want to see the decades-long path to globalization reversed. Higher trade tariffs and barriers will lessen global trade and increase import prices and potentially increase domestic production costs due to diminishing economies of scale.

As former U.S. Treasury Secretary Lawrence Summers points out, “This is probably the largest transition ideologically and in terms of substantive policy that we’ve seen in the U.S. in the last three quarters of a century.”9

We have no idea what comes next but we do know that the largest engine of our economy – the consumer – isn’t firing on all cylinders and some broader trends are concerning: The mortgage refinance boom has ended thanks to rising interest rates, housing affordability has declined to an eight-year low, the growth rate of per-capita discretionary income has been slashed by more than half in two years, and gasoline prices have risen 27% since their February lows and appear headed higher.10 Although the case today, this could always be temporary.

We build a potentially treacherous environment into our models in the downside scenarios for our individual investments. Most things have a price at which we’d be buyers. Today, however, asset prices have had tremendous support globally from the indiscriminate buyer, the likes of which we have never seen, thanks to both quasi-government action and the trend towards passive investing. We lump central banks into the government category because we find it hard to find the distinction that divides the world’s central bankers from the elected officials who appoint them.

The general attitude seems to be to flood economies with so much money that they have to get moving again. So far, the only thing really moving are asset prices and generally in one direction: up. Price distortions can’t help but develop as a result.

The Bank of Japan (BOJ) was the biggest buyer of Japanese ETFs in 2016 for the second consecutive year, more than offsetting shares sold by foreign investors.11

The European Central Bank (ECB) has been aggressively buying corporate bonds since mid-year 2016. As of December 31, 2016, the ECB held about €51 billion of corporates, which equates to 7%-8% of an estimated €600-€700 billion eligible market. JP Morgan estimates that this could rise to more than 20% by year-end 2017.12

Our own U.S. Federal Reserve’s balance sheet has almost quintupled since 2009, using its expanded capacity to now own $2.5 trillion worth of U.S. Treasury securities and $1.7 trillion of mortgage-backed securities.13

Low interest rates, the printing of money and artificial buying support have created pricing distortions. Deere might be one example but not anywhere near the most egregious. Consider that Henkel and Sanofi became the first public companies to sell new Euro bonds to investors for more than buyers will receive in return. Henkel found lenders willing to pay them 0.05% for a bond with a 2-year maturity. Sanofi did Henkel one better, also borrowing at -0.05% but for 3.5 years. When compared to the 2-year German Bund that had bond holders paying the German government 0.67%, both of these corporate issues seemed favorable at the time.14

As the U.S. stock market continues to perform well, more dollars continue to flow into passive funds such as ETFs and index funds. Buy programs are initiated to put these incremental dollars to work, ultimately influencing thousands of stock prices without regard to relative value of the underlying businesses.

A good example of this was the reaction of bank stocks immediately following the presidential election. Bank stocks deserved to rise, all else equal, given the likelihood of less restrictive governmental regulation and the benefits of rising interest rates for those institutions with asset-sensitive balance sheets. However, little distinction seemed to be made between those banks that would be helped by rising rates and those that would be hurt. The latter includes banks whose liabilities reprice faster than their assets and those with larger mortgage origination businesses that saw their stock prices rise in line with their more advantaged brethren.

We don’t suggest that passive management is bad and that active management is good. They can both be effective tools, if used wisely. It’s hard to argue with passive investing’s lower fees, tax efficiency and market-matching performance. Passive investing, however, is only as good as an investor’s ability to buy and hold those funds in periods of volatility. Excessive shareholder turnover could cause a typical investor to underperform the benchmark even in a passive fund. To the detriment of long-term returns, most investors have shown a greater propensity to sell into a bear market and then not return until the market has rebounded to levels above where they initially sold. In our view, these investors exchange the higher fees of actively-managed funds for an illusory peace of mind associated with passive investing.

Many active managers offer little by way of differentiation, structuring portfolios that all too often mimic an index but at a higher fee. Such “closet” index funds are silly. Others, however, offer real differentiation both in terms of portfolio composition and downside protection. Crescent, for example, benefits from its unusual breadth, investing in different regions and asset classes and exhibiting a willingness to sit on the sidelines while waiting for better opportunities (hopefully to the benefit of our investors even if it might prove to the detriment of our business). We can act quickly when we find something attractive, which is particularly important when there’s only a narrow window of time in which to take advantage of the opportunity. Our team’s flexibility to invest in stocks and/or bonds, whether they be domestic or international, and/or in the periodic special situation opportunities we come across has translated into something differentiated – attractive risk-adjusted returns over full market cycles. As managers, we are definitely out of the proverbial closet. That makes it challenging to use just one index as a benchmark which is why we offer a number: a domestic and international stock index, a balanced benchmark and the rate of inflation.

Passive U.S. equity assets now total $5 trillion (up from $4 trillion at the end of 2015) and represent approximately 20% of U.S. market capitalization. Passive investing’s market share will likely continue to increase as long as the stock market rise continues unabated. There is some natural limit to passive investing’s penetration as without any research and indiscriminate buying there is no price discovery, fewer dollars available for IPOs and secondary offerings, and less of an ability to hold managements accountable. That, therefore, puts some theoretical upper threshold on passive share yet it could still be far larger than it is today.

Similarly, the influence of central banks is not infinite. Their balance sheets are already larger than they’ve ever been and there are only so many assets that can be purchased. For that, all they’ve been able to exhibit thus far is some control over the pricing of risk assets (and derivatively the financial system).

Closing

We like to ski when there’s soft snow covering the slopes. When ski conditions are poor, you’re more likely to get hurt. Investing is no different. Money can be made when the market is rising just like one can conceivably get down a mountain of icy slopes without breaking a bone but taking that risk is open to question. Give us some powder in the form of good valuations and you’ll see us put some capital to work.

Low and negative interest rates, amongst the aforementioned artificial forces, have pulled forward spending, benefiting today’s economy at the expense of tomorrow’s. We suspect that will cause some market disruption…one day. That fallout could be toxic but should create the kinds of opportunities we seek but we need to be careful what we wish for too.

Investing other people’s money is a great responsibility and is based on trust. We’re not going to deliver market rates of return with less risk over time by investing the same as the market, which means that our returns when compared to the market will differ wildly at times – for better or worse. Here’s to being different.

Respectfully submitted,

Steven Romick

Co-Portfolio Manager

January 15, 2017

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