FPA Crescent Fund 4Q18 LetterJacob Wolinsky
FPA Crescent Fund commentary for the fourth quarter ended December 31, 2018.
Stock markets around the world had a dismal 2018, particularly in the fourth quarter with December delivering the brunt of the decline. December 2018 was the worst December for the S&P 500 since 1931 — and that’s after bouncing back 6.62% over the last four trading days of the year.
We are disappointed that your portfolio managers did not cover themselves in glory in 2018. The FPA Crescent Fund (“Fund”) declined -10.52% in the last quarter of the year and -7.43% for the full year. In comparison, the S&P 500 and MSCI ACWI declined -13.52% and -12.75% respectively in the fourth quarter and -4.38% and -9.42% for the full year. The Fund, with its global exposure and value focus, outperformed the global and value indexes but lagged the U.S. market.
In the context of its global and value focus, the Fund thankfully did not wholly disappoint as shown in the following table of the Fund’s 2018 performance relative to domestic and global equity indexes.
The Fund’s performance remains consistent with its stated long-term goals. During 2018, the Fund’s downside capture was reasonable in the context of the overall market’s drawdown and net risk exposure – the S&P 500 declined by more than 10% and then almost 20%, which was close to a bear market and bit more than general market “noise”. This was especially true in light of our net risk exposure each quarter, which increased from 63% in the first quarter to 73% by the fourth, largely as a result of the greater number of bargains that developed amid December’s volatility.
Importantly, the Fund’s 2018 drawdown was almost entirely mark-to-market; that is, the stocks we owned declined in price but we do not believe the intrinsic value or long-term earnings power of the underlying businesses was impaired.3 As long as these companies deliver on earnings in the coming years, we believe their stock prices should do just fine. We discuss specific examples in the Portfolio Commentary section.
Despite the aforementioned mediocre performance last year, we believe the Fund has achieved its stated goals this cycle, producing equity-like rates of return over the long-term while avoiding permanent impairment of capital.
We took advantage of what we believed were attractive opportunities in 2018, finding possibilities to purchase good, growing businesses (albeit cyclical in some cases) at reasonable, if not good, prices. At the same time, we sold entirely or reduced positions in many of the companies that had helped drive past returns. We focus on where a company will be over the next five to seven years, consistent with a long-term holding period. Just because we believe in a certain outcome, however, doesn’t mean ‘Mr. Market’ will see it our way immediately. In fact, ‘Mr. Market’ held quite a different view from our own in 2018, as on average, what we sold performed better than what we purchased.
The winners and losers for both the full year and Q4 2018 are listed here. In these periods, mark-to-market price changes in the bottom five detractors from the Fund’s performance outweighed the benefit realized from the top five contributors. Other than the announcement that Transdigm plans to acquire Esterline Technologies and favorable developments in the restructuring of Puerto Rican municipal debt, there was no news that we believe to be substantive in driving both quarterly or annual winners and losers.
The price of a company’s stock can perform better or worse than its underlying business, sometimes for extended periods. Such was the environment last year that the businesses of the companies we own performed on average within the range of our expectations – the companies we held for the full year actually beat analyst expectations. But we believe their stock prices failed to reflect that performance.
For more than a quarter century, the Fund has leaned into weakness. That is a hallmark of our past success, and we expect it to be no different in the future. We have never been able to dial in timing, however. We habitually buy and sell early which has led to Fund performance untethered from the benchmarks. The most glaring example of such divergence in the Fund’s portfolio was the 1998/1999 tech bubble, when the Fund underperformed by 59.30% versus the S&P 500 during those two years. Some have suggested, only partly tongue in cheek, that once we decide to make an investment, we should consider waiting six months before we start to buy it.
Shares in a good, growing business purchased at a reasonable price should perform well over time. That doesn’t mean they will perform well for all periods of time, and for the Fund’s portfolio, 2018 was one such out-of-sync period. We wish we could guarantee our companies will continue to perform as expected and that the stock market will appropriately value them, but we can’t. We are now midway through our third decade of operating with the same investment philosophy supported by a consistent research and portfolio management process, which we believe will allow the Fund to continue to perform well over time.
Eventually, we believe that fact trumps emotion and hope, and businesses receive a just valuation. In the interim, however, the inexplicable can frustrate and stymie both client and portfolio manager.
Given the Fund’s positioning, which we discuss below, we are genuinely more encouraged than we have been in the past few years.
Last year was one of the Fund’s more active periods on record. We took advantage of the inevitable return of volatility to eliminate and reduce certain positions while initiating and increasing others. We bought 18 new names and sold or reduced 23 names, some by more than half. The opportunities to put capital to work in 2018 allowed us to increase the Fund’s net risk exposure by nearly 10 percentage points – from 63.3% to 73.1%.
The Fund’s top 10 long positions, comprising roughly one-quarter of the Fund’s holdings and almost 40% of its net risk exposure, have declined an average of 20% from their peaks making them relatively and absolutely attractively priced.
We believe these businesses have increased their intrinsic value per-share over the past year, and we expect them to make further progress in the years ahead, though the rate of that improvement will depend on economic conditions and management execution. But given current valuations, which we discuss below, we believe share prices should now at least keep up with business progress.
We invest on a bottoms-up basis but find it useful to group the portfolio into similar economic categories for the purposes of discussion. Below are a few of these categories.
The Fund had 14.1% net exposure to balance-sheet intensive Financials at year-end — but please keep in mind that Financials as a category inadequately distinguishes between the different types of companies in it, which include traditional banks, other types of lenders, investment banks, insurance companies, service providers/middle-men, etc. Each of these have different risk characteristics. A strong balance sheet would include well-underwritten loans and insurance policies and an appropriate amount of equity to support it, and we believe the companies we own have such balance sheets, far stronger than the stock market currently appreciates. They are collectively valued at just 91% of their tangible book value as of year-end and 8.4x consensus 2019 earnings. Some of our bank holdings have strong franchises and we believe are likely to grow and earn excess returns through the cycle, for instance, Bank of America, Signature Bank and Wells Fargo. So we primarily value these on an earnings basis. Others, like AIG, Ally Financial, CIT and RBS, operate less differentiated businesses or are undergoing corporate turnarounds, and in thesecases, we rely more heavily on tangible book value when thinking about value. At year-end, these companies traded at an average of 73% of tangible book value.
Jefferies Financial Group, our remaining balance sheet-intensive holding in this category, does not fit neatly in either group described above, though it serves as a good illustration of the type of financial investments we like. Jefferies operates a strong broker/dealer and a successful merchant bank. We like the owner/operator mindset of management, who have their money invested alongside ours. It has historically succeeded in creating value through timely investments through the merchant bank and by opportunistically repurchasing its shares at a sizeable discount to net asset value, or NAV. Last year, Jeffries met earnings expectations; enhanced NAV by reducing its stake in National Beef, and aggressively repurchased its shares at attractive prices. Despite those moves, Jefferies stock price declined 35% in the calendar year and now trades at just 65% of its tangible book value and an even larger discount to our low $30 assessment of NAV.
You should expect that we will increase our exposure to Financials in the event that their recent underperformance persists.
Industrials & Materials
The Fund has 21.9% of net exposure to businesses that have exposure to the industrial economy and materials. These companies range from mining to semi-conductors, and all trade in our view at inexpensive valuations based on mid-cycle earnings. As a group, they are trading at only about 11x 2019 consensus earnings expectations, or more than a 20% discount to the U.S. stock market. We believe these companies will grow on average at least as fast as the typical public company and that their economics are less susceptible to disruption by new competitors or technology. If the global economy is larger in five to seven years, we believe these companies should be worth appreciably more per-share, even with a recession along the way. On the downside, these companies would still be valued at slightly less than the stock market average even if their earnings declined by 25%, which we think is highly unlikely unless the rest of the companies in the stock market were to have earnings shortfalls.
Internet & Related (Including Cable)
In 2018, we initiated and increased stakes in a number of global internet platform companies that we believed offered good growth prospects at attractive prices, while we reduced our stake in others that were profitable investments and whose stock prices already reflected that success. This category represents 19.0% of the portfolio.
We sold down our Microsoft position, for example, which had appreciated markedly over the last eight years, and we bought a number of Asian internet platform companies at prices well below recent peaks. Our timing, though, made us look foolish over the short term. The Asian companies continued to trade poorly, declining more in the back half of the year than Microsoft. We believe these investments still have the same growth prospects but now at even more attractive prices. As a group, these investments trade at an average of around 16x earnings net of cash (and lower still net of non-earning assets) as of year-end and are expected to grow their revenues by 18% in 2019.
Cable has had a taint to it for much of 2018 due to the twin fears of “cord cutting,” which would displace the video business, and the development of 5G, which is supposed to allow wireless to make in-roads into broadband. We do not place much stock in either view. First, we do not believe that video is as profitable as industry segment reporting suggests. Video’s free cash flow per subscriber will likely slowly erode, but we believe that will be more than offset by the latent pricing power of broadband, which is necessary for those who wish to cut the cord. Next, although 5G is something to consider, there is so far only one wireless company with any substantive investment in the technology, and it’s too early to speak to its capability. Plus, cable infrastructure will still be required for the back-haul. We believe increasing demand for faster broadband makes cable a necessary and winning asset and that well-positioned cable companies will gain subscribers and the ability to increase pricing over time. We therefore purchased Charter Communications and Comcast, two geographically diversified cable companies with we think less risk of overbuilding and controlled by owner operators (although we are admittedly suspect of Comcast’s purchase of Sky).
Others Including Credit
The Fund continues to maintain very low exposure to high-yield bonds, which account for just 4.7% of the portfolio. High debt levels, poor interest coverage, weak covenants, low yields, and a decade into a relatively decent economy have left us with few options that offer any reasonable margin of safety. We expect to once again be larger investors in credit when more attractive yields exist.
We recently published a white paper titled Risk is Where You’re Not Looking that discusses in greater detail the impending challenges likely to face the corporate debt market, which the equity markets are unlikely to exit unscathed when they emerge.
We own a number of other companies that do not fall into a neat little box but we believe offer attractive prospects for good returns over time. For example, Kinder Morgan, once a master limited partnership but now a C-Corp — and always a pipeline transportation and energy storage company — is a younger investment in our portfolio. We believe Kinder has differentiated infrastructure assets; a great management team led by Richard Kinder, owner of around $4 billion of its stock, and reasonable growth prospects. It’s a bit like a utility with the toll it takes on the oil and gas that flow through its pipes and reside in its storage facilities, but with better management, less regulation, good capital allocation, and a higher dividend yield.
It may further an understanding of our portfolio positioning to discuss what we don’t own, for example, REITS, utilities and consumer staples. Simply, we do not believe that the stock of the typical company in these sectors will offer reasonable risk-adjusted returns over the next decade, given a combination of current valuation and prospective growth.
Proctor & Gamble, or P&G, the storied consumer products company, is an example of a company we don’t own. Like many consumer staples companies, its moat is still substantial but not what it once was. The result is earnings growth of less than 2% over the past seven years, but its stock inexplicably trades at 20.8x 2019 consensus earnings estimates. Nonetheless, the Fund would have been better off owning it rather than many of its existing positions last year, as P&G delivered a total return of 3.57%. Yet P&G’s historic growth rate is lower than the Fund’s portfolio companies, which more importantly in our eyes, trade more inexpensively and offer better growth prospects. P&G is no better nor worse than a number of other consumer staples companies we could have discussed.
We find this illogical. Maybe the valuation disparity is due to expectations for a weaker economy that might allow consumer staples to outperform for a time. Or maybe it is due to passive investing, which makes indiscriminate purchases as a function of inflows. However, if the stock market didn’t offer irrational moments, everyone would invest in passive vehicles, and we wouldn’t be in business. We prefer our portfolio.
A stock can trade higher or lower than one might expect, but if the underlying business successfully grows over time and generates free cash flow that management then allocates intelligently, said stock should make its shareholders happy over a longer period. We are happy with what we own – more happy than we have been in a number of years – and as much as we look forward to looking back, we appreciate where we are in the moment.
Although we have increased the Fund’s exposures, we still have a lot of capital, about 27%, held in reserve to take advantage of lower prices. To put more capital to work, we require a larger margin of safety than what the market currently offers. Either: 1) the cyclical companies we would like to own must price in attractive returns based on our low case estimates of long-term earnings; 2) shares of the high quality companies we would like to own, such as P&G, need to decline significantly in price to offer rewarding prospective returns; or 3) the yield on high-yield bonds needs to increase from a paltry 7% to at least 9% to 10%. When such attractive valuations might occur alas lies beyond our limited capabilities.
February 1, 2019
We are ever mindful of the Fund’s tax efficiency and so prudently take long-term gains whenever possible. We estimate potential capital gain exposure in the Fund was just 9% at year-end 2018, with 115% of that in the form of long-term gains — a multi-year low.
Through February 1, the Fund is up 8.23% for the year, a bit more than the S&P 500 at 8.13%, despite only being 73% invested. This significant difference when compared to last year’s performance only serves to highlight why we prefer to assess rolling five-year periods and full-market cycles when judging performance, rather than focusing on the short-term.6