Steve Romick’s FPA Crescent Fund commentary for the fourth quarter ended December 31, 2015.
Dear Shareholders:
The FPA Crescent Fund increased 2.80% in the fourth quarter but declined 2.06% in 2015, only the third year out of the last 22 in which the Fund has lost money. Global markets were down for the year. The S&P 500 was up 7.04% and 1.38% in the fourth quarter and year, respectively. However, the MSCI All Country World Index (ACWI)1 was up 5.03% in the quarter but fell 2.36% for the year.
If you look under the covers, S&P 500 performance was extremely narrow and markedly influenced by just five stocks or 1% of the companies in the S&P 500 – Amazon, Facebook, General Electric, Alphabet (Google) and Microsoft – which as a group added approximately 2.9% to the S&P’s return. Excluding these names, the S&P would have declined 1.5%. Needless to say, the FPA Crescent Fund benefited from its ownership of three of the five.
Growth companies fared better than value. Although the Russell 3000 Index returned 0.48% in 2015, the Russell 3000 Growth Index increased 5.09%, while the Russell 3000 Value Index declined 4.13%. And, all else being equal, the bigger the company, the better its performance. S&P 500 companies with market caps above $100 billion returned 4.4% last year but those below $5 billion declined 19.6%.2
In addition, global stocks underperformed domestic ones, cash underperformed bonds and high yield declined in general.
FPA Crescent Fund 2015 Performance
Performance in 2015 was as much a function of investments that haven’t worked out (yet, we hope) as much as it was the result of a conscious choice to reduce or eliminate our stakes in companies that we viewed as expensive. As it happens, the companies we sold outperformed, on average, the investments we purchased. This is far from unusual in value investing. Buying and selling early has always been the bane of the value investor, who must have the fortitude to live through periods of being out of favor. What was a good value at one price is presumably a better value when it has declined 20%, assuming one’s analysis was correct at the outset. We believe that’s the case with the majority of the companies in our portfolio; cheaper on average than they were a few months ago but not yet at prices we’d call “no-brainers.”
Crescent naturally moves up and down with the stock market but generally has less of a move in either direction. Traditionally, we lag on the upside but outperform on the downside. At first glance, it appears that we’ve declined as much as the market – down 11.71% since May 2015’s market peak against the S&P 500’s 11.30% decline – but that’s looking at the market only through the lens of the S&P 500.3 However, roughly half of our equity holdings (totaling almost a third of the FPA Crescent Fund’s equity exposure) are not included in the S&P 500 index. Our quest for value has increasingly taken us overseas and our portfolio is more global than it has been in the past. We therefore consider the MSCI ACWI a pertinent alternative benchmark. When we published The Importance of Full Market Cycle Returns last April, we began to share the FPA Crescent Fund’s performance over the current market cycle as compared to the S&P 500, MSCI ACWI and a blended benchmark of 60% S&P 500 and 40% Barclays U.S. Aggregate.4 Bearing this in mind, the FPA Crescent Fund’s downside participation is more in line with its historic average. Crescent captured 65% of the MSCI ACWI decline of 18.11% since the May 2015 peak.5 It never feels good to see your portfolio decline in value but over three decades of investing we appreciate that we can neither “time” nor always be in step with the market.
With the average S&P 500 stock down about 18% from its 52-week high, 2015 was not a good year any way you cut it.6 Crescent’s winners for the quarter and year contributed 2.08% and 2.34%, respectively, while its losers detracted 0.95% and 2.86%. The more cyclical companies, particularly those with commodity exposure, were the weaker part of our portfolio. In hindsight, we thankfully had a small allocation to such businesses.
FPA Crescent Fund – Protfolio Performance
We had some puts and takes that drove 2015’s performance. Microsoft and Alphabet (formerly Google) performed quite well but Oracle lagged. Oracle continued to transition its business to the cloud last year but it has been proceeding more slowly than investors or the company expected. Concern about the transition and weak software license sales led to the stock’s decline. Given the undemanding valuation and high level of recurring revenue, we used a drop in the share price to increase our position.
Weak aluminum prices and inventory adjustments in the aerospace supply chain negatively impacted Alcoa’s profitability and its stock price in 2015. We support the company’s decision to separate its highly engineered, value-added aerospace business from its commodity aluminum operations. As the price has declined in the last year, we have doubled the number of shares we own and are hopeful that the pending spin-off will create clarity and value for the enterprise.
Joy Global was with hindsight an outright mistake, a poor investment decision that we wish we could take back. When analyzing the situation, we gave too much weight to the company’s strong market position and attractive aftermarket sales profile. We failed to appreciate the degree to which the coal market had changed. Many regions in which Joy has a particularly strong competitive position are likely to produce significantly less coal going forward. This has resulted in a permanent impairment to our position in Joy. Realizing our mistake, we have reduced the position.
This is a challenging time and we maintain a more risk-averse portfolio. Interest rates remain near historic lows and the Fed has begun tightening for the first time since 2006. The global economy is muddling along at best, with the China growth engine sputtering. And stocks aren’t particularly cheap. We fear, as is oft intoned in television’s Game of Thrones, that “winter is coming.” We wish we knew when the weather would change. Since we don’t, we want to make sure we always have a heavy coat on hand to keep us warm. Although the FPA Crescent Fund’s risk exposure8 has increased somewhat as markets have declined, it remains just 61%, which offers us plenty of room to deploy capital should asset prices fall to more attractive levels of risk and reward.
We are, as always, conscientious about matching assets and liabilities. We appreciate that our mutual fund shareholders have daily liquidity and therefore consider, in turn, the liquidity of the investments we make. The greater the liquidity, the easier it is to purchase or exit a position. Selling an illiquid position is of greater concern today, given this more volatile market. If a security owner is forced to sell a position, whether it be due to a margin call, redemption or some other reason, the time frame thrust upon that investor can be quite short. The negotiating leverage shifts to the buyer, possibly causing the seller to take a low price in order to convert the investment to cash. We like to be the ones taking advantage of forced selling rather than the other way around. We have two paths that afford some protection. First, we have 39% cash that can be drawn down. This has the commensurate impact of increasing our position sizes but that was already a consideration when we made the initial investment. Second, our average market capitalization of our equity positions is more than $100 billion, offering us tremendous flexibility.
We’ve been arguing for some time that the market isn’t cheap and, even with the broad stock market averages having declined in 2015, it’s not like businesses are being given away. Take the U.S., for example, and compare the trailing median Price/Earnings (P/E), Price/Sales (P/S) and Price/Book (P/B) ratios on December 31 to the month-end of the two prior market peaks. The P/E and P/B ratios are in line with past peaks while the P/S is as high as it has ever been. No bargains here. Investment discipline has given way to complacency even for the normally resolute. The only explanation we can find for a fully-invested portfolio is that some managers seek to protect their businesses while others feel the siren call of low interest rates that make everything seem cheaper than it might otherwise.
Although we have no idea what comes next, we haven’t been – nor are we currently – particularly enamored of stock valuations. This doesn’t mean the stock market won’t continue to rise. We don’t feel we’re being adequately compensated to be more fully invested. We’re a lot more excited about troughs than peaks and also note that the S&P 500 declined in the subsequent period following the prior two valuation peaks.
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