FPA Capital Q2 letters to shareholders, brief excerpt followed by full letter in scribd.
We reviewed other contemporary periods of time (see the table below) when equity markets were, in our opinion, expensive – similar to the current environment – and then how equity markets performed subsequent to those high valuation periods. For example, in the middle of 2000 the FPA Capital Fund was trading at just 14.7x earnings. However, the Russell 2500 and S&P 500 were both trading above 25x earnings, and the markets then declined over 40% during the following couple of years. In the middle of 2008 the Russell 2500 was trading at 20x earnings while the S&P 500 was trading at over 16x. Again, the equity markets experienced a sharp decline of greater than 40% the following year. We want to be clear, we are not forecasting a decline in the equity markets of the magnitude exhibited during those two prior periods. We are merely pointing out that the equity markets today are rich and being driven principally by Fed policy, in our opinion.
While the Fund has underperformed over the last year-and-a-half, there have been two other periods, consistent with the aforementioned frothy periods above, when the Fund underperformed for roughly three years. For instance, during the period between 1997 and 2000 the FPA Capital Fund underperformed the Russell 2500 by over 600 basis points compounded annually. However, from 2001 through 2005 the Fund outperformed the Russell 2500 by over 1,000 basis points compounded annually. The Fund also underperformed from 2006 through 2008, and then outperformed the benchmarks from 2009 through 2011 by over 600 basis pointsv per year.
The point of looking back over the past couple of decades is to underscore that our strict absolute value philosophy has resulted in 3-year or 4-year periods of time when we underperformed because we did not own or chase expensive stocks. However, when reviewed over a longer period of time, our Fund’s returns have exceeded the Russell 2500 by over 300 basis points compounded annually since 1985.