From FPA Capital Q3 letter to investors, also see FPA 2013 Q3 Fund Fact Sheets
Portfolio Commentary & Outlook
The all too often heard phrase of “don’t fight the Fed” continues to be proven true, as evidenced by protracted appreciation across equity markets. During the third quarter, the market for both large-cap and small-cap stocks experienced healthy gains between mid-single digit to high-single digit returns. The Fund returned 8.28% for the quarter. The Russell 2500 appreciated 9.08% in Q3, while the Russell 2500 Value and S&P 500 gained 6.43% and 5.24%, respectively. Despite the portfolio’s large cash position, your portfolio achieved superior returns compared to the Russell 2500 Value and the S&P 500, but could not quite match the Russell 2500.
Your portfolio’s return on invested capital has matched or exceeded the major indices’ returns this year, depending on which index one observes. Nearly 40% of the stocks in the portfolio appreciated more than 30% year-to- date through the end of the third quarter, and roughly 85% of the stocks achieved double-digit returns over the same time frame. The good news is that the portfolio companies are performing well, the management teams for these companies are executing on their business plans, and the stocks in the portfolio still provide investors with good value. The bad news is that small/mid-cap stocks are, in general, about as expensive as we can recall over the past few decades and the pickings remain slim. For instance, the Russell 2500 is now trading at 26.5x trailing twelve-month earnings, and the Russell 2000’s P/E1 is at the nose-bleeding level of 31.2x.
Despite the “overvalued” asset class, we were still able to add three new names to the portfolio this year, including one in the third quarter. Each of these three companies operates in different industries (Education, Healthcare, and Retail) and has their own set of reasons why they are attractive to us as absolute value investors. In a normal year, and clearly this is not a normal year, we would expect to add four or five new companies to the portfolio. Hence, our antenna remains acutely tuned to capture any signal that alerts us to highly attractive investment opportunities, but our equipment is mostly picking up the noise of bull hoofs rampaging wildly as Ben Bernanke pours endless liquidity into the capital markets.
Speaking of Mr. Bernanke and the Federal Re serve, we would immensely appreciate it if he and his cohorts would explain to the American people what would happen if the Fed stopped buying $85 billion worth of Treasury and mortgage securities every month. Does the Fed believe the U.S. economy would collapse sending all of us into the poorhouse? Do they think the stock market would nosedive and wipeout trillions of dollars of wealth? Do they think interest rates will rise substantially and by enough to snuff out the recovering residential real estate market? If the answer is yes to any or all of the above, then our economic foundation is shakier than many might believe.
Recently, the International Monetary Fund’s (IMF) Global Financial Stability Report (GFSR) estimated that scaling back the Fed’s asset purchases could lead to bond market losses of up to $2.3 trillion. José Viñals, financial counselor to the IMF, says the U.S. needs to control its systemic risk. However, the IMF notes that containing longer-term interest rates and market volatility has already proven to be a substantial challenge, and that is before there has been any change in short-term interest rates.
We know the Fed has mentioned, ad nauseam, their concerns about unemployment rates in the country being too high and the lack of decent job growth, and we share their concerns about people not finding jobs. However, isn’t it logical to think that if a new job is created because of the Fed’s “quantitative easing (QE)” that that job will disappear once the easing ends? If it were as easy as printing money to create jobs, why not print tens of trillions of dollars and solve the problem? The answer is that, in our opinion, jobs are not created because the Fed prints a bunch of money. Rather jobs are created when businesses want to expand their operations. Businesses generally expand their operations when they are producing rising profits, unless you are Twitter and have access to Wall Street’s brightest minds and capital.
If we assume that businesses add employees to the payrolls when profits are increasing, or at least steady, and the Fed understands this relationship, then the Fed must hope that their QE policy will increase the aggregate level of demand and, therefore, profits in the U.S. However, the Fed cannot just give the money to individuals and force them to spend it. Nor can the Fed give money to companies and the companies then, voila, report to shareholders the “new found” profits.
So how does QE affect demand? The answer likely lies in something called the Wealth Effect. That is, the Fed believes that business and consumer spending increases when businesses and consumers are wealthier. Higher stock prices certainly increase the wealth for those who own shares. But this theory makes sense as long as businesses and individuals believe their “new” wealth is sustainable.
When businesses and individuals believe their larger wealth is temporary, the much sought after increased spending is not nearly as much if the increased wealth was expected to be permanent or long lasting.
Intuitively, we know if two people each get a job paying $75,000 annually, but one is expected to be a permanent job with a solid company and the other is with a temp agency that could end at any time, the individual with the permanent job is likely to spend more money, especially on bigger ticket items such as housing or an automobile. This is not true in all cases, but in an economy with tens of millions of participants the monetary velocity and aggregate spending should be higher when people believe their incomes are sustainable rather than on tenuous footing.
Investors are no different than our simple illustration above. If the stock market’s rise is not due entirely to sound fundamentals, investors will question the sustainability of those returns. So why won’t smart investors sell over-priced securities and cash in their chips and buy a yacht or beach house? Clearly, some investors are doing just that today.
However, many investors, especially large pension plans and other institutional investors, are being forced to remain in the stock market because the alternative investment choices are just as bad, or worse, as owning stocks. Ominously, if too many investors run for the exits at the same time, share prices are likely to materially decline and upset the Fed’s goals. Thus, the Fed has to be careful with all of this taper talk, lest they upset the proverbial apple cart.
In any case, the Fed’s policy of increasing aggregate wealth, facilitated by the stock market’s rising share prices, will likely benefit only a relatively few investors. The so-called 1%ers will indeed buy fancy cars, build more McMansions, and acquire other luxury goods, which will help the economy grow. However, the policy is unlikely to unleash a torrent of spending from the vast majority of Americans. The reason why is