FPA Capital Fund portfolio commentary from q4 letter.

Steven Romick FPA Crescent Fund

FPA Capital Fund: Introduction

Who said thirteen was an unlucky number? It must have been an equity short seller because the thirteenth year of the new millennium was an incredible year for shareholders of U.S. publicly-traded companies. The Dow Jones Industrial Average gained 26.5%, the S&P 500 appreciated more than 32%, and the Russell 2500 outdid them both by gaining over 36%. The Russell 2500’s performance was its third best showing since we started managing the FPA Capital Fund (Trades,Portfolio) in 1984 (only eclipsed by the performance in 1991 and 2003). To put that 36% into perspective, if one were to invest $46,200 and achieve a 36% annual compounded return, one would become a newly minted member of America’s millionaire club in just ten years. Or, one could merely start with $100,000 and thirty years later be a billionaire, if one were to realize a 36% annual compounded return.

Market Commentary

We begin this section with further analysis on the Russell 2500 index. In our opinion, this index most closely (while not exactly) represents companies which could be investment opportunities for our strategy. The ability for the Russell 2500 to repeat recent returns, in our opinion, is highly unlikely. Here is why:

At the end of 2013, the Russell 2500’s Price-to-Earnings ratio (P/E)1 was 27.8x, and this is with near record highs in corporate profit margins. If you recall, the S&P 500 traded at approximately 30x earnings in the year 2000 and then collapsed nearly 50% between the years 2000 and 2002.

To see how challenging it would be for the Russell 2500 to produce a 36% compounded annual return over the next ten years, let alone the next thirty years, let’s assume earnings will grow 10% each year for the next decade, despite the fact that earnings for the market have grown less than 7% annually since the year 2000 and roughly 7% annually over the past eighty years. Thus, the Russell 2500’s P/E ratio in ten years would be over 230x if that index were to achieve an annual compounded return of 36% for the next decade and earnings were to grow 10% annually. We do not believe there are enough “supporters” who could keep that enormous bubble afloat, but the Pols in Washington are a determined group that continually prove folly has no boundaries.

Some people might ask, why are we so fixated on the P/E ratio? The answer is simple. If one were to invert the P/E ratio (E/P), one would get the cash-on-cash return of that investment if one were to acquire the entire company. For our illustrations, we are ignoring the accounting timing differences for working capital and assuming depreciation equals capital expenditures. Therefore, net income, or earnings per share, equals free cash flow in our example. Thus, with the Russell 2500 trading at 27.8x, investors are currently realizing just a 3.6% return on their invested capital. A P/E of 230x equates to a cash-on-cash return of 0.4%, or four-tenths of one percent. At that valuation, one might want to consider playing the Powerball lottery and buying Mega Million tickets for a better return, instead of endeavoring to become the next Warren Buffet.

When we explain this simple math to people they intuitively understand it is better to buy equities with a lower P/E because the cash-on-cash return is higher. The problem everyone has, including us, is that nobody knows with 100% confidence what earnings will look like next year, in three years, or in five years or longer. The stock market cares about future earnings, not last years or prior year earnings.

While we do not pretend to have a crystal ball that gives us perfect insight into future earnings, we can make some educated assumptions about how to think about future earnings. In recent letters, we mentioned that we were expecting very modest economic and earnings growth. This outlook was predicated on a myriad of factors, but sluggish wage growth and high debt levels were material factors. Our modest outlook for earnings growth proved correct in 2013, with earnings growing roughly 4.5% for the Russell 2500, despite the index appreciating more than 36% last year. In other words, nearly 90% of

The point in analyzing these scenarios is to objectively evaluate the viable outcomes, based on a set of relevant input factors. Our team does this with stocks all of the time to gauge the base case, downside case, and upside case for individual securities th at go into the portfolios we manage. This rigorous and quantitative analysis helps us frame the risks and return opportunities for an investment. We applied this analysis to the Russell 2500 merely to illustrate the plausible market scenarios so our invest ors and shareholders have a better understanding of the market risks. It is important to note that we are bottoms up investors and put very little weight on the macro factors, especially when we can invest in market – leading companies at very cheap absolute valuations.

Portfolio Commentary

Speaking of bottoms up analysis, the companies in the portfolio performed very well in 2013. More than 50% of the companies in the portfolio appreciated 42% or more during the year, and 40% of the stocks rose double digits in the fourth quarter. There was one disappointment in the portfolio that we will discuss later, but even that company performed well operationally.

There were no thematic winners or losers last year. Our best performing stock was a technology company, but our worst performer was a tech nology stock as well. Our second best performer was an energy company, but our second worst performer was also an energy company. Our retailers performed well, as did our education and industrial companies.

Importantly, we like the industry in which Centene (CNC) competes. Some of our investors might recall that one of our prior investments, Amerigroup, was acquired in 2012 by Wellpoint at a val uation that allowed us to achieve a return on investment of greater than 100% over the roughly one – year time period that we owned the shares. Medicaid managed care companies not only save states money but also offer better service; therefore, more states a re letting managed care companies run their Medicaid programs. To that end, states are expanding both the geographies carved out to managed care companies and the types of programs. The next phase of growth will come from the dual – eligible population. D uals (or dual – eligible population) are 8.3mm 3 people in the U.S. that are eligible to receive both Medicare and Medicaid benefits (mainly low – income seniors). According to the Kaiser Foundation, Duals accounted for almost 40% of Medicaid spending although they made up only 15% of the Medicaid population. We believe there are ample growth opportunities for CNC and other companies to meet the challenges of managing these disparate Medicaid members for the foreseeable future.

As we alluded to above, CNC inc urred some unusual expenses in 2012 due to a bad contract in the state of Kentucky. Thus, in 2012, CNC barely earned any money for the year, but we believed that was a temporary situation. Sure enough, CNC exited the Kentucky

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