FPA 2013 Q4 Capital Fund Conference Call (see comments from Steve Romick’s call to FPA Crescent shareholders here, and FPA Capital call here).
One other quick update since we usually receive many questions regarding the Fund’s size and the Fund’s expense ratio: as of Friday, the end of January, Fund assets are now at around approximately $325 million. In terms of the expense ratio, we expect that, if the Fund maintains its current asset level in 2014—that is, above $325 million—the total expense ratio for the Fund should be less than the expense ratio cap of 1.32% on a going-forward basis.
And with that brief update at this time, it is my pleasure to introduce Portfolio Manager, Pierre Py. Over to you, Pierre.
Pierre: Thank you, Ryan, for the introduction, and thank you all for taking the time to be on the call today. Starting with performance, during the fourth quarter, the Fund was 2.57% compared to the MSCI All Country World Index gain of 4.77%. For the year, the Fund was up 18% versus the index’s gain of 15.29%. And since inception on December 1st, 2011, the Fund as appreciated 20.70% annualized versus 14.75% for the index.
At the end of the quarter, we were 63% invested versus 61% at September 30, 2013. Over the past three months and year-to-date, our cash stake averaged in excess of 38%. Since inception, our average cash holding has been around 35%, growing steadily from low teens over the past two years with the exception of a three-month period that started in February 2012 when the market corrected, and we were finding more rather than less opportunities for a short while.
The way we seek to generate superior returns over the long run is by selecting good companies, buying them with a high margin of safety, and building a benchmark-agnostic concentrated portfolio whereby we deploy a greater portion of the Fund’s assets towards our best ideas. What our experience tells us unfortunately is that there are times, no matter how big our investment universe or broad our market cap reach, when it is simply not possible to do this. There are times when there are just no well run, financially robust, high-quality companies for sale at a discount to intrinsic value in excess of 30%. And we visit more than 30 countries a year. We speak to well in excess of 500 companies a year—mostly senior management representatives. We monitor a focus list of more than 700 companies, and we price a so-called best-of-breed list of close to 300 companies. What we end up with based on this research work is around 50 companies that fit our investment criteria and trade at more than 10% discount to intrinsic value. That to us is a margin of error; it’s not a margin of safety. So what that means is these companies are trading below fair value, but it doesn’t mean that they all have enough of a margin of safety for us to invest in them. And within these 50 companies that trade at some discount to intrinsic value, we are only happy to own currently about 23 of those, with a greater concentration, as you would expect, towards those that give us the greater discounts to intrinsic value.
We articulated an investment philosophy and elaborated a process around that for a reason—primarily because it minimizes our risk of permanent losses. The share prices of the companies we own may go down, but the companies themselves will continue to exist, and over the long run they will continue to create value, and more and more value. So if we cannot find anything to buy—anything that would meet all of our investment criteria—we don’t see why we would change our investment philosophy and process just to populate the portfolio. We should do nothing, which is what we do, and this is why our cash exposure remains elevated. Just because we don’t see any opportunities, though, it doesn’t mean that prices cannot continue to go up. As they do, we may experience short-term relative underperformance like we saw in the fourth quarter.
Even if we underperform on a relative basis in the near term, we will not change course, however, as we have see this play out several times before. We may find ourselves at odds with the market for awhile, but we know how the story ends, and we trust that our approach is the winning strategy in the long run. As this unfolds, as we have done consistently over the past two years, we will remind our investors to always judge performance (1) with a long-term horizon and (2) being aware of the risk of permanent losses that’s being taken to achieve the results. Or what the alternative history, to borrow from a famous investor and writer of the investment might have been—how the investment might’ve turned out differently and what the consequences of that would’ve been then.
That consistency in our approach shows in our portfolio metrics for the quarter. Not much has changed there. On a P/E basis, our companies are trading slightly ahead of the index. As we pointed out in the past, though, we don’t think that P/E is a very meaningful metric—for one, because of how much distortion there is, or there can be, between accounting earnings and the unencumbered free cash flow that a business generates on a level playing field; also because the index includes businesses that typically trade at lower multiples, and for a reason, and to which we have little exposure, such as financials, materials, or energy stocks.
On an equal footing, we think our companies are in fact cheaper than the market even on a P/E basis. We also think that they have greater staying power, stronger earning generation power per dollar invested, and superior management teams. In fact they generate a return on equity of an average 19% versus 14% for the index. On top of this, they do this without much financial engineering, without much financial leverage, and thus without taking on the additional financial risk to deliver compelling returns. Their weighted average debt-to-equity ratio is 0.4 time versus 0.6 time for the index.
So if we wanted to do this—not that we would—but if we wanted to do this and we were to put the same amount of leverage on our businesses, their return on equity would be twice as high as that of the index. This idea of quality and sustainability of the business, that’s the first thing we look at rather than the multiple at which a stock trades. The multiple to us is meaningless without being able to put it in the context of the quality of the business.
Then what we prefer to focus on to assess whether the stock is in fact attractively priced is the discount to intrinsic value. On that metric, the weighted average discount to intrinsic value of our holdings was just 24% at the end of the fourth quarter. That compares to 25% at September 30, 2013, which means that we were effectively able to keep it relatively stable in