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FPA 2013 Q4 Capital Fund Conference Call (see comments from Steve Romick’s call to FPA Crescent shareholders here).FPA Capital call here, FPA International Value CC here).
We believe the Fund’s company research and valuation process, its focus on high-quality companies, its broad benchmark-agnostic mandate, and its ability to concentrate on the team’s best ideas are some of the Strategy’s structural competitive advantages, which we believe should enable it to outperform the MSCI All Country World Index over a full market cycle. For more detailed information regarding the Strategy, we strongly encourage you to read the Strategy’s policy statement available at fpafunds.com.
At this time it is my pleasure to introduce Greg Herr. Greg, over to you.
Greg: Thanks, Ryan, and thanks everyone very much for joining us today on the call. Before we begin our Fund update, I’d like to briefly review the history of the last two years for those of you on the call who aren’t familiar with it. In August 2011, the Fund adopted a more global approach in order to take advantage of a broader opportunity set and to continue FPA’s tradition of benchmark-agnostic investing. As part of that process, Pierre and I were named portfolio managers of the Fund. If we now fast-forward two years to 2013, FPA announced that on September 1st the Fund would become part of the new FPA Global Value Strategy, and that Pierre and I would serve as lead managers.
So with that preamble explaining what’s brought us to this point, we’d like to provide an update on the process we’ve undertaken and the resulting portfolio developments. On our last webcast we discussed the first step in our process, which we completed by the end of September. This involved analyzing the Fund’s existing holdings to reevaluate their fundamental characteristics and valuations. Based on our updated fundamental assessments, the companies remaining in the Fund at that point all possessed the quality attributes we look for. In many cases however, their stock prices that have performed well over the past few years were no longer priced at a significant discount to intrinsic value. Based on valuation, those companies were candidates for sale.
Now the second step involved completing the work on new investment ideas. Companies must meet our fundamental quality criteria and offer a significant discount to our estimate of intrinsic value in order for us to purchase them. Assessing business quality begins by discussing business operations, strategy, capital allocation with the various management teams. We also interview competitors, suppliers, and customers to understand the industry value chain and market forces. At the same time we’re reviewing the long history of annual reports, conference call transcripts—basically any public reports for both the companies themselves and other industry participants. All of these conversations and readings are used to help us assess the normal economics of the business and to estimate the present value of its future cash flows.
When we’re convinced about a business’s quality and its stock trades at a significant discount to our estimate of intrinsic value, it becomes a candidate for purchase. As a result of this two-step process, we exited 17 positions and we added 10 U.S. and 10 international companies to the Fund. At the same time, we adjusted all the portfolio weightings of the existing positions and the new additions based on our assessment of their relative discounts to intrinsic value.
Pierre, do you want to say a few things about some of the specific international names that were bought and sold?
Pierre: We can either do that now, or we can… maybe if there are some questions at the end of the call… so how about I do that after the prepared remarks?
Greg: Okay. In the future, the portfolio will continuously evolve based on market opportunities, but it’s unlikely to experience the changes of such magnitude as we implemented since September 1st of last year. It’s also important to note that we have no preconceived amount of time for a company to remain in the portfolio. We’re waiting for the discount to intrinsic value to close, and we typically expect that to happen on average over a five-year period. In some instances however, we’ve seen the time it takes for the market to fully recognize a company’s value can be much shorter. In that case, the holding periods would obviously be less.
Finally, turning to tax considerations for the Fund, we expect no further exceptional distributions from large unrealized capital gains. After the December 19th and the January 9th distributions, the total unrealized and undistributed gains make up just a little more than 2% of Fund net asset value.
And now let’s turn to performance. During the fourth quarter 2013, the Fund rose 5.32% compared to the MSCI All Country World Index gain of 7.31%. We don’t view this as a representative period for the Fund under the Global Value Strategy since the portfolio positions were changing and cash balances were elevated. But for the full year, the Fund rose 27.75% versus the index, which gained 22.8%. In 2012 the Fund returned 15.97% versus 16.13% for the index. Since the fourth quarter of 2011, which was the first full period when we were both named managers, the Fund has appreciated 27.52% versus 20.75% for the index.
We’re showing longer annualized periods of performance here based on reporting requirements, but they provide we think limited comparability because the Fund had a domestic focus over those periods, and we were not managers during those historical results.
Now in response to an investor question, we’d like to mention that we chose the MSCI All Country World Index, or MSCI ACWI, as a benchmark because the Fund had a broad flexible universe, meaning we can invest across developed and emerging markets. We also have the FPA International Value Fund utilizing the MSCI ACWI ex-U.S., which covers both developed and emerging markets outside the U.S. So based on the Paramount Fund’s broad purview and a philosophy and process which is similar to International Value, we thought it made sense for us to use the ACWI.
Finally as a general comment on performance, we think it’s our job to vet and purchase high-quality companies when they’re selling at attractive discounts to our estimates of their fair value. We’re benchmark-agnostic, and we build the portfolio so that our best ideas get weighted accordingly. There will inevitably be market environments when our approach will lag the benchmark. But recently equity multiples have been broadly expanding, while meaningful improvements in long-term cash flow prospects seem limited for many companies. It’s possible that, if stock prices begin to rise again, based on those trends, we could suffer in terms of short-term performance.
Through the disciplined application of our approach along with clear communication about what we’re doing and why we’re doing it, we’re trying to attract investors who look at the world the same way we do. Like us, we hope they evaluate investment performance over a long time horizon and try to understand the risks that are being taken to achieve that performance. To expand on that last point and to paraphrase Warren