Steven Romick’s Q2 FPA Crescent Fund Shareholder Letter
Nothing seems to slow this stock market in overdrive. The S&P 500 returned 5.23% in the second quarter and 7.14% year-to-date. The FPA Crescent Fund returned 2.94% and 5.04% for the same periods, albeit with an average net exposure to equities in the low 50% range.
The value of our positions obviously fluctuates every day and using calendar quarter-end period is nothing more than arbitrary, although it does help explain what contributed to the portfolio’s rise or fall in the period. This quarter, for example, turned out to be a good period for companies beginning with the letter “A”, with 60% of the winners coming from the beginning of the alphabet. Our top five contributors in the second quarter added 1.28%, while the bottom five detracted just 0.21%. Our top performer, Covidien, increased on the news that Medtronic intends to acquire it. Overall, capturing a price at a moment in time will not explain how we will perform long-term. Instead, our attention is focused on years out in the future, which allows us to block the cacophony that comes from listening to the market’s daily rhythms.
FPA had its second bi-annual Investor Day on June 2, 2014. We welcomed the opportunity to spend time with many of our investors and hope, for those who attended, that you found it informative. If you weren’t there, you might enjoy reviewing presentations made by Mark Landecker, Brian Selmo and me, which are available on our website – www.fpafunds.com.
FPA Crescent Fund: Economy
With a nod to Sonny & Cher, the beat goes on. As has largely been the case since 2009, the stock market is the star performer while the economy resembles a shaky back-up singer. The first quarter witnessed a decline in GDP, the first such drop since 2009. A horrible winter certainly had an impact. Since then, the economy seems to have rebounded somewhat but our conversations with companies and our reading materials point to an economy that continues to be anything but robust. U.S. GDP remains below the Fed’s target projections. Employment has increased but, due to people dropping out of the workforce, it’s close to a four-decade low as a percentage of the population. Equally concerning, there’s more part-time work and average wages remain weak. As Sonny & Cher sang: La de da de de, la de da de da.
Disappointing economic growth offers a silver lining, in that it discourages central banks from becoming less accommodative, despite jawboning to the contrary. The Federal Reserve continues to keep interest rates low and to quantitatively ease albeit with some negligible tapering. This effort clearly hasn’t had much of an economic impact but it has continued to elevate the price level of risk assets around the globe. The chart below gives rise to our observation that the Fed has been the biggest driver of the stock market.
In the U.S., the real rate of interest is barely above zero.
With yields remaining artificially low, we observe zero interest-rate policy perverting capital allocation decisions. Money continues to flow around the globe in a quest for yield, instigating a continued rise in risk assets. Many who have been accustomed to the lower risk of high-grade bonds and Treasuries are now finding themselves looking elsewhere. There is no better example of this than the first six months of this year when global stock markets, high-yield bonds, gold, oil and long-dated Treasury bonds all saw their value increase in chorus, a real rarity. As yields have declined, the expectations and spending needs of investors appear to have remained constant, leading them to assume additional risk in varied asset classes around the world. Whereas many past bull-market rallies have been greed-based, this one seems more need-based. The U.S. isn’t alone in keeping rates low. Many countries continue to harbor deflation fears. Japan is still below its inflation target. EU countries have just marginal inflation and it wouldn’t take much to tip them into deflation. Some EU countries like Greece and Portugal are already suffering from outright deflation. As a result, the EU overnight rate is now a negative 0.1%, which means it costs banks to keep money on deposit with the European Central Bank (ECB). Its main lending rate is now down to just 0.15%. It’s hard to argue that such low rates wouldn’t affect an investment decision.
With slow growth and low inflation (and fear of deflation) plaguing most developed economies, it’s hard to see the current easy-money regime ending any time soon. For it to end, the Fed must first slow its buying, then stop buying and then either liquidate or roll the assets they’ve purchased. It appears that we have a ways to go before they aren’t accommodative – unless their hand is forced. The U.S. is increasingly on its own in financing its deficits, with foreigners having largely stepped out of the U.S. Treasury market.3 If we need financing assistance from our trading partners, then we might need higher interest rates to get them to step up their Treasury buying. Or, the Fed could always reverse course on the QE taper and continue to self-finance. Or, the current account balance shrinks, thereby requiring less funding, with either exports and the economy growing, or imports and the economy shrinking. That’s a lot of “oars” needed to keep the boat moving – which begs some degree of caution.
We consider the economy only to ascertain what’s possible at some point, rather than to opine as to what will happen when. With a healthy dose of skepticism and appreciation of our fallibility, we understand that things can always go wrong (including our own projections), but we are happy to commit capital to new or existing investments as long as the given opportunity offers an attractive risk/reward, even after taking into account bad news that brings about a reasonable worst-case scenario.
FPA Crescent Fund: Investments
Investing today feels a bit like dancing the limbo, i.e. how low can you go? With interest rates, volatility, and short interest all near lows, it’s no surprise that opportunities are scarce as you can see in the following two charts that depict valuations being above normal, historical figures.
If you were to then surmise that there isn’t much trading at low valuations, you would be correct. With many stocks hitting new highs, the number of stocks trading at lower Price/Earnings (P/E) ratios is near its low. We continue to trust that long-term thinking will pay dividends in the form of good returns and allow us to avoid the frequent mistakes more commonly associated with the need for more immediate gratification. Patient investors have created more than one great family fortune over time and over diverse industries by disregarding present performance in an effort to create wealth at some point in the future; e.g., Buffet, Crown, Tisch, Koch, Frère and Pritzer, just to name a few.
FPA Crescent Fund: Alcoa & Norsk Hydro
We initiated positions in two aluminum companies last fall, Alcoa Inc (NYSE:AA) and Norsk Hydro ASA (ADR) (OTCMKTS:NHYDY), that we saw as commercial opportunities or, as we like to call them, “3 to 1s”, i.e., 3x the perceived upside to its downside. The oversimplified and bigger picture view was that we saw the price of