FPA Capital Fund commentary for the second quarter ended June 30, 2015.

FPA Capital Fund

Introduction

After three quarters of underperformance, we are pleased we were able to stem the negative comparisons and outperform both the Russell 2500 and Russell 2500 value, which had -0.34% and -1.27% results, respectively, for the June quarter. More encouraging was our energy investments which produced a positive return, in aggregate, during the June quarter.

There are a number of risks investors are worried about today that could explain the market’s flat to negative results in the second quarter, but Greece and China are two areas where the media has focused a lot of attention. From our perspective, it is important to understand what is happening in those two regions, but if the USA Today newspaper is running headline stories about the problems these countries have it is very likely that the market has largely discounted much of the concerns.

In our opinion, the biggest risks remain the high valuations in the stock market and the large federal budget deficits being financed with ten-year treasuries yielding 2.3% and three-month bills at 0.02% interest rates. While FPA Capital has a modest valuation of approximately 13x weighted price-to-earnings, the P/E for the Russell 2500 is 29x and for the Russell 2000 it is a striking 35×1. The counter argument could be that the profits for these companies are growing fast, but that is not the case. The growth in net income over the past year for the Russell 2000 was just 3.02%. For the Russell 2500 and S&P 500, the growth rate was negative 2.48% and negative 3.11%, respectively.

A slow-growing or declining earnings environment, with ever-increasing multiples, is not a recipe for investment success. At the end of the quarter, we ran a quick analysis and looked at what type of companies have accounted for Russell 2500’s outperformance relative to other benchmarks. The results were fascinating: In the first six months of the year, almost 150 companies experienced stock price increases of more than 50%. 60% of these companies were biotech, pharmaceutical, or other healthcare. When we looked at this subset, we were shocked to learn that 80% of them were unprofitable and they, in aggregate, accounted for $145b of market capitalization and more than $3b of cumulative net losses.

FPA Capital Fund

Clearly, it hard for us to see how the weak earnings growth for these companies can justify paying “nose-bleeding” valuations. When we talk with other investors about these high valuations, the justification seems to be a resigned “where else are you going to put your money?” Certainly not Chinese or Greek stocks, not paltry-paying government debt, maybe real estate, but a resounding thumbs-up for U.S. stocks because they only go up in price –at least over the past six-and-a-half years. Investors are not the only constituency that is plowing money into stocks. In May 2015, $141b of new stock buybacks and $243b of M&A were announced – both all-time monthly records.

Perhaps the market’s lackluster second quarter results portend a change in the six-year bull market. On the other hand, we have seen the equity markets pause a couple of times since the great recession ended in 2009, and this may be just another period when equity investors catch their breath before resuming their appetite to take on more risk.

FPA Capital Fund – Market Commentary

We normally do not discuss what is happening in the credit markets, as our fixed income colleagues do a more than credible job elucidating on the comings and goings of that enormous market. However, we feel compelled to scribe a few thoughts for equity investors to chew on. To start off, for the first time in our collective memories creditors had to pay borrowers interest income for the right to use the lender’s money for a certain period of time. This insane fact is a result of the European Central Bank’s (ECB) new Quantitative Easing (QE) policy. In Europe, there are floating rate European bonds tied to the Euribor reference rate. This is the interest rate European banks lend to each other for a specified period of time –generally from one week to one year.

Well, as it turns out, it is not uncommon for European asset-backed loans to be priced at the Euribor rate. For example, an automobile debt issuer may issue an asset-backed security tied to the Euribor rate minus 50 basis points, or 0.50%. When the Euribor went below 0% (the current three-month Euribor is negative 6 basis points or -0.06%), any asset-backed security that did not specify a floor, had the weird situation where the investor not only did not receive his interest but also where he may have had to pay the borrower money. This is the equivalent of a landlord paying a tenant to rent his apartment.

Volkswagen and other auto debt issuers are now inserting clauses into their deal documents to protect creditors from having to pay if interest rates on their investment fall below zero. We are sure investors love reading the quote from Stefan Rolf, head of asset-backed securities at Volkswagen Financial Services AG in Braunschweig, Germany. Herr Rolf said “we want to give investors comfort about what’s going to happen, which is why we included a clause for the first time to make clear that we will never ask investors to pay us interest.”3 That is indeed comforting. Rolf did not comment about the credit quality of the 0% interest rate loans being made to people who otherwise might not have been able to afford the purchase a new car without the financial inducement.

Regarding residential mortgages, Spain’s Banco Popular Espanol asset-backed bondholders were not asked to a make a coupon payment this past April after rates dropped below zero. Whew! On the other hand, in May, Stockholm-based Nordea Bank said it planned to charge investors on some new mortgages should rates drop below zero.4 We are not sure if we should be more stunned by the audacity of Nordea or the foolishness of investors who would buy those securities. Nevertheless, the ECB’s extraordinary QE policy is not only confounding investors it is also warping credit markets.

While fixed income investors are gnashing their teeth about when central banks eventually will move away from their zero-percent interest rate policy (ZIRP), equity investors continue to jump for joy at all the free money. Since the ECB announced its QE policy, stocks in Germany are up over 20% during the past six months. In Japan, stocks are up nearly 130% since the Bank of Japan (BOJ) embarked on its own version of QE over two years ago. However, in the U.S., the Federal Reserve has hinted that it will raise rates sometime later this year after nearly seven years of unprecedented monetary stimulus, but stocks have shrugged off those concerns and seemingly continue to hit record highs every day.

With Puerto Rico nearing a default and Greece defaulting on its debt obligations, perhaps central bankers will continue their QE and ultra-low interest rate policies a bit longer than many are expecting. Central bankers, in our opinion, are well aware of the massive government leverage countries have assumed–particularly Japan,

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