FPA Crescent Fund commentary for the year ended December 31, 2016.
FPA Crescent Fund – Performance
The markets continued to move higher in the fourth quarter after overcoming the initial misgivings surrounding the results of the U.S. election. The FPA Crescent Fund (“the Fund”) returned 4.51% in the period and 10.25% for the full year. This compares to the 3.82% and 11.96%, respectively, for the S&P 500 and 1.19% and 7.86%, respectively, for the MSCI ACWI index.
As has been the case since the Fund’s inception, Crescent outperformed its exposure in the quarter and full year.1 The alpha generated by our equity security selection, as shown in the table below, has helped the Fund meet its two-pronged goal of lower risk and equity-like returns despite maintaining large cash balances for extended periods.
One of Crescent’s secondary benchmarks, a balanced stock/bond blend (60% S&P 500/40% Barclays Aggregate Bond), has had a huge tailwind thanks to interest rates that steadily declined starting in 1982, through the Fund’s inception in 1993 and up until 2016.
The Barclays Aggregate Bond Index has compounded at 5.42%, far better than the return on our greater than 30% average cash balance since Crescent’s inception thanks to this generational bond bull market. Despite what is a comparative headwind for the Fund, we have beaten the balanced benchmark from inception by 2.45%, although the Fund has lagged in the last five years by 0.54%.
We saw a reversal of this trend in Q4 with interest rates turning up, thereby causing bond prices to fall. The yield on the 10-year U.S. Treasury note increased from 1.60% at the end of Q3 to 2.45% at the end of Q4. A 0.85% increase in rates may not seem like much in basis points but a 53% increase in just three months wreaks havoc on a 10-year bond, causing a 7.3% decline in the value of its principal. As a result, the Barclays Aggregate Bond Index declined 2.98% in Q4 after having increased 5.80% for the first nine months of 2016.
We don’t know if the bull market in bonds has ended but given how low rates continue to be, it’s hard to imagine the next decade will feature the same drop in interest rates (and rise in bond prices) that the last decade had. If, in fact, rates continue to rise from here – causing further losses in the bond market – Crescent’s perpetual eschewing of interest rate risk should accrue to the benefit of our shareholders.
Morningstar nominated our team for 2016’s U.S. Allocation/Alternatives Manager of the Year. Both longtime shareholders and Morningstar understand, though, that we judge our performance over full market cycles of which 2016 was just one calendar year. We appreciate their interim recognition nonetheless.
Our exposure to financial firms along with our investment in high-yield bonds both benefited 2016‘s performance as exhibited in the tables below.3 All but one of the winners were financials in the Q4 and full-year periods, the opposite of what we saw in Q1. The losers lacked a theme but it should be noted that our Naspers/Tencent arbitrage continued to suffer (see Q3 2014 commentary).
As lower-grade corporate bonds declined in price in late 2015 and early 2016, we quintupled our exposure. That sounds like a lot but, in truth, we took it from just ~1% to ~5%. The broader high-yield opportunity we hoped for didn’t come to pass. Index yields traded above 10% for just one day in February 2016, and have subsequently declined to just 6.19% today.4 Our corporate bond investments outperformed the index, returning 41.87% in 2016 vs 17.49% for the BofA Merrill Lynch U.S. High Yield Index, and contributing 2.22% to Crescent’s full year return.5
Our equity book was led by our overweight position in financials. The tale of our fluctuating financial exposure is emblematic of our approach to investing: Buy good businesses when others don’t want to own them and avoid them when they’re popular. Owning the unloved can be trying at times as these companies may be suffering from general economic weakness, industry malaise or internal missteps. Since we lack any ability to discern the bottom in a company’s earnings or stock price, our initial purchases are generally early. That can be uncomfortable for the holder – or worse, the holder of the holder, like shareholders of a mutual fund, for example. The more removed one is from primary research, the less comfort understandably exists in observing a manager maintain a position while it’s declining in price. Worse, if in that instance the manager were to increase its stake, a fund investor’s discomfort may compound. We don’t let our judgment become unduly influenced by stock price, preferring to focus instead on fundamentals.
Going back to the Fund’s inception, we have had an on/off affair with lenders (e.g., banks and thrifts). Using the S&P 500 Bank Industry Price/Book as a proxy for valuation, you can see that Crescent’s exposure to financials has vacillated inversely. As lenders get cheaper (lower Price/Book), we buy. When they become more expensive (higher Price/Book), we sell. Therefore, when the bank index was at a high valuation in the late 1990s and early 2000s, Crescent’s exposure was negligible but we reengaged when valuations were bottoming earlier this decade and our exposure has now increased to an all-time high.
We lacked the foresight to build an entire position once the bottom had been reached in the financials or any other sector or asset class for that matter. As a result, we regularly endure periods of underperformance while waiting for our thesis to play out but our buying program generally continues as long as our opinion remains constant.
Lenders declined in price in 2015. We bought. They declined further. We bought some more. Early 2016 brought more of the same. Our investment in financials contributed to Crescent’s performance lagging its exposure for a period of time. We had plenty of phone calls from shareholders questioning the wisdom of these investments. Those calls reached a crescendo in Q1 2016 when four of the five losers in the period were the same financials that round out the winners list in Q4. No surprise that Q1 was a bottom for the sector (and the market). Since we are closer to the investments than our shareholders, we can appreciate their discomfort. And yet discomfort is a kind of petri dish that cultures opportunity. Anxiety creates selling pressure and lower prices, which allows us to invest with a margin of safety.6 The comfort of going it alone is, for us, preferable to that of running with the crowd. In periods of such solitude, we hope we succeed in providing you a modicum of reassurance as we tried to do when we articulated our rationale for financials in our commentaries (particularly, Q1