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From FPA Capital Fund:

Realistically, the Federal government will continue to spend money far beyond what it collects in revenue for the foreseeable future, higher oil prices will eat into the scarce discretionary income of consumers, and the sovereign
debt problems will eventually take its toll on investors. We have tried our best to position your portfolio to withstand a permanent loss of capital from the above risks. At the same time, the securities that we purchased over the past several years exhibited very attractive valuations, and ones that we expected would prosper during these challenging times.

As the companies in your portfolio proved the strength of their business models and generated excellent profits and cash flow, their share prices appreciated — in some cases quite substantially. Yet, no company, not even Apple, will grow forever and produce ever-rising profits. It is for this reason, among others, why we are more cautious about stocks in general and why we have reduced the shares in a number of the holdings in your Fund’s portfolio. Your Fund has considerable liquidity which can and will be used strategically to purchase securities when valuations hit our target levels.

In light of this, we did not add to any existing stocks and added only one small new position to the portfolio during the past six months. Ironically, despite the large gains over the last six months and past two years, we have a handful of
attractive companies that we are monitoring very closely and which are close to an entry-level valuation for your Fund. We continued to perform due diligence, during the quarter, on a few companies by visiting their operations and talking with management and industry experts to ascertain the individual company’s risks and prospects. However, none of the five or six stocks which we are closely monitoring currently provide an adequate risk-reward ratio that would give us confidence to initiate a position. Patience is a key attribute and distinguishing characteristic of our investment process, and one which appears to be in scarce supply today across the broader investment management industry.

We did, however, reduce a number of positions during the past six months. While the majority of the stocks we reduced were energy related, we also cut back our exposure in technology, retail and industrial companies.

Two stocks worth highlighting in the most recent six month period were Trinity Industries (TRN) and Patterson- UTI (PTEN). TRN gained almost 65% during the six months ended March 31 and closed at $36.67. We had believed that the market was not properly valuing the company, based on our view thatindustry railcar shipments would get back to more normalized levels. We also believed that TRN’s profits would  rise substantially as the company’s railcar shipment growth mirrored the industry’s growth, and the company’s barge business continued to produce good returns. As the backlog of railcar orders for the company accelerates, TRN’s consensus earnings for next year is expected to nearly triple last year’s roughly $0.85 per share. With the stock recently doubling, and more than tripling from late 2008, we trimmed back TRN as the company’s valuation is now closer to our estimate of fair value.

PTEN also performed well over the past six months, appreciating over 72% and closed at $29.39. PTEN is among the largest land-based oil & gas drilling rig operators in North America, with ownership of approximately 350 rigs. PTEN added to its pressure pumping services line of business with the acquisition of Key Energy’s pressure pumping and wireline services assets last year. This acquisition more than doubled PTEN’s pressure pumping horse power to nearly 420,000hp, and also expanded the company’s geographic reach from the northeast U.S. to the Permian Basin and Eagle Ford Shale areas in Texas. Investors have bid up PTEN’s shares because the daily rental rates for the company’s drilling rigs are increasing, and pressure pumping services are in greater demand as more exploration and production companies require these assets to fracture shale rock to release the oil and gas for production. PTEN achieved $0.76 in EPS last year, but the consensus EPS for next year is $2.14. We trimmed back the position as more investors are now seeing this higher profit potential for the company.

Finally, over the past six months Foot Locker (FL) was up just over 35%. We believe Ken Hicks, FL’s CEO, is doing an excellent job focusing the company on better inventory management, meeting the needs of its customers, and
generating higher returns on capital. Although there are no guarantees, we would not be surprised to see FL earn nearly $1.50 in EPS this year, relative to current EPS of $1.07, should the company’s apparel business turn around its
recent lackluster performance and the economy does not fall into another recession.

Two themes are foremost in our current thinking. Firstly, growth in corporate profits will slow considerably, and could turn negative, which will provide little support to currently elevated valuations, and secondly, we feel that the U.S.economy is not on a healthy growth path with fiscally irresponsible trends which, if they continue, should lead to far greater financial market volatility. As both become more apparent to market participants, the stock market rally that we’ve seen should peter out and may reverse.

Growth in corporate profits has had a large impact on the rally in the stock market. How sustainable is this profit growth? With corporate profit margins hitting multi-decade highs, our view is that it is not sustainable. At best,
corporate profits are likely to grow in line with GDP growth, should margins hold at current peak levels. And that is the big question. The current after-tax corporate profit margin level of 9.5% of national income is fifty percent above
the long-term average margin for the last sixty years of just above 6%. Besides the last decade, the after-tax corporate margins have only barely surpassed the 8% level three times in the previous five decades. We wouldn’t bet that margins are going to stay here forever or go higher.

Valuations have been supported by the rapid profit growth, driven primarily by the corporate profit margin expansion, but also by the Fed’s record low interest rate policy. Current price to earnings ratios are 29.9x for the
Russell 2000 and 25.3x for the Russell 2500. These valuations are not being impacted much by the non-recurring charges that hit earnings in 2009. We have difficulty seeing how valuation multiples will expand from here, and expect them to contract over time to more normal valuations in the teens. A likely scenario in our eyes is a contraction in multiples, a contraction in profit margins, and higher interest rates. Should all or just a couple of these occur, we could have significant capital destruction in the stock market again, like we had in 2008. We would not be surprised if this happens at some point in the next several years, because of the excesses that are building in financial markets as a result of record low interest rates, excessive growth in money supply, and fiscal irresponsibility with large deficits

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