Steven Romick, CFA, managing partner of First Pacific Advisors LLC, has released his investor letter for the fourth quarter of 2012. The letter comments on the fund’s 2012 performance, and looks ahead to investment opportunities in 2013. The major point of the piece, however, is that investors are currently taking on more risk than they are willing to admit, and this might lead to serious problems in the future.
The problem, according to Romick, is embedded in the Federal Reserve’s attempt to solve the economic woes of the United States. The yield on ten year bonds has fallen to absurdly low levels, and that has driven investors, who would normally prefer to maintain very low risk, into risky assets. The attitude of those investors, according to Romick, is that “in the quest for return, risk can be conveniently redefined, if not wholly ignored.”
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Equities did well in 2012, the S&P 500 (INDEXSP:.INX) returned 16%. Risk adverse investors like Romick, who kept to less risky equities and assets, saw their returns come in lower than that benchmark. FPA’s Cresent fund returned 10.3% in 2012, making him look like a poor investor according to the indexes, but Romick disagrees.
The fund manager said he decided to forgo the returns from equities in 2012 because they didn’t look cheap and he would prefer to leave money on the table than deal with a permanent loss of capital from the fund. Other investors have been forced to take the risks offered in equities in order to achieve returns that look good beside the indexes. That attitude might lead to disaster once the bond markets change.
According to Romick, “We are generally more concerned about what people aren’t discussing, rather than what’s in the headlines.” That attitude led to FPA not worrying about the Fiscal Cliff at the end of 2012, but instead worrying about the long term impact of the spending habits of the US government, another level of risk ignored by many investors.
“Certain decisions can allow economies to feel superficially good, but like any Faustian bargain, a price will ultimately be paid.” That sentence, applied to the current easy money policies across the world, asserts a risk factor in the economy that is simply not being taken into account.
Eternal quantitative easing is not an option, it will cause another economic crash. Investors do not seem to be thinking long term, Romick wants to ensure long term stability rather than short term returns.
There is an artificial feeling of safety in the current economy. Romick believes that the real dangers out there means that it is better to under-perform relative to the indexes if it means insulation from a crash in the future. Despite that risk, FPA LLC is still 61% exposed to equity. There are certain areas the manager expects to recover sustainably. These include the auto market and the real estate market.
The unseen risks are the defining attribute of the market right now, but Romick, who says that he’s in the “time-arbitrage” business expects FPA’s returns to be solid going forward. Sometimes they’ll lag, and sometimes they’ll be ahead, but overall, using its strategy, FPA will remain stable.