Steven Romick FPA Funds Commentary – The Importance Of Full Market Cycle Returns

The full market cycle can be defined as a peak-to-peak period that contains a price decline of at least 15% from the previous market peak, followed by a rebound that establishes a new, higher peak.1 Few publications or data providers publish, let alone highlight, full market cycle returns, yet we believe understanding them can help the return of your portfolio over the long-term.

Warren Buffett, in Berkshire Hathaway’s 2013 Chairman’s Letter, wrote “Over the stock market cycle between year ends 2007 and 2013, we overperformed the S&P. Through full cycles in future years, we expect to do that again. If we fail to do so, we will not have earned our pay. After all, you could always own an index fund and be assured of S&P results.”2

Because Berkshire Hathaway’s book value compounded better than the S&P 500 over this time, it doesn’t matter that Mr. Buffett underperformed in 4 of the 7 years (after 2014, now 5 in 8 years). And yet, Mr. Buffett’s shareholders are still ahead of the S&P since 2007.3 This supports our view that it is relevant to have a portfolio manager do well over time rather than at a moment in time.

Some managers may perform well in a bull market, while others may outperform in a bear market. FPA aspires to manage successfully throughout entire market cycles. Thoughtfully analyzing performance is an important aspect of choosing a fund manager with whom to entrust your capital. Selecting a manager by using too short of a period or one that only includes a discrete type of market (bull or bear) may be misleading – and costly – over the long-term as undue consideration to short-term performance is unlikely to accrue to your financial benefit.

Many portfolio managers with strong trailing three- and five-year performances in 2000 and 2007 saw their records (and, more importantly, their clients’ capital) decimated by subsequent bear markets. There are other portfolio managers, however, who successfully protect principal in a weak environment yet fail to adequately commit capital when markets are inexpensive, leaving their clients with a sub-par return over the full cycle.

If you are a long-term investor, what happens in between market peaks may be nothing more than noise. Consider both the current market cycle (2007— to the most recent quarter-end peak), as well as the preceding market cycle (2000—2007) for the S&P 500 in the chart on the following page. If you owned shares in good businesses or invested with capable managers, you were better off covering your ears (and sometimes eyes) through the volatility between the green dots.

1 Morgenson, Gretchen. 2002. The New York Times Dictionary of Money and Investing: The Essential A-to-Z Guide to the Language of the New Market, 181. Most peak-to-peak market cycles include economic recessions and periods of high stock return dispersion. See Petajisto, Antti. 2013. “Active Share and Mutual Fund Performance” Financial

Analysts Journal, vol. 69, no. 4 (July/August): 73-93.

2 http://berkshirehathaway.com/2013ar/2013ar.pdf

3 http://berkshirehathaway.com/2014ar/2014ar.pdf

We encourage investors to examine performance over full market cycles that include both bull and bear markets, and suggest they study not only total but risk-adjusted4 returns as well. We include on the first page of our mutual fund fact sheets how our equity and equity-like funds have performed on an annualized basis against their relevant benchmark indexes during the current and previous full market cycles.5

Human nature is to gravitate towards those managers who have recently outperformed. This trait pushed some into Internet managers at the beginning of 1999 and others into short-biased managers at the beginning of 2009, both ill-fated decisions. And as it has in the past, it might again keep some from investing with those committed to delivering returns over complete market cycles.

Steve Romick
Steve Romick

Ryan Leggio and Steven Romick

April 27, 2015

4 In our view, risk-adjusted returns are not just volatility or max drawdown related statistics but also how much and the type of capital that was at risk in order to generate a given level of return. For example, if two strategies that invest in the same types of stocks have identical performance over a full market cycle but one had 75% of its capital at risk, on average, and the other was consistently leveraged (e.g. 120% long), the former most likely had better risk-adjusted performance, based on how we evaluate risk.

5 The last quarter-end high is used in the case of an ongoing market cycle as the peak has not yet been established. This may result in a materially different comparison upon cycle completion. Market cycle performance is not included on the FPA Paramount fact sheet because its investment universe and benchmark index changed since 2007, on the FPA International Value fact sheet because its inception date is in 2011 and on the FPA New Income fact sheet because it is a fixed-income fund and fixed-income funds have different market cycles (interest rate and credit).