Value Investing

FPA Capital Fund 1Q15 Letter: Do investors know what they own?

FPA Capital Fund letter to investors for the first quarter ended March 31, 2015.

Also see Steve Romick Q1 letter

Our Fellow Investors,

There’s no easy way to put this, but the FPA Capital Fund got off to a poor start this year. We underperformed our benchmark by about 10% in the first quarter of 2015; notching a 4.92% loss, while the Russell 2500, our benchmark, recorded a 5.17% gain. While we are disappointed with our short-term results, we believe the investment process and philosophy that helped us deliver 14.11% outperformance over the last 30 years will allow us to achieve our stated goals, again, if we stay true to it. And that’s exactly what we intend to do.

FPA Capital Fund

As we considered our performance this past quarter, we’re reminded of a simple truism from a 2006 Howard Marks memo, Dare to Be Great, “You can’t take the same actions as everyone else and expect to outperform.” It’s as true as it is obvious and that’s why our portfolio looks radically different than the benchmark we track. We are significantly more concentrated; we hold a high cash balance; and our companies tend to be higher quality, have better balance sheets, and are less expensive than the market average. We believe these differences have been key to our success historically and will ultimately drive our performance over the long run. But over the short run, these differences could drive periods of underperformance like we saw last quarter. In this quarterly letter, we will discuss and analyze what drove the market’s performance and talk about some specific components that impacted our results.

FPA Capital Fund – Market Commentary: Do investors know what they own (aka how did the market do?)

Do the current market prices depict the fundamentals? After a lackluster start to the year, stock prices shot up in February. By the middle month of the first quarter 2015, the Russell 2500 index had increased by 3.79% and the S&P 500 index was up 2.57%. Based on the stock market’s strength, one might think that February was a great month for the US economy. The financial blog ZeroHedge compiled a list of all the macro data announcements during that month1: 38 readings were below expectations (personal spending, construction spending, ADP employment, retail sales, non-farm productivity to name a few) and only six were above expectations. By quarter’s end, the Russell 2500 was up 5.17% and S&P 500 was up 0.95%.

CEO’s were bearish on their companies’ prospects but bullish on their stocks. According to an analysis by Bespoke, the delta between companies that are cutting profit forecasts versus those who are increasing guidance is at a six-year high. Bloomberg’s analysis of such guidance predicts a 2.1% year-over-year EPS decline in the S&P 500 for Q1’15 and a 1.1% decline in Q2’15 – compare that to the expectations at the end of 2014 for 3.3% growth for both the first and second quarters of 20153. Despite that, companies went ahead full steam with buybacks. In 2014, companies in the S&P 500 bought back $550 billion worth of stock and Russell 2000 companies repurchased $23 billion worth – the highest figure since 20074. The pace accelerated in 2015 with companies announcing $104 billion of purchases in February alone, bringing the total to around $2 trillion since 2009.

At the end of the first quarter, the Russell 2500 was trading at 28.6x (based on trailing twelve months earnings, TTM) with the S&P 500 Index trading at 19.8x (TTM). Just like the dot-com era of the late 1990’s, today we believe many people are simply unaware of the individual stocks moving different indices. We wonder whether the investors that are pouring money in to the market are similarly complacent this time around. Morningstar published an article at the end of this quarter and stated that the mutual fund “at the nexus of both performance and trends” in the US during the first quarter of 2015 was a small cap growth fund with 56 positions, 25% of which had negative net income in the past 12 months. The top performing stocks came from biotechnology, life sciences, and pharmaceuticals. We briefly looked at the components of the Russell 2500 index to see what has moved these small and mid-cap stocks. At the end of the first quarter, there were 140 companies in the index that experienced price increases of over 30% (yes, in one quarter). The increases ranged from 32% (a company that is trading at 177x price to sales and -40% return on equity) to 155% (a company that is trading at 16x price to sales and -60% return on equity). A detailed look at these 140 companies showed that 71 of them had negative earnings, only two of the top 15 performers were profitable and 65 of them were either a pharmaceutical, biotech, healthcare equipment, healthcare provider or a life sciences company with only one of the top 15 performers not belonging to one of these groups. If you think that 2014 was simply one down year among many profitable for these companies, you would be mistaken – only 65 of the 140 companies have positive five-year cumulative net income. 35% of Russell 2500’s first quarter performance came from one of these groups.

What is an absolute value manager (yours truly) to do when markets are expensive and risky strategies are outperforming conservative ones? Many believe that what goes up will continue to go up and keep pouring money into the markets despite ever-increasing valuations. Should the markets turn, as they have done in all cycles past, many will get scared – particularly those who do not really know what they own (i.e. index investors) – and start selling (some will be forced to sell for liquidity reasons). Buying high and selling low has been a key reason that many investors’ returns have not kept up with the market over long periods. No wonder the annualized returns for the average equity fund investor over the past 20 years was 5.0% vs. 9.2% for S&P 500.

The US is not the only place we see these excesses. Let’s look at Europe, where about $2 trillion of sovereign debt offers negative yields. Was it not just a short while ago when Italy and Portugal were deemed to be in dire straits? Today, they can borrow at 1.2% and 1.6%, respectively, and no, not for one year paper, but ten.

We have seen this movie before. The people that see all news as good news will point to the NASDAQ index hitting an all-time high figure in Q1’15. We would remind them that it took about 15 years to reclaim that territory. For those, who believe that a picture is worth more than 1,000 words, here is an indicator that Warren Buffett has talked about before:

FPA Capital Fund

See full PDF below.