FPA U.S. Value Fund webcast audio, transcript And slides for the fourth quarter ended December 31, 2015.
FPA U.S. Value Fund 4Q15 Webcast Audio
FPA U.S. Value Fund 4Q15 Webcast Transcript
Greg Nathan: The primary objective of the FPA U.S. Value Fund is the growth of capital over the long term. My goal is to outperform the S&P 500 over full market cycles.
Here is a quick summary of my professional background and experience, as well as my alignment of interest with fellow shareholders. It should be noted that I increased my personal investment in the FPA U.S. Value Fund during the last quarter and plan to further increase my investment throughout this year.
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Now I’d like to walk you through my investment philosophy. The most important thing in investing is to avoid permanent capital impairment. Permanent capital impairment could result from investing in a business whose profitability is structurally declining, paying too high of a multiple for a company, investing in a company with too much financial leverage that can’t make it through a tough business cycle without having to restructure. Thus I focus on finding quality companies at attractive valuations with low financial leverage. I want the portfolio to have an appropriate level of diversification by number of investments and industry exposure.
So how do I find quality companies at attractive valuations? I look for quality companies that appear misunderstood, as well as industries that are out of favor. I define “quality” as companies with strong and enduring competitive positions, growing businesses within growing industries. A growing industry is key because without it there will typically be poor earnings growth and investment returns—more on this in a minute. Lastly I want my companies to have high returns on capital and robust free cash flow generation. I prefer companies with good management. However, often the reason good businesses are offered at attractive prices is because of poor management. Therefore I will consider such companies provided there is not a structural impediment to replacing management and there’s a large enough discount to my estimate of their intrinsic value. Bottom line, the quality of the business and valuation are the most important investment criteria.
Now I put this slide together to highlight how important it is to invest in a healthy industry. This shows the ten-year performance of eight hard-line retailers. There are four categories represented: drug stores, home improvement, office supplies, and electronics. Each company is the number one or number two player in its respective market. As you can see, the four companies that outperform the S&P 500 over this time period were CVS, Walgreens, Home Depot, and Lowes. These companies operate within secularly growing industries. Also the recession allowed these companies to further distance themselves from the competition. Additionally the two best performing companies—CVS and Home Depot—are number one players and benefited from good management, whereas Walgreens and Lowe’s have been impacted by various management missteps over the years but still managed to outperform.
Conversely, the four companies that underperformed in the market… And they didn’t just underperform; an investment in any of these four resulted in permanent capital impairment. This occurred because the electronics and office supplies industries experienced fundamental changes that impacted the level of demand for its products and how consumers purchase them. What’s worth highlighting is that the delta between the returns of the winners compared to the losers increased dramatically over the last four years. This speaks to the importance of having a long-term view and time horizon for investing in high-quality companies and growing industries at cheap prices because ultimately time is on your side.
Let me walk you through the key parameters as to how the portfolio is constructed. The FPA U.S. Value Fund’s multi-cap strategy affords me the ability to invest wherever the best opportunities arise. At least 80% of the portfolio will be invested in U.S. companies. At the same time, I have the ability to make opportunistic foreign investments. Appropriate diversification— typically 20 to 30 companies; individual positions will not exceed 5% of total assets at the time of purchase. Approximate average position size of 3–4%. Normally fully invested—the reason for this is the portfolio is made up of what I believe are undervalued, high-quality companies that should compound in value over time. Cash will usually not exceed 10% of the portfolio.
Constructing a portfolio begins with idea generation. I find potential investments in multiple ways. Having researched and analyzed various companies and industries for over 15 years, I have a very good knowledge base to pull from. For example, I have done extensive research on the healthcare sector, and in particular the pharmaceutical supply chain. So when several high-quality companies in the sector sold off in the fourth quarter, I was able to quickly brush up on various companies, understand why these companies were out of favor, and confirm these investments provide a good risk-adjusted return for the portfolio.
I constantly read various publications, news articles, and buy-side as well as sell-side research. When I’m on vacation, this is also what I do for pleasure—something my wife absolutely loves. I think it’s important for existing and potential shareholders to understand just how much of a passion I have for investing to find the next great company to put into the portfolio.
Once I have identified a potential investment, I conduct thorough research and analysis of the company and its respective industry. What is the current health and long-term growth rate of the industry? How competitive is the industry? Does the company have a strong, lasting competitive advantage? Is the company operating at an efficient level compared to its key competitors, or is there room for improvement? Does management have a good track record? How is management compensated, and by what metrics are then incentivized? How does management allocate capital? Lastly, after building realistic low-base and high-case scenarios, does an investment at current prices provide a good risk-adjusted return?
In summary, this investment process shows just how selective the criteria is before coming to make it into the portfolio. Out of approximately 3,000 companies that could be considered for investment, when factoring in my strict criteria of quality, valuation, and growth, there are usually not more than 100 companies that make the cut. This helps explain why the FPA U.S. Value Fund concentrates its investments in only 20–30 companies, as so few companies are able to provide the upside potential I seek while minimizing the risk of permanent capital impairment.
Once the portfolio is constructed, there are a few reasons for selling an investment. One would be that the market has recognized the company’s quality with a valuation re-rating such that estimated future returns from a new price are projected to be below average. These are what I call “happy sales.” Another is that the investment thesis is proven wrong. In this case, I will not rationalize holding an investment even if the price or valuation has declined. These are what I like to call “unhappy sales.” Lastly, a superior opportunity becomes available, and these are what I like to call “thankful sales.”
As you can see on this slide, this is a list of the various risk management tools I put in place to help achieve the FPA U.S. Value Fund’s objective of long-term growth of capital. I’ve already touched on several of these points, so I don’t want to be redundant. One thing we’re keeping in mind is that I take a long-term view on the companies and their respective industries when considering an investment. A byproduct of this should be relatively low portfolio turnover. However, with the recent volatility in the markets, what isn’t cheap one day can quickly become a good value. Since my mindset is always “how can I improve the portfolio each and every day,” when there is an opportunity that presents itself, I will not hesitate to act.
See full transcript below.