FPA Crescent Fund webcast audio, transcript And slides for the fourth quarter ended December 31, 2015.
Steven Romick – FPA Crescent Fund 4Q15 Webcast Audio
Steven Romick – FPA Crescent Fund 4Q15 Webcast Transcript
Steven Romick: Thank you, Brande. So going through our usual slide presentation at the beginning, the familiarity of these slides is, I’m sure, there for most of you, and we’ll get to some original slides later on.
The philosophy of the FPA Crescent Fund remains unchanged: equity-like rates of return with less risk over time. We delivered on our goals over more than two decades, albeit not every period in between. Our focus, as always, is to deliver returns over the long term which encompasses full market cycles.
2015 is a good example of not beating all benchmarks in shorter timeframes. The FPA Crescent Fund increased 2.8% in the fourth quarter but declined 2.1% for the full year—only the third year out of 22 in which the FPA Crescent Fund has lost money. Although Crescent has not recently outperformed the S&P 500, it has outperformed the broader global indices like the MSCI ACWI Index, and that global index dovetails with the FPA Crescent Fund’s more global exposure in the last seven years.
We seem to have witnessed the end of the commodity super cycle last year. Price movement of steel, oil, copper, etc. felt like something like the straight line down of this chart. So with broad global indices declining last year, this has had a significant impact on many companies around the world—the commodity index and the commodity price declines I’m talking about—and helped contribute to decline (2:02) in the MSCI ACWI Index, which ended the year down 2%. However that doesn’t seem so bad when compared to the year-to-date number through yesterday, with the ACWI Index being down 8%.
Most of the U.S. stocks didn’t perform as well as the S&P 500. Just to express the narrowness over a few series of slides, the broader Russell 3000 Index with six times as many companies was up just 0.5% in 2015, and growth outperformed value by more than nine percentage points.
We’ve always argued that high-yield bonds are more like equities than high-grade bonds, and in 2015 we certainly evinced that with the Barclays U.S. Corporate High-Yield Index declining 4.5%. Again expressing the narrowness in the market, without the top five Index contributors, the S&P 500 would have also declined. Google, Amazon, Facebook, General Electric, and Microsoft contributed almost 3% to the S&P 500 returns last year without which the Index would’ve declined about 1.6%. We at least own three of the five—Google, GE, and Microsoft.
On average, the bigger a company’s market cap was, the better it performed. Companies with market caps greater than $100 billion increased on average 4.4%. Those less than 100 billion but larger than 50 billion increased a couple percent, and everything else declined— particularly smaller companies. Those with less than $5 billion in market cap declined almost 20% last year. Further reflecting the narrowness of the market, the largest 30 companies delivered returns of almost 3%, while the other 470 on average declined 1.5%.
2015 was not a good year any way you cut it. Crescent’s winners for the quarter and year contributed 2.1% and 2.3%, while its losers detracted 1% and 2.9%. The more cyclical companies, particularly those with commodity exposure, (4:01) were the weaker part of our portfolio. In hindsight, we thankfully had a small allocation to such businesses.
We had some puts and takes that drove 2015’s performance. Of our technology investments, Microsoft and Google performed quite well, but Oracle lagged. Oracle continued to transition its business to the cloud last year but has been proceeding more slowly than either investors or the company expected. Concern about the transition and weak software license sales led to the stock’s decline. Given the undemanding valuation and high level of recurring revenue, we used the drop in the share price to increase our position.
Alcoa’s stock price was negatively impacted by weak aluminum prices and inventory adjustments in the aerospace supply chain. We support the company’s decision to separate its highly engineered value-added aerospace business from its commodity aluminum operations. As the prices declined in the last year, we’ve double the number of shares we own and are hopeful that the pending spinoff will create clarity and value for the enterprise.
Joy Global was just an outright mistake—a poor investment decision that we wish we could take back, which… unfortunately the market doesn’t let us. When analyzing the situation, we gave too much weight to the company’s strong market position and attractive aftermarket profile. We failed to appreciate the degree to which the coal market had changed. Many regions in which Joy is particularly strong competitive position are likely to produce significantly less coal going forward. This has resulted in a permanent impairment to our position in Joy. Realizing our mistake, we have been sellers.
Our active long positions lost us money in 2015, down about 1%, behind the S&P 500, but our performance was ahead of the 3% loss in the S&P 500 Value Index and the 2% decline seen in the Global MSCI Index. If one were to call 2014 a wash, this is only the second year of the last ten that our long positions underperformed the S&P. But we’ve been ahead of the Value Index in every year since 2008 and ahead of the MSCI ACWI Index every year since 2007.
In the last year, we spoke of the importance of gauging performance over market cycles. (6:00) As you can see from these charts, Crescent continues to meet its goal of achieving equity rates of return with less risk in the market. Our returns have exceeded the indices and have done so with less of a drawdown.
Let’s look at the FPA Crescent Fund’s draw-downs versus pertinent benchmarks beginning in the financial crisis when the market declined in excess of 10%. Our quest for value has taken us overseas, and our portfolio is more global than it has been in the past. Almost half of our equity holdings and almost one-third of our equity exposures are foreign domiciled. Since having tilted our portfolio more globally, our draw-downs continue to fall in that 55–65% range over time.
We recognize that value isn’t always in vogue, but we aren’t going to change our style to accommodate the latest fashion. It never feels good to see a portfolio decline in value—our portfolio too—but over three decades of investing, we appreciate that we can neither time nor always be in step with the market. It wouldn’t surprise us that we begin to find more opportunities and further increase our risk exposure but our downside capture could increase.
It’s not just where a company is based that’s important—and we think globally. It’s where a company gets it sales. Less than half the revenues of the companies we own are derived from business conducted in the United States. The market capitalization in our portfolio remains a sizable $112 billion, although the median market capitalization is a much smaller $26 billion. Our companies on average are of good quality, well capitalized, and recently getting cheaper.
The FPA Crescent Fund’s risk exposure at 61% is higher than 55% that you saw a year ago, a function of beginning to take advantage of price declines, but still below our historic average.
Some of the market tailwinds that we’ve seen globally aren’t structural and will therefore come and go. It is not our birthright to have declining rates throughout our lifetime, yet a persistent declining interest rates to all-time lows has been the biggest driver of asset prices.
Low interest rates can drive you away from conservative bonds or bank savings accounts (8:00) and lead you to assume more risk than might be appropriate for either your net worth or your psyche. That’s low rates. How about negative rates that are now found in sovereign debt in other parts of the world? You’re negative out to the ten-year in Switzerland, to the six-year in Germany, to the four-year in France, and three-year in Japan. People are willing to pay these countries to store their money. There’s no way negative rates don’t impact investor behavior, causing people for example to put money in stocks and bid them up— stocks, real estate, and other risk assets.
We can only guess as to what’s going to happen next. Listening to interviews with former Fed Chairman Ben Bernanke lead us to wonder if we’re also due for negative rates in the U.S., as he has been talking about the idea that the Fed might have no choice but to drop rates below zero for the first time in history.
Part and parcel with low rates is central bank quantitative easing. Central banks at developed economies have seen their balance sheets balloon, and it should be no surprise that stocks around the world have ballooned with it.
Rates haven’t been the only tailwind. There have been others like the huge shareholder repurchases in recent years that’s been additive to earnings per share growth. Without share repurchases, EPS would’ve been negative in the third quarter of 2015. The data’s not out for the fourth quarter yet.
Companies on average have not been great timers of their purchases. I’m generalizing here, but many have either not optimized or destroyed capital along the way thanks to indiscriminate share repurchase programs. Corporate share repurchases also take supply out of the market, aiding stock market performance assuming constant demand. Companies have repurchased $2.6 trillion of stock in the last five years alone. That’s more than what the Fed has spent on QE and equates to about 15% of the market capitalization of the S&P 500.
(10:03) Meanwhile, thanks to M&A activity, companies have been taken out of the market more quickly than ever. Fewer companies to buy reduces supply. Demand picks up when market performance is aided by companies being taken at a premium. This has been more fuel for the stock market. 304 public companies were acquired last year, a record amount that makes stocks feel like an endangered species, and only a very small fraction of that found their way to market via IPOs and offset. Now that we’re left with less, the Wilshire 5000 Index should probably change its name to the Wilshire 3704.
Those have been some of the tailwinds, and until recently there hasn’t been much in the way of headwinds. So the stock market remains relatively elevated. As you can see, P/Es still aren’t particularly low—about 24 times and in the 89th percentile. That’s the year end number. At year end 2015, the S&P was valued at the same high levels seen at the market peaks in 2001 and 2007—P/Es around 18–19 times earnings; price-to-sales higher now, 2.1, than it was at prior peaks; and price-tobook that’s around three times.
So the question is: what comes next? We saw significant decline after prior market peaks in the market. The question is: what happens to this right side of the chart? On past conference calls, we said that more volatility was likely. That’s happened, and we expect that to continue to be the case. It’s interesting to us though that people only seem to think about downside volatility. You never hear people say, “Wow, the market’s up 50%. Boy, is it volatile.”
High-yield and distressed debt has been a tool in our tool chest since our inception. However we don’t feel particularly compelled to invest in junk bonds all the time. For good investments in high yield, we want to make sure the adjective “high” is there. As you can see, our exposure to high-yield fluctuates (12:00) and is a function of both yield and spread. It’s been as low as 1–2% in our portfolio and higher than 30%. It’s been on the low end for some time and has just begun to pick up.
We thought we’d chat a bit about high-yield because we hope that yields rise further still and the FPA Crescent Fund’s exposure along with it. The FPA Crescent Fund’s exposure in high-yield currently stands at 3.9%. As spreads widen between high-yield and Treasuries, we continued to increase our exposure last quarter, but only moderately, as we suspect that there’s more disruption to come.
It’s been mostly energy that’s collapsed. Since the energy sector represented about 13% of issuance at the beginning of the year, it couldn’t help but pressure high-yield index returns. We’ve done a tremendous amount of work on energy, and a lot of members of the team have devoted time to it. We’ve tiptoed into this sector. But as we’ve discussed in past letters and on calls, it’s not something where we’ve yet gained great comfort, mostly due to our own inability to either discern the appropriate price of oil or when it might get there. And although spreads are wider—7.1% at year end versus 5.9% average—yields are still below average—8.9% at year end versus 10.4% average.
A few things could cause this to change. (1) Default rates can uptick. We are still sitting at a low level—just 1.8% for the trailing 12 months. They’ve been as high as 11% in the past. We suspect they’ll rise, although we don’t know how high. Junk bond yields would rise along with it, which means of course that bond prices would decline. Once a bond defaults, there’s a restructuring or liquidation and some level of recovery. Recently, recoveries in defaulted debt have been about as low as they’ve ever been—running just around 28% last year, well below an average of slightly in excess of 40%.
The return distribution of a high-yield portfolio can be considered in the context of three variables: gross of starting yield, default rate, and recovery. To aid in understanding our thinking, we lay out a (14:00) range of incremental outcomes beginning with what yields were at the end of 2014 and culminating in the extreme case of yields seen during the financial crisis in early 2009. We used various starting yields, average versus peak default rates, and average recoveries in our scenarios.
So to walk through these cases, you can see Case 1 on the screen right here. We use a 7% gross index yield at year end 2014 and apply the historic average default rate of 3.6% and recovery rate of 41.5%. The net yield to maturity recovery would be 4.9% in that case. However, if default rates were to hit peak levels, then the net yield would decline to 0.6%. And if recoveries were to be below average as they’ve been recently, then the net yield could become a loss.
Looking at Case 2, high-yield bonds declined in 2015, so the gross yield was higher at year end 2015 than it was at the end of 2014. Using the same default and recovery assumptions as Case 1, Case 2’s range of outcomes extends from 0.3% to 6.8%.
Looking at Case 3, rather than using the Index yield, we’ll use the yield to maturity of FPA Crescent’s high-yield bond book at the end of last year, 13.4%, as our starting point, which was 4.5% wider than the Index. With the same default and recovery assumptions as the prior cases, the range of expected returns if held to maturity improves to 4.8% to 11.3%.
And that leaves us with the pie-in-the-sky what-if scenario. What if yields reach past peaks? Keeping the other assumptions constant, the net yield range improves further to 11–18%. Although we aren’t waiting for Case 4, you’ll likely find our exposure to junk bonds will rise should yields continue to increase, as was happening in Q4.
We think we are being appropriately prudent rather than greedy. We have seen in the past yields and spreads in excess of 20%. (16:00) We don’t know if they’ll blow out as much in the future, but we aren’t going to get that aggressive until they at least move in that general direction. We recognize we can’t pick a bottom, and we welcome the opportunity to add to a position as prices decline. We’d be getting the opportunity to invest additional capital at a better price. However—and this is important—that does mean there could be negative marks in the portfolio. Our Strategy succeeds only if we and shareholders have staying power.
We’ve seen unprecedented high-yield issuance of $1.7 trillion in the past six years. To put that in perspective, the entire high-yield market is a slightly smaller number—something on the order of $1.5–1.6 trillion. Of that, around 300 billion was issued either triple-C or without a rating—also unprecedented. We expect some portion of this to be our future opportunity set.
It’s been easy money for quite some time, but lax underwriting standards usually lead to an increase in defaults. But it hasn’t really happened to any great degree—yet anyway. We think defaults will bump up, and maybe it will be due to a recession, or maybe it’s because a business never should’ve had that kind of debt to begin with. Or maybe it’ll be that capital isn’t available when it comes time to refinance. It’s going to be up-ticking over the next few years, but it may take a little bit longer because the bulk of junk bond maturities come in the 2020–22 timeframe—about $750 billion worth, roughly half the market.
Now before I turn it over to Q&A, I’d like to set the stage. If you submitted a question that we don’t answer, then some combination of the following conditions may apply: our answer may impact our ability to position the portfolio, and this might pertain to positions that we’re either currently buying or selling, or reasonably intend to do so; (2) we don’t have either an educated view or a strong view; therefore an answer from us would be of little value to you; (3) we believe that prepared remarks or answers to previous questions have already addressed a topic; and (4) we’ve received some questions about companies we don’t own. (18:01) For the most part we think it is more productive as part of this hour together to focus only on our portfolio. If there are questions we don’t have time to get to or should there be questions to which you’d prefer a more robust response, then please reach out to Brande Winget, who leads our Client Service Team. We will do our best to get the information you seek.
See full transcript below.