FPA Crescent Fund webcast audio, transcript And slides for the second quarter ended June 30, 2016.
Steven Romick – FPA Crescent Fund 2Q16 Webcast Audio
Steven Romick – FPA Crescent Fund 2Q16 Webcast Transcript
Steven Romick - We believe it’s important to educate our investors as to how we invest. In addition to these calls, we publish quarterly commentaries, provide the transcripts to speeches we've given, and offer the occasional special commentary. We also share our investment policy statement that reflects the path we've taken for more than two decades and that we continue to follow today. All of these are available on our website.
Crescent’s philosophy remains the same. We want to make our shareholders money without accepting undue risk. That’s a hallmark of a value investor. For Crescent’s shareholders, our goal isn't to beat the market over time. It’s to do as well over market cycles while avoiding permanent impairment of capital. The goal is not to outperform in short-term market downdrafts, although it would be nice. That’s an impossibility, although who wouldn’t like to?
We manage an idiosyncratic portfolio, one that at a point in time may be more or less exposed to any given company, sector, or asset class. In narrow timeframes, anything can happen. Just because our work suggests that a given investment offers an attractive risk/reward doesn't mean that others will immediately agree. As a friend of mine has said, “No one becomes a value investor for the group hugs.”
We've accomplished our goals over the long term. Note the 1998, 2000 time period when Crescent underperformed. The green line that is the S&P 500 gapped up, while the blue line that is the Crescent Fund gapped down. Nevertheless, by 2001, the lines crossed as Crescent earned back that previous underperformance.
Over the most recent market cycle, the Fund’s performance is about in line with the S&P 500 but well ahead of the MSCI ACWI Index. It’s important to note that our max drawdown in this current cycle is more than 60% of either of these two benchmarks, but not a lot more. We concern ourselves with protecting in large drawdowns. We view 5 to 10% moves, as has come to pass recently, as nothing more than general market noise.
The Q2 rebound in the energy sector pulled three of our investments into the top five quarterly performance contributors: Occidental Petroleum, Halliburton, and the CONSOL Energy bonds. Other than that, there wasn’t much of note.
Crescent continues to maintain large exposure to companies based outside the United States. More importantly is that of the companies we own, more than half of the revenue is derived from outside the U.S. We believe that’s a more appropriate way to look at geographic exposure.
The Fund continues to be more exposed to larger capitalization companies and there's a weighted average market cap of $98 billion, although the median market cap is a smaller $32.7 billion. Other than our exposer to financial companies, the companies we own continue to have better-than-average balance sheets as is expressed in the debt-to-capital line you see here with a -17%.
Our portfolio, importantly, is less expensive on a price-to-book basis at 1.3x versus the S&P 500’s 2.8x. The MSCI ACWI price-to-book is 2x. The Fund’s P/E is higher in a trailing basis at 25x versus the S&P’s 21x or the MSCI ACWI at 19x. That would seem to be inconsistent with being a value manager. There's an old saying, “Buy the high P/E and sell the low P/E.” We will frequently buy companies when their earnings are low ebb, which of course make the P/E higher. It’s what comes next that’s important. If consensus estimates are accurate, then Crescent’s forward P/E is 15x as compared to the S&P’s 17x.
The Fund’s net exposure at 65% is about in line with its historic average. Although our corporate debt exposure has moved up to 5.6%, it’s still well below average. A function of high-yield bonds offering a paltry 7.6% yield, close to its all-time low.
Given that the S&P’s P/E is at its second-highest level in history, we'll remain cautious. The S&P, and for that matter markets around the world, have benefited from interest rates declining to historic lows. That's not a coincidence. Lower yield means a lower discount rate used to value a company’s expected cash flows, increasing its equity value all else equal. And in the hunt for something better than what bonds offer, investors have shown a willingness to assume more risk.
This has left stocks at their highs. The earlier slide that showed P/E using 10-year average earnings is a little bit different than this one that shows P/E on a trailing 12-month basis. And on the trailing 12-month basis it’s now higher than it was in the prior two market peaks. Other commonly used valuation measures, price-to-sales and price-to-book, are also now higher than they were in either March of 2000 or September of 2007. Some investors are substituting the certainty of income for the uncertainty of capital appreciation. It’s understandable given certain alternatives, but that doesn't make it right.
This chart shows that there are $9.6 trillion of sovereign bonds trading with a negative yield. I’ve seen other sources quoting almost $12 trillion. It’s hard to fathom why someone would buy a security guaranteeing that, if held to maturity, they would receive less than their principal back. But that’s what's happening.
In a bit of a disconnect, we find ourselves with stock valuations at highs, bond yields at lows, but the economy’s slogging along delivering the weakest economic expansion off of a recession since at least the Great Depression. Cumulative GDP since the Q4 2007 peak is shown here as the blue line at the bottom of the chart and is lower than every other instance since the 1940s.
The S&P 500 earnings peaked in Q3 2014. In each of the subsequent seven quarters, its earnings have declined year over year and, yet, the S&P 500 has hit new highs. Crescent owns a portfolio of businesses that have recent been growing fast on the market, yet trades less expensively. According to CapIQ, Crescent’s equities had trillion 12-month earnings growth of +3.3% compared to a -4.5% for the S&P and a -10% for the MSCI ACWI. And as I already pointed out, our portfolio is less expensive. Imagine you have two stocks; one’s earnings is growing and its P/E is going down, while the other one’s earnings is doing down and its P/E is going up. Which would you rather own?
The best performing securities on average have been the highest quality, highest yielding, and longest duration. Value stocks are generally of lower perceived quality and they've underperformed. The green bars depict the years when value has beaten growth. The red bars reflect when values underperform growth. Since the last downturn the Russell 3000 Value Index has had a cumulative return of 134%, while the Russell 3000 Growth Index delivered a cumulative return of 201%. Value outperformed growth in just one of the last seven years.
We'll start with some of the questions that came in in advance of the call, the questions that are currently coming over the transom. First question will address, “Can you speak to the allocation decision for such a high cash position and its drag on performance?” Cash has always been a byproduct of our investment process for those who know us well. It decreases when there's opportunity and it increases where there isn't.
For us to draw cash down substantially today—in other words, to increase our exposure to risk assets—we'd have to see a meaningful decline in a broad U.S. market or in other markets around the globe or in some industry group or asset class. If markets continue to rally then one shouldn’t expect that the fund will keep up. On the other hand, we feel that we are reasonably well-positioned to take advantage of opportunity when it arrives one day.
There is a specific question about “Given our exposure investment in Microsoft to their LinkedIn acquisition."
Now, there are a few questions looking for the drivers of performance both absolute and relative to the market and what's been higher than the norm downsize capture of late. First, it’s important to know we don't target a specific downside capture percentage. As value investors, one should expect over time that our downside capture would be or should be less than the market. That has historically been the case and we expect that will continue to be the case; however, there have been and will be times when we do participate more on the downside.
Stocks can trade higher and lower than you might think. We don't know why internet stocks peaked in March of 2000. They could have just as easily have peaked at a higher level, or a lower level for that matter. We don't know why our financial lenders were trading at such large discounts to book in Q1, but they certainly could have traded lower still.
There are only two sectors in the S&P that declined through June 30, financials and technology, which happen to be Crescent’s two largest sector exposures, although our technology exposure actually increased somewhat in value. Just because they decline, though, doesn't mean that they won't rebound and even outperform in the future.
But, in truth, we don't know what will happen. The biggest drag in performance has been financials. Crescent’s financial exposure declined 8% in the first half, but it’s also been a drag not owning other sectors. For example, we don't own any utilities, an interest-rate-sensitive sector that’s up more than 20% this year. If rates stay lower for longer, maybe utilities that already trade an all-time high P/E, will continue to outperform. Again, anything’s possible.
All we can promise is that we will continue to consistently apply our value-oriented principles. We focus on how the Fund performs over full market cycles over which there'll be a bear market, something we haven't seen in almost eight years. We do hope to protect capital in the large market declines. More importantly, it’s how we do over time rather than a moment in time.
In the first six months of 2016, Citigroup, CIT, and Bank of America, a few of the companies in Brian’s table, declined an average of 19%. We don't think any of these companies’ intrinsic values changed much at all. In fact, each of these companies has seen its tangible equity per share increase in 2016. And it also increased in 2013, ‘14, and ‘15. In fact, it increased almost every year for all these companies since the recession and there's just one instance where one company didn't.
It shouldn’t then be a surprise that we increased our exposure during the period. Foreign stocks have been weaker on average than U.S. stocks, which has been a drag as well, (though Crescent is still ahead of the MSCI ACWI over the trailing 12 months. Holding cash has hurt performance recently. As we've said, cash is not an asset allocation decision. It’s the result of not having more attractive opportunities. Just because a stock is up 30% doesn't mean it was attractively priced to begin with.
I read in the LA Times today about a guy who jumped from 25,000 feet without a parachute and landed safely in a hundred-foot-by-hundred-foot net. Just because he didn't die doesn't mean he should have made the jump. We continue to judge ourselves over full market cycles. On that basis, we are still meeting our stated goals compared to each of our benchmarks.
There's a question here, it’s “How insulated are financials and information technology from a drop in global trade?”
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