FPA Crescent Fund webcast audio, transcript And slides for the third quarter ended September 30, 2016.
Steven Romick – FPA Crescent Fund 3Q16 Webcast Audio
Steven Romick – FPA Crescent Fund 3Q16 Webcast Transcript
Steven Romick: In the third quarter, Crescent returned 5.29% versus the S&P 500’s 3.85% and the MSCI ACWI’s 5.30%. The big driver in the quarter was the rebound in the financial sector and an ongoing rally in high-yield bonds, both of which benefitted Crescent thanks to its 23% current exposure to financials and 6% to high yield and distressed debt. The Fund returned 5.5% for the nine months, as compared to the S&P’s 7.8% and the MSCI ACWI’s 6.6%.
The agenda today will include a review of the Fund’s philosophy, performance, and portfolio characteristics. We’ll also offer some portfolio insights and market views, as well as an update on our team. We’ll end with Q&A.
For the uninitiated, our goal is to generate equity rates of return with less risk than the stock market. We define risk as a permanent impairment of capital. This means that we operate with an absolute return focus, which is to say that we won’t invest your capital unless there is a compelling risk/reward dynamic. This means that if we can’t find enough upside to offset the downside, then cash will build as residual. Cash will not rise or fall as a function of some macro view.
We operate with an unusual amount of flexibility, primarily investing in both equity and debt, and big and small companies both here and abroad. We pride ourselves in conducting thoughtful research on businesses and the industries in which they operate. A hallmark of our process is that we’re patient. We patiently complete our research. We are price takers and patiently await prices that come our way. And once we make an investment, we realize it could take quite some time to work out so as long as fundamentals remain intact, we patiently wait while we hold an investment.
Our security selection has, on average, been robust which has helped Crescent to outperform its exposure, allowing the Fund to achieve its stated goals with respect to the relevant benchmarks in both the current market cycle, the last market cycle, and since inception.
Looking at the three charts on Slide 4, you can see that the Fund has delivered on its objective since its inception more than 23 years ago. The chart on the left shows our market-like returns, 10.3% for the Fund since inception versus 9.1% for the S&P 500. The chart in the middle reflects that the Fund has generally declined less than the stock market—the S&P 500, that is—capturing 58% of its downside. The Fund’s upside participation has been 76%. If we continue to capture more of the upside than we do of the downside, then the Fund will continue to accomplish its goals.
The Fund has historically exhibited far less volatility than the stock market, as can be seen in the chart to the right, but volatility is not something we think about. It’s merely a by-product of the value-conscious manner in which we invest. We are far more concerned with avoiding a permanent impairment of capital than we are with any security moving up or down a lot ephemerally.
In the last 12 months winners added 3.75% to Crescent’s returns, while losers detracted 1.41%. Three large-cap technology companies were additive. Rounding out the list is our long-held investment in Aon and our more-recent investment in the debt of Consol Energy. There isn’t any particular theme that can be attributed to the Fund’s detractors over the past 12 months.
Of note is that the Naspers/Tencent arbitrage has detracted 0.6%. We’ve discussed Naspers in the past. Naspers is a South African media company that owns a stake in Tencent, a Chinese company involved in internet, technology, and media. The value of the Tencent stake that Naspers holds exceeds its total market cap. With a negative value of the position at -0.60%, you can see that the market is paying us for all of the Naspers assets other than Tencent. We are confident these assets have a value substantially greater than zero. But for now anyway, the market doesn’t care. The rebound in financial stocks and high yield is apparent in the table for Q3 winners and losers. All of the winners fell into these two categories and added 1.87% to the Fund’s quarterly return. The losers detracted -0.6% and lacked any specific theme.
Crescent currently has more invested in equities than its historic average but less in high yield with a net risk exposure more or less in line with our average since its inception, 64.5% versus 63.3%. With some cleaning house in 2016, the number of long equity positions stands at 40 down from 46 at year-end 2015 and closer to our average of 38 since inception.
Crescent continues to have more exposure to larger-capitalization companies which is where we continue to find better opportunities. However, it’s not that we don’t have investments in small- and medium-sized companies. Thirteen percent of the Fund’s equity exposure has a market capitalization of less than $10 billion while around seven percent of that are market caps less than $5 billion. Further explaining Crescent’s cash build you can see the portfolio is more pricey than at points in the past. Both trailing and projected P/Es are higher than the Fund’s historic average. Trailing P/E for the Fund is 25.9x versus our historic average going back to 1996 of 17.1x. Things don’t look as expensive when looking at projected P/E which is 15.7x, but that’s still greater than the Fund’s 14.0x historic average. Crescent’s P/E is less expensive than the S&P 500’s 17.2x and the global MSCI ACWI Index’s 16.2x.
On a price-to-book basis, the Fund also trades less expensively than its benchmarks. Crescent’s price-to-book is 1.4x at quarter end as compared to 2.9x for the S&P 500 and 2.1x for the MSCI ACWI Index. With a mind to protecting the downside, the companies we own (excluding the lenders) for the most part have strong balance sheets which translates on a weighted average basis to a net cash position for the companies we own, which is better than the market as a whole.
Twenty-three percent of the invested equity capital is invested in companies based outside the United States. More relevantly, the companies we own derive more than half of their revenues from outside the U.S. The market continues to be expensive, but that continues to be explained by low, low, low interest rates. P/Es smoothed by using trailing 10-year earnings are higher than they’ve been in all but two periods: 1929 and 2000. Low rates make risk assets that much more valuable, all else equal.
Looking at valuations another way, median P/E, price-to-sales, and price-to-book for the S&P 500 are now higher than they were at the prior two market peaks. That’s also largely true of the valuation of the MSCI ACWI Index where the median P/E and price-to-sales is also higher than the prior two market peaks, although its price-to-book is lower than 2007 but higher than 2000. This can partially be explained by financials that both make up a larger portion of the MSCI than the S&P and trade at a lower price-to-book thanks to their lower-quality balance sheets.
One doesn’t have to look much further than interest rates to understand what’s driving the market. Rates are negative in many developed economies. We showed this chart in the second quarter call. The blue reflects negative yield at various maturities while the less abundant green depicts a less-attainable positive yield. If you look at the end of the third quarter, you can see that rates have gone increasingly negative, that there is more blue and less green.
See the full transcript below.