Value Investing

FPA Crescent Fund 2Q17 Commentary & Webcast Slides

FPA Crescent Fund commentary and webcast slides for the second quarter ended June 30, 2017.

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Introduction

Dear Shareholders:

Global markets had a strong performance in the second quarter of 2017. The FPA Crescent Fund (“the Fund”) returned 1.84% in the second quarter. This compares to the 3.09% return of the S&P 500 and the 4.27% return of the MSCI ACWI indices in the same period. Year-to-date, the Fund has returned 5.27%, as compared to the 9.34% return of the S&P 500 and the 11.48% return of the MSCI ACWI indices.

FPA Crescent Fund 2Q17

Portfolio Commentary

The Fund’s top five performing positions added 1.83% to our return, while the bottom five detracted -1.18%.1 We did not find any meaningful surprises when our companies reported prior quarter earnings.(We address the Naspers/Tencent pair trade later in this commentary.)

FPA Crescent Fund 2Q17

Unusually, we did not initiate a position in any new company during the second quarter, a function of an elevated market.

In a recent speech, I shared some views that explain our current thinking about stock and corporate bond markets and our resulting current portfolio positioning. I refer you to Two Decades of Winning by not Losing (attached), where we suggest that always owning the hot stocks may not be necessary to keep up with the equity market over time.

Markets and Economy

Despite the turbulent changes to the political terrain in the United States and Europe, the global economy continues to putt-putt along, much as it did before Brexit and the U.S. elections. The U.S is now in year nine of its economic expansion – the third longest since 1900. Yet despite its long duration, the rate of GDP growth has fallen well below past expansions.2

Low interest rates and the absence of bad news have been the twin pillars underpinning stable markets worldwide. The S&P 500 is in its 99th month of a bull market – the second longest since 1926, and hasn’t corrected more than 20% since 2009.3 US stocks trade at historically high valuations, which we believe is more a function of the low rates than earnings growth.

Other parts of the world are less expensive – not to be confused with inexpensive. The MSCI ACWI has a median valuation higher than the prior two market peaks. Asia and Emerging Markets are trading closer to their median valuation. At best, one can argue that parts of the world are relatively cheap, which causes us to be less active buyers while we await better values.

FPA Crescent Fund 2Q17

Just because we aren’t actively allocating capital doesn’t mean that everyone else is standing still. Given continued low interest rates, the prospect of an economic Armageddon having faded into the past with nothing looming on the horizon, and a lack of investment alternatives, stock markets seem to be one of the few games in towns, villes, stadts, cittas, ciudads, ?? …. From these more elevated levels, we expect to see less robust returns over the not-so-foreseeable intermediate term.

Part of our historical bread and butter has been finding opportunities in the high yield sector, but today we find the bread burned. The yield-to-worst of the US high yield market is a paltry 5.7%, while the EU high yield sector offers a pathetic 2.7%. Importantly, those yields are gross of some future default and recovery rates. If one were to look at the US as a proxy over the past thirty-five years, with an average default rate of 3.7% and recovery of 40.9%, the US gross yield would be reduced to a net yield of 3.5%. In Europe, the return would be negative.

FPA Crescent Fund 2Q17

We have called this set-up “return-free risk.” We won’t put our/your capital in the position of having to bank on interest rates remaining low – and a good economy keeping defaults at bay – in order to justify participating in the high yield sector. What we might otherwise have invested in high yield in a riper period stays on the sidelines in cash until the return justifies the risk.

Investing

The three current investments discussed below can serve as a window into our investment philosophy and process.

Naspers/Tencent Arbitrage

We have been long Naspers and short Tencent for longer (and less profitably) than we care to remember. Naspers, a South African holding company, made a prescient investment in Tencent, a technology business with a market capitalization among the top 10 globally. Naspers’ $34 million investment in 2001 is now valued at $113 billion – a 63% IRR. The passion to own Tencent shares has caused it to be valued at 40x current year’s earnings (36x excluding cash and investments) and dwarfs investor interest in Naspers. Its Tencent stake now exceeds its $86 billion market cap by $28 billion!7 We don’t believe this should be the case. Naspers profitably operates a Pay TV business in South Africa and has made successful investments in other valuable technology investments, such as Allegro, Avito and Ibibo. Yet, the market insists on paying us to own Naspers. Unfortunately, we’re being paid far more today than when we initiated the trade. The price of the Naspers ‘stub’ was trading then at negative $1.5 billion but is now trading at negative $27 billion.

The charts below show the points in time we initiated and added to the Fund’s position. Although paired trades have a long and short component, we refer to them in the following charts as Buy and Sell, reflecting when we put trades in and when we took them out of the portfolio, respectively. If nothing else, you should note that we have no ability to pick either bottoms or tops. We continue to think, however, that Naspers will not be valued so irrationally in the future.

FPA Crescent Fund 2Q17

We’ve had experience waiting things out in the past. A similar thought process led us to invest in Renault at two different times (in 2006 and in 2012-2013), while shorting its ownership stakes in Nissan and Volvo Truck — whose combined value exceeded Renault. In the most recent instance, we established our position when their Nissan and Volvo Truck interests exceeded Renault’s enterprise value. The market was paying us to own Renault, but its stock price appreciated slower than that of its equity stakes, creating unrealized losses in our portfolios. This lasted for ~1.5 years but eventually the market appreciated that Renault was worth more than zero, let alone a negative number, and we profitably unwound our trade.

FPA Crescent Fund 2Q17

We anticipate that the same could be true of Naspers/Tencent. Nevertheless, this trade exemplifies both the type of attractive risk/reward sought by our Contrarian Value team, and our willingness to buy down as long as the thesis remains intact.

(For more detailed attributes of the Naspers/Tencent trade, including a description of each business and our investment thesis, please see my speech to CFA Society of Chicago: Don’t Be Surprised.)

Sears Canada Loans

We made a loan to Sears Canada in the second quarter, the details of which you may find in the Two Decades of Winning by Not Losing speech I referenced earlier. I suggested that its existential challenges were similar to many other brick-and-mortar retailers and that it could very well go bankrupt at some point. Well, that point came within months of the loan origination. Since we underwrote the loan predicated on liquidation value, we remain comfortable that we will be paid in full in the next couple of months. We expect that our 2% commitment fee will now be amortized over a shorter maturity, resulting in a higher-than-budgeted IRR.

We are in the process of seeking to fund the DIP (debtor-in-possession) loan that, if approved by the Canadian courts, will allow the company to conduct either its restructuring or its liquidation in an orderly manner.

This prospective DIP loan should afford us somewhat better asset coverage, with a higher starting yield, an additional and higher commitment fee, and a shorter expected duration, which we think should result in underwriting at a higher than expected IRR, as exhibited in the table below.8

FPA Crescent Fund 2Q17

Financials

The Fund’s investment in balance sheet intensive financials have performed well over the past year. Earnings have improved and book value has increased but the largest driver has been an increase in valuation, as seen in the table below. In that time, the Price/Tangible Book ratio of our portfolio of financials has increased from 0.73x to 1.04x.

FPA Crescent Fund 2Q17

As we discussed more than a year ago, we thought it was reasonable to expect equity-like returns in all but extremely negative scenarios. Our companies still trade at a discount to historic norms based on tangible book value, as exhibited in the chart below, but can no longer be viewed as “dirt” cheap.

FPA Crescent Fund 2Q17

The current investment case for these financials to continue to perform well increasingly relies on a continued favorable regulatory climate, our avoiding a recession, increasing capital return – the recent CCAR12 is a step in the right direction – and, in some cases, higher interest rates and/or a steeper yield curve.

If our portfolio companies can improve ROTE to an average of 12% (less than their historical average) and trade at 1.25x their TBV (up slightly more than current TBVs and still a sizeable discount to historical multiples as depicted in the prior graph) our positions would offer decent returns over the next three years. Note, however, that a little more than a year ago, when these institutions were trading at just 0.75x book, we believed we were well-protected on the downside (and we had more upside). We don’t have that same protection today.

FPA Crescent Fund 2Q17

We aren’t finding much of anything that’s so statistically inexpensive, which explains why we maintain a significant position in these financials although we have taken some money off the table. Our exposure to balance sheet intensive financials at quarter-end stands at 14.7%.

Closing

The business of investing is harder than investing itself because one must ably manage both the capital and the high expectations of others. It is unlikely that every client’s expectations mirror those of their investment counselor or fund. We write and speak so we can inform our co-investors about our philosophy and current positioning, but recognize that we can only realize long-term success by remaining true to our longstanding investment philosophy, even in those periods where it might not align with the general tenor of the market.

We have enough self-awareness to know that we’re not smart enough to determine the direction of either markets or economies, and appreciate that more things might happen than will happen. We therefore leave the future to either the more capable or more foolhardy. We can only speak to a present dictated by price and with that in hand, we always query: does an asset price today afford us an acceptable rate of return after taking into account the good, the bad, and the ugly? Should we find a good business (or other asset), and should winning offer a return well in excess of what might be lost in our downside case, and should chance to win be more likely than the chance to lose, then we’ll be buyers. Until such time, we exercise a patience – a quantity seemingly in limited supply today. I wish I could remember where I recently read one person’s clear view of the stock market, so I’ll paraphrase: “Markets are only lived forwards, but only understood backwards.”

Respectfully submitted,

Steven Romick

Portfolio Manager

See the full PDF below.

FPA Crescent Fund 2Q17 Webcast Slides