FPA Capital Fund commentary for the third quarter ended September 30, 2017.
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On August 22, 2017, FPA announced that I would become the sole Portfolio Manager of the FPA Capital Fund as of the beginning of the fourth quarter of 2017. I appreciate the trust that the FPA Managing Partners and the FPA Capital Fund Board have placed in me, and I will work hard to earn the trust of all our stakeholders.
I have already started repositioning the portfolio. I chose to eliminate five companies and add three new names amounting to 21% of invested capital. Our first full month of performance since the announcement against our benchmark was 6.51% vs. 4.54%. But as many of you know, we – here at FPA – do not focus on the short-term results. As we have stated on our website, one of our firm values is “the value of the long view,” which we described as market cycles rather than a short period.1 Our team’s overarching goal is to generate strong returns over a market cycle and we urge everyone to judge our team the same way.
The primary objective of the FPA Capital Fund is long-term growth of capital. The Fund’s performance relative to its targeted objective has been disappointing over the last five years. As we continue to evolve, and as we strive for continuous improvement, there will be a number of changes. However, let me start with what will not change. We do not plan to change our mandate or our values. You can continue to expect the same level of commitment, focus, and integrity that you have always expected from us.
As a refresher, the FPA Capital Fund is a long-only, absolute-value fund that is benchmark indifferent. We look for market leading companies with a history of profitability, strong balance sheets, and good management teams. Once we identify and research these companies, we will buy when there is a compelling reward-to-risk ratio and we will sell when we believe the ratio is unfavorable. The resulting portfolio tends to be concentrated. I eat my own cooking. I am (and will continue to be) invested in the Fund alongside you.
We put all of our investment candidates through rigorous analyses. The process starts with reading publicly available filings and studying the financial statements. Our goal here is to develop a thorough understanding of how a company makes money and what major challenges it could face. Then we expand our knowledge by talking to anyone who can shed more light on the company or industry. For example, we talk to management teams, competitors, suppliers, clients, and industry experts. We prepare in-depth investment memos that summarize all of our learnings. We then decide whether we want to invest in the company, and if so, at what price and at what weighting. Once a company becomes a portfolio holding, we continuously monitor it and its competitors.
“An organization’s ability to learn, and translate that learning into action rapidly, is the ultimate competitive business advantage.” - Jack Welch
The core of our investment process and our investment philosophy is not changing, but we have learned some lessons from the past, and we intend to incorporate those lessons into our process going forward. Our analysis of the Fund showed that since the beginning of 2011, the vast majority of our shortfall against our benchmark was caused by our investments in energy and carrying significant amounts of cash. The steps outlined below should help minimize both of those issues going forward.
We will diligently avoid position inertia - We will seek to act quickly to adjust position sizing when there are changes in our analysis of facts and the risk/reward profile. We will guard against the natural tendency to remain attached to positions we like even when information and prices change. If we observe a shift in the underlying fundamentals of a position, or find it expensive, we will look to trim/exit that position as aggressively as possible (market conditions permitting). We will not make small adjustments when we believe bigger changes are warranted.
We will differentiate between long-term and opportunistic investments - We expect our long-term holdings will be in high quality businesses. High quality can come in a variety of forms, such as a strong market position, pricing power, or a unique business model that translates into a high return on capital over a cycle. We will be more vigilant and disciplined about exiting lower quality businesses once valuations are no longer extreme. As such, you can expect us to trim our lower quality energy holdings once prices normalize (again, market conditions permitting). That does not mean that we will not occasionally take positions in lower quality businesses when valuations are at extreme levels (e.g. some energy names following the great recession, or where they are trading today).
We will be more nimble – Our research process is very robust, and it takes at least a month to fully research a company. Before we decide whether to embark on a full analysis, we need to make sure that we are spending our time wisely. To that end, we initiated an interim step of generally spending just two days looking at an idea and preparing a short memo to assess whether an idea warrants further research. This way we should be able to look at more companies and spend our time on those that are more likely to become portfolio positions. I expect our faster process to allow us to convert more of our ideas into new investments. Moreover, having just one portfolio manager making the final decision should accelerate investment decisions.
Despite our lackluster performance in the past few years, not all was bad for the Fund. Let’s quickly review what has worked:
We stayed true to our process and our mandate - Value investing has been out of favor for the last five years, and that has hurt our results, but we have never strayed from our process or our mandate. We continued to search for the same types of opportunities we always have with the same level of diligence, and an unwavering insistence on an attractive absolute valuation. And going forward, you can expect the same unwavering commitment to our mandate and process.
Our research process, apart from a few tweaks, remains unchanged - A continuing source of pride for the Capital Team is our internal research process. When researching investment ideas, we hope to understand and quantify potential sources of upside and risk and to understand the key drivers of a business and industry at a fundamental level. This deep understanding helps us build the confidence required to weather the many rainy days that inevitably come with value investing. Our research process remains as thorough and as committed to objectivity as ever.
Our new positions added value - We continued to insist that new positions must be thoroughly vetted prior to adding them to the portfolio. This includes a detailed memo and model as a result of our research process. The good news is our new positions (positions added since the beginning of 2011) have performed well, with the majority of them profitable and with gains handily outstripping losses.
“When the facts change, I change my mind. What do you do, sir?” - Attributed to John Maynard Keynes
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