Steven Scruggs' FPA Queens Road Small Cap Value Fund 1st-Quarter Commentary: A Look Back

Dear Shareholder:

The FPA Queens Road Small Cap Value Fund (“Fund”) returned 3.36% in the first quarter of 2024 vs. 2.90% for the Russell 2000 Value Index (“Index”). As a reminder, we expect to outperform in down markets and trail somewhat in speculative markets as a result of our diligent, disciplined, and patient process.

Market Commentary

Although small caps have underperformed substantially over the last 10 years, small value and small quality have outperformed over longer time periods. Please see our 2023 Q4 letter for a fuller discussion.²

We have a preference for high-quality compounders – companies with high returns on capital and steady or growing margins where we can be reasonably comfortable that earnings will be higher in three to five years. While we are willing to pay reasonable prices for these high-quality compounders, we remain disciplined on valuation and risk management. A lot more can go wrong at high valuations when margin of safety is diminished.

On a headline basis, small caps are still cheap relative to large caps ³. But the discrepancy is largely compositional. Small cap indices hold many more banks and financials, a little more energy and a lot less tech than the S&P 500. Small cap indices also hold a collection of companies that have been overearning from some combination of Covid stimulus and supply chain induced scarcities. Economist Ed Yardeni has great index-level chart packages that show that small cap margins are currently elevated relative to history but that forward earnings are coming down (Figures 4, 5 and 6).⁴ Please see our 2023 Q2 letter for more detail.⁵

This corroborates what we are seeing from a bottom-up perspective. We are fundamental investors, spend our time looking at companies one by one and don't prognosticate on macro trends or the short term direction of the market. While we like the companies that we own, finding new investments that meet our rigorous criteria for quality is challenging. Small companies that are cheap but junky, where we have significant questions about medium-term earnings and higher debt levels, are relatively plentiful in the current market environment.

Last year, portfolio turnover was roughly 13%, about average for the history of the Fund. This quarter we continued to trim around the edges in the service of portfolio maintenance.

We reduced the Fund's positions in a collection of high-quality compounders including Deckers (DECK, Financial), Fabrinet (FN, Financial), CSW Industries (CSW) and Graco (GGG) that had performed well and had become more expensive. These are some of our highest-quality holdings and, in total, their allocation decreased from 11.9% of the portfolio on December 31, 2023 to 8.5% as of March 31, 2024 with further price appreciation offsetting some of our share sales.

We also substantially sold out of a pair of positions where the operational performance had deteriorated and what looked like reasonable debt loads had become problematic. We have been writing about United Natural Foods (UNFI, Financial) in the “Top Five Detractors” section of our last several quarterly letters. We also completed our exit from Owens and Minor (OMI), a process that was substantially executed in the fourth quarter of 2023.

We redeployed capital into a breadth of potentially better opportunities in the portfolio including Enstar (ESGR), Arrow Electronics (ARW), MDU Resources (MDU), Vishay Technologies (VSH), CSG Systems (CSGS), Levi Strauss (LEVI), UGI Corp (UGI, Financial), Darling Ingredients (DAR), MGIC Investment Corp (MTG), Aaron's (AAN) and Upbound Group (UPBD). In general, we view these companies as good but not great quality and substantially cheaper than the four compounders we trimmed. We own less of, and added less to, the lower-quality names in this group.

These actions were tweaks rather than jolts to the portfolio. Our sensitivity to trading down in quality contributed to the incremental nature of our buys and sells. Higher quality companies give us more confidence in the future. Lower-quality companies have more existential issues, a wider range of outcomes and a tendency for nasty surprises. A lower valuation can compensate for this, but only somewhat.

We added a new mid-sized position, John Bean Technologies (JBT), a manufacturer of industrial-scale food processing equipment – portioning, cooking, frying, freezing, juicing, sanitizing, bottling, packaging, etc. Its products are fairly technical with a lot of moving parts (that can break), and JBT's customers require stringent safety, sanitary and regulatory requirements. Aftermarket is approaching 50% of sales, and food is less cyclical than other industrial end markets. We paid a high-teens multiple of forward earnings, but JBT has a strong history of accretive acquisitions and margin growth. We still have questions about the ultimate ROIC that JBT gets on its acquisitions and, after we bought our position, JBT announced its largest deal ever, the acquisition of Marel in Iceland for €3.5B or 2x sales in cash and stock. We believe management can continue to compound capital at attractive rates over the long term but have limited our position size given JBT's relatively full valuation and our questions about the Marel deal. Thematically, JBT fits our quality compounder template.⁶

The Fund's cash position is a residual of the investment process. When we cannot find companies that meet our stringent criteria, we will allow cash to build. Over the long term, we would prefer to own a diversified portfolio of quality companies (acquired at reasonable prices) instead of cash. But we weigh this objective against our reluctance to sacrifice a margin of safety and risk of permanent impairment of capital. At quarter end, the Fund's cash position was 9.6%.

Quality and the Four Pillar Process

Our investment process has four pillars:

1. Balance-Sheet Strength –We seek companies with strong balance sheets. We are notcomfortable owning companies that have significant liabilities (e.g., debt, legal, regulatory, pension, or something inherent in their business models) that could cause insolvency concerns when there is an economic, financial, or any other kind of crisis. We want to make sure we are invested in companies that have staying power.
2. Valuation –We normalize economic earnings over full market cycles, primarily using free cash-flow discount valuation models. We demand a margin of safety.
3. Management – We evaluate management's track record oflaying out a long-term strategy andsuccessfully executing their stated objectives.
4. Sector and Industry Analysis –We own companies in growing industries with stable competitivedynamics and favorable economics. We avoid commoditized or overly-competitive industries.

As previously mentioned, we have a preference for long-term compounders that we hope to own forever. These are high-quality franchises with strong balance sheets, proven management teams and attractive industry dynamics. Compounders don't usually come cheap, and while we are always valuation-conscious, we are generally willing to pay a little more for higher-quality companies.

So, what do we mean by quality? At the most basic level, quality means we can have confidence that a company's earnings and cash flows will be greater in three to five years than they are today. Different investors look at different metrics to describe quality. High returns on capital, high operating margins, organic growth, high cash conversion, and low debt are all indicators of quality. But at the end of the day, we take a holistic look at our companies, identify their risks, try to remain conservative and judicious, and compare their current prices to our confidence in their futures. Our four pillars – balance sheet strength, valuation, management, and industry analysis – guide this process.

Historically, quality has been a large contributor to our outperformance during market downturns.⁷ Low leverage allows companies to survive and reinvest when the business cycle turns. Strong management teams can be trusted to shepherd their companies through headwinds and seek out new growth opportunities. Entrenched competitive positions and industries with favorable outlooks mean that the passage of time is our friend. In practice, it is never this easy. It is rare to find a company that sits cleanly atop each of our four pillars. But when things get complicated and the future seems uncertain, the four-pillar framework helps us maintain a long-term perspective.

Trailing Twelve Months (TTM) Contributors⁹

• Fabrinet (FN, Financial) is a contract manufacturer of optical communications components and modules. Thecompany has a dominant position in hard-to-replicate precision-manufacturing technologies and an enviable track record of execution. The majority of Fabrinet's sales are to networking equipment manufacturers but it has been successfully diversifying into the data center, industrial, auto, and medical end-markets. FN's stock jumped after reporting June 2023 earnings – datacenter sales increased 50% sequentially and more than 100% over the previous year, driven by their 800-gigabyte transceivers for Artificial Intelligence applications. The company also announced that Nvidia is a 10%+ customer.
  Fabrinet was a top-five holding in the Fund before its June 2023 earnings announcement. Since then, the stock has appreciated considerably and we have trimmed in keeping with our risk management policies. Given the growth in its forward earnings estimates, Fabrinet trades in line with its historical earnings multiples and remains a top five position for us.
• Deckers (DECK, Financial) is a footwear and apparel company that owns the UGG, Hoka, Teva, Sanuk, andKoolaburra brands. Management has done a terrific job growing and extending the UGG franchise. Now they are replicating that success with Hoka running shoes which surpassed $1 billion in sales last year. At over thirty times forward earnings (as of Mar. 31, 2024), we have weighed Deckers' valuation against the quality of its management team, strong brands, and net cash balance sheet and have trimmed our position.
  We first bought a small position in Deckers in 2015 and 2016 when the company was struggling with supply chain issues. Its stock price has increased more than ten times since then on excellent operating performance, and we have trimmed all the way up. Given the company's exceptional financial performance and growth, we think the stock still trades in the “range of reasonableness.”

• PVH (PVH, Financial) is an apparel company that owns the Tommy Hilfiger and Calvin Klein brands globally. Most of PVH's earnings come from Europe, where the Tommy and Calvin brands are considered “almost luxury” and PVH has generally recorded high single-digit organic growth with demonstrated pricing power during the preceding decade. CEO Stefan Larsson has done an excellent job revitalizing the company and improving margins at PVH's moribund U.S. operations. Over the past year, PVH and our other apparel companies have performed well as the worst fears for consumer spending didn't play out. PVH has become a top five holding for us and our apparel holdings (PVH, GIII, LEVI and DECK) now make up almost 10% of the portfolio. On April 2, post quarter end, PVH announced fiscal 23Q4 results where they missed on earnings guidance for the coming year. The stock is down ~20% from its high but now trades at less than ten times forward earnings. We have held our position.

• Sprouts Farmers Market (SFM, Financial) is a natural grocer with great merchandising and best-in-class margins. The company has very high returns on capital, great new store economics, and they are accelerating their unit growth from 12 stores a year to 35 stores this year on a base of roughly 400 stores. Over the past year, the stock has performed well after reporting strong operating results and from a low initial valuation. The stock jumped when the company reported 23Q4 results and gave strong 2024 guidance on Feb. 22, 2024. We have maintained our position and allowed it to appreciate.

  Although SFM's share price has increased faster than bottom line results, we believe SFM still trades in the “range of reasonableness” for a high-quality, non- cyclical franchise that can reinvest capital at high rates of return.

• InterDigital (IDCC, Financial) is a research and development organization that develops and acquires wirelessand video patents across key technologies. The company has a history of strong financial performance, opportunistically buys back shares, and pays a modest dividend. IDCC has been successfully renewing its wireless licensing agreements (Apple in 2022, Samsung in 2023) and has a growing stream of recurring licensing revenues across consumer electronics, internet of things (IoT) and automotive customers. CEO Liren Chen joined IDCC in 2021 from Qualcom and has been hiring other former Qualcom managers. The company bought back $338m of stock last year and authorized another $300m buyback in its Q4 2023 earnings release.

Trailing Twelve Months (TTM) Detractors

• Concentrix (CNXC, Financial) is one of two top customer experience (CX) vendors globally. The company startedmanaging call centers but has since evolved into a high-tech business process outsourcer (BPO) that also designs and manages customer-facing websites and apps, integrates the data, and optimizes a client's customer interactions. The company was spun out from TD Synnex, another of the Fund's core holdings, and we have always been impressed with the company's innovation and growth. CX is a relatively new business model, and Concentrix has been rolling up smaller competitors. In March, 2023 they bought WebHelp, a leading European CX player, for $4.8B in cash and stock. We believe the WebHelp acquisition will help consolidate an industry where Concentrix and Teleperformance are the largest players.
  On Jan. 24, 2024 Concentrix reported Fiscal 2023 earnings that included weak 1% - 3% organic growth guidance for 2024. The market's current concern about the potential of artificial intelligence to disrupt Concentrix' core call center business has resulted in the underperformance in the shares across the industry. Concentrix has three turns of debt from the Webhelp deal which will be a problem if earnings deteriorate quickly. But Concentrix now trades at less than five times adjusted EPS. We think, but don't know, that Concentrix' domain knowledge and integration into customers' workflows make for meaningful switching costs. We have held on to our Concentrix shares but have not added to the position.
• United Natural Foods (UNFI, Financial) distributes natural and organic food. Whole Foods is a 20% customer,but UNFI has done a reasonable job diversifying its product and customer base, with a big boost from its acquisition of SuperValu in 2018. The company's share price has declined after a year's worth of earnings misses and guidance revisions. UNFI is suffering from a combination of volatile food prices, consumers trading down from high-priced organic food items, and pricing and execution mistakes. Distribution is usually a resilient business model and, on a normalized basis, UNFI looks cheap. But UNFI is in full bore turnaround mode. Most distributors run pretty lean, and we are wary of UNFI's ability to wring operating efficiencies out of the business. Funds that could be used to pay down debt are required for warehouse automation investments. We lost confidence in UNFI and exited our position.
• MasTec (MTZ, Financial) is a contractor that builds and repairs infrastructure for telecoms, electric utilities, oiland gas pipelines and the clean energy industry. The company benefits from strong spending for 5G in telecom and government support (including the Infrastructure Investment and Jobs Act) for clean energy and the electrical grid.¹⁰ The Mas brothers have an impressive history of rolling up smaller players and growing earnings, most recently in the electrical and clean energy spaces. But we became uncomfortable with the low margins and competition in the electrical utility and clean energy businesses. On Aug 4, 2023, in its Q2 2023 earnings release, the company reduced guidance, and we began to exit our position, partially in Q3 2023 and fully by the end of Q4 2023.
• UGI (UGI, Financial) owns gas utilities and pipelines in Pennsylvania and West Virginia and the largest propanedistribution businesses in the United States and Europe. Despite its disparate parts, UGI has increased consolidated earnings at a relatively steady high- single-digit rate while distributing excess cash through dividends. UGI's share price has declined because of a combination of poor execution and too much debt at AmeriGas, UGI's U.S. propane business. On August 30, 2023 UGI announced a review of strategic alternatives. We believe the company's stock price is attractive at less than 10x earnings, and we have been incrementally adding to the Fund's position.
• Arcadium Lithium (ALTM, Financial) is an integrated, low-cost, well-managed lithium producer that was formedfrom the merger of Livent, which the Fund already owned, and Allkem in Australia. The merger was completed at the beginning of the year and we received, and decided to hold, shares of Arcadium.¹¹ The share price is down due to volatile lithium prices that collapsed from bubbly levels at the beginning of 2023.¹² Estimates for electric vehicle production are slowing and capacity got ahead of demand; the industry is now waiting for a supply response.¹³

  Arcadium is an unusual investment for us - we normally avoid the commodity and materials sectors and have kept our position in Arcadium small. But we believe Arcadium has a unique position in an industry with a strong long-term outlook. The company has low-cost production assets, is virtually debt-free, and has considerable capacity additions planned near-term.

Conclusion

Despite the recent market volatility and an uncertain macro environment, we feel good about the Fund's long-term prospects. We do not make short term predictions on market direction. But the current valuations, competitive positions, and track records of execution at the Fund's portfolio holdings give us confidence that they will be worth considerably more in three-to-five years than they are today.

As always, and as significant co-investors in the Fund, we appreciate your trust in us to be good stewards of your-capital. If you would like to discuss performance or the Fund's portfolio holdings in greater detail, please let us know.

Respectfully,

Steve Scruggs, CFA, Portfolio Manager

Ben Mellman, Senior Analyst

1. As of March 31, 2024. Source: Morningstar Direct, FPA. Data shown for the FPA Queens Road Small Cap Value Fund – Investor Class (“Fund”). Inception of the Fund was June 13, 2002. The periods referenced above reflect Russell 2000 Value drawdowns 20% or greater and are calculated from that index's peak and trough dates, (i.e., 6/28/2002-10/9/2002, 6/4/2007-3/9/2009, 6/23/2015-2/11/2016, 8/22/2018-3/23/2020, 11/8/2021-10/27/2023). Please see page 1 for net performance of the Fund since inception. Please also see the end of this commentary for Important Disclosures and Definitions of Key Terms.
2. Source: FPA; 2023 Q4 Commentary; https://fpa.com/docs/default-source/funds/fpa-queens-road-small-cap-value-fund/literature/fpa-qr-small-cap-value-fund-commentary-2023-12.pdf
3. Source: Ed Yardeni; LargeCaps vs. SMidCaps, Figure 9; https://yardeni.com/charts/largecaps-vs-smidcaps/
4. Source: Ed Yardeni: S&P 600; https://yardeni.com/charts/sp-600/
5. Source: FPA; 2023 Q2 Commentary; https://fpa.com/funds/fpa-queens-road-small-cap-value-fund-quarterly-commentary-archive
6. Past performance is not indicative, nor is it a guarantee, of future results. There are many factors that may affect theintended acquisition and there can be no assurance JBT will be successful in its efforts.
7. Please refer to the table on page 2 for performance of the Fund during 20% or greater downturns in the Russell 2000 Value Index.
8. Reflects the top contributors and top detractors to the Fund's performance based on contribution to return for the trailing twelve months (TTM). Contribution is presented gross of investment management fees, transactions costs, and Fund operating expenses, which if included, would reduce the returns presented. The information provided does not reflect all positions purchased, sold or recommended during the TTM. A copy of the methodology used and a list of every holding's contribution to the overall Fund's performance during the TTM is available by contacting [email protected]. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities listed. Totals may not sum due to rounding. ‘Percent of Portfolio' reflects the average weight over the period.
9. The company data and statistics referenced in the TTM Contributors and Detractors sections are sourced from company earnings and press releases, and financial disclosures unless otherwise noted.
10. Source: Factset; Credit Suisse Industrials Conference; Dec 1, 2022.
11. Source: https://www.prnewswire.com/apac/news-releases/arcadium-lithium-announces-completion-of-merger-of-equals-between-allkem-and-livent-302026367.html
12. Source: https://tradingeconomics.com/commodity/lithium
13. Source: https://www.fastmarkets.com/insights/battery-materials-market-facing-oversupply-and-macroeconomic-headwinds-in-2024-2024-preview/

This Commentary is for informational and discussion purposes only and does not constitute, and should not be construed as, an offer or solicitation for the purchase or sale of any securities, products or services discussed, and neither does it provide investment advice. Any such offer or solicitation shall only be made pursuant to the Fund's Prospectus, which supersedes the information contained herein in its entirety. This Commentary does not constitute an investment management agreement or offering circular.

The statements contained herein reflect the opinions and views of the portfolio managers as of the date written, is subject to change without notice, and may be forward-looking and/or based on current expectations, projections, and/or information currently available. Such information may not be accurate over the long-term. These views may differ from other portfolio managers and analysts of the firm as a whole and are not intended to be a forecast of future events, a guarantee of future results or investment advice.

Portfolio composition will change due to ongoing management of the Fund. References to individual securities or sectors are for informational purposes only and should not be construed as recommendations by the Fund, the portfolio manager, the Adviser, the Sub-Adviser or the distributor. It should not be assumed that future investments will be profitable or will equal the performance of the security or sector examples discussed. The portfolio holdings as of the most recent quarter-end may be obtained at fpa.com.