FPA Crescent Fund: The Portfolio Has Its Largest Weighted Average Market Cap; Comments on PetSmart (PETM) and Wal-Mart (WMT)
Steven Romick of FPA Crescent Fund released his Q4 shareholder letter today. The fund slightly underperformed the market in 2010, but it has great long term track record. Steven Romick likes large cap now. He thinks large caps are undervalued. Steven Romick highlighted two large caps: PetSmart (PETM) and Wal-Mart (WMT)
The following is the excerpts from the shareholder letter:
We continue our preference for owning larger capitalization companies as they are both less expensive (fact) and have better growth prospects (belief). The Russell 2000 (a reasonable small-cap proxy) trades at a 29.5 P/E, while the Russell 1000 trades at 17.4x earnings, 41% less expensive. In fact, small-cap stocks trade at close to their most expensive valuation vs. their larger rivals since 1982, as can be seen in the following chart from The Leuthold Group.
We think most investors recognize this small-cap/large-cap valuation disparity and have either chosen to focus on large-cap stocks (if they have the flexibility in their charter to do so), or do not believe that large-cap stocks can grow faster than their smaller counterparts. Generalizing (with a capital "G"), we believe that small-cap stocks are less efficiently priced, easier to understand, and more likely to be acquired, but they are less liquid, not cheaper, don't necessarily grow faster, and have less product diversification, less market dominance, and less of an international presence.
We surmise that greater overseas sales as a result of exposure to faster growing foreign economies has contributed to the fact that large-cap stocks (Russell 1000) have exhibited better earnings growth than small-cap stocks (Russell 2000), predicated on rolling 5-year trailing earnings growth since 1994.19 Even we were surprised by this 16-year winning streak. In the last 33 years, large caps exhibited better growth than small caps 70% of the time.
We expect the trend to continue, except for a possible blip due to the rebound from the recent recession (but we suspect that is already largely reflected in small-cap stock prices). As a result, your portfolio has its largest weighted average market cap in its 17.5 year history – $54.3 billion, as compared to our historic average of $13.1 billion.
We thought we would highlight PetSmart, the largest retailer of pet supplies and services in the U.S., because it was an investment we made despite concerns about the consumer and it exemplifies our strategy to buy the bad news. We first mentioned our investment in our 3rd Quarter 2009 commentary. We felt an investment in PetSmart in the low-$20s offered a very compelling risk/reward. Since then, the company has done everything management said it would and then some. Not only did it begin to reap the rewards of its store remodel program and distribution center rationalization, but it also entered new categories such as flea & tick and launched the Martha Stewart line in its stores. Management remained committed to returning excess free cash flow to shareholders by increasing its quarterly dividend by 25% and continuing to repurchase its attractively priced stock, which reduced the share count by 5%. These successful efforts helped boost PetSmart's trailing twelve month (TTM) EPS by approximately 15%. Even though the share price rose more than 80% in the past 17 months, the stock still trades at a relatively attractive valuation of less than 7x 2011 EBITDA and 14x after-tax free cash flow.20 Thus, we continue to hold our investment in what we consider one of the better American retail businesses with an excellent operational and shareholder friendly management team.
Wal-Mart (WMT) seems anomalous in a world where stocks have rebounded so dramatically from the stock market's 2009 bottom. Wal-Mart's stock averaged $48.59 in February 2009 (We are using the average in the month its price hit bottom, as it seems more relevant since it is only the rare circumstance and good fortune that allows one to accumulate a position on the day the market decides to price a stock at a low). At that price, it traded at a TTM and Forward P/E of 14.5 and 13.0x, respectively. Wal-Mart closed 2010 at $53.93 per share – more dear in price but cheaper in valuation – trading at a lower TTM and Forward P/E of 13.3 and 12.1x, respectively.
So where does that leave us, and how do you make money in a company that already has revenues exceeding $400 billion and a market capitalization approaching $200 billion? We now feel that Wal-Mart has grown its way (via earnings) into its stock price. We view Wal-Mart as an infinite duration bond with a rising coupon – a "bond-like equity." We believe Wal-Mart can grow at an acceptable rate well into the future and that the company will pay a fair dividend, as well as opportunistically repurchase shares, which should provide a high single-digit to low double-digit total return over time – not bad in the context of low single-digit interest rates.
Read the complete letter.