The optimists held sway in the first quarter of 2011 and ended the quarter on a good note, with the stock market having returned 5.9%.(1) Crescent returned 4.7%, capturing 80% of the market’s return with risk exposure at just 58% of capital during the period. (2) We have provided a more detailed performance summary at the end of this letter.
Quarterly Winners Quarterly Losers
AON MSFT
COV WMT
ESV CSCO
Two investments – Aon (AON, Financial) and Covidien (COV, Financial) – accounted for more than 10% of the Fund’s return in the period. No investment detracted from the return to that degree. The greatest negative impact in the quarter came from Microsoft (down 19 bps), a holding we have increased to take advantage of price weakness, given the current low expectations and a P/E of just 10x. There were no developments or news events to explain the price movements in any of those stocks.
Economy
As we noted previously, the world just doesn’t change enough in three months to warrant quarterly commentaries on the broader economic picture. We had been doing so anyway, but found ourselves becoming needlessly repetitive. Therefore, as we discussed in our year-end 2010 shareholder commentary, the June and December letters will henceforth be more detailed, with commentary on macro issues, such as the economy and global considerations. The March and September letters will be a brief overview of what took place in the markets in the most recent period and how your portfolio may have changed, plus comments on performance.
In the interim, we will soon post to our website, www.fpafunds.com, “Wait and Hope,” a speech I will deliver May 3 to the Value Investing Congress. In it, we lay out some of our larger ongoing concerns and give a detailed overview of one of our more recent investments.
Investments
We have found some value in larger, higher-quality businesses, so we continued to increase our equity exposure, and ended the period at 60.0% gross long and just 3.6% short – slightly above our historical average net exposure. On the other hand, given that there is nothing “high” about the current 5.7% yield of our corporate bond investments, such exposure continues to decline and is now just 8.3%.
Office Building Loan
Crescent is unusual among public funds in that it retains the flexibility to invest in a host of asset classes. Capitalizing on that uniqueness, we recently acquired a participation interest in a $130 million senior construction loan originated by Canyon Capital Realty Advisors LLC to fund the completion of an office building in the southeastern United States. (3) A number of conditions had to be met before we committed funds to an illiquid private loan: 1) the borrower had to be both capable and well-intentioned; 2) the asset coverage had to be rock solid; 3) the IRR had to be equity-like; 4) the yield and yield spread had to be better than what’s available in the more liquid public market; and 5) the position size had to be small enough that, if there were a significant decline in assets under management, we would not be forced to exit the investment. This investment satisfied all of those conditions.
At the time of the loan closing, the borrower had already funded approximately $170 million in equity to bring the building to 80% completion. The loan will provide the borrower with the capital to finish the 615,000 square foot, 40-story office building. Our loan is the only debt on the property, and once the loan is fully funded, it will amount to just 43% of the building’s replacement value and 48% of its appraised value. Providing a further margin of safety, the deal stipulates that 35% of the loan proceeds will be “good news” money to fund tenant improvement and leasing commission costs. Under such terms, we do not provide the last $45 million dollars until after leases have been signed. The loan’s economics are projected to provide our investment with an 11.8% internal rate of return – a yield that’s more than 10 percentage points higher than U.S. Treasury yields and a level that provides comfort with the investment.
CVS
Although we have owned CVS since early 2010, we have subsequently purchased additional shares and hedged a portion of their Pharmacy Benefit Management business. Since the nature of the investment changed in both size and structure, we thought further discussion was warranted.
CVS lacks the international component we’ve sought, but we believe the pharmacy companies are wellpositioned to benefit from a number of macro trends. We prefer investments where the wind is at our backs, and we believe that is the case with this company. The aging population will drive utilization. The population of older people is growing more quickly than younger age groups, and pharmacy visits will therefore increase. What’s more, the 65+ cohort has almost 3x the number of prescriptions filled per year as the 19-64 cohort. In addition, the Medicare market is growing significantly and CVS is wellpositioned to benefit from an estimated 32 million people expected to gain coverage, beginning in 2014.
Demand Drivers
We look at the expansion of Medicare coverage as a free option. If it hits, it could provide a 20% bump to the 636 million scripts CVS dispensed in its drugstores in 2010, and add 35% to CVS’ current earnings. (CVS’ 18% market share x 32 mm people x 2 Rx per person per month x 12 months x $9 incremental after-tax profit per Rx = $0.90 per share.) We don’t know what health care reform will ultimately look like, but we take some comfort in the knowledge that prescription drugs represent just 10% of the total health spend and that increasing patient adherence to drug regimens is among the most cost effective ways to lower medical costs.
The pharmacy companies, particularly the two largest national chains, are well-positioned to benefit from those trends. With half of all Rx dispensed being unplanned, retail pharmacies are a necessity for just-intime dispensing. Retail pharmacies dispense 81% of all prescriptions – a share that’s been unchanged over four years. Among pharmacy retailers, CVS and Walgreens are the best positioned, with each company operating more than 7,000 stores and ranking either #1 or #2 in 70% of the top 100 markets. CVS fills 18% of the U.S. retail drug market and has a store within three miles of 75% of the population. We expect that CVS and Walgreens will continue to gain share in a growing market, particularly from the smaller independents whose market share has been halved in the past couple of decades to about 20% today. The third significant national chain is Rite-Aid, but the company isn’t much of a threat to the larger rivals because it’s highly leveraged, has a third lower sales per square foot, and fulfills less than half the number of prescriptions dispensed by either CVS drugstores or Walgreens.
There has been some concern that mail order will erode walk-in business. We expect that may have some small impact over time, but over the last four years, mail order’s share of the market has remained at a relatively constant 19%.
The peak of Big Pharma’s productivity occurred in the mid-90s, and those drugs are now facing the end of their patent lives. Note that the R&D spend is almost 6x what it was in 1990, but the number of approvals is lower. This speaks to the fundamental challenges facing Big Pharma today.
Retail pharmacies will enjoy better margins from the coming generic wave that’s due to peak in 2012, since they make more money selling generic drugs than branded. The margin expansion comes from both having more vendor options and – since they self-distribute – capturing the distributor margin for themselves on every prescription. In the example below, unit gross profit increases at CVS’ pharmacies from $11.50 to $16.00, a 39% increase.
CVS has become a brand unto itself, and with that, private label opportunities will continue to proliferate. Private label products offer CVS a better gross profit opportunity on every sale. At my local supermarket, I buy Thomas’ English Muffins because the private label version lacks the nooks and crannies. In general, I’ve found that consumers are more willing to switch to a private label item if it is something they can’t taste. Medication certainly falls in that category. I now buy the little blue pills that are CVS’ substitute for Aleve, the CVS brand multi-vitamin instead of Centrum, and I find their sunscreen works fine as well. The production issues and recall problems at Johnson & Johnson are adding momentum to the trend. CVS expects its private label business will rise to 20% of overall revenue in the next 2-3 years, up from 17% today. Private label sales hurt comparable store sales because the average price can be 15% to 20% less than for the equivalent branded product, but gross margin can be 10 percentage points higher, increasing the gross profit dollar by about 10%. So we believe the increase in private label over the next two years could increase retail operating income by 3.5%. This still leaves a ton of room for private label expansion. U.S. retailers like Kroger have 28% private brand penetration, which pales next to UK-based Tesco’s 50%. Clearly, this leaves CVS a lot of runway for years to come.
We would be remiss not to talk about Caremark, CVS’ Pharmacy Benefits Manager, since it represents almost half of CVS sales and a bit more than one-third of its profits. For those of you less familiar with the industry, a Pharmacy Benefits Manager, or PBM, is a third-party administrator of prescription drug programs. Among other services, PBMs aggregate the buying power of their many large customers to obtain lower prices from pharmacies and drug manufacturers and induce pharmacists to switch from brands to generics, thereby lowering costs in the supply chain. Caremark fills or manages 20% of all U.S. scripts, serving a network of 64,000 pharmacies and covering 53 million lives. They are the secondlargest mail order pharmacy after Medco, but they lead the market in Specialty Pharmacy and Generics.
Caremark’s Maintenance Choice program differentiates the company from the competition. With this uniquely integrated model, customers can get mail order pricing and still pick up their prescriptions in a CVS store -- something other PBMs and drugstores don’t offer. It’s a great benefit for people who get caught short of necessary meds because they forgot to refill their 90-day prescription, or because it got lost in the mail. Only 15% of Caremark’s members are on Maintenance Choice today, leaving an addressable opportunity of another 42%. (4)
In addition to the opportunities, we see some challenges facing the PBM space, including the possibility of lower future rebates, the introduction by Medicaid of legally mandated transparency of drug acquisition costs, and challenges from traditional health insurers in Specialty Pharma. As a result, we’ve chosen to hedge out a piece of the PBM exposure. With this hedge, we would still benefit if -- as we believe -- Caremark outperforms its rivals over the next few years, and would also be protected if headwinds erode the industry’s profitability.
CVS’ executives have proven themselves to be skilled operators as well as prudent capital allocators. Their attention to the wise use of cash makes sense because they’re invested alongside us. In fact, CVS management has millions of reasons to get it right. Tom Ryan, the retiring CEO, has about $300 million of CVS equity exposure, and three other top executives have a combined exposure of more than $80 million.
By the end of this year, CVS will have returned almost $6 per share in capital to their shareholders over four years, or approximately 18% of their average market capitalization since 2007. If you were to add debt repayment to this, the equity benefit would be 20%. CVS has publicly stated that it intends to spend $3-4 billion per year on share repurchases. Add in the dividend, and you get 7.5-9.5% per year in cash used to enhance shareholder value. Said another way, the cumulative free cash flow over the next five years should exceed 50% of the current market capitalization, and the majority of that will be returned to shareholders.
We also think the current valuation ignores what could be significant working capital improvements. CVS grew through acquisition, and it still isn’t where it needs to be. For example, each distribution center (DC) serves only 378 stores compared to the 473 stores that run through the typical Walgreens DC. In 2010, CVS operated with seven inventory management systems, while Caremark had five different claims platforms. By 2013, their goal is to be down to one platform each. The company has said it can reduce retail store inventories by $2 billion over the next three years, representing about a $1.50 per CVS share, or 4.2%. That seems reasonable, since the company’s retail business has 12.8% of its sales tied up in inventory net of payables, compared to Walgreens at just 6.0%. We are not suggesting that CVS is likely to get to the Walgreens’ efficiency anytime soon, but it does lend some comfort to the company’s guidance.
When we first purchased CVS in 2010, it was trading at about 11.5x 2011’s earnings. We felt the valuation adequately compensated for our concerns regarding their PBM business – as well as for our admittedly less robust understanding of its prospects. As CVS’ stock price began to tick up, the PBM comps, Medco and Express Scripts, moved up even more, actually making the CVS stub value less expensive. Using the PBM competition as a comp, we felt that the Caremark value attributable to the total enterprise was about 46%. On that basis, the value of the CVS retail stub traded to just 9.4x free cash earnings. We therefore ended up hedging a portion of the PBM exposure – to capture the lower valuation as well as to eliminate some of the risk and accompanying discomfort of what we don’t know regarding the PBM business. At this point, we still have some PBM exposure, albeit reduced. We believe that Caremark can outperform its peer group as it is now being better managed by Per Lofberg, the former Medco head as its President, and is poised to benefit vis-à -vis their competition. Contributing to this will be their improved customer service, the aforementioned systems improvements, as well as the competitive advantage of their Maintenance Choice integrated model. We wouldn’t characterize CVS as a homerun stock, but it should nevertheless prove to be a solid compounder over the next few years as the macro tailwinds begin to blow and are recognized by other investors.
Japan
With its aging population, a manufacturing base that has become less competitive, and the highest debt/GDP of any major economy, Japan would hardly seem worthy of our attention. However, where we find bad news, we find emotionally-guided investment decisions and an opportunity for those with a longer view and the time and capability to distill fact from fiction. Furthermore, being a value fund that is willing to pinch its nose and buy under the philosophy that “everything has a price,” Japan’s poor performance of -1.3% in 2010 and -17.9% over the last three years caught our attention.
During trips to Japan in March and December of 2010, our team visited more than 50 companies across the country. Our research was primarily focused on domestically oriented companies which, despite mundane growth opportunities, were trading at exceptionally low valuations of enterprise value to earnings. However, such valuations often only existed due to a sub-optimal build-up of cash over the past decade.
After visiting these investment candidates and hearing firsthand the apathetic answers to our questions regarding capital allocation, we refined our search to focus on high-quality companies that traded at a reasonable price/earnings multiple (e.g. giving no benefit for a large cash balance) and also allocated capital in a reasonably intelligent manner. It goes without saying that we applied a quality overlay to our search, and that we sought out firms occupying strong competitive positions, and whose earnings three years out were unlikely to be demonstrably lower than they are today, and hopefully higher.
Having identified a handful of investment candidates, we established embryonic positions and then largely sat on our hands and held out for lower prices before we added to our positions. We seized such a moment in the midst of the Fukushima related market sell-off, markedly taking up exposures to roughly coincide with the point of market capitulation (better to be lucky than smart). Nonetheless, the market recovered so rapidly that we failed to establish full positions, and we continue to retain dry powder to add to a select group of Japanese names if another buying opportunity presents itself. Crescent has therefore grown from zero exposure to Japan to 1.5%. Such a meager investment merits mention only because it highlights our disciplined process of waiting for opportunity
Closing
Alexandre Dumas wrote, “All human wisdom is summed up in two words – wait and hope.” We are doing both.
Quarterly Winners Quarterly Losers
AON MSFT
COV WMT
ESV CSCO
Two investments – Aon (AON, Financial) and Covidien (COV, Financial) – accounted for more than 10% of the Fund’s return in the period. No investment detracted from the return to that degree. The greatest negative impact in the quarter came from Microsoft (down 19 bps), a holding we have increased to take advantage of price weakness, given the current low expectations and a P/E of just 10x. There were no developments or news events to explain the price movements in any of those stocks.
Economy
As we noted previously, the world just doesn’t change enough in three months to warrant quarterly commentaries on the broader economic picture. We had been doing so anyway, but found ourselves becoming needlessly repetitive. Therefore, as we discussed in our year-end 2010 shareholder commentary, the June and December letters will henceforth be more detailed, with commentary on macro issues, such as the economy and global considerations. The March and September letters will be a brief overview of what took place in the markets in the most recent period and how your portfolio may have changed, plus comments on performance.
In the interim, we will soon post to our website, www.fpafunds.com, “Wait and Hope,” a speech I will deliver May 3 to the Value Investing Congress. In it, we lay out some of our larger ongoing concerns and give a detailed overview of one of our more recent investments.
Investments
We have found some value in larger, higher-quality businesses, so we continued to increase our equity exposure, and ended the period at 60.0% gross long and just 3.6% short – slightly above our historical average net exposure. On the other hand, given that there is nothing “high” about the current 5.7% yield of our corporate bond investments, such exposure continues to decline and is now just 8.3%.
Office Building Loan
Crescent is unusual among public funds in that it retains the flexibility to invest in a host of asset classes. Capitalizing on that uniqueness, we recently acquired a participation interest in a $130 million senior construction loan originated by Canyon Capital Realty Advisors LLC to fund the completion of an office building in the southeastern United States. (3) A number of conditions had to be met before we committed funds to an illiquid private loan: 1) the borrower had to be both capable and well-intentioned; 2) the asset coverage had to be rock solid; 3) the IRR had to be equity-like; 4) the yield and yield spread had to be better than what’s available in the more liquid public market; and 5) the position size had to be small enough that, if there were a significant decline in assets under management, we would not be forced to exit the investment. This investment satisfied all of those conditions.
At the time of the loan closing, the borrower had already funded approximately $170 million in equity to bring the building to 80% completion. The loan will provide the borrower with the capital to finish the 615,000 square foot, 40-story office building. Our loan is the only debt on the property, and once the loan is fully funded, it will amount to just 43% of the building’s replacement value and 48% of its appraised value. Providing a further margin of safety, the deal stipulates that 35% of the loan proceeds will be “good news” money to fund tenant improvement and leasing commission costs. Under such terms, we do not provide the last $45 million dollars until after leases have been signed. The loan’s economics are projected to provide our investment with an 11.8% internal rate of return – a yield that’s more than 10 percentage points higher than U.S. Treasury yields and a level that provides comfort with the investment.
CVS
Although we have owned CVS since early 2010, we have subsequently purchased additional shares and hedged a portion of their Pharmacy Benefit Management business. Since the nature of the investment changed in both size and structure, we thought further discussion was warranted.
CVS lacks the international component we’ve sought, but we believe the pharmacy companies are wellpositioned to benefit from a number of macro trends. We prefer investments where the wind is at our backs, and we believe that is the case with this company. The aging population will drive utilization. The population of older people is growing more quickly than younger age groups, and pharmacy visits will therefore increase. What’s more, the 65+ cohort has almost 3x the number of prescriptions filled per year as the 19-64 cohort. In addition, the Medicare market is growing significantly and CVS is wellpositioned to benefit from an estimated 32 million people expected to gain coverage, beginning in 2014.
Demand Drivers
We look at the expansion of Medicare coverage as a free option. If it hits, it could provide a 20% bump to the 636 million scripts CVS dispensed in its drugstores in 2010, and add 35% to CVS’ current earnings. (CVS’ 18% market share x 32 mm people x 2 Rx per person per month x 12 months x $9 incremental after-tax profit per Rx = $0.90 per share.) We don’t know what health care reform will ultimately look like, but we take some comfort in the knowledge that prescription drugs represent just 10% of the total health spend and that increasing patient adherence to drug regimens is among the most cost effective ways to lower medical costs.
The pharmacy companies, particularly the two largest national chains, are well-positioned to benefit from those trends. With half of all Rx dispensed being unplanned, retail pharmacies are a necessity for just-intime dispensing. Retail pharmacies dispense 81% of all prescriptions – a share that’s been unchanged over four years. Among pharmacy retailers, CVS and Walgreens are the best positioned, with each company operating more than 7,000 stores and ranking either #1 or #2 in 70% of the top 100 markets. CVS fills 18% of the U.S. retail drug market and has a store within three miles of 75% of the population. We expect that CVS and Walgreens will continue to gain share in a growing market, particularly from the smaller independents whose market share has been halved in the past couple of decades to about 20% today. The third significant national chain is Rite-Aid, but the company isn’t much of a threat to the larger rivals because it’s highly leveraged, has a third lower sales per square foot, and fulfills less than half the number of prescriptions dispensed by either CVS drugstores or Walgreens.
There has been some concern that mail order will erode walk-in business. We expect that may have some small impact over time, but over the last four years, mail order’s share of the market has remained at a relatively constant 19%.
The peak of Big Pharma’s productivity occurred in the mid-90s, and those drugs are now facing the end of their patent lives. Note that the R&D spend is almost 6x what it was in 1990, but the number of approvals is lower. This speaks to the fundamental challenges facing Big Pharma today.
Retail pharmacies will enjoy better margins from the coming generic wave that’s due to peak in 2012, since they make more money selling generic drugs than branded. The margin expansion comes from both having more vendor options and – since they self-distribute – capturing the distributor margin for themselves on every prescription. In the example below, unit gross profit increases at CVS’ pharmacies from $11.50 to $16.00, a 39% increase.
CVS has become a brand unto itself, and with that, private label opportunities will continue to proliferate. Private label products offer CVS a better gross profit opportunity on every sale. At my local supermarket, I buy Thomas’ English Muffins because the private label version lacks the nooks and crannies. In general, I’ve found that consumers are more willing to switch to a private label item if it is something they can’t taste. Medication certainly falls in that category. I now buy the little blue pills that are CVS’ substitute for Aleve, the CVS brand multi-vitamin instead of Centrum, and I find their sunscreen works fine as well. The production issues and recall problems at Johnson & Johnson are adding momentum to the trend. CVS expects its private label business will rise to 20% of overall revenue in the next 2-3 years, up from 17% today. Private label sales hurt comparable store sales because the average price can be 15% to 20% less than for the equivalent branded product, but gross margin can be 10 percentage points higher, increasing the gross profit dollar by about 10%. So we believe the increase in private label over the next two years could increase retail operating income by 3.5%. This still leaves a ton of room for private label expansion. U.S. retailers like Kroger have 28% private brand penetration, which pales next to UK-based Tesco’s 50%. Clearly, this leaves CVS a lot of runway for years to come.
We would be remiss not to talk about Caremark, CVS’ Pharmacy Benefits Manager, since it represents almost half of CVS sales and a bit more than one-third of its profits. For those of you less familiar with the industry, a Pharmacy Benefits Manager, or PBM, is a third-party administrator of prescription drug programs. Among other services, PBMs aggregate the buying power of their many large customers to obtain lower prices from pharmacies and drug manufacturers and induce pharmacists to switch from brands to generics, thereby lowering costs in the supply chain. Caremark fills or manages 20% of all U.S. scripts, serving a network of 64,000 pharmacies and covering 53 million lives. They are the secondlargest mail order pharmacy after Medco, but they lead the market in Specialty Pharmacy and Generics.
Caremark’s Maintenance Choice program differentiates the company from the competition. With this uniquely integrated model, customers can get mail order pricing and still pick up their prescriptions in a CVS store -- something other PBMs and drugstores don’t offer. It’s a great benefit for people who get caught short of necessary meds because they forgot to refill their 90-day prescription, or because it got lost in the mail. Only 15% of Caremark’s members are on Maintenance Choice today, leaving an addressable opportunity of another 42%. (4)
In addition to the opportunities, we see some challenges facing the PBM space, including the possibility of lower future rebates, the introduction by Medicaid of legally mandated transparency of drug acquisition costs, and challenges from traditional health insurers in Specialty Pharma. As a result, we’ve chosen to hedge out a piece of the PBM exposure. With this hedge, we would still benefit if -- as we believe -- Caremark outperforms its rivals over the next few years, and would also be protected if headwinds erode the industry’s profitability.
CVS’ executives have proven themselves to be skilled operators as well as prudent capital allocators. Their attention to the wise use of cash makes sense because they’re invested alongside us. In fact, CVS management has millions of reasons to get it right. Tom Ryan, the retiring CEO, has about $300 million of CVS equity exposure, and three other top executives have a combined exposure of more than $80 million.
By the end of this year, CVS will have returned almost $6 per share in capital to their shareholders over four years, or approximately 18% of their average market capitalization since 2007. If you were to add debt repayment to this, the equity benefit would be 20%. CVS has publicly stated that it intends to spend $3-4 billion per year on share repurchases. Add in the dividend, and you get 7.5-9.5% per year in cash used to enhance shareholder value. Said another way, the cumulative free cash flow over the next five years should exceed 50% of the current market capitalization, and the majority of that will be returned to shareholders.
We also think the current valuation ignores what could be significant working capital improvements. CVS grew through acquisition, and it still isn’t where it needs to be. For example, each distribution center (DC) serves only 378 stores compared to the 473 stores that run through the typical Walgreens DC. In 2010, CVS operated with seven inventory management systems, while Caremark had five different claims platforms. By 2013, their goal is to be down to one platform each. The company has said it can reduce retail store inventories by $2 billion over the next three years, representing about a $1.50 per CVS share, or 4.2%. That seems reasonable, since the company’s retail business has 12.8% of its sales tied up in inventory net of payables, compared to Walgreens at just 6.0%. We are not suggesting that CVS is likely to get to the Walgreens’ efficiency anytime soon, but it does lend some comfort to the company’s guidance.
When we first purchased CVS in 2010, it was trading at about 11.5x 2011’s earnings. We felt the valuation adequately compensated for our concerns regarding their PBM business – as well as for our admittedly less robust understanding of its prospects. As CVS’ stock price began to tick up, the PBM comps, Medco and Express Scripts, moved up even more, actually making the CVS stub value less expensive. Using the PBM competition as a comp, we felt that the Caremark value attributable to the total enterprise was about 46%. On that basis, the value of the CVS retail stub traded to just 9.4x free cash earnings. We therefore ended up hedging a portion of the PBM exposure – to capture the lower valuation as well as to eliminate some of the risk and accompanying discomfort of what we don’t know regarding the PBM business. At this point, we still have some PBM exposure, albeit reduced. We believe that Caremark can outperform its peer group as it is now being better managed by Per Lofberg, the former Medco head as its President, and is poised to benefit vis-à -vis their competition. Contributing to this will be their improved customer service, the aforementioned systems improvements, as well as the competitive advantage of their Maintenance Choice integrated model. We wouldn’t characterize CVS as a homerun stock, but it should nevertheless prove to be a solid compounder over the next few years as the macro tailwinds begin to blow and are recognized by other investors.
Japan
With its aging population, a manufacturing base that has become less competitive, and the highest debt/GDP of any major economy, Japan would hardly seem worthy of our attention. However, where we find bad news, we find emotionally-guided investment decisions and an opportunity for those with a longer view and the time and capability to distill fact from fiction. Furthermore, being a value fund that is willing to pinch its nose and buy under the philosophy that “everything has a price,” Japan’s poor performance of -1.3% in 2010 and -17.9% over the last three years caught our attention.
During trips to Japan in March and December of 2010, our team visited more than 50 companies across the country. Our research was primarily focused on domestically oriented companies which, despite mundane growth opportunities, were trading at exceptionally low valuations of enterprise value to earnings. However, such valuations often only existed due to a sub-optimal build-up of cash over the past decade.
After visiting these investment candidates and hearing firsthand the apathetic answers to our questions regarding capital allocation, we refined our search to focus on high-quality companies that traded at a reasonable price/earnings multiple (e.g. giving no benefit for a large cash balance) and also allocated capital in a reasonably intelligent manner. It goes without saying that we applied a quality overlay to our search, and that we sought out firms occupying strong competitive positions, and whose earnings three years out were unlikely to be demonstrably lower than they are today, and hopefully higher.
Having identified a handful of investment candidates, we established embryonic positions and then largely sat on our hands and held out for lower prices before we added to our positions. We seized such a moment in the midst of the Fukushima related market sell-off, markedly taking up exposures to roughly coincide with the point of market capitulation (better to be lucky than smart). Nonetheless, the market recovered so rapidly that we failed to establish full positions, and we continue to retain dry powder to add to a select group of Japanese names if another buying opportunity presents itself. Crescent has therefore grown from zero exposure to Japan to 1.5%. Such a meager investment merits mention only because it highlights our disciplined process of waiting for opportunity
Closing
Alexandre Dumas wrote, “All human wisdom is summed up in two words – wait and hope.” We are doing both.
