An unresolved European sovereign and financial dilemma, in concert with a U.S. economy that’s been a disappointment compared to the once-rosy projections of most economists, caused global markets to retreat in the third quarter. Crescent declined as well, but it fell 30% less than the U.S. market for the quarter and 40% less in the year-to-date period.1
The U.S. markets actually fared quite favorably – and Crescent more favorably still – when viewed in context of the global financial upheaval. A sampling of the market declines on global bourses is in the table below.
As long-term investors, there was no way to avoid what we feel will prove temporary “negative” marks in our portfolio. Crescent’s few winners in the quarter failed to offset the losers in our portfolio. However, our long equity book performed more than a few points better than the market.1
The top contributors and detractors from our quarterly performance are as follows:
The macroeconomic outlook is worrisome. As mentioned in previous letters, we have been less than convinced of the strength and legitimacy of the 2009-10 recovery. In the third quarter, our concerns became consensus. Despite our inherent discomfort in sharing a more accepted view, the macroeconomic picture continues to cause us concern. We see potential headwinds in the over leveraged position of Western governments and the apparent excess development/potential real estate bubble in China. In the United States, it's more than a little worrisome that, despite flooding the financial system with money, the government hasn’t gotten the traction it expected (or at least hoped for).
Instead, the money clots bank balance sheets as idled reserves, with lenders not willing to lend to borrowers who don’t want to (or can’t) borrow. The Federal Reserve started by blowing on a string, but then moved the string into a wind tunnel – to no avail. The Fed’s moves merely created inflation tinder that has yet to be ignited. In the interim, with global economies slowing, deflationary pressures continue to mount, and that pressure would get worse if the Chinese economic luster were to tarnish.
We feel the need to reverse what we’ve said in the past. Policy makers do consider the long-term, they just view the future as a place where today’s decisions have no impact, problems don’t exist, and where all the raindrops are lemon drops and gum drops. That’s not what we see. We feel like we’re living in the fictional town of Rock Ridge in Blazing Saddles. À la Sheriff Bart, we see a gun pointed at our head, and the scary thing is that we’re the ones holding the loaded weapon. Sheriff Bart escaped the dimwitted and hostile townspeople by taking himself hostage at gunpoint – I’m not sure that we will be similarly fortunate.
Our year-end letter will offer more detailed thoughts.
Though macroeconomic concerns inform our analytical assumptions, we remain committed to purchasing well-understood businesses and assets at attractive prices when they become available. Volatility is our friend, as we like to say, and we’ve had plenty of it. The VIX index, a measure of the S&P 500’s projected volatility, traded upwards of 3x higher than its April low.2 Viewed another way, in the first and second quarters, the difference between the S&P 500’s daily high and low prices was 3.6% and 3.8%, respectively. In the third quarter, that difference exploded to 11.4%, and that was predicated on the price movement on consecutive days. The S&P 500 declined 6.7% on August 8, rebounded 4.7% the following day, then declined 4.4% on August 10, only to increase 4.3% on August 11 – not a ride for the less resolute.
With stocks declining as they did, we took the opportunity to increase our exposure. Crescent ended September 30 with a net equity exposure of 62.8%, an increase of 6.1% since June 30. Some additional buying at the beginning of October, combined with some stock price appreciation, pushed Crescent’s net exposure to 66.0% 3 – close to the Fund’s all-time high. However, we do not believe that the shift has increased our risk exposure higher than our historic average. Compared to the past, the businesses we currently own are of a higher quality, with larger market caps, more robust balance sheets, stronger competitive positions, and lower-than-average valuations. In addition, Crescent’s risk is reduced by its lower than average high yield bond exposure – 41% less than average.4,5 Given recent investment opportunities, portfolio liquidity has declined to less than 21%, consistent with the equation we discussed in our June 30, 2011 commentary, Portfolio = Investment Opportunity + Cash %.6
Maybe the fact that economist Nouriel Roubini, celebrated for calling both the most recent recession and the collapse of the U.S. housing market that precipitated it, has placed his econometrics firm up for sale is a short-term bullish signal (we’ve got to hang our hats on something.)
In the quarter, we were able to make new investments in two leading retailers. The companies have what we believe to be practically bulletproof balance sheets, attractive operating economics, competitively important real estate holdings, muted risk of internet-based business disruption, and a commitment to improving return on invested capital (ROIC) and to returning capital to shareholders. Both companies were purchased at less than 10x our estimate of normal owner earnings.
Tesco PLC is the third-largest retailer in the world, behind Wal-Mart and Carrefour. It earns approximately two-thirds of its profit from the United Kingdom, where it has ~30% share of the grocery market. The other third of its earnings come from countries in Asia and Central Europe. The company holds a particularly strong #2 market position in South Korea, Thailand, and Hungary. Tesco appears to be at an inflection point in several countries where it has captured enough scale to drive high returns on newly invested capital. Tesco has long been considered a strong operator of a leading franchise in the United Kingdom, but international operations have lagged. The company recently committed to improving ROIC, with management putting its money where its mouth is (bonuses are now based on achieving ROIC targets). We purchased Tesco at a low ~10x 2012E core EPS (excluding amortization of intangibles and losses in the United States and Japan). As an additional margin of safety to our investment, Tesco owns the real estate underlying 75% of its stores – ownership that arguably provides some measure of asset backing.
Lowes is the second-largest home improvement retailer in the United States. The company operates in a duopoly-like market with Home Depot. We believe Lowes is operating somewhere near the bottom of a significant industry downturn (home improvement spending is at the lowest % of GDP in 70 years). We bought Lowes at roughly 10x current (depressed) owner earnings. We expect earnings to improve materially when the U.S. economy improves. In the meantime, Lowes is aggressively repurchasing stock (10% of the company per year, based on our purchase price).
We expect continued volatility in the months to come, and we’ll take advantage of the opportunities along the way. Our task is always a challenge, and certainly humbling, but we see the utility of our flexible strategy, and with hard work, level heads, and patience, we strive to continue to offer in the future what we’ve provided in the past.
October 18, 2011
1 We use the S&P 500 as a proxy for the U.S. market.
2 The 2011 VIX low was 14.62 on April 28. The 2011 VIX high was 48.00 on August 8.
3 As of October 17, 2011.
4 Since we started tracking the data in March 31, 1996, Crescent’s average corporate bond exposure has been is 15.1%.
5 Crescent’s projected price/earnings ratio for the current year is 11.0x, and its price/book ratio is 1.3x compared to the averages since June 30, 1997 of 13.9x and 1.7x, respectively.
6 As of October 17, 2011, liquidity stood at ~21.0%, versus 25.8% at June 30, 2011.
The discussion of Fund investments represents the views of the Fund’s managers at the time of this report and is subject to change without notice. References to individual securities are for informational purposes only and should not be construed as recommendations to purchase or sell individual securities.
FORWARD LOOKING STATEMENT DISCLOSURE
As mutual fund managers, one of our responsibilities is to communicate with shareholders in an open and direct manner. Insofar as some of our opinions and comments in our letters to shareholders are based on current management expectations, they are considered “forward-looking statements” which may or may not be accurate over the long term. While we believe we have a reasonable basis for our comments and we have confidence in our opinions, actual results may differ materially from those we anticipate. You can identify forward-looking statements by words such as “believe,” “expect,” “may,” “anticipate,” and other similar expressions when discussing prospects for particular portfolio holdings and/or the markets, generally. We cannot, however, assure future results and disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. Further, information provided in this report should not be construed as a recommendation to purchase or sell any particular security.