Steve Romick's FPA Crescent Fund Q1 2013 Commentary
The third quarter’s winners and losers are as follows:
The top three contributors to performance each added just less than 0.50% to the quarterly return. The worst performer set the Fund back less than 0.20%. There were no newsworthy events during the period that caused these securities to either rise or fall.
Though the players involved may change from one generation to the next, investing at its core is, and always will be, nothing more than a tug of war between fear and greed. Fear summons the wanton selling of assets without regard to value, a scenario that often allows us to purchase assets from panicked sellers at a discount to intrinsic value. Conversely, greed creates reckless accumulation, also without regard to value, and makes it easier to find a buyer at prices higher than we paid to the frightened seller. Fear gives us an “in”, while greed gives us an “out”.
At the moment, the side pulling the “greed” end of the rope would seem to have the momentum, so as you can guess we have been feeding them some of our slack. Rest assured however, this is a tug of war that never ends, and while we don’t know when it will happen, “fear” will eventually turn the tide in the future, just as it has in the past. At that point we will rise each morning and put our well rested muscles to work by once again actively deploying capital.
The VIX Index, a measure of volatility depicted in the chart below, could be described as the market’s mood ring. When investors are fearful, the market becomes more volatile and the VIX increases. When people act greedily, the VIX trades at lower levels. Look at the index in 2002, when Enron, Worldcom, and Tyco were making headlines as the poster children for funky accounting. The VIX rose dramatically as investors lost trust in corporate America. As they voted with their feet by selling, it was an opportunity to buy. Conversely, in 2005/06 the VIX reflected a dangerous complacency that set up the financial crisis in 2008-9 which propelled the VIX to a record high that exceeded 80, and ultimately produced another great buying opportunity. In short, volatility is our friend, but it hasn’t shown its face over the past year. The VIX currently trades not far above its historic low and, as one should expect, we therefore find fewer occasions to commit capital.
As for how this relates to equity valuations, the last time we significantly increased our invested exposure was in the summer and fall of 2011, when the VIX was rising. The market has increased 40.4% since3 but not because of business performance. In this weakest of economic recoveries, the S&P 500 earnings have grown just 7.6% since Sept. 30, 2011, so most of the market’s move can be attributed to multiple expansion4.
Using Bloomberg to construct an oversimplified view, the S&P 500 has seen its P/E5 increase from 12.0x at the September 2011 low – when the VIX was trading above 40 – to 15.6x today. Valuations have increased faster than earnings, making P/E’s the new growth vehicle. We believe it is impossible for the stock market to continue to increase at 5.4x the rate of earnings.
Those who remain fully invested have made an implied bet that the world will tilt towards inflation. Although we find it hard to argue that point longer term, over shorter periods of time that may not prove true. Deflation might rule the day in the months to come, particularly if the Chinese economic engine begins to misfire. We frankly confess that we just don’t know if we’ll have inflation or deflation. And we also don’t know how much of either or when. We wish we could say otherwise. Those who believe that significantly higher levels of inflation are inevitable, and probably sooner rather than later, would be better served remaining fully invested in risk assets that will help protect against such vagaries that erode cash instruments. On the other hand, those who conclude that deflation will harm those very investments, would be better off keeping their portfolios safely liquid. We have chosen the middle, a lonely place that offers little conviction in either direction. We therefore maintain a Fund that we believe will not succeed terrifically well in either scenario, but may perform adequately in any scenario.
As stakeholders ourselves, we do to you as we do unto ourselves. Our continued commitment to our shareholders is that we will work for you as if we manage all of your savings-even though, we don’t think that’s prudent.
Safeguarding your capital requires us to maintain the best possible team of investment professionals. We take pride in the group of hardworking, high-quality individuals who sustain the core values espoused in both the
FPA Way and the Contrarian Value Policy Statement7. We welcome Sean Korduner as the newest member of our team who is exemplary of these values. We have never had a job candidate invest more than 300 hours preparing a research report (in his spare time), until Sean. We appreciate his commitment and look forward to his future contributions.
April 10, 2013
1 The Barclays Capital U.S. Aggregate Bond Index is a market capitalization-weighted index, meaning the securities in the index are weighted according to the market size of each bond type. Most U.S. traded investment grade bonds are represented. Municipal bonds, and Treasury Inflation-Protected Securities are excluded, due to tax treatment issues. The index includes Treasury securities, Government agency bonds, Mortgage-backed bonds, Corporate bonds, and a small amount of foreign bonds traded in U.S.
2 Source: Bloomberg. The Chicago Board Options Exchange Volatility Index reflects a market estimate of future volatility, based on the weighted average of the implied volatilities of S&P 500 index Options. S&P 500 is the S&P 500, or the Standard & Poor's 500, is a stock market index based on the market capitalizations of 500 leading companies publicly traded in the U.S. stock market, as determined by Standard & Poor's. VIX levels shown from April 10, 2000 thru April 11, 2013.
3 S&P 500 appreciation from Sept. 30,2011 (1131.42) to April 12,2013 (1588.85).
5 P/E = Price/Earnings ratio, or a valuation ratio of a company's current share price compared to its per-share earnings.
6 S&P 500 is The S&P 500, or the Standard & Poor's 500, is a stock market index based on the market capitalizations of 500 leading companies publicly traded in the U.S. stock market, as determined by Standard & Poor's. Trailing P/E is trailing price-to-earnings ratio, or the sum of a company's price-to-earnings, calculated by taking the current stock price and dividing it by the trailing earnings per share for the past 12 months.
7 FPA Way: fpafunds.com/about us/way. FPA Contrarian Value Investment Policy Statement:fpafunds.com/docs/policy-statements/2011-06-c-value-policy-statement---template-wo-header.pdf?sfvrsn=2
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