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Steven Romick: We have found ourselves with little alternative but to make some sales

October 29, 2013
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FPA Crescent returned 3.78% in the third quarter, and 14.5% year-to-date compared with the S&P 500's returns of 5.24% and 19.79%, respectively.

Though we have lagged equity markets in general, our returns continue to meet our goal of delivering equity-like retutns over the long-term, taking less risk than the market while avoiding permanent impairment of capital. As we have written in the past, when putting capital at risk, we worry about defense first and offense second.

Nevertheless, a recent report would indicate that we have found a happy medium between both preserving and compounding your capital. Specifically, Morningstar evaluated the "investor return" that shareholders have received for each of the Morningstar 500 Funds over the last 15 years and we ranked in the top 20. As we explained in our Q1 2007 commentary, investor return is the money you actually earned in Crescent. In contrast, fund return, which does not take into account shareholder redemptions and contributions, is the published figure you see, for instance, in a newspaper's mutual fund tables.

Few funds actually have investor returns larger than fund returns, though Crescent is one of them. The credit for this accomplishment goes to our patient shareholders who have responded rationally to market dislocations, maintaining or increasing their positions rather than selling. This accrues to your advantage in two ways: You avoid selling at market lows and you allow us to focus on taking advantage of investment opportunities that those lows present.

We are fortunate to have such thoughtful shareholders and hope this trend continues in the future. For our part, we will continue to communicate our process and positioning, so that you will be comfortably able to keep your wits about you when others are losing theirs. Turning to the third quarter, nothing out of the ordinary drove the portfolio's performance. The market's continued move upward in 2013 has been broad-based and the price action of the Fund's quarterly top five winners and losers derived little from company specific news. The third quarter's winners listed below added 1.44% to the Fund's quarterly return, while the losers detracted just 0.30%.

Per custom, our first and third quarter letters avoid a redundant discussion of the economy as the world spins slowly on its axis – albeit with a bit more than the usual tilt these days.

Investments

We would prefer that some of the lunacy we see out there translate into fear as that generally causes investors to sell assets without regard to value. Many of you would probably agree that people nowadays are anxious about both the economy and federal governance. And yet, the Federal Reserve's QE (Quantitative Easing) policies continue to support asset prices, despite slower economic growth and myriad other uncertainties. This can be seen in the returns of more speculative stocks. As a proxy for shares of that ilk, we turn to the most heavily shorted companies at the start of 2013. The top 100 most-heavily shorted stocks in the Russell 3000 returned 44.6% for the nine months ended September 30, dwarfing the index's return of 19.52%.

With a reluctant nod to obliging central banks, the stock market seems to be the only game in town so equities continue their unabated rally, regardless of quality. It seems a lot of people share CNBC's Jim Cramer's view that, "We all know it's going to end badly, but in the meantime we can make some money."

If you believe this trend will continue, you will most likely be better served having your capital with a manager who is more fully invested. As Morningstar analyst Dan Culloton observed in his most recent commentary about Crescent, "The past 10 years included two bear markets and were fraught with volatility, which plays to the fund's strengths."

Absent volatility, we are like an automobile whose gas gauge is nearing empty. That doesn't mean we are stuck in idle. We continue to read, speak to executives, visit companies, and then read some more. We'd like nothing more than to shift to a higher gear and increase our exposure, but given the lack of securities offering a genuine margin of safety, we're content to stay out of the fast lane for now.

In the meantime, we've taken advantage of the kindness of others who seem to have plenty of petrol and have bid up many of our investments to a point where we find the risk/reward unattractive. To remain intellectually honest and clinically dispassionate, we have found ourselves with little alternative but to make some sales. The number of equity positions now number 46 as a result – 7 fewer than our 2012 peak.9 Each of the eleven companies purged from the portfolio in 2013 were profitable investments, posting an average gain of 64%.10 Fewer names and little in the way of attractive opportunities have caused our gross long equity exposure to shrink to 54.2%, down from 63.8% at 2012 year-end. Individual security exposure has not declined ratably, however, as some companies have seen their stock prices perform better than others, and not always justifiably.

The net result is that Crescent's available liquidity has increased to 39.4%. As has occurred in the past, we expect that liquidity will inevitably be our friend again once opportunity returns. Although little excites us, we have made some small purchases. Since we are in the process of building these investments while hoping for lower prices, it would be premature - and to our collective economic disadvantage - to discuss them now. For the most part, these positions are aggregated in the "Other" category in the Portfolio Holdings shown on our website, www.fpafunds.com.

Conclusion

We naturally care about making money for our clients. As committed investors ourselves, we've put our money right alongside yours. Over any short-term period, we don't worry – or expect – that our returns will exceed or trail the market. Short-term does not mean one quarter or even one year. It could mean a few years. Admittedly, the way we invest requires patience as only time will prove us correct. Rabbi Shlomo Riskin pointed out the fine and portable line between smart and dumb. "When you're one step ahead of the crowd, you're a genius. When you're two steps ahead, you're a crackpot."11 The only way we know to invest comfortably in the present is to look down the road, knowing at some point that there will be a place to refuel.

Respectfully submitted,

Steven Romick

President,

October 18, 2013

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