Steven Romick's Q2 FPA Crescent Fund Shareholder Letter
Nothing seems to slow this stock market in overdrive. The S&P 500 returned 5.23% in the second quarter and 7.14% year-to-date. The FPA Crescent Fund returned 2.94% and 5.04% for the same periods, albeit with an average net exposure to equities in the low 50% range.
The value of our positions obviously fluctuates every day and using calendar quarter-end period is nothing more than arbitrary, although it does help explain what contributed to the portfolio’s rise or fall in the period. This quarter, for example, turned out to be a good period for companies beginning with the letter “A”, with 60% of the winners coming from the beginning of the alphabet. Our top five contributors in the second quarter added 1.28%, while the bottom five detracted just 0.21%. Our top performer, Covidien, increased on the news that Medtronic intends to acquire it. Overall, capturing a price at a moment in time will not explain how we will perform long-term. Instead, our attention is focused on years out in the future, which allows us to block the cacophony that comes from listening to the market’s daily rhythms.
FPA had its second bi-annual Investor Day on June 2, 2014. We welcomed the opportunity to spend time with many of our investors and hope, for those who attended, that you found it informative. If you weren’t there, you might enjoy reviewing presentations made by Mark Landecker, Brian Selmo and me, which are available on our website – www.fpafunds.com.
With a nod to Sonny & Cher, the beat goes on. As has largely been the case since 2009, the stock market is the star performer while the economy resembles a shaky back-up singer. The first quarter witnessed a decline in GDP, the first such drop since 2009. A horrible winter certainly had an impact. Since then, the economy seems to have rebounded somewhat but our conversations with companies and our reading materials point to an economy that continues to be anything but robust. U.S. GDP remains below the Fed’s target projections. Employment has increased but, due to people dropping out of the workforce, it’s close to a four-decade low as a percentage of the population. Equally concerning, there’s more part-time work and average wages remain weak. As Sonny & Cher sang: La de da de de, la de da de da.
Disappointing economic growth offers a silver lining, in that it discourages central banks from becoming less accommodative, despite jawboning to the contrary. The Federal Reserve continues to keep interest rates low and to quantitatively ease albeit with some negligible tapering. This effort clearly hasn’t had much of an economic impact but it has continued to elevate the price level of risk assets around the globe. The chart below gives rise to our observation that the Fed has been the biggest driver of the stock market.
In the U.S., the real rate of interest is barely above zero.
With yields remaining artificially low, we observe zero interest-rate policy perverting capital allocation decisions. Money continues to flow around the globe in a quest for yield, instigating a continued rise in risk assets. Many who have been accustomed to the lower risk of high-grade bonds and Treasuries are now finding themselves looking elsewhere. There is no better example of this than the first six months of this year when global stock markets, high-yield bonds, gold, oil and long-dated Treasury bonds all saw their value increase in chorus, a real rarity. As yields have declined, the expectations and spending needs of investors appear to have remained constant, leading them to assume additional risk in varied asset classes around the world. Whereas many past bull-market rallies have been greed-based, this one seems more need-based.
In the U.S., the real rate of interest is barely above zero.
With yields remaining artificially low, we observe zero interest-rate policy perverting capital allocation decisions. Money continues to flow around the globe in a quest for yield, instigating a continued rise in risk assets. Many who have been accustomed to the lower risk of high-grade bonds and Treasuries are now finding themselves looking elsewhere. There is no better example of this than the first six months of this year when global stock markets, high-yield bonds, gold, oil and long-dated Treasury bonds all saw their value increase in chorus, a real rarity. As yields have declined, the expectations and spending needs of investors appear to have remained constant, leading them to assume additional risk in varied asset classes around the world. Whereas many past bull-market rallies have been greed-based, this one seems more need-based. The U.S. isn’t alone in keeping rates low. Many countries continue to harbor deflation fears. Japan is still below its inflation target. EU countries have just marginal inflation and it wouldn’t take much to tip them into deflation. Some EU countries like Greece and Portugal are already suffering from outright deflation. As a result, the EU overnight rate is now a negative 0.1%, which means it costs banks to keep money on deposit with the European Central Bank (ECB). Its main lending rate is now down to just 0.15%. It’s hard to argue that such low rates wouldn’t affect an investment decision.
With slow growth and low inflation (and fear of deflation) plaguing most developed economies, it’s hard to see the current easy-money regime ending any time soon. For it to end, the Fed must first slow its buying, then stop buying and then either liquidate or roll the assets they’ve purchased. It appears that we have a ways to go before they aren’t accommodative – unless their hand is forced. The U.S. is increasingly on its own in financing its deficits, with foreigners having largely stepped out of the U.S. Treasury market.3 If we need financing assistance from our trading partners, then we might need higher interest rates to get them to step up their Treasury buying. Or, the Fed could always reverse course on the QE taper and continue to self-finance. Or, the current account balance shrinks, thereby requiring less funding, with either exports and the economy growing, or imports and the economy shrinking. That’s a lot of “oars” needed to keep the boat moving – which begs some degree of caution.
We consider the economy only to ascertain what’s possible at some point, rather than to opine as to what will happen when. With a healthy dose of skepticism and appreciation of our fallibility, we understand that things can always go wrong (including our own projections), but we are happy to commit capital to new or existing investments as long as the given opportunity offers an attractive risk/reward, even after taking into account bad news that brings about a reasonable worst-case scenario.
Investing today feels a bit like dancing the limbo, i.e. how low can you go? With interest rates, volatility, and short interest all near lows, it’s no surprise that opportunities are scarce as you can see in the following two charts that depict valuations being above normal, historical figures.
If you were to then surmise that there isn’t much trading at low valuations, you would be correct. With many stocks hitting new highs, the number of stocks trading at lower Price/Earnings (P/E) ratios is near its low. We continue to trust that long-term thinking will pay dividends in the form of good returns and allow us to avoid the frequent mistakes more commonly associated with the need for more immediate gratification. Patient investors have created more than one great family fortune over time and over diverse industries by disregarding present performance in an effort to create wealth at some point in the future; e.g., Buffet, Crown, Tisch, Koch, Frère and Pritzer, just to name a few.
Alcoa & Norsk Hydro
We initiated positions in two aluminum companies last fall, Alcoa and Norsk Hydro, that we saw as commercial opportunities or, as we like to call them, “3 to 1s”, i.e., 3x the perceived upside to its downside. The oversimplified and bigger picture view was that we saw the price of aluminum was at an inflation-adjusted low and the stock prices of these companies were down in kind, as can be seen in the following graphs.
…but the industry participants were acting rationally and closing capacity. Alcoa, alone, has already reduced its smelting capacity from ~4.5 to ~3.0 mm tons.9 With ~6% demand growth expected for the current decade, helped along by emerging markets and increased usage in the aerospace and auto industries, we kept researching.
We studied their competitive position, understanding relative strengths vis-a-vis competitors, customers and suppliers. We looked closely at Alcoa’s and Norsk Hydro’s businesses, financials, free cash flow, and the capabilities of their management teams (particularly their capital allocation decisions). We ultimately determined that these companies met our hurdles and represented a commercial opportunity. Our estimates of what might eventually happen look like this – although it may or may not play out this way or could but for different reasons than we think.
Talking about these two companies as if they’re synonymous does each a disservice. There are distinctions in business lines, geography and management. Norsk Hydro is more a pure play on the aluminum supply chain, while Alcoa has a hidden gem in its high-margin, high-return on capital Engineered Products Solutions business. However, we did feel that this abbreviated view would serve to illustrate how we decide what to work on and how we begin to understand a business and industry.
Jardine Matheson (SGX:J36) & Jardine Strategic (SGX:J37)
Crescent Co-Portfolio Manager Mark Landecker profiled our investment in the “Jardines” at our FPA Investor Day. These Hong Kong-based holding companies can trace their roots back to 1832 and the founding family remains in control and continues to manage and shepherd the growth of these sister entities.
About 80% of the value of our estimate of the net asset value (NAV) of the Jardines is comprised of the following listed companies: HK Land, Mandarin Oriental Hotels, Dairy Farm, Jardine Lloyd Thompson and Astra. We discussed the merits of the largest of these businesses at our recent Investor Day.
As is typically the case, one often needs a little bit of market distress or company specific hair to buy a high-quality business at an attractive price. In the case of the “Jardines”, we got a bit of both earlier this year. The hair is the convoluted cross-shareholding structure that is confusing and requires some mental gymnastics to figure out what you are actually buying. Although he walks around our office barefoot at times, we don’t know if Contrarian analyst Chris Lozano will ever be mistaken for an Olympic gymnast, but he did gold medal work in disaggregating the financial statements of the various holdings so we could figure out what we were paying for this fine collection of businesses.
Throw in a small emerging-market selloff earlier this year and we had the ingredients to purchase what we viewed as a compounder with high-quality assets, an unlevered balance sheet and a long-term, owner-operator management team at the helm for a reasonable multiple of 12x earnings. On an NAV basis, this equated to discounts of 37% for Jardine Strategic and 28% for Jardine Matheson, respectively, with Strategic being our larger holding due in large part to the greater discount.
Thanks to its management’s excellent stewardship, Strategic has grown its equity/share at a 22% rate over the past decade, more than 2x the 10% rate of the far better-known Berkshire Hathaway. We don’t know what the future holds but we think putting them in the same sentence as Mr. Buffet’s company is not unreasonable.
Early in the year, we began to focus on Russian companies as many global businesses seemed reasonably priced. We ultimately settled on a commodity basket that we could buy if and/or when its
stock market sold off. We chose commodity companies because their dollarized revenue stream limited exposure to the ruble, which is expensive to hedge. Furthermore, these businesses account for 25% of Russia’s GDP and 50% of the country’s governmental revenue so it’s clear they are of critical importance to the state. We also believed that there was some ability to mitigate U.S. sanctions as the underlying asset is globally traded.
When Russia “annexed” Crimea, we had our opportunity. The companies in our basket traded at huge discounts to their global peers and, despite low-payout ratios, had dividend yields that were much higher than their P/Es. The average P/E of the basket at purchase was less than 4x current year consensus estimates while the average current dividend yield was greater than 5%. We appreciate the risk of investing in a country with a complex, authoritarian political system and that our upside could potentially be taken by the government, but we also believe that the prices at which we purchased these securities were sufficiently discounted to offer an asymmetric risk/reward that was skewed in our favor.
A recent headline from credit research firm CreditSights illustrates the current state of the high-yield market: “Five Attractive 5+% Yielding HY Bonds.”12 Well, we guess one can be thankful there are at least five.
We continue to see no reason to participate in lower-grade corporate debt. We would also note that just because corporate bonds aren’t attractive doesn’t mean stocks are by default as we have seen some argue.
We have not historically participated in the sovereign debt market but it’s worth noting that investors are willing to lend money to a host of countries with fiscal and social challenges at surprisingly low rates. As examples of risk/rewards we will not accept: Spanish and Greek 30-year bonds offer a yield of 4.0% and 6.5%, respectively, and recently Mexico was able to sell a century bond (100 year maturity) with a 5.75% yield-to-maturity.13
Since we can't will the world to unfold in a fashion to benefit your portfolio, although we’ve tried, we instead try and maintain a level head in the most uneven of moments. Thanks to a constant philosophy and clear process, we believe we are well-positioned to execute on our Contrarian Value Strategy. If we continue to keep our head down and play our game, we believe we’ll continue to find good investment opportunities that meet our strict value parameters, exemplified by the 8 new positions bought in the Fund in the first half of this year.
Branch Rickey, former baseball player, manager, and executive, once said that “Things worthwhile generally don’t just happen. Luck is a fact, but should not be a factor. Good luck is what is left over after intelligence and effort have combined at their best…Luck is the residue of design." Like Branch, we expect that our design will create our luck.
Steven Romick (Trades, Portfolio)
July 25, 2014