Steven Romick's 1st Quarter Crescent Fund Commentary

Dear Shareholders:

As we pointed out in the Q4 2015 letter, the U.S. stock market was trading at a valuation previously seen at market peaks with price/earnings, price/sales and price/book multiples at levels similar to the highs of 2000 and 2007. At such elevated levels, it’s not surprising to see the market decline as it did intra quarter.

In Q1 2016, the FPA Crescent Fund declined 0.19%. In the U.S., the S&P 500 increased 1.35% while globally, the MSCI ACWI increased 0.24%.

There wasn’t any one position that added or detracted an unusual amount to or from the fund’s performance in the quarter. Winners contributed 1.66% while the losers detracted 1.71%.1 Market volatility can create the opportunity to build positions, as was the case in the first quarter when we purchased additional shares in each of the top five losers.

Investing

Our focus on delivering risk-adjusted returns causes us to follow our own path. This might be uncomfortable at times but, as Seth Klarman (Trades, Portfolio) wrote in a recent Baupost letter, "You don't become a value investor for the group hugs."2 We're not going to beat the market (nor meet our stated objective of delivering market rates of return with less risk) by investing the same way the market does. For instance, we won't ever have the same sector exposures as the market. Sometimes, we'll own a lot of financials - like we do now - but sometimes we'll own none. The sum total of this means that our returns, when compared to the market over short and intermediate periods, might differ wildly, possibly making us appear unusually smart or stupid.

Our equity exposure to financials has increased to 20.5%, up from a net negative exposure in 2008 and higher than the S&P 500’s current weighting of 15.6%. We seek the inexpensive and care not a whit about market weightings. Financials, particularly lenders, meet that hurdle. Citigroup, as an example, traded down to ~60% of tangible equity at one point in the first quarter. We believe tangible equity is pretty solid, even after assuming a higher level of charge-offs. Investors will frequently act as if they are still fighting their last war but the balance sheets of U.S. banks and thrifts are far stronger now than they were in 2008 when many financial institutions were wounded and close to dying.

On the eve of the global financial crisis, Citi (C, Financial) had just 3% tangible equity propping up its tangible assets whereas today, it has 10.5%, higher by a factor of more than three. Some of Citi’s loans will default and it won’t get full recovery in all cases. When we stress test its balance sheet and assume an unusually bad outcome for its loan book, its capital ratios remain solid. If half of its China, energy and metals & mining loans were to default this year and Citi recovered just 40 cents on the dollar, and if consensus earnings are correct, then Citi would still earn money this year and end 2016 with more than $60 per share of tangible book value and tangible equity to tangible assets of more than 10%. That would mean book value would actually increase despite the write-offs. We, therefore, thought Citi at a 40% discount to its minimum worth was a great risk/reward. We purchased additional shares in the midst of its Q1 downturn along with shares of other lenders that saw similar declines.

Shareholder Engagement

We strongly favor long-term, business-minded owners exercising influence and control over the companies in which we have an investment. Since the majority of American businesses are professionally managed (with different levels of capability), instilling an ownership culture is important. In a perfect world, all of our investments would be in such owner-oriented companies trading at bargain valuations. But we don’t live in utopia. We always have some investments in companies with imperfect governance and management teams. Sometimes, we buy into difficult situations because the price is compelling and sometimes, we buy into companies whose problems take time to unearth.

Pressure to deliver short-term performance frequently drives company executives to make suboptimal decisions. This is particularly true of managements and boards who lack either real ownership or, at the very least, an owner’s mentality. Not having any skin in the game increases the risk that a company’s managers will fail to improve its competitive position or, worse yet, misallocate capital.

When we are in an investment with governance or management challenges, we remind ourselves that investors can – and, in some instances, should – make their voices heard as owners to improve the situation. Such action has been termed “shareholder activism,” but we view it as being engaged as a shareholder.

Stereotypical activist tactics like delivering poison pen letters to boards and management and short-term financial engineering often produce ephemeral benefits. Real engagement by meaningful owners seeking to maximize long-term intrinsic business and per-share value tends to have longer-lasting effects. We are only interested in the latter approach, as we believe that dovetails with our desire to have an ownership culture in the boardrooms of companies in which we invest. Over the past number of years, the fund has benefited from the involvement of other constructive shareholders (“constructivists”) at a number of companies, including household names such as Microsoft (MSFT, Financial), General Electric (GE, Financial), Alcoa (AA, Financial) and AIG (AIG, Financial).

We believe large, long-term shareholders have a responsibility to constructively engage with the managements and boards of the businesses they own. An economically-interested party can hold management and its board accountable for operating and financial performance. Well-intentioned shareholders can educate and provide support for managers to help them make appropriate, longer-range decisions, even if those decisions might hurt earnings in the short term. The same shareholders might also aid those managers who find themselves dealing with a variety of competing interests that have nothing to do with strengthening the long-term competitive position of the business and maximizing value. For example, a retailer might be pushed to spin-off its real estate to boost short-term profits whereas decades from now, retaining ownership may have proved to be a competitive advantage that added value.

To varying degrees, we may engage with many of the companies we own, meeting regularly with executives to better understand their businesses and offer our views on strategy and capital allocation. We carefully evaluate proxy proposals and compensation plans and vote against them if appropriate. We have engaged with directors to encourage compensation plans that both properly incentivize management and align their interests with those of long-term owners. Ordinarily, we are just one of many voices in such a process and our influence may be limited. On occasion, however, our views have been embraced, helping lead to value creation.

We will continue to be constructively involved with a number of companies. While it is our strong preference to remain behind the scenes, we will not hesitate going forward to engage more publicly and to potentially use more vocal and/or traditional activist tools when we believe that an investment calls for owner-oriented involvement. Such future participation could take the form of SEC filings, proxy contests and board representation.

Availing ourselves of the tools to directly influence a company - if and when necessary - will help drive value in our portfolio.

Benchmark

The fund’s quest for value has increasingly taken us overseas, as our long standing shareholders are aware. Today, almost 30% of the Fund’s long equity exposure is foreign-domiciled, totaling almost half of the number of names in the portfolio.

We, therefore, consider the MSCI All Country World Index (MSCI ACWI) a pertinent additional benchmark in that it captures large and mid-cap companies across developed and emerging markets. The United States has the largest country weight of the index at 53.2%.3

The choice of the additional benchmark reflects our team’s growing capability to analyze and invest in overseas companies.

Conclusion

Emotion drives many, if not most, investors, particularly in periods of distress. People seem much more concerned with downside volatility than upside. Rare is the investor who complains, “My portfolio is up 30%. What the heck happened?” Emotion drives the mutual fund investor as much as it does the stock investor; the professional as much as the individual. We know that our asset levels will be higher or lower based in part on emotions but, as much as we want to, we can't control that. But thank goodness for emotions, because – aside from having to respond to those of our investors now and again – such visceral sentiment drives market inefficiencies and gives us the necessary opportunity to make money for our shareholders.

Respectfully submitted,

Steven Romick (Trades, Portfolio)

Portfolio Manager

April 27, 2016

1. Reflects the top contributors and top detractors to the Fund’s performance based on contribution to return for the quarter, as qualified by this footnote. The second largest detractor is a position for which the name of the issuer and of the issue is not required to be disclosed pursuant to Section 210.12-12 of Regulation S-X. Accordingly, we have excluded that position from the chart and presented the sixth largest detractor in its place. The top five losers including the undisclosed position detracted 1.91%.
2. Baupost 2015 year-end investor commentary.

3. As of March 31, 2016