As you are well aware, stocks around the world declined on the back of the COVID-19 pandemic in the first quarter. Most businesses were ill-prepared for what was a near simultaneous and instantaneous shut-down of the global economy that swiftly destroyed supply and demand.
The stock market extended its long advance well into the beginning of the quarter – and then the correction hit like a Category 5 hurricane, entirely erasing (at least temporarily) those historic gains and then some. From peak to trough during the quarter, both the MSCI ACWI Index and the S&P 500 Index declined about 34 percent, while the FPA Crescent Fund (“Fund”) declined 29 percent.1 For the S&P 500, this was the steepest decline of 30 percent or more in history, occurring more quickly than what previously were historic declines in 1929, 1931, and 1934.
When all was said and done, the global MSCI ACWI Index fell 21.37% and the domestic S&P 500 Index dropped 19.60% in the first quarter. The Fund declined 20.51% in the quarter, roughly matching the first-quarter average decline of 20.49% of those two comparative equity indices.
On an early first quarter conference call on March 27, we offered our thoughts on portfolio positioning, including information about recent purchases and existing holdings, the Fund’s performance, the economy and answers to shareholder questions. In the service of efficiency, we have attached our prepared remarks and subsequent Q & A for your review. We do, however, want to reiterate three points we hope our investors took away from that call.
First, the world isn’t coming to an end. The impact on the Fund is largely a mark-to-market exercise in the midst of the most unsettling series of events that many of us have ever experienced. We appreciate that it is unpleasant to have your portfolio decline in price – though not necessarily in value – and to share in a downside at the higher end of the Fund’s historical performance. With the companies we owned and the cash we held, we believed we were well-positioned for a normal to deep recession. We were certainly unprepared for the near instantaneous and simultaneous global destruction of supply and demand wrought by COVID-19.
Second, we put almost 30 percent of the Fund’s cash to work during the quarter, with its cash position shrinking to 26% of the portfolio from 36%. We added more than a dozen new holdings and are genuinely happy with what we own overall, although we are not yet eager to get fully invested.
Lastly, we believe Crescent’s portfolio of securities at the end of this tumultuous quarter is attractive and interesting. As a result, your portfolio managers have recently increased their own investment in Crescent and continue to have the largest portion of their invested net worth in FPA’s strategies alongside our firm’s clients.
Market cycle perspective
We have often expressed the need to judge a manager over full market cycles, and so it is worth noting that we are still in the market cycle that started in 2007 as we can’t yet confirm that cycle has ended.2 As of April 30th, the market had recovered much of its losses and was only down about 8.5 percent for the year.3 In short, we are not in a “bear market” yet, and it is too soon to tell if the cycle, let alone the correction caused by the pandemic, is truly over.
Our honest assessment of what your managers have delivered for Fund investors during this extended cycle is mixed. Importantly, though, we did accomplish our goal of delivering equity-like rates of return with less risk than the market.
From October 10, 2007, when the previous market cycle peaked, to March 31, 2020, Crescent returned 4.60%, which is below the S&P 500’s 6.34% return but above the MSCI ACWI’s 2.51% return. The average of the two comparative indices was 4.42% over that same time period. 4
Periodic losses are inevitable, but only rarely did the Fund experience a permanent impairment of capital. Returns can be driven as much by what you own as by what you do not own. Crescent’s focus on good businesses with a wind at their backs rather than in their faces has protected it from getting caught in value traps, or in businesses that are statistically inexpensive for a reason, typically because they haven’t much in the way of prospective growth. Even taking into account Crescent’s increased downside capture year-to-date, the Fund has since 2007 delivered on average less than 70 percent of downside capture whenever the equity market corrected more than 10 percent and about 70 percent of the volatility. Finally, and crucially, we have delivered an equity-like return over this cycle with an average of just 63% of the Fund’s capital at risk.
Given how unsettling the recent market decline was, we think it is important to unpack the Fund’s performance. Crescent captured about 86 percent of the stock market’s downside during the dip in February and March, exceeding its 68.9% average net risk exposure. This was largely due to two factors: investments made as the market fell and certain holdings more meaningfully affected by the pandemic.
The Fund significantly increased its net risk exposure as we leaned into price weakness, which explains roughly 35 percent of the Fund’s decline relative to the 64% net risk exposure at the start. Increasing investment during stock market declines is consistent with our practice during every major drawdown since 1994 – we tend to get a bit greedy when others are fearful. Had we done nothing during the drawdown, the Fund’s net risk exposure would have dropped to about 42 percent. Contrarily, we took net risk exposure to 74% – an increase of about 1000 basis points in less than a month. In comparison, during the 2008/09 downturn, it took about a year to increase net risk exposure by a similar amount.
Some of the companies in the Crescent portfolio declined significantly more than the market during the sudden recent collapse. Its five worst performers explain about 40 percent of the Fund’s performance relative to its exposure. As of March 31, we continue to own all the companies referenced in the portfolio section below and discuss in the transcript. The three main industries and/or companies that detracted most from performance – but whose stories have yet to be written – are: banks, particularly Citigroup (C, Financial) and Wells Fargo (WFC, Financial); Howmet Aerospace (HWM, Financial) (formerly Arconic); and, American International Group (AIG, Financial). In short, the dents in the Fund were not the result of any permanent impairments of capital but rather because we stuck to our process.
We hosted our first quarter conference call on March 27, somewhat earlier than normal, to answer shareholder questions and to provide an update on many topics, including the Fund’s positioning; our thoughts on newly purchased and existing holdings, and recent performance and the economy. Please refer to our prepared remarks and Q&A available here, in a lightly edited version of the transcript of the call.
The world has changed over the last couple of months and with it, stock prices. There is no question that emotion drove much of the share price movement. Businesses owned by the Fund may have seen their stock value move 25% day-to-day, or even intra-day, but we can assure you that their business value did not similarly change.
Contributors to and detractors from the Fund’s trailing 12-month returns are listed in Exhibit B.
One reason we are excited about the portfolio right now is the compelling valuation of the banks that we own, equal to 6.8% of the Fund, even after accounting for a potentially prolonged recession. Banks in the S&P 500 Index trade at some of the lowest valuations since either the financial crisis from 2008 into 2009 or the savings-and-loan crisis in the early 1990s. In general, banks not only have better loan portfolios today than they did in those crises, they also have capital ratios, or tangible equity-to-assets, two to three times greater than before the last recession.7 The banks held by the Fund trade at an average 40 percent discount to book value. Assuming no growth and permanently reduced returns on tangible equity due to lower interest rates and/or upcoming loan write-downs, we believe these banks should still be able to generate in the neighborhood of a 10 percent return on tangible equity in a downside case. At just 0.6x book value, that equates to an owner earnings yield of 16.7%. We find this valuation math to be undemanding and therefore appealing.
During the initial market decline, AIG (AIG, Financial) sank more than 60 percent, dramatically underperforming its peers in what we believe will prove to be an overreaction. Life insurance companies were down 40 percent to 50 percent while their property and casualty, or P&C, peers were down 20 percent to 30 percent. 8 Our conviction in AIG stems from several factors. We do not think its life insurance business, which accounts for 40 percent of premiums, will be overly affected as we are thankfully seeing a flattening of the COVID-19 infection curve. Its P&C business, generating about 60 percent of premiums, does not cover pandemics. Some states have said they may try to force coverage of pandemics, but we are confident the U.S. Constitution does not allow such a retroactive revision. There also is a case to be made that reduced activity around the country will lower P&C claims. We believe that AIG has earnings power in the next few years of around $6 per share. Panicked selling caused its stock price to trade as low as an unchallenging 0.3 times tangible equity. We added to the Fund’s position in AIG on this weakness.
It’s important to remember that chaos creates opportunity. Like our Contrarian namesake, we do not shy from market sectors that others avoid, too paralyzed by uncertainty to act. In late March, we put a little over 2 percent of the portfolio into the travel space, specifically into well-financed companies that have a long enough runway to get through a temporary shutdown or even longer delay in travel-and-leisure spending. We purchased Booking Holdings (BKNG, Financial), or “Booking,” at what we believe are low double-digit multiples of enterprise-value-to-trailing earnings. We did not take this position, however, simply because it was trading at a low multiple of our estimate of trailing or normalized earnings. Instead, Booking attracted us with, in our view, the long-term strength of its business and a strong balance sheet with net cash, further complemented by several billion dollars of investments in various securities. We also expect Booking to pare its expense structure, albeit with some lag, to protect profitability. We believe those attributes should more than sufficiently ensure that Booking emerges from the other side of this pandemic in a stronger position than its poorly financed peers. Regardless of what the new normal looks like, we are highly confident that Booking, with excellent stewards of its business and capital at the helm, will emerge as a profitable company generating excellent free cash flow.
We also took advantage of market weakness to add more than a dozen new positions in companies that have sat for years on our wish list and whose stock price declines finally afforded us appealing opportunities to buy.
The long view
We enumerate below some significant drivers of performance relative to the indices over the last decade. The Fund has met its objectives despite certain headwinds, and in the future, some headwinds may turn into tailwinds. We have not, however, positioned the portfolio to depend on the direction of the wind.
- We are value managers, which to us simply means making an investment that has an appropriate margin of safety. Traditional value investors have sought such protection in a company’s balance sheet. We prefer a margin of safety more predicated on the quality of the business – its returns on capital; the defensibility of its market position; pricing power; good management, and future top-and bottom-line growth potential among other attributes. Since value received for a price paid does matter to us, we have all too frequently found ourselves not owning businesses priced to perfection and then some during this unprecedented market cycle. 9
Growth stocks have reigned supreme for a long time, and we have held positions in growth businesses like Alphabet (GOOG, Financial) and Facebook (FB, Financial) (that were initially purchased when the market thought less of their investment merits). These have allowed us to perform reasonably well relative to our value investing peers. 10 More traditional value names that are more cyclical on average have not performed as well, however, including the aforementioned banking and aerospace investments.
Growth’s outperformance of Value has left Value appearing relatively inexpensive (Exhibit C). This cannot continue unabated unless Value fails to deliver even a modicum of growth. The Fund should benefit from some reversion to the mean to the extent that it holds positions that are clearly Value names.
- Quality and low-volatility indices have outperformed for much of the last decade, pushing prices to valuation levels too high to give us comfort that there are reasonable margins of safety (Exhibit D). Such indices have historically been populated by less cyclical businesses. We are quite comfortable with growing cyclical businesses as long as we are paying an appropriate price for them. Just because some of these prices are lower today than when we made our purchases does not mean we overpaid, although they are certainly more “appropriate” today than they were. As
Warren Buffett (Trades, Portfolio) has said, “I would much rather earn a lumpy 15 percent over time than a smooth 12 percent.” 12
Many businesses of historically high quality but very low earnings growth now trade at price-to-earnings ratios exceeding 20 times, including many consumer product companies. Investors are currently more comfortable paying for the perceived stability of an earnings stream regardless of price. Paying a rich multiple for such a business, however, might prove no different than buying a long-dated bond at a yield that approaches zero.
- On average, foreign stocks have underperformed domestic stocks in local currency and, thanks to U.S. dollar strength, even more so in dollars. This has caused the Fund to look suspect when compared to a U.S. benchmark only. On the other hand, it appears more than competent in comparison to international benchmarks. How we have done in recent years has become a matter of geographic perspective.
There are many wonderful businesses domiciled outside the United States with characteristics similar to their U.S. counterparts yet trading at discounted prices. The Fund’s exposure to these companies has therefore increased from 20.3% at year-end 2017 to 37.2% today. Should investors once again become willing to pay similar valuations for similar businesses regardless of geography, then the Fund’s exposure to international stocks should deliver nice returns.U.S. dollar strength also has proven a headwind for the investor in foreign securities. In dollar terms, the MSCI ACWI’s return is 0.84% lower than the return in its local currency during the current market cycle. Should the dollar weaken, the Fund’s foreign exposure should look better still in dollar terms.15
- High-yield bonds have offered very poor yields in recent years, and there has been no distressed cycle since the 2008-2009 downturn. The paltry yields of the sector have kept us away. Simply because we can invest in an asset class doesn’t mean we should. Nevertheless, not owning much in high yield has hurt performance as interest rates kept going down and risk spreads narrowed, despite increasing corporate leverage, declining average credit quality, and weaker covenants for borrowers. That has finally started to reverse.
We believe that now is the time to begin to seek ideas in the universe comprised of the overleveraged and economically challenged. Never mind that the Federal Reserve is buying corporate debt for the first time – and even some recently downgraded, less-than-investment-grade debt – we strongly expect a spate of restructurings to bring opportunities.
- Cash had accumulated in the Crescent portfolio as a result of finding few attractive risk/reward propositions. This mattered more in this market cycle than the previous cycles for two reasons: One, the current market cycle is the longest in history, so standing on the sidelines caused us to look more foolish than we believe we are; and two, when cash did build prior to 2008, we had the benefit of receiving attractive returns on our cash, something that has not existed during an era of low and lower short rates.
There are two reasons that you can expect us to act differently and run with less cash going forward.
For one, cash offers an even lower yield than at the beginning of the last market cycle. Governments cannot afford to let rates rise, particularly in the wake of the deficits being created by the massive support packages to mitigate the economic impact of COVID-19. We believe central banks and sovereign treasuries will do everything in their power to keep rates low. U.S. government debt will shortly exceed $25 trillion and is increasing at such a rate that the debt-to-GDP ratio will hit a level not seen since World War II. Even excluding $6 trillion of intragovernmental holdings, the country still has $19 trillion of debt. At that level, even a 1% increase in rates would increase the U.S. deficit by $190 billion for that year – and that doesn’t consider continued growth of the U.S. national debt, which most certainly and dramatically will happen in the coming months, if not years.
For another, we have posited over the last decade that we would eventually find ourselves on a deflationary path to inflation. Up to this point, governments have kept the economic party going, thanks in part to expansive fiscal and monetary policy. We thus expected more of the same when the next downturn hit. Given the suddenness and magnitude of this recent economic decline, however, the U.S. government felt obliged to act in an unprecedented (and unproven) fashion. The economy is the lab, apparently, and we the people its rats. The worse the economy, the greater the stimulus; and the longer the downturn, the longer the presses print money, which we suspect will eventually lead to inflation. That inflation may not be broad-based and may yet occur even amid general economic malaise – remember stagflation? – but stocks may nonetheless perform well nominally as there may be little alternative.
Our investors should be keenly aware that we will likely operate with less cash in the future, which will likely increase the Fund’s volatility. Crescent’s lower volatility has always been a by-product of our strategy, not a goal. We will nonetheless aspire to avoid any permanent impairment of capital and not be bothered with the ephemeral, and usually visceral, mark-to-market that investments we own might have during their life-cycle in the Fund.
- Crescent often is compared to balanced mutual funds, which typically run 60 percent stocks and 40 percent investment-grade bonds. Balanced funds generally hold growth stocks, and in addition, these funds have enjoyed a major tailwind boosting performance as bond prices have risen in lockstep with declining interest rates. The rate on a U.S. government 10-year bond declined from 5.3% to 0.5% since 2007, helping the Bloomberg Barclays US Aggregate bond index return 4.8% over that time. 18
Balanced Funds, with their large dedication to investment grade bonds, will likely find the future more challenging. Yes, the tailwind of declining rates is unlikely turn into a headwind of rising rates, but for the bond portion of a balanced fund’s portfolio to have as bright a future, the 10-year bond would have to fall to a negative 3 percent return. That is an uncomfortable bet to make. Additionally, we expect some corporate bonds currently considered investment grade will end up as junk bonds.
We are excited about the opportunities that we believe are destined to come our way. Let us consider how the six points mentioned above, which were relative headwinds in the last market cycle, could become tailwinds in the near future.
It’s a bit surprising that from where we are today, the market is only off 13 percent from its February peak.19 The world today is more than 13 percent worse than it was then, but the more pertinent question is what the future will look like. As emotion is wrung from the stock market, it tends to look forward to what the economy looks like on the other side of a virulent downturn.
Eventually we will have a COVID-19 vaccine that will also boost our ailing economy. Additionally, central banks are unlikely to raise interest rates for years to come – how many countries can afford to pay a higher rate for their burgeoning national debt? With those two things in mind, it is difficult to act as your fiduciary and not become more invested over time, largely in equities with some high-yield and distressed debt. Cash just won’t produce the return to which we collectively aspire. For better or for worse, we believe central banks have set the stage for inflation in risky assets, and since we can’t tell you when the show starts, we have to be in our seats in advance. If we successfully find a sufficient number of investments with attractive risk-to-reward ratios, this may mean greater volatility – but we see little alternative as we look out five to 10 years.
Our philosophy hasn’t changed, and our strategy, although evolved, remains largely unaltered. Sometimes you don’t appear as smart as you are, and other times you look much smarter than you actually are. As we continue to focus on delivering good, risk-adjusted returns, we suspect our clock will be right more than just twice a day.
We appreciate your trust and patience. While unsettling, we hope for continued volatility in the equity and credit markets as we would love nothing more than to become even more fully invested. From all of us at FPA, we hope you and your family are safe and healthy.
May 8, 2020
- Market peak was February 19, 2020 and the trough was March 23, 2020.
- Please see our market cycle white paper for more information: https://fpa.com/docs/default-source/default-document-library/2015-04-29-market-cycle-performance-final.pdf?sfvrsn=2.
- For simplicity we reference the S&P 500 as the ‘market’.
The MSCI ACWI was not considered a relevant illustrative index prior to 2011 because the Fund was not classified as a global mandate until this point in time. Market Cycle performance for MSCI ACWI is being shown for illustrative purposes only to illustrate how global equities have performed in the current market cycle.
Source: FPA, as of March 31, 2020. Reflects S&P 500 market cycles. Lower volatility is represented by standard deviation. Capital at risk is represented by the Fund’s average net risk exposure over each time period. Largest S&P Drawdowns were during the following periods: Since Inception and Market Cycle 2: (10/10/2007-03/09/2009); Market Cycle 1: (09/02/2000-10/09/2002).
- Reflects the top five contributors and detractors to the Fund’s performance based on contribution to return for the trailing twelve months (“TTM”). Contribution is presented gross of investment management fees, transactions costs, and Fund operating expenses, which if included, would reduce the returns presented. The information provided does not reflect all positions purchased, sold or recommended by FPA during the quarter. A copy of the methodology used and a list of every holding’s contribution to the overall Fund’s performance during the TTM is available by contacting FPA Client Service at [email protected] It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities listed.
- Source: Bloomberg, as of March 31, 2020.
Source: Bloomberg, as of March 31, 2020.
- FPA Crescent Fund Commentary 2017 – Q4; https://fpa.com/docs/default-source/funds/fpa-crescent-fund/literature/quarterly-commentaries/fpa-crescent-fund-commentary-2017-q4.pdf?sfvrsn=6.
- Source: Morningstar. As of March 31, 2020. Past performance is no guarantee of future results. Refers to Fund performance relative to the “US Fund Allocation--50% to 70% Equity” and “US Fund World Allocation” Morningstar categories over the period between October 10, 2007 and March 31, 2020. The “US Fund Allocation--50% to 70% Equity” category seeks to provide both income and capital appreciation by investing in multiple asset classes, including stocks, bonds, and cash. The “World Allocation” category seeks to provide both capital appreciation and income by investing in three major areas: stocks, bonds, and cash. While these portfolios do explore the whole world, most of them focus on the U.S., Canada, Japan, and the larger markets in Europe. There were funds in these categories reporting performance for this period.
Source: Bloomberg, as of March 31, 2020. Chart data covers period March 31, 1995 to March 31, 2020. Uses the z-score of the ratio of the Russell 1000 Growth Index divided by the Russell 1000 Value Index.
- Warren Buffet on Business: Principles from the Sage of Omaha, p72, Richard J. Connors, ©2010.
- Source: J.P. Morgan U.S. Equity Strategy: Style Positioning, Value Squeeze, Winner Takes All, p4, as of April 3, 2020. “LowVol” is represented by JPM’s quantitative group metrics. Market is represented by the S&P 500 Index. Chart data covers period December 31, 1986 to March 31, 2020.
- Source: Factset, as of March 31, 2020. Data is represented by the respective indices in the charts.
- For the period 10/10//07 to 3/31/20, the MSCI ACWI (USD) returned 2.49% annualized; while the MSCI ACWI (Local) returned33% annualized.
Source: Federal Reserve Bank of St. Louis, Bloomberg, as of March 31, 2020. Chart data covers period March 31, 1998 to March 31, 2020. High Yield bond market data is represented by ICE BofA US High Yield Index.
- Source: Federal Reserve Bank of St. Louis, as of September 30, 2019. 2020 year-end projection is calculated by adding at least $4 trillion to the Gross Federal Debt levels and estimating that GDP will be 5% lower than at September 30, 2019 levels.
Source: Morningstar. The US Government 10-year bond yield peak and trough dates were June 12, 2007 and March 9, 2020, respectively. Return for the Bloomberg Barclays US Aggregate Bond Index is annualized between those dates.
- Source: Bloomberg, as of April 30, 2020. Market refers to the S&P 500 Index. The S&P 500 Index peak was on February 19, 2020.
This Commentary is for informational and discussion purposes only and does not constitute, and should not be construed as, an offer or solicitation for the purchase or sale with respect to any securities, products or services discussed, and neither does it provide investment advice. Any such offer or solicitation shall only be made pursuant to the Fund’s Prospectus, which supersedes the information contained herein in its entirety. This presentation does not constitute an investment management agreement or offering circular.
The views expressed herein and any forward-looking statements are as of the date of the publication and are those of the portfolio management team. Future events or results may vary significantly from those expressed and are subject to change at any time in response to changing circumstances and industry developments. This information and data have been prepared from sources believed reliable, but the accuracy and completeness of the information cannot be guaranteed and is not a complete summary or statement of all available data.
Portfolio composition will change due to ongoing management of the Fund. References to individual securities are for informational purposes only and should not be construed as recommendations by the Fund, the portfolio managers, the Adviser, or the distributor. It should not be assumed that future investments will be profitable or will equal the performance of the security examples discussed. The portfolio holdings as of the most recent quarter-end may be obtained at www.fpa.com.
Investments, including investments in mutual funds, carry risks and investors may lose principal value. Capital markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. The Fund may purchase foreign securities, including American Depository Receipts (ADRs) and other depository receipts, which are subject to interest rate, currency exchange rate, economic and political risks; these risks may be heightened when investing in emerging markets. Foreign investments, especially those of companies in emerging markets, can be riskier, less liquid, harder to value, and more volatile than investments in the United States. Adverse political and economic developments or changes in the value of foreign currency can make it more difficult for the Fund to value the securities. Differences in tax and accounting standards, difficulties in obtaining information about foreign companies, restrictions on receiving investment proceeds from a foreign country, confiscatory foreign tax laws, and potential difficulties in enforcing contractual obligations, can all add to the risk and volatility of foreign investments.
Small and mid-cap stocks involve greater risks and may fluctuate in price more than larger company stocks. Short-selling involves increased risks and transaction costs. You risk paying more for a security than you received from its sale.
The return of principal in a bond investment is not guaranteed. Bonds have issuer, interest rate, inflation and credit risks. Interest rate risk is the risk that when interest rates go up, the value of fixed income securities, such as bonds, typically go down and investors may lose principal value. Credit risk is the risk of loss of principal due to the issuer’s failure to repay a loan. Generally, the lower the quality rating of a security, the greater the risk that the issuer will fail to pay interest fully and return principal in a timely manner. If an issuer defaults the security may lose some or all of its value. Lower rated bonds, callable bonds and other types of debt obligations involve greater risks. Mortgage-backed securities and asset-backed securities are subject to prepayment risk and the risk of default on the underlying mortgages or other assets. High yield securities can be volatile and subject to much higher instances of default. Derivatives may increase volatility.
Value securities, including those selected by the Fund’s portfolio managers, are subject to the risk that their intrinsic value may never be realized by the market because the market fails to recognize what the portfolio managers consider to be their true business value or because the portfolio managers have misjudged those values. In addition, value style investing may fall out of favor and underperform growth or other styles of investing during given periods.
In making any investment decision, you must rely on your own examination of the Fund, including the risks involved in an investment. Investments mentioned herein may not be suitable for all recipients and in each case, potential investors are advised not to make any investment decision unless they have taken independent advice from an appropriately authorized advisor. An investment in any security mentioned herein does not guarantee a positive return as securities are subject to market risks, including the potential loss of principal. You should not construe the contents of this document as legal, tax, investment or other advice or recommendations.