We closed our first quarter letter with the observation that economies were worse than stock indices might suggest. What we thought true then is only more true today, yet in the second quarter, the market made one of its larger quarterly moves.
The global MSCI ACWI Index advanced 19.22% in the second quarter, while the domestic S&P 500 Index increased 20.54%, erasing the majority of the year-to-date decline to March’s trough. The FPA Crescent Fund (“Fund” or “Crescent”) increased 15.00% over the same period.
Long equities held by the Fund returned 22.29% and -13.11% in the second quarter and six months, respectively, performing better than the MSCI ACWI and S&P 500 indices for the quarter.1 Including a small amount of other risk assets and cash it held, the Fund generated 75.5% of the market’s return in the second quarter (where “market” is the average of the 2020 second quarter returns for the MSCI ACWI and S&P 500 indices) but slightly underperformed its own risk exposure of 76.7%, on average, during the quarter.2
We would have thought that a global pandemic, social disturbances, extreme political polarity, and all that has accompanied those trends would have created more fear – or at least caution – in global markets. Yet stock markets and debt markets are up around the world, and in many cases, way up. Koyantsqatsi, a word used by the Hopi Native American tribe to describe a life out of balance, is as apt a description for this disconnect as any.
At the beginning of the year, the global economy was expected to grow 2.5% this year, but thanks to COVID-19, that outlook has darkened significantly and the consensus view now looks for a -5.2% contraction.3 Although you wouldn’t know it from the popular indexes, this darkened outlook has pushed the average stock down 10.92%.4 Economic data suggest we won’t return to normal in the near future (see Exhibit A).
In March, we were particularly concerned with the high COVID-19 transmission and fatality rates and what a “closed” global economy might look like. Rightly or wrongly, that influenced our judgment. Securities were on sale and we went shopping, but we could have bought even more. There is no lesson here; as presented with the same facts, we would do the same thing again. This coronavirus has delivered less death than initially anticipated, but we are far from done with it, hitting new highs in daily infections almost every day.
We never believed COVID-19 posed existential risk to the global economy, confident that we will eventually reach the other side as we always do. But we still do not know how bad things might get along the way. The world remains, as always, uncertain, though uncertainty has narrowed for now. The left tail of the probability distribution has flattened from what we expected.
Although stocks are still expensive, the portfolio was cheaper to assemble, and we believe the companies in it have more growth and better balance sheets than the stock market overall. In an uncertain world, this gives us some margin of safety, particularly since governments seem willing to do anything to resolve the crisis, including keeping interest rates low or even negative, printing money, giving money away, and making loans that can be forgiven.
In our last letter, we commented on the six headwinds faced over the last market cycle and our belief that they could become tailwinds in the near future. They are worth repeating here, though the details can be found in our first quarter commentary.
- Value vs growth
- Low volatility vs high volatility (or business quality perception differential)
- United States vs. international
- High-yield window of opportunity
- Interest rates
Whether the stock market buying spree is driven by need (given the lack of an alternative) or greed, the result is the same. Investors are showing a willingness to look across a deep chasm and accept a sanguine view of the future for many businesses, particularly those in the tech space. However, prices for high quality businesses have not fallen to levels we might have hoped. And thanks to unprecedented U.S. government involvement in the country’s corporate debt markets, high-yield bonds also have not presented the opportunity that one might have expected. This story, however, is far from written.
Contributors to and detractors from the Fund’s trailing 12-month returns are listed below.
As is clear from the above, the Fund’s investments in the tech sector have continued to outperform its more traditional value investments. While we own a number of high-quality growing businesses that trade at reasonable valuations, it seems no price is too high for some “quality” stock, and no price is too low for lower quality ones. Similarly, growth can’t be expensive enough, nor value cheap enough.
We have come across a number of references made to work done by Empirical Research that identified 75 large-cap stocks with great growth characteristics. Looking back to the 1950s, that firm has not seen a period as expensive as the current – at 66 times forward price-to-earnings (“P/E”) estimates, and the highest relative P/E multiple for these 75 names when compared to the rest of the large cap market. This is not to suggest that these companies are bad (although, approximately 30 percent of them do lose money).12
A lot must go right in the future for such companies to justify their current valuation. Conversely, a lot would have to go incredibly wrong for many of the value stocks that have been left behind in this bull run to prove to be unreasonable investments in the future.
Investors have found comfort in those businesses that have a less volatile earnings stream, for instance, consumer products companies selling staple goods, and have recent and seemingly great future prospects, such as a Netflix (NFLX, Financial) or Tesla (TSLA, Financial). We believe there is better opportunity in the uncomfortable, where the short-term is more challenged but with respectable long-term prospects, like industrial, travel and leisure and hospitality, and foreign-based companies. Given the Fund’s avoidance of more richly priced companies, we believe this dichotomy should position the Fund well for the future.
It is not the first time that our style of investing has been so out of favor. As shown in Exhibit C below and based on consensus earnings projections at that time, Crescent’s equity portfolio has remained attractive relative to the market over the past year.13 Crescent’s equity portfolio had better earnings-per-share (“EPS”) and book value than the indices, while achieving higher historic and forecasted EPS growth. Over time we would expect the relationship between valuation and growth to support improved performance, but, of course, we can make no guarantees and the disconnect may continue to try our patience. Relative to the indices, Crescent’s equity holdings continue to trade at a significant discount on forward P/E and Price/Book. One might suggest that the growth rate of the companies held by the Fund is lower, but as you can see in Exhibit C, both the trailing and forecasted consensus 3-year EPS growth is higher than the market. There are a number of puts and takes that make these Wall Street consensus numbers far from precise, but directionally, suggests that Crescent’s equity portfolio is (and has been) less expensive than the market and the earnings growth potential of its underlying companies is at least as good if not better than the market as one looks through the economic cycle.
We remain intent on preserving capital and purchasing power over time, though we acknowledge that the Fund’s current risk exposure represents a greater concern for the former. We can understand why price volatility and increased equity exposure may feel incompatible with this goal, but we think that it makes sense to increase the Fund’s exposure to an equity portfolio with the characteristics of Crescent as depicted above. We continue to like the optionality of cash, but given the increase of the global money supply and an expressed commitment by central bankers to hold rates near zero, we are reluctant to hold too much dry powder.
If we consider the equity portfolio as depicted in Exhibit C, it trades at a 5.2% earnings yield (earnings/price) on depressed COVID numbers. Assuming the consensus earnings growth of 18.9% over the next three years, then the prospective earnings yield will have increased to 8.8%.15 If we then assume a more pedestrian 4% growth for the rest of the decade, our equity portfolio would trade at 11.5% yield in Year 10, and we will have earned a 2.2% dividend along the way, or approximately 20% of your capital, assuming no increase in dividends. If instead one were to buy a 10-year bond at 0.66% yield, in 10 years you’d have collected 6.6% of your capital pre-tax and have the option to reinvest in whatever the opportunity set might be at the time. Framed over the long-term, the Crescent equity portfolio’s earnings and dividend yields appear superior to the bond and cash markets. So we have chosen to accept a bit more volatility in exchange for the opportunity for a better longer-term return on capital. We believe when global economies recover, investors will appreciate the merits of many of these unloved companies with deeply discounted valuations compared to the market. People will again stay in hotels, and Marriott (MAR) will be there to accommodate them. The cruise industry will not disappear, as vacationers will once again set sail (though the industry could suffer more than the hotel business). During the downturn we therefore established a position in Marriott stock but opted to retain our perch atop the capital structure in the cruise industry, purchasing senior secured loans of Carnival Cruises (CCL, Financial) and Royal Caribbean (RCL, Financial) at close to 12 percent yields.
For the most part, our more significant 2020 purchases were in companies hurt in this economic downturn, in many cases quite severely. Expectations have changed, but prices sank much more than those expectations changed. Looking toward an eventual economic recovery, we believe these recent investments – LG Corp (XKRX:003550, Financial), Swire Pacific (HKSE:00019, Financial), Booking Holdings (BKNG, Financial), Marriott International, NXP Semiconductors (NXPI, Financial), Compagnie Financiere Richemont (XSWX:CFR) and Wabtec (formerly Westinghouse Brake Technologies), complemented by additions to many of the Fund’s existing holdings – will fare quite well and once again return to investor’s favor.
Whenever possible, we have traded lower quality businesses for higher quality ones for which growth, even if cyclical, should hopefully ensure a prosperous future. Owning higher quality businesses gives us the comfort to invest more over this next decade than previously.
We believe that irrational behavior has once again entered pockets of the market. We also believe that the Fund owns good businesses at good prices, though their stock prices appear dwarfed at the moment by the unnaturally levitating shares of businesses with unproven operating models.
Faith-based investing has a checkered history, whether it be blind faith in a charismatic CEO or in central bankers around the world. Having set zero-bound interest rates in most parts, central banks have successfully forced the move into riskier assets – but that has failed to translate into real economic growth. Those who started with an investment portfolio are generally wealthier, while those who did not are generally worse off. Central bankers have spiked the Kool-Aid punch bowl, widening by fiat the gap between the Haves and Have Nots.
Negative interest rates take money away from savers and lenders and give it to borrowers and investors, including speculators. In one shocking example, LVMH Moët Hennessy (XPAR:MC) – Louis Vuitton SE (“LVMH”) acquired Tiffany (TIF) for $16 billion, selling $10 billion of bonds to finance its purchase. Even the longest maturity of the bonds it sold, a tranche with an 11-year maturity, promised a yield of just 0.43%. As if that wasn’t stunning enough, the European Central Bank has snapped up about 20 percent of European bond issues that meet certain qualifications, which this new LVMH debt appears to meet. Two of the five LVMH tranches denominated in Euros were even sold with negative yields – in other words, the holders of these bonds are literally paying Berrnard Arnault, LVMH’s largest shareholder and the richest man in a country with historically left liberal leanings, to buy into a foreign-based luxury brand at a time when Covid-19 has vastly diminished consumer appetites. It’s no wonder we have found so few high yield bonds to put into our portfolio.
When money costs almost nothing, or even less than nothing, it perverts price discovery. If there is no cost of capital, then one theoretically can pay an infinite price for assets, which creates a difficult backdrop for investors such as ourselves who insist on a margin of safety.
The U.S. Federal Reserve and European Central Bank are doing their best to inhibit what should have been (and might hopefully still be) a historic opportunity to buy high-yield debt. But investors thirsty for yield, coupled with central bank purchase of high-yielding corporate bonds, has propped prices up at higher levels than they otherwise would be.
The pandemic has brought the global economy to its knees. How long it will take the economy to reopen and what the world might look like when the economy does revive remains in question. We believe there will be no high interest rates in the years to come. Governments have an imperative to keep rates low, if for no other reason than minimizing budget damage. As a result, a portfolio light on risk assets might be disadvantageous.
Crisis foments change, and a new economic order can translate into a new social order. Currently, there is movement in the United States to establish greater equality, racially and financially. The coming U.S. elections are a cipher at this point. It’s impossible to know which presidential candidate will win or what the ramifications might be if one were to remain in office or the other were to take over. We think the more significant variable could be the Senate races. If the Senate were to flip to the Democrats, we can expect higher personal and corporate taxes together with more generous and costly social programs -- and an attendant increase in Federal deficits and the U.S. national debt. This would likely put an even more significant crimp in our economy, and we don’t think the markets yet appreciate that. That, along with more attractive valuations outside the United States, further supports our continuing investment overseas.
We believe what one pays for a business shall guide returns. We will continue to prudently manage your portfolio.
None of us have seen anything like this, with so many businesses closed, people afraid to leave their homes, necessary socialization hijacked, and the loss of life. As Frodo said in J.R.R. Tolkien’s The Fellowship of the Ring, “I wish it need not have happened in my time.”
“So do I,” replied Gandalf, “and so do all who live to see such times. But that is not for them to decide. All we have to decide is what to do with the time that is given us.”
We wish everyone as well as can be during these extraordinary times.
July 30, 2020