Dear Shareholders:
Overview
The FPA Crescent Fund ("Fund" or "Crescent") gained 3.80% for the third quarter and declined -5.12% for the first nine months of 2020.1
The global MSCI ACWI Index ("ACWI") advanced 8.13% in the third quarter, while the domestic S&P 500 Index ("S&P") increased 8.93%. Year-to-date through September, the ACWI and S&P returned 1.37% and 5.57%, respectively.
Guided by the incredible performance of a few large growth companies, these indices have recovered from being deeply in the red following the global onset of COVID-19. Stock market breadth is as narrow as we've ever seen it. Notably, more than half of the stocks in the ACWI and S&P have declined in value this year, which helps explain the negative year-to-date performance of the ACWI and S&P when measured on an equal-weighted basis. The largest 10 companies delivered all of the performance (and then some).
Exhibit A: Index Return Composition Reflects Lack of Market Breadth2
| Year-to-Date as of September 30, 2020 | MSCI ACWI | S&P 500 |
| Total Return | 1.4% | 5.6% |
| Return Contribution of Largest 10 Companies | 5.7% | 9.4% |
| As a Percentage of Total Return | 415% | 169% |
| Percentage of Stocks with Negative Returns | 60.5% | 56.5% |
| Equal-weighted Return | -2.2% | -5.1% |
| Median Return | -7.9% | -3.6% |
| Largest 5 Companies as a Percentage of Market Capitalization | 12% | 23% |
In last quarter's letter, we pointed out that the Fund's long equity portfolio, for trailing twelve month and forward periods, was cheaper on a price-to-earnings and price-to-book basis than the S&P and ACWI, and had higher 3-year historic and forecasted earnings-per-share growth than the indices, although you wouldn't know it from its price performance.3 On average, it appears investors are placing much greater weight on what earnings might look like in the (sometime distant) future, rather than what they are in the here and now. Joel Greenblatt (Trades, Portfolio), in a recent Bloomberg podcast, pointed out that, "If you bought every company that lost money in 2019 that had a market cap over $1 billion…you'd be up 65% so far this year."4
Long equities held by the Fund returned 4.43% and -11.32% in the third quarter and nine months, respectively, underperforming the ACWI and S&P in both periods.5 Including some minor risk assets and cash held, the Fund generated 51.88% of the market's return in the quarter (where "market" is the average of the 2020 third quarter returns for the ACWI and S&P). The Fund underperformed its own risk exposure of 78.9%, on average, during the quarter.6 Growth continues to outperform value for the year on a global basis, as illustrated by the MSCI ACWI Growth Index Q3 and YTD return of 12.00% and 18.13%, respectively, versus its value counterpart, MSCI ACWI Value Index, returns of 3.97% and -14.54%, respectively, for the same period.
Portfolio discussion
Contributors to and detractors from the Fund's trailing 12-month returns are listed below.
Exhibit B: Trailing Twelve Month Contributors and Detractors as of September 30, 20207
| Contributors | Perf. | Avg. % | Detractors | Perf. | Avg. % |
| Cont. | of Port. | Cont. | of Port. | ||
| TTM | |||||
| Broadcom (AVGO, Financial) | 1.25% | 2.7% | AIG (AIG, Financial) | -1.92% | 3.1% |
| Facebook (FB, Financial) | 1.19% | 2.4% | Howmet Aerospace (HWM, Financial) | -1.26% | 2.4% |
| Charter Communications (CHTR, Financial) | 1.16% | 2.4% | Wells Fargo & Company (WFC, Financial) | -1.10% | 1.6% |
| Alphabet (GOOG, Financial) | 1.14% | 5.0% | Ally Financial (ALLY, Financial) | -0.88% | 0.5% |
| Microsoft Corporation (MSFT, Financial) | 0.92% | 1.8% | Meggitt (LSE:MGGT, Financial) | -0.77% | 0.9% |
| 5.67% | 14.2% | -5.94% | 8.5% |
As value investors, we aim to understand the value of a business and purchase it at a price that offers both a margin of safety and the opportunity for a good longer-term rate of return. Sometimes, a company captures the imagination of investors right away and that return comes quickly, but often the exact opposite may occur. Four of the contributors in the Fund over the trailing twelve months are technology companies, and the fifth is a cable company that offers the broadband delivery system for new technology (streaming). The contributors have either been beneficiaries of COVID-19 (e.g., more streaming and thus more demand for broadband) or haven't experienced much of a negative impact on their businesses due to the pandemic. The detractors are aerospace or financial companies, whose businesses have been harmed to various degrees and their stock prices reflect these changes. However, in most cases, when COVID-19 recedes, we believe these businesses will rebound and incite investor interest that could lead to higher stock prices.
The need for return has most investors feeling the tension between current income and capital appreciation. Finding yield in this environment has caused investors to either accept lower yields or move out on the risk curve to capture yields that are only marginally higher and generally don't appreciate the inherent risk in many of those credits. That has accrued to the benefit of the equity markets in recent months where total return is being sought in its stead.
No one has ever lived through the grand monetary experiment that central bankers and government treasuries are cooking up. These are unproven and untested theories where the outcome is not yet clear. However, if one has a long-term time horizon, choosing between investments in cash (no return), fixed income (low return), and equities (likely higher return), equities would be the logical choice.
We therefore continue to maintain the Fund's net risk exposure at ~78.3%, but with less than average exposure to low-yielding, sub-investment grade corporate debt, the Fund's equity exposure has crept up to 70.4%. We believe the more value-oriented names in our portfolio continue to offer good value, both on absolute and relative terms. Should these companies continue to execute well, we believe it is only a matter of time before the valuation gap narrows between them, the stock market, and certainly the expensive, large-cap stocks.
We alluded in the second quarter to central bank policies widening the societal gap between the Haves and the Have-nots. Within the equity market, a similar valuation gap between the Haves and Have-nots is about as wide as we've ever seen it.
Low multiples are certainly justified for those businesses that face existential risk.
We have largely avoided the secularly challenged industries over the last decade: including brick and mortar retail; mall real estate; oil and gas; and broadcasting. However, there are many good businesses in sectors that are cyclically challenged and have not performed well of late: such as aerospace; property and casualty insurance; and cement.
If the companies in our portfolio grow at the same rate as the stock market (they've actually been growing faster), while trading at lower valuations, then it stands to reason that our portfolio should perform well in the future. Though we wish it might be sooner, we expect business performance will eventually be recognized in stock prices.
Respectfully submitted,
Steven Romick (Trades, Portfolio)
Co-Portfolio Manager
October 15, 2020
- Effective September 4, 2020, the current single class of shares of the Fund was renamed the Institutional Class shares. All data herein is representative of the Institutional Share Class.
- Source: Factset.
- Source: CapIQ, Factset, Bloomberg, FPA calculations. For illustrative purposes only. Statistics mentioned as of June 30, 2020. The long equity segment average weight in the Fund was 70.2% and 69.2% for Q2 2020 and YTD through 6/30/20, respectively. Long equity holdings exclude paired trades, short-sales, limited partnerships, derivatives/futures, corporate bonds, mortgage backed securities, and cash and cash equivalents. Long equity portfolio statistics noted herein do not represent the results that the Fund or an investor can or should expect to receive. Fund shareholders may only invest or redeem their shares at net asset value. https://fpa.com/docs/default-source/funds/fpa-crescent-fund/literature/quarterly-commentaries/fpa-crescent-fund-commentary-2020-q2.pdf?sfvrsn=14
- Source: Bloomberg, October 9, 2020, Joel Greenblatt (Trades, Portfolio) on Relative Value Investing, https://www.bloomberg.com/news/audio/2020-10-09/joel-greenblatt-on-relative-value-investing-podcast
- For illustrative purposes only. The performance of the long equity segment of the Fund is presented gross of investment management fees, transactions costs, and Fund operating expenses, which if included, would reduce the returns presented. The long equity segment average weight in the Fund was 73.3% and 70.4% for Q3 2020 and YTD through 9/30/20, respectively. Please refer to the first page for overall net performance of the Fund since inception. The long equity performance information shown is for illustrative purposes only and may not reflect the impact of material economic or market factors. No representation is being made that any account, product or strategy will or is likely to achieve profits, losses, or results similar to those shown. Long equity performance does not represent the return an investor can or should expect to receive. Fund shareholders may only invest or redeem their shares at net asset value.
Risk assets are any assets that are not risk free and generally refers to any financial security or instrument, such as equities, commodities, high-yield bonds, and other financial products that are likely to fluctuate in price. Risk exposure refers to the Fund's exposure to risk assets as a percent of total assets.
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 overallFund'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: Empirical Research Analysis, National Bureau of Economic Research. As of August 31, 2020. Cheapest quintile refers to the most undervalued 20% of stocks in an analysis of large-capitalization US stocks. Standard Deviation is a measure of dispersion of a data set from its mean. Prior to 1952, the spread is measured using the price-to-book data of the largest 1,500 stocks. Current Level refers to the valuation spread as of August 31, 2020 which is 2.4 standard deviations above the mean.
Important Disclosures
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 val ue 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.
Please refer to the Fund's Prospectus for a complete overview of the primary risks associated with the Fund.
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.
