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Sydnee Gatewood
Sydnee Gatewood
Articles (3504) 

Steven Romick's FPA Crescent Fund 4th-Quarter Shareholder Commentary

Discussion of markets and holdings

Dear Shareholders:

Overview

The FPA Crescent Fund – Institutional Class ("Fund" or "Crescent") gained 18.15% for the fourth quarter and 12.11% for the full year 2020.1

The Fund's performance and that of its underlying equity exposure can be considered in the context of the following illustrative indices.

Exhibit A: Performance versus Illustrative Indices2

Q4 2020

2020

Crescent

18.2%

12.1%

Crescent – Long Equity

23.8%

12.6%

S&P 500

12.2%

18.4%

MSCI ACWI

14.7%

16.3%

Including some minor risk assets and cash held, the Fund generated 135.3% of the average of the S&P 500 and MSCI ACWI return in the fourth quarter. The Fund outperformed its own risk exposure of 79.0%, on average, during the quarter.3

The Fund's strategy may have appeared out of step in the first quarter, and as we argued at the time in the Fund's Q1 2020 commentary: "Businesses owned by the Fund may have seen their stock value move 25% day-to-day, or even intra-day, but in our assessment their business value did not similarly change."

Stock prices generally appreciated over the last three months; and in many cases increased by quite a lot. While the Fund showed an outsized improvement in the fourth quarter, which was generally a function of the many positions we pointed out as being inexpensive in our Q3 2020 commentary. And still, in our assessment, not a lot has changed in the underlying fundamentals of the companies held in the portfolio.

Portfolio discussion

It's been a year of extreme, nerve-wracking volatility. Our longer-term mindset is our anchor in choppy seas, guiding us to seek out what is currently out of favor while avoiding the inflated valuations of what is in vogue. However, these portfolio decisions can cause us to appear out of touch with the crowd – hopefully a temporary phenomenon, and incumbent on us to prove to you over time.

In our Q2 2020 commentary earlier this year, we shared what we believed would be temporary impacts on certain businesses: that people would get on planes and stay in hotels again, and what that might mean for the travel and aerospace industries, for example.

We owned and subsequently purchased many stocks that experienced dramatic price declines in the first quarter. The shares of these companies were priced at such low valuations, suggesting that their businesses would never recover.

As a result, the Fund saw more changes in its portfolio last year than it has had in many years. We took the opportunity to increase equity exposure earlier in 2020 as investors were running for the exits. We reset the portfolio by reducing or eliminating certain holdings that in our view offered less attractive long-term potential, while increasing existing and new positions in those businesses that we believed were temporarily harmed by the global pandemic but whose stock prices were disproportionately decimated.

The contributors to and detractors from the Fund's trailing 12-month returns are listed below and reflect the realities of 2020: technology and other growth stocks performed well, while more cyclical "value" stocks did not.

Technology: It's no great surprise that the top five contributors to performance over the last year were our technology investments that floated upwards on the rising tide. Despite taking some profits, we retained many of these positions. These companies share the common characteristic that they operate successful business models and trade at valuations that, although not as inexpensive as they once were, we believe will still provide a reasonable return in the years to come.

Financials: The financials in our portfolio underperformed as investors sold shares in a panic, fearing that the economic downturn would cause such damage to loan and investment portfolios and that there would be, in general, less demand for their products and services. The market was correct that their businesses would be harmed, but not to the degree that was ultimately priced into their stocks. There has been some recent recognition of this as financials were strong performers in Q4 and in the early days of 2021. Given strong balance sheets, a post-COVID economy within sight, stimulus packages, and the Fed's security purchase support, combined with inexpensive valuations, we suspect that there is still gas left in their collective tank.

Aerospace: We own two aerospace suppliers, Howmet and Meggitt, which saw their stock prices decline by around two-thirds from their Q1 2020 highs.5 Howmet's (NYSE:HWM) price increased about three times from its low and ended the year at its all-time high. Meggitt's (LSE:MGGT) stock price doubled from its bottom but is still significantly below its peak. The value of their necessary and large market share businesses did not fluctuate as much as their stock prices.

When things look bleakest, the prospects for returns are typically brightest. As much as that might have been the case earlier this year, in our assessment the opposite is true today. Now that the stock market has run to new highs, we would suggest that we have borrowed from future returns.6 In general, the more you pay for an asset, the lower you can expect for its future return. We therefore retain approximately 25% in cash and conservative fixed income as available to be redirected for future opportunities.

Markets and Economy

It's always good to take stock at the end of a calendar year, and no better time than now with 2020 delivering more than the usual share of surprises.

At the end of 2019, no one predicted that the unemployment rate would hit its highest level since the Great Depression and most Americans would struggle financially; US national debt would cross $27 trillion, an increase of almost $5 trillion; GDP would shrink 3.5%; average wages would decline but household incomes would increase, thanks to government stimulus checks (Exhibit C); yet the stock market would hit new highs, delivering a double-digit rate of return.

The economy and, by extension, the securities markets have been supported by the friendliest financial conditions in U.S. history including: a negative real rate of interest, liberal fiscal policy, business subsidies, stimulus checks for most individuals, and a ballooning Fed balance sheet used to buy treasuries, agencies, and now corporate bonds.

People were fearful of what might be. As is usually the case, however, more things could happen than will happen. We certainly did not predict that 2020 would unfold as it did, but the three meta-points we communicated in our Q1 2020 commentary, when fear was near its peak, reflect our steady bearing.

We said then that;

  1. "…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."
  2. "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…."
  3. "We believe Crescent's portfolio of securities at the end of this tumultuous quarter is attractive…."

Investors typically anchor to the average annual market return, while disregarding that the actual annual returns vacillate tremendously around that average.

Ironically, people will one day look back at 2020 and see a year that delivered a market return of approximately 2x the long-term average. There will be less attention paid to the market having declined approximately 34%, only to then rebound approximately 67%.8 That's comforting in a way as it suggests that this unusual year was not really so abnormal.

Investors focus on average annual stock market returns without often appreciating that the stock market never returns the average. Long-term equity returns are achieved with significant variability around the mean. The MSCI ACWI Net Return Index has returned an average of 6.12% over the past 20 years, but in only three instances were the returns even within 2% of the average. In 65% of the cases, the returns were more than 10 percentage points higher or lower than the average, with a 77% spread between the best and worst years (34.6% in 2009; -42.2% in 2008). Therefore, notwithstanding the tremendous volatility during the year, as it relates to the global stock market returns for the full calendar year 2020, it was truly an exceptionally unexceptional year (Exhibit D).

The pendulum swung hard to the downside in March and now has swung even harder to the upside since those market lows. We also wrote in our Q1 2020 commentary that "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." That happened sooner than we expected. Far be it from us to say this rebound was overdone, but there's little question that the markets are pricing in a COVID-free world (Exhibit E).

In comparison to trailing indicators, large-cap US stocks (S&P 500) trade at 22.3x forward earnings at year-end, 45% higher than the 20-year average. 11 Larger market cap companies based outside the U.S. (ACWI ex-U.S.) trade less expensively at 16.7x, although still 25% higher than its 20-year average. These higher valuations can, in part, be supported by lower interest rates and the higher growth rates of many businesses. However, ~12% of the S&P 500 now trades at more than 10x sales – its largest percentage and more than during the dotcom bubble (Exhibit F). Only time will tell if it is truly different this time, but it has always been dangerous to utter those words during previous periods of market exuberance.

International stocks continue to trade more inexpensively (relatively) when compared to U.S. stocks even with many operating globally (Exhibit G). A lower valuation on its own, though, does not warrant a place for a stock in our portfolio. Those slots are reserved for growing businesses. We have been fortunate to find many such companies in the last couple of years, which explains our 40.7% exposure (as a percent of net equity investments) to foreign-domiciled companies; including global companies like Lafargeholcim (XSWX:LHM), Groupe Bruxelles Lambert (XBRU:GBLB), Glencore (LSE:GLEN), and Richemont (XSWX:CFR).13

Generally high valuations create a friendly market for raising capital. This past year was no different. Initial public offering volume hit a record $175 billion; while SPACS, the special purpose acquisition companies that have a "blank check" to invest, have raised more than $60 billion.15

According to Bloomberg, "a record $120 trillion of stock changed hands on U.S. stock exchanges last year, up 50% year-over year. The average Russell 3000 stock saw average daily share volume surge 46% to 1.9 million shares."16 The stocks that performed best were those with better projected prospects than current earnings and companies that were either less impacted by or benefited from the pandemic. Needless to say, we did not own many of these companies. The momentum-driven buying of many individuals, including those utilizing commission-less platforms like Robinhood, have helped drive stock prices higher. Many of these "investors" operate with the core tenet that past performance is indicative of future performance, and have piled into stocks with the aid of record amounts of borrowed money and the use of derivatives (Exhibits H&I).

It's interesting to see how people find solace in different industries in which they have little grasp of the economics, let alone what might be the right price to pay. Momentum, more than understanding, drove the Nifty 50 in the 70s; Oil stocks in the 80s; Tech stocks in the 90s; Diversified industrial stocks and certain financials - like General Electric (NYSE:GE) and Bank of America (NYSE:BAC) in the 00s; and now back to technology and healthcare stocks today. 19

This has led to a clear bifurcation in the market with a widening gulf between the haves and have-nots – as pronounced as we've ever seen it (Exhibit J). The valuations of many "haves" are too rich for our blood and are less likely to deliver reasonable returns over time, despite many high quality businesses in the mix. The lower valuations of the "have-nots" can often be appropriately justified by the secular challenges these businesses face. As price conscious investors, we focus on the cohort in between. Much of the oxygen in the room has gotten sucked up by those stocks that have been "working", leaving the share prices of many good businesses gasping for air.

Grounded in the philosophy of not paying more for an asset than we believe it is worth, our true north remains bottom-up security selection. We evaluate the risk/reward of each of our investments over a three to five-year period, and innately believe that anything less is speculation. As risky as investing in stocks appeared at the March lows, particularly with regard to the financial, travel, and aerospace sectors, we'd argue that higher stock prices today, all else equal, translates to greater risk.

We therefore expend the bulk of our energy and capital on those businesses that we believe offer secular growth, good returns on capital, have operators who are either owners or function with an owner mentality and, finally, trade at prices that should allow for an acceptable rate of return over time.

Investors today are paying more for certainty – or for the illusion of certainty. However, there are numerous companies (many with unproven business models) whose valuations can only be justified by high earnings growth well into the future. Further, achieving those growth rates does not assure good stock price performance. Take Microsoft (NASDAQ:MSFT) for example. It posted 19.5% earnings growth through the first decade of the millennium, but its stock price declined 48% in that time.21 Price may not matter over the short-term, but it certainly does over the long-term. The Crescent portfolio will hopefully continue to prove that point.

High Yield and Distressed Debt

Our inability to find attractive high yield and distressed debt opportunities has been disappointing. Higher yielding corporate debt had always been an integral part of our portfolio, yet we have been sidelined for much of the last decade. We watched the yields of lower tier corporate credits decline over the last decade, and then decline some more.

In a quest for return, investors have bid up the price of high yield bonds so that this yield is now at an all-time low of 4.2%, and that's a gross yield before some measure of defaults (Exhibit K).

Adding to the risk factors, corporate debt generally has the worst lender protection in its history; i.e., fewer and weaker covenants and more covenant relief than we've ever seen (Exhibits L & M).

Should we once again see opportunities in high yield (higher yields with the necessary lender protection), then you will likely see more fund exposure to the asset class. There is, unfortunately, no guarantee that this will materialize, particularly in a world where lenders are now paying borrowers. Almost $18 trillion of global debt now has a negative yield (Exhibit N).

Closing

What was a bad year in March turned into an average year by December, emphasizing how noisy short-term performance can be for long duration assets. From a valuation perspective, we believe we are well-positioned for future performance, although more relatively than absolutely: our portfolio is less expensive than the market but certainly not as cheap as it was in March.26 And we have available liquidity that will allow us to capitalize on future opportunities.

Although we do not like losing money, we can't forget about making money. This balance between capital preservation and appreciation must always consider the macro environment: the sovereign desire to inflate, the continued low interest rates, and the negative real return on cash. Given that setup, if we can continue to be successful with our long equity security selection, then we should run Crescent more invested even if that may involve greater volatility.27

We will continue to pay closer attention to how things might unfold over time, rather than to emphasize any moment in time.

Respectfully submitted,

Steven Romick (Trades, Portfolio)

Co-Portfolio Manager

January 29, 2021

  1. Effective September 4, 2020, the current single class of shares of the Fund was renamed the Institutional Class shares. Unless otherwise noted, all data herein is representative of the Institutional Share Class.
  2. Comparison to the indices is for illustrative purposes only. The Fund does not include outperformance of any index or benchmark in its investment objectives. An investor cannot invest directly in an index. 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. Long equity holdings only includes equity securities excluding paired trades, short-sales, and preferred securities. The long equity performance information shown herein 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 in the Fund can or should expect to receive. Fund shareholders may only invest or redeem their shares at net asset value.
  3. 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. The Fund's net risk exposure as of December 31, 2020 was 78.5%.
  4. 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. Positions in Naspers and Prosus are look-through investments to gain exposure to Tencent. Raytheon and Otis were results of a Merger between Raytheon and United Technologies. As such, the contribution to return and weight of these separate companies has been combined for purposes of this analysis.
  5. As of December 31, 2020. The TTM average portfolio weight of and contribution by Meggitt were 0.8% and -0.43%, respectively. The TTM average portfolio weight of and contribution by Howmet were 1.9% and -1.25%, respectively.
  6. Unless otherwise noted, any references to "market" in this Commentary refers to the S&P 500 Index.
  7. Source: Bureau of Economic Analysis. Data is from March 2020 through November 2020 and compared to the same time period in 2019.
  8. Source: Bloomberg. As of December 31, 2020. The 'market' statistics noted refer to the S&P 500 Index.

  9. Source: Bloomberg. As of December 31, 2020. MSCI ACWI Net Return Index.
  10. Source: Factset. As of December 31, 2020. Data is represented by the respective indices in the charts.

  11. Source: J.P. Morgan Asset Management, Guide to the Markets. Slide 55. As of December 31, 2020.
  12. Source: What were you thinking? Part Tres. Jesse Felder, The Felder Report. Data as of December 31, 2020. The 'number of components' refers to individual stocks.
  13. Portfolio composition will change due to ongoing management of the Fund.

  14. Source: Factset. As of December 31, 2020.
  15. Source: A Speculative Frenzy is Sweeping Wall Street and World Markets. Bloomberg News. As of December 19, 2020.
  16. Source: Day Traders Put Stamp on Market with Unprecedented Stock Frenzy. Bloomberg Quint. As of January 1, 2021.
  17. Source: Yardeni Research, Inc. As of December 31, 2020. Debit balances in margin accounts at broker/dealers. Beginning in 1997, data reflects debit Balances in customers' securities margin accounts.
  18. Source: Bloomberg. U.S. Total Option Call Volumes. As of December 31, 2020.
  19. Nifty 50 was an informal designation for fifty popular large-cap stocks on the New York Stock Exchange in the 1960s and 1970s that were widely regarded as solid buy and hold growth stocks, or "Blue-chip" stocks.
  20. Source: Bloomberg. As of December 31, 2020.

  21. Source: Bloomberg, for the period 12/31/1999 to 12/31/2009. Microsoft's stock price on the respective dates was $58.38 and $30.48.

  22. Source: Bloomberg. As of December 31, 2020. High yield bonds market data represented by ICE BofA US High Yield Index. Yield to worst is a measure of the lowest possible yield that a bond can receive operating within the terms of its contract without defaulting.
  23. Source: LCD, S&P Global Market Intelligence. As of December 31, 2020.
  24. Source: Markets betting on the Fed's dovish policy shift on inflation, Credit. The Daily Shot, as of August 27, 2020. Data for 2020 is through July 31. Data for 2020 is through July 31, 2020 and is sourced from LCD, an offering of S&P Global Market Intelligence.

  25. Source: Bloomberg. Bloomberg Barclays Global Aggregate Negative Yielding Debt Index Market Value. As of December 31, 2020.
  26. The forward P/E of the Fund's long equity and the S&P 500 Index as of 03/31/2020 and 12/31/2020 were 11.8x and 16.1x; 26.9x and 29.8x, respectively.

  27. For illustrative purposes only. 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. Long equity holdings only includes equity securities excluding paired trades, short-sales, and preferred securities. The long equity performance information shown herein 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 in the Fund can or should expect to receive. Fund shareholders may only invest or redeem their shares at net asset value.

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 and are subject to change without notice. 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.


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