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Steve Romick First Pacific Advisors – Q2 Commentary

July 28, 2011

The second quarter exhibited a bit more volatility than the first, with the stock market declining 6.4% from peak to trough intra-quarter and ending the period on a flat note. The S&P 500 increased 0.10%, while the Crescent Fund rose 0.50% in the period. We have provided a more detailed performance summary at the end of this letter.

The contribution from the top three winners was almost entirely offset by the losers, but it was stock price movement without significant news.

Quarterly Winners

Quarterly Losers

CVS Corporation

Ensco Plc

Wellpoint, Inc.

Owens-Illinois, Inc

Petsmart Inc.

Hewlett-Packard Company

We enjoy the flexibility to invest in various asset classes, yet having the ability to go anywhere loses its advantage if there’s nowhere to go. That’s the position we find ourselves moving closer to today, given that many stocks aren’t particularly cheap. Few industries, countries or asset classes are out of favor, and even fewer meet our strict risk/reward parameters and fall within our circle of competence. It’s starting to feel like our strategy is merely going to give us more ways to find frustration.


We pay attention to the macro environment because it sometimes allows us to identify significant opportunities and, at other times, to avoid or limit catastrophic risk. From 2005-07, we worried about unsustainable home prices, the over-levered consumer, and fragile financial institutions. Our anticipatory and conservative stance helped protect the portfolio when those fears proved well-founded as the panic of 2008-09 viciously punished the excess of the earlier era.

We still find ourselves worrying today, particularly about unreasonable government budgets that have helped foster unmanageable burdens. Over the past three years we have witnessed a shift in financial obligations from the personal to the public (governments) that has done nothing to enhance the solvency of the overall system, although the optics appear favorable to some.

A country can be viewed as a proxy for the collective economic production of its populace, but if that society finds itself unable to shoulder the debt burden necessary to finance its lifestyle, then simply shifting its financial obligation to the government will eventually bankrupt the nation. We currently bear witness to such a shift. However, it’s easier to determine if an individual or business is bankrupt than to determine a nation’s insolvency (particularly those with access to an established printing press). Many countries walk a fine line that separates the solvent from the bankrupt. Those that tip to the latter will be forced to default and/or dramatically cut programs and services. We expect such action will likely have a significant negative impact on that country’s GDP, and to a lesser degree, on that of its larger trading partners. Companies that do business in those countries will find themselves similarly harmed.

The day of reckoning may not come quickly, as there exists more than one way to default: you can stop paying, or just let inflation erode what you owe in real terms. For example, for the $14.3 trillion dollars the U.S. owes today (ignoring any future borrowing), a 3% inflation rate would reduce the purchasing power of that debt to $10.6 trillion dollars in ten years, but at 5% inflation, the “real” debt would be just $8.8 trillion, and at 10%, it drops to $5.5 trillion. Inflation benefits debtors – at least as far as paying it back is concerned. The ancillary effects can prove dramatic though, as attendant higher interest rates can crowd out spending. How many of you have already seen fewer police on the street, or had your local fire station or library close? It’s terrible; but make no mistake, it can get worse.

Much can be done to avoid default but, unfortunately, we see little progress being made as we anxiously observe global leaders continuing to make decisions meant to address the problems of today, without regard for tomorrow. In the process, they are rewriting economic law based on need rather than common sense. As Stephanie Pomboy of MacroMavens writes, the Fed remains ‘steadfast in the conviction that there is no problem money can’t solve.” Until we gain confidence in our elected officials, we will work under the assumption that eventual default (outright or inflationary) and the commensurate austerity will prove the most likely outcome.

President Obama emphatically stated in a recent speech, "We have to live within our means." Different views abound as to what “means” means. We cannot agree on where we are trying to go, let alone how to get there. Our representatives in Washington, D.C. are performing something less than their civic obligation, whiling away the time playing Nero’s lost fiddle and dancing around their respective political third rails. The result: the successful avoidance of constructive consensus. Democrats don’t want to cut spending, and Republicans don’t want to raise taxes, so together they avoid imposing the shorter-term pain that’s required to ensure solid economic footing in the long run. Such narrow-mindedness saps the marrow from our bones, leaving us with the osteopathic challenge of an infrastructure too fragile to withstand shocks or support our future needs.

We have expected little from Washington in the way of bipartisan action. Sadly, they have lived up to expectations. Even now, party ideology trumps appropriate and compromising resolutions, and it’s evident in Congress‟ inability to reach an agreement on a higher debt threshold. Ultimately, Republicans must recognize the need to increase revenues; Democrats must accept spending cuts, especially with respect to previously untouchable entitlement programs. We see no alternative. Waiting for an improved economy and better employment picture to boost tax revenue may be like waiting for Godot – a prospect that’s both uncertain and interminable (if foisted upon you by your high school English teacher). An organic increase in tax revenues certainly helps, but it won’t solve the problem. As we have often discussed, government spending continues unabated – federal, state, and loco (oops, we meant local). We have learned that one can spend what he doesn’t have, thanks to the munificence of others. Or, maybe it’s not generosity that motivates Treasury purchasers, but their hopeful belief that 3.16% (for 10-year Treasuries) represents good value.

Current squabbling over raising the debt ceiling and who will make what concessions aside, our nation will continue to borrow more money from our trading partners. The real question is will we repay it with U.S. dollars that retain their value in the future relative to our kind lenders‟ currencies? In a word, no, which begs the earlier question, "who the heck would lend us money at such low rates?‟

Lenders to the U.S. are watching our current debt level as well as our deficit-driven need for future increases in debt. Unfortunately, there’s no easy prescription for curing a $1.6 trillion deficit. Returning the highest marginal tax rate to pre-Bush tax cut levels would raise just $700 billion dollars over ten years, or call it $70 billion per year for simplicity sake.4 Let’s say we could also cut federal spending by 20%. We would then raise an additional $767 billion, but at just less than half this year’s deficit, that still wouldn’t be enough. That’s an impossible expectation anyway. Since 1950, the government has successfully cut the federal budget year-over-year only twice – and that was back in 1954 and 1955, for an average cut of just 5.2%. In other words, we won’t see a balanced budget for many years.

Spending cuts won’t come easily, particularly given what’s considered mandatory versus discretionary government expenditures. Mandatory spending includes social programs, defense, and interest expense on our national debt. What’s left over is just 14% of our budget. We won’t solve the problem by addressing such a small slice.

We have to address the “mandatory” spending. We can keep trying to bring interest expense down by buying our own debt (particularly longer maturities), but that suicidal solution would be overwhelmed by the higher debt balance anyway. If one considered the defense of our nation to be necessary, but not the support to so many others, we could eliminate the annual cost of multiple wars, and save $168 billion5 – still not enough. Sure, defense spending has bloat, but note it has already fallen more than 50% as a percent of the federal budget since 1970, from 42% to 20% today. Inevitably, we must address the high cost of our social programs.

It seems it might be some time before personal tax receipts recover enough to help narrow the budget deficit. In his July 13 Congressional testimony, Federal Reserve Chairman Ben Bernanke pointed to decelerating growth expectations. Fed forecasts for 2011 real GDP have dropped from 3.3-3.7% to 2.7-2.9%. As we projected, the stimuli ended and economic growth slowed. Surprised? Apparently, the Fed was. It’s scary that government action hasn’t gotten traction after opening the money spigots. By this point, we would have thought someone would have drowned, but instead, the money has either been spent without long-term benefit or just lies dormant on bank balance sheets. The Fed has gone from blowing on a string to sticking that string in a wind tunnel ‒ to no avail. Although inflation tinder on the one hand, it does point to serious deflation consequences should China’s economic luster tarnish. So now we‟re back to square one, or maybe we‟re too pessimistic and it’s back to square two. At least the stock market found temporary comfort in Mr. Bernanke’s hint at more stimulus; after opening down that morning, the market rallied 0.6% during his prepared remarks. If he can keep that streak going, we might just wish him to speak ad nauseam.

When considering stimuli, the question too often posed is „have we spent enough?‟ rather than „have we spent wisely?‟ We have argued that putting money directly into our wallets via all sorts of transfer payments provides nothing more than an ephemeral boost. The vicious circle of „borrow, give, borrow, give‟ leaves us indebted and without the necessary investment for self-sustaining growth. The preferred path of "borrow, invest, borrow, invest‟ apparently lacks the feel-good sensation of being able to walk into the Apple store and buy the iPad2. We know people who have done just that instead of putting the money in their child’s college fund or paying down their mortgage. We make the distinction between the government providing the immediate necessities of food, shelter, and health care, and the more the superfluous needs that many Americans feel is their right. The lack of investment in areas that could yield long-term benefits, such as education and scientific research, is appalling. It’s therefore no surprise that consumer confidence remains low and companies aren’t creating jobs at the rate that you would hope at this stage in a recession. Of the 8.5 million jobs lost during the recession, only 1.75 million – or just 21% ‒ have been replaced.

Although there’s plenty of blame to go around, we regrettably have to point to Washington for its fair share. We are long past the days of having our political leaders perform a civic duty as an interlude in their private lives as philosophers, lawyers, soldiers, scientists, or businesspeople. It’s now a profession, and not a bad job at that. Members of Congress earn more than four times the pay of the average American and, amid massive job losses, they have seen their wages increase 5.3% since 2007.7 Interestingly, in FDR’s time, Congress took a pay cut when the going got tough.

Does QE2 by necessity beget QE3? If U.S. stimulus spending is unsustainable (no doubt), or ineffective (possibly), then interest rates can easily spike because of higher inflation expectations and/or because foreign buyers of our debt view our fiscal position as tenuous and fear default.9 This won’t bode well for the U.S. dollar down the road, but it’s a long road. For example, consider the once-mighty British pound’s two centuries of erosion. The pound averaged north of $5.00 dollars per pound during the nineteenth century, but was worth 32% less on average in the twentieth century ($3.38). Thus far in the twenty-first century, it’s averaging another 50% less ($1.69). At first glance at the next chart, it’s easy to conclude that the pound is worth a heck of a lot less versus the dollar over the last couple hundred years. A hotel stay for a Brit visiting New York would cost 3x more today than it would have two hundred years ago. However, please also note that the pound didn’t decline in a straight line, but instead had decade-long periods of stability and shorter periods when its value spiked. We continue to expect the U.S. dollar to weaken versus a basket of global currencies over time. The chart for the U.S. dollar versus a basket of global currencies won’t look exactly the same over the next two centuries, but it will also have periods of stability and price spikes.

We aren’t alone in our currency challenges. We would even take our dollars over Euros because we question the long-term success of the European Union (EU), particularly as it faces the Herculean challenge of reconciling the competing interests of a central monetary authority and independent fiscal fiefdoms. Xenophobic Europeans still swear greater allegiance to their own country than to the EU. The UK had its doubts from the beginning and declined to join. Now it seems to rest on the shoulders of the stronger European countries such as Germany to continue supporting the unkindly (but not entirely inappropriately) termed PIIGS (Portugal, Italy, Ireland, Greece, and Spain. We don’t know how the Euro will play out.

Germany has offered its support thus far, but will it continue? The German economy has clearly benefited from its place in the EU. Had Germany gone the way of the U.K. and remained independent, its strong economy would likely have dictated a stronger Deutschemark, making their goods more expensive and curtailing their exports – thus negatively impacting their economic output.

Weakness or fear in other regions can cause others to seek refuge in the dollar, just as during the U.S. Civil War, the British pound doubled in value versus the dollar. Maybe China temporarily rolling over could cause such a flight. There’s a certain lack of data integrity coming out of the PRC, and they can’t continue to invest in infrastructure at the same pace ad infinitum, particularly when their ‘spending on (fixed) assets is now equal to 70 percent of its GDP, a ratio no other nation has reached in modern times.”10 As with every developing economy, there will be hiccups. The only questions are when, from what level, and how bad?


Central banks have succeeded in a coordinated effort to drive asset prices higher, thereby creating wealth but eliminating opportunity. When committing capital, we have a high tolerance for uncertainty, provided the prospective investment offers a sufficient margin of safety ‒ something that’s becoming less and less the case today. In general, stocks presently trade above their historic average. Although low interest rates contribute to this, we believe that risk is above average. We have, in effect, borrowed from our future returns, and we therefore continue to find less to get excited about in the equity markets.

Quality larger-capitalization companies remain attractively priced and, given our macro uncertainty, if we are to bend, it will be more on price than quality. We own more such high-quality businesses than in the past, since the market has priced them in a way that has allowed us entry – making good businesses available at average prices, as opposed to our more typical investment in average businesses at good prices. These opportunities have emerged because investors have taken current fears and projected them into the future. Take Johnson & Johnson and Microsoft as examples.

We were able to purchase Johnson & Johnson (JNJ) at an 8%+ free cash flow yield, giving no consideration to the company’s cash position, in part because of negative stories caused by the company’s consumer recalls. Although the consumer business is a terrific asset, it generates less than 25% of the company’s free cash flow and is almost certain to recover from recent missteps. Occasionally, the media’s undue focus on one division will allow us the opportunity to acquire the entire business at an attractive price. When we look at JNJ, we worry about many things (long-term health care spending, unusually low tax rate, and very high margins), but JNJ is one of the world’s great franchises, with over 50% of sales derived internationally, plus tremendous product/business diversification, a AAA balance sheet, and compelling long-term demographic trends benefiting each of their businesses. The combination of business franchise and low price attracted us to the company. JNJ’s shares were as inexpensive as they‟d been in thirty years, giving us another of what we consider to be infinite-duration bonds with rising coupons, i.e., 8% plus the growth.

Microsoft has gotten its share of not-entirely-undeserved bad press in recent months. During our Q1 2011 letter we disclosed that, “The greatest negative impact in the quarter came from Microsoft (down 19bps), a holding we have increased to take advantage of price weakness, given the current low expectations of a P/E of just 10x.” Despite the modest recovery this quarter, we still think the shares are attractively valued, as reflected by an equity multiple that remains at roughly 10x earnings, and an enterprise value of about 7x operating profit.

Irrespective of the stock’s lowly valuation, we actually have some enthusiasm for Microsoft’s earning prospects. As measured by operating profit, Microsoft’s fiscal 2011 earnings may actually be more than 50% higher than five years ago. Though the company clearly faces challenges, we can point to a number of opportunities that suggest earnings five years hence should exceed today’s – though by what amount is open to debate. We like that the market appears to have priced its business as one in permanent decline. We believe the market has therefore handed us a free option on the possibility for future growth.

Rather than provide an exhaustive list of the levers available to Microsoft to improve earnings or discuss the tremendous market share in its various business segments, we instead use an example to reflect how little credit Microsoft gets by comparing it to a current tech darling. Salesforce.com, a leading cloud player with $2 billion in revenues and valued at greater than 100x forward earnings, is – forgive us – a cloud company trading in the stratosphere. Microsoft is already a leading cloud player, as measured by number of users and revenue, and yet the market seems blind to this fact, awarding it just one-tenth the P/E. To secure Microsoft’s place in the cloud, Jean-Philippe Courtois, president of Microsoft International, said earlier this year that the company would spend 90% of the company’s annual $9.6 billion R&D budget on cloud strategy (more than 4x Salesforce.com revenues). With Microsoft’s R&D staff of 40,000 and a portfolio of product offerings that touches almost every organization in one way or another, we give “Mr. Softee” at least a fighting chance at remaining relevant in the world of corporate cloud computing.

As for the legacy Windows franchise, the recently introduced Version 7 had the fastest take-up in the company’s history. We recognize, though, that many of you may read this commentary on a computer running a predecessor, Windows XP – which continues to have the largest global installed base of any operating system. Come April 2014, we regret to inform you, Microsoft will no longer provide XP support (e.g., no more maintenance updates). We suspect this will drive another strong cycle of upgrades, contrary to what Microsoft’s valuation would suggest is a business in steep decline.

Microsoft isn’t the only large-cap technology company to be viewed so negatively, as can be seen in the following chart. Large-cap tech stocks are as cheap as we’ve ever seen them, both on an absolute basis and relative to the broader market and historical sector multiples. We have therefore invested in a basket of other such companies that we find inexpensive.

We sometimes opt for such a basket approach when we have greater conviction on the prospects of the group and its attendant risk-reward than we have on individual companies. Some of these investments are smaller in size than is typical, but that is not to say that our research has similarly shrunk. The baskets come about through bottom-up work and are only created after we complete significant write-ups of each potential company. One of the benefits of having a big team is that we don’t have to compromise on the depth of our research on even our smaller investments.

The select universe of technology bellwethers charted above trades at less than half the valuation of a decade ago. Low overall expectations for the group have caused the current EV/EBIT multiple to contract to 8.4x, an unprecedented ~28% discount to the S&P 500, versus an average 4% premium over the past decade. While company-specific issues vary, there are two commonly perceived risks for tech incumbents: 1) capital allocation, particularly given current large cash positions; and, 2) business disruption brought on by the emergence of cloud computing models and related mobile device proliferation. We believe current valuations provide a healthy margin of safety given the bulletproof balance sheets, strong continuing cash flow, and leading market positions for many of the most out-of-favor tech stalwarts. Ravi Mehra, our analytical lead on technology investments, worked for Cisco in a prior life and brings with him a mix of relevant industry, consulting, and investing experience. As of June 30, Crescent had 5.60% of long exposure to large-cap technology. We would expect to increase that basket position should individual companies and/or the sector allow us entry at lower price levels.

Financial services companies also seem inexpensive. Given the bad news surrounding financials these past few years, we have recently reengaged in the sector by assembling a host of companies in a basket that now represents 5.5% of the portfolio. Just a few years ago, financial service companies had overstated book values, high valuations, and the companies seemed to be doing great. Since then, many companies have ceased to exist, and most of the rest had the stuffing knocked out of them. Write-downs have driven book value lower, valuations have come down, and prospects look dim. Two industry subsectors, banks and property & casualty (P&C) insurance, now trade cheaply by any historic measure. While valuations are now low, lack of transparency and balance sheet risk remain. As the table below illustrates, it seems that every 5-10 years, one or more of the large financial services companies gets into trouble and incurs large write-downs. This last period, 2008-09, was obviously the worst of these episodes. By taking a basket approach, we minimize the idiosyncratic risk to future unforeseen crises, while exposing the portfolio to the historically cheap valuations in these two subsectors.

As the chart below illustrates, we are currently near an aggregate 1.0x price/book ratio for banks in the S&P 500 ‒ a level not seen since the savings and loan crisis concluded back in the early 1990s. We have begun investing small amounts of capital in select banks and are actively looking for more opportunities. To date, our investments have been in the larger-cap banks, where the valuations are the lowest. We are looking for opportunities among regional banks, but their valuation levels have not come down as much as the large-cap banks.

We have recently established a small position (just 1.3%) in three large banks. Though each company is unique, the group has some similar attributes, namely:

Although our position is currently small, we have spent a great deal of time considering the merits of each company, as well as the group as a whole in the context of our entire portfolio. From a strictly bottom-up perspective, each of the banks merits a much larger portion of our portfolio. Our investment (or lack thereof, depending on one’s perspective) is a result of the intersection of our bottom-up approach with our consideration of the macroeconomic environment.

The situation today is quite different from the environment we discussed in our Q4 2006 and Q3 2008 shareholder commentaries, when we explained why we refused to own financials (and had, in fact, not owned them for much of the last decade) as we believed that any potential upside to the stocks could not be justified by the risk assumed. At the time, we pointed out the elevated level of ROE (18-22%) being earned by financials, the extreme amount of balance sheet leverage (26x equity in the case of the investment banks), and the pricey multiple to book value (2-3x) and earnings (12-15x) at which financials traded. At our purchase price, our basket now trades at an average 85% of tangible and recently scrubbed book value and 7x our best estimate of normalized earnings power. It is rare to find leading franchises available at such prices. Not only does each company have its strongest balance sheet in a least a decade, but we are also cognizant that a strategy of buying leading financials at a discount to tangible book after a recession/credit dislocation has repeatedly produced outstanding results over the past thirty years. If the world doesn’t fall apart, our basket could double over the next 2-3 years, based on conservative business results and exit multiples. Although there are no guarantees, on a bottom-up basis, we really like the opportunity.

However, our appreciation for the macro-environment causes us trepidation, leaving us with a relatively small position. Our concerns about the functional insolvency of Western governments, the potential real estate bubble in China, unnaturally fixed currency exchange rates, untrustworthy official data, and highly manipulated interest rates, create the fear that the oasis of bottom-up bargains we see could prove a mirage.

While we worry about the macro, we also appreciate that we don’t know what will happen. On one hand, the unsustainable increases in government obligations could lead to default and a second crisis (one that’s perhaps worse than that of 2008-09), as governments might prove incapable of providing a backstop. On the other hand, it appears to be in everyone’s interest for responsible officials to cut spending, increase revenue (in part though the resulting economic strength), and tweak certain entitlement programs to put developed economies on solid footing. If we could place a higher probability on the likelihood of officials making necessary the adjustments, we could then envision a larger position in banks.

Our financial basket also includes property & casualty insurance. The sector is historically cheap, with aggregate valuations near 1.0x. We believe the industry’s underwriting cycle has bottomed and that current valuations fail to reflect a more normal environment. To date, we have invested in several insurance companies. One of our investments, Transatlantic Holdings, is currently the target of a bidding war between two suitors. We are evaluating the competing proposals and working with Transatlantic to maximize shareholder value.

High Yield / Distressed

High yield is distressing. Higher yielding corporate bonds just don’t really exist, certainly not with enough yield to justify the twin risks of interest rates and credit. We have been sellers, either through maturity or in reduction of position size. Our exposure is a frustratingly low 6.9% and that doesn’t even tell the whole story, because we believe there is very little risk to our book. Companies, on the other hand, have been issuers. High yield originations hit an all-time high in 2010, and 2011 is on track to handily trump that as both yields and credit spreads remain low.

As can be seen in the table below, the average credit quality of new high yield bond issuance has been deteriorating, with 17% of the issues either Caa or unrated. Although this is down from 2007-08, when 24% of the issuance was Caa or unrated, it is 29% higher than the 17-year average. But the percentage of lower-quality issuance fails to tell the whole story. The dollars issued in the Caa and unrated totaled $47.6 billion in 2010, and in 2011's first half, $28.6 billion has been issued, 60% ahead of last year. Note that in the prior peak years of 2006-07, Caa and unrated issues totaled just $56.2 billion. The total for the past 18 months ‒ $106.2 billion ‒ is almost double that peak. Lest one challenge our conclusion by saying that refinancings account for most of this, we counter with the argument that refinancings are 53% of new issuance today, as compared to 92% in 2007-08.

High yield bonds are easily sold when alternative yields are low and, easier still, when a company gets all gussied up. It’s easy to sell something that looks good, but is it as good as it looks? Who buys a new car and thinks they’ll ever have a problem with it? There will be some wrecks on the road, and we’ll be there to pick through them. So while we’re without high yield opportunities today, we‟re expecting them tomorrow. Until then, cash will continue to be the residual of investment opportunity.


We manage per the equation Portfolio = Investment Opportunity + Cash. The rules of algebra therefore dictate that Cash = Portfolio – Investment Opportunity. Cash will be invested only when the risk/reward of a given investment dictates its deployment. You don’t know how valuable cash is until the day you need it. It is important to note we lived by this equation when the fund had $100 million in assets under management, when it had $5 billion, and we continue to do so today.

Slow economic growth and high unemployment can lead to further societal polarization, and yet, politicians lack the political will to do anything more than pay lip service to the larger issues. Candidly, we‟re not sure they really understand either what to do or what’s really going on. We see them, and their EU brethren, packing surfboards for a tsunami – something that won’t end well. We continue to “wait and hope” as we enjoy what we believe to be relative calm between two crises.

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