Steven Romick's FPA Crescent Fund 2nd-Quarter Letter

Dear Shareholder:

Overview

The FPA Crescent Fund – Institutional Class (“Fund” or “Crescent”) gained 3.26% in 2021’s second quarter and 39.00% for the trailing twelve months.¹ The Fund generated 97.4% of the average of the S&P 500 and MSCI ACWI’s return in the trailing twelve months, outperforming its own 77.8% average net risk exposure.² Crescent’s performance and that of its underlying equity exposure are captured in the following table:

Exhibit A: Performance versus Illustrative Indices³

Portfolio discussion

As stewards of your capital, we presently find ourselves feeling uncomfortably comfortable, which we find an odd sensation. We don’t mean to imply that we feel complacent; however, the Fund’s cash levels are significantly lower than in recent years. With a relatively modest amount of dry powder, we no longer wake each morning hoping for a market pullback that offers a flood of potential bargains. Instead, we would now be happy with a sale in just one section of the store, allowing us to pick up a few discounted securities to go along with a shopping cart that is already relatively full - and we may have tempted fate and invited such an opportunity with our opening line.

But just because we do not currently welcome a large drawdown for the markets, it does not mean that it will not happen. In fact, we are virtually certain at some point it will, but we just can’t tell you when. Though the portfolio will not be immune to the next selloff, whenever it may arrive, we remain committed to seeking equity-like returns over the long-term while avoiding permanent impairment of capital.

Consistent with the above philosophy, back in Q3 2019 the Fund began reporting contributors and detractors on a trailing twelve-month basis rather than the most recent quarter. At the time we wrote “Quarterly price movements, however, are generally not much more than “noise,” frequently reversing in the coming months or quarters. It is therefore more informative to focus on what has happened in the most recent year.”⁴

The top 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 June 30, 2021⁵

See here.

Truth be told, even one year does not align with how we view the world. While many equity-oriented mutual funds have an average holding period of less than one year, Crescent walks the walk with lower turnover than two thirds of the broad equity-oriented and allocation mutual funds.⁶ Of course a longer than average holding period does not guarantee higher than average returns, but it reflects how we are willing to manage your capital (with ours alongside) in a differentiated manner in our quest for differentiated after-tax returns.

With the above in mind, we thought it would be interesting to look at the historical performance of the ten largest holdings which the Fund has held for at least the past three years. Though the returns for all fell broadly into the range of the targeted equity-like returns we aim to deliver, each name went through a period of at least two quarters for which performance was at best flat. However, what we find particularly interesting is that some of the better performing names required significant patience, with 30% of the observations compounding at 20%+ per year from our first purchase despite multi-year periods of flat performance during our ownership.

Exhibit C: Top Ten Holdings as of June 30, 2021⁷

While it certainly would have aided Fund returns if we had been able to enter, exit, and ultimately re-enter each name to avoid the periods of fallow results, such ambidexterity is easier said than done. We say this with experience, having previously sold shares in high quality equities assured in the belief we would be able to repurchase them in the future at a lower price. Oddly, even when the shares did subsequently trade off, we demonstrated an uncanny consistency for proclaiming the right price for re-entry to be some 5-10% lower than where the shares ultimately bottomed. This has led us to conclude that when it comes to investing in quality equities, one of the keys to generating attractive compound returns is to not interfere with the process of compounding.

So, while at times it may look like we are sitting on names that are stuck in the mud, it is fair to assume we are not overly perturbed by short-term underperformance provided we remain confident that such securities are simply building kinetic energy ahead of delivering future gains. In this manner you can think of us coming into the office each day and not eating the marshmallow lying on our desk, confident that our delayed gratification will be rewarded in the form of a much larger marshmallow at a future date.

We believe this approach has served us well over time at the portfolio level. Looking at rolling five-year periods since the inception of the Fund, we would argue the Fund has done a respectable job of consistently delivering equity-like rates of return over extended periods. The kink of course is that one could only realize these returns by holding the Fund through periods of underperformance and resisting the urge to look for a tastier marshmallow elsewhere. We realize this style of investing with a multi-year outlook is not for everyone, but if you are reading this commentary, we thank you for partnering with us on the journey.

But past aside, the matter at hand is how the Fund is currently positioned and what prospective returns will be in the coming years. Unfortunately, we still do not have a crystal ball to tell us what the future holds for inflation, variants, or GDP growth. We can tell you with confidence that we like what we own in terms of quality and value and are comfortable with our current level of net exposure. Though we do not view the market at large as particularly inexpensive at present - as we called out in our Q1 2021 letter, we are not overly concerned with where the market may trade, as we don’t own the market. As for what we do own, as illustrated in Exhibit E, the Fund’s long equity holdings are cheaper than the market as measured by 1-year forward price to earnings and current price to book despite not making any sacrifices as it relates to historical or perspective earnings growth.

Stepping back for a moment, many managers start with an index benchmark when constructing their portfolio and then play a game of over- or underweighting various names or sectors. In sharp contrast, we start with a completely blank page and have a portfolio that looks nothing like any index we have ever observed. So, while we own many well-known companies, such as three of the FAANG constituents, which we believe are reasonably valued, we also round out our holdings with a collection of names that either remain starkly out of favor or are largely absent from the major indices.10 Examples of such securities include our Asian holding companies such as LG Corp (XKRX:003550, Financial), Samsung C&T (XKRX:000830, Financial), Softbank (TSE:9984, Financial), and Swire Pacific (HKSE:00019, Financial), as well as our “Chinternet”-focused positions in Alibaba (BABA, Financial), Naspers (JSE:NPN, Financial)/Prosus (XAMS:PRX, Financial), and Baidu (BIDU, Financial).11

Though we have discussed the Chinese internet conglomerates regularly in prior commentaries and conference calls, LG Corp, Samsung C&T, and Softbank are names that were purchased in 2020, and we have yet to publicly profile. Interestingly, LG Corp and Samsung C&T trade at discounts to our estimates of intrinsic value greater than 50% based exclusively on publicly traded marks, while also trading at a single digit multiple to our estimates of look through after-tax earnings for 2021. As for Softbank, look through earnings are challenging to calculate due to limited disclosure for many of the private holdings, but the discount to intrinsic value estimates based on private and public marks is similarly wide to the other two names. Regardless, in all instances we are afforded the privilege of investing alongside the controlling family or founder, and moreover, we believe the underlying asset quality of each conglomerate has significant appeal, as we will briefly review in this quarter’s public conference call.

As for Alibaba, Tencent (HKSE:00700, Financial) and Baidu, we believe they trade at very wide discounts to intrinsic value estimates based on the “sum of the parts” – a four word phrase analogous to a four letter curse word for investors with time horizons shorter than our own. While we readily acknowledge many of these “parts” may not contribute to earnings for several years, as genuine long-term oriented investors, we relish the opportunity pick up cheap or even free options, as we believe exists in the form of autonomous driving within Baidu or the cloud business within Alibaba. This is no different to how we viewed asymmetric optionality in past years in the form of Waymo/Youtube within Alphabet (GOOG, Financial), and Occulus/Whatsapp within Facebook (FB, Financial).

Speaking of free options, we have also spent the past quarter assembling a portfolio of special purpose acquisition companies or “SPACs”, for which we see a positively skewed potential for returns versus the commensurate risk. For those not familiar, a SPAC is a non-operating corporate shell set up by a sponsor to pursue an acquisition of an unknown business on unknown terms. Mechanically, a SPAC’s IPO proceeds are placed into an interest bearing trust, and the money in trust can only be used to complete an acquisition or it will be returned to investors if the sponsor fails to complete a deal (typically a two-year window from the SPAC IPO).

In each case, we seek to acquire the SPACs at roughly equal to or slightly less than the trust value per share, mitigating the long-term risk of a permanent loss of capital. The upside occurs if the market takes a favorable view on a potential deal, which would result in the shares trading at a premium to trust value and provide the option to exit the holdings with a capital gain. Alternatively, should investors take a dim view of an announced transaction, we could simply exercise our redemption rights to receive the trust value of the shares in cash.

Quite often we are also buying a share in a SPAC with a unit for warrants attached. In this instance, we have the opportunity to retain the warrants and participate in the future upside of the SPAC even if we choose to sell or redeem the shares prior to the closing of the actual acquisition. In summary, we view our SPAC basket as a case of “heads we win, tails we don’t lose.”¹²

As for other activity in the portfolio, our valuation discipline has made it challenging to put capital to work in this market that has largely been up and to the right. Nonetheless we have used the occasional pullback to opportunistically establish toehold positions in a handful of new names. Of the roughly 600bps of current exposure attributed to new purchases in 2021, half has been towards SPACs, and the balance largely towards digitally focused firms. Though our recent digital investments are not necessarily bleeding edge tech companies, we believe the purchase of each is an additional step towards the never-ending goal of further future-proofing the portfolio.

Closing

In order to optimize the likelihood of future success, we operate in a perpetual state of adaptation. We tackle each day in the hopes that we learn something new that helps us to be better prepared to face the inevitable challenges and act on new opportunities.

Al Osborne, a long-time investor in Crescent and one of the FPA Fund’s valued independent board members, offered us this observation from the novelist, playwright, essayist, poet, and activist James Baldwin, “Not everything that is faced can be changed, but nothing can be changed until it is faced.” We can’t bend the world to our will, but we can always improve.

Thank you for entrusting us with your capital.

Respectfully submitted,

FPA Crescent Portfolio Management Team

July 27, 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. 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 June 30, 2021 was 76.9%.
3. 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.
4. The Q3 2019 Commentary can be found at: https://fpa.com/docs/default-source/funds/fpa-crescent-fund/literature/quarterly-commentaries/fpa-crescent-fund-commentary-2019-q3b0f6f4531b0367849d6cff0000f7084a.pdf?sfvrsn=2de9939d_6.
5. 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.
6. Source: Morningstar Direct. Broad equity-oriented mutual funds are represented by the “Equity” Morningstar Global Broad Category Group and equity-oriented allocation mutual funds are represented by the “Allocation” Global Broad Category Group. As of 12/31/2020, the average turnover for the funds in these categories is 73.5%. The Fund’s turnover rate as of the year-ended 12/31/2020 was 29%.
7. Source: FPA, Bloomberg. For illustrative purposes only.
8. Source: Morningstar Direct. The chart illustrates the monthly five-year rolling average returns for the FPA Crescent Fund-Institutional Class (‘Fund”) from July 1, 1993 (the first full month of performance since inception) through June 30, 2021 compared to the S&P 500 Index (“Index”). The horizontal axis represents the five-year rolling average returns for the Index, and the vertical axis represents the Fund’s five-year rolling average returns. The diagonal line illustrates the relative performance of the Fund vs. the Index. Points above the diagonal line indicate the Fund outperformed in that period, while points below the line indicate the Fund underperformed in that period. The table categorizes returns for three distinct market environments: a “down market” is defined as any period where the five-year rolling average return for the Index was less than 0%; a “normal market” is defined as any period where the five-year rolling average return for the Index was between 0-10%; and a “robust market” is defined as any period where the five-year rolling average return for the Index was greater than 10%. There were 277 five-year rolling average monthly periods between July 1, 1993 and June 30, 2021. Comparison to the S&P 500 index is for illustrative purposes only. The Fund does not include outperformance of any index or benchmark in its investment objectives.
9. Source: CapIQ, Factset, Bloomberg, FPA calculations. 3-Year Forward Estimated EPS Growth is based on FPA calculations using consensus data from CapIQ, Factset and Bloomberg. Forward looking statistics are estimates and subject to change. Comparison to the S&P 500 and MSCI ACWI Indices is being used as a representation of the "market” and is for illustrative purposes only. The Fund does not include outperformance of any index or benchmark in its investment objectives. Please refer to Footnote 3 for the definition of the long equity holdings and other important information, and refer to Page 1 for net returns of the Fund. The long equity holdings average weight in the Fund was 75.0% and 74.6% for Q2 2021 and TTM through 6/30/21, respectively. The long equity holdings average weight in the Fund was 70.2% and 69.3% for Q2 2020 and TTM through 6/30/20, respectively. The long equity statistics shown herein are 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 results similar to those shown. Long equity statistics noted herein do not represent the results that the Fund or an investor can or should expect to receive. Fund shareholders can only purchase and redeem shares at net asset value.
10. The FAANG constituents include: Facebook (FB, Financial), Apple (AAPL), Amazon (AMZN), Netflix (NFLX), and Alphabet (GOOG, Financial).
11. Portfolio composition will change due to ongoing management of the Fund. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities listed. This is not a recommendation for a specific security and these securities may not be in the Fund at the time you receive this commentary. The portfolio holdings as of the most recent quarter-end may be obtained at fpa.com.
12. SPACs involve risks. There is no guarantee that the Fund’s investments in SPACs will be profitable. Please see Important Disclosures for more information about the risks of investing in SPACs.

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 or sectors 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 or sector examples discussed. The portfolio holdings as of the most recent quarter-end may be obtained at www.fpa.com.