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

Dear Shareholder:

Overview

The FPA Crescent Fund – Institutional Class (“Fund” or “Crescent”) gained 1.87% in 2021’s fourth quarter and increased 15.17% for the calendar year.¹ The Fund generated 64.2% of the average of the S&P 500 and MSCI ACWI NR USD’s (“MSCI ACWI”) return in 2021, underperforming its own 75.8% 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

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 December 31, 2021⁴

Economic recovery and persistent easy money continued to underpin the financial markets, allowing 2020’s global stock market rally to continue in 2021 and benefiting certain positions held in the Fund (as much as global stock volatility temporarily hurt their stock prices in Q1 2020). Crescent’s top five contributors added 8.2% to the Fund’s return in 2021, about 3.2x the sum of the top five detractors. Importantly, there was a lack of significant news that impacted the individual investments in the above table.

Exposure to each of the top five contributors was reduced in 2021, as their respective valuations reached levels high enough to warrant a reduction in holding size, but not their complete elimination from the portfolio. We did sell out of nine stocks completely in 2021, however. We similarly moved on from these positions largely as a result of valuation, which also drove other changes. Along with the reduction in position size of six financial service companies, we also eliminated positions in Bank of America (BAC, Financial) and CIT Group (CIT, Financial). The Fund’s exposure to travel-related companies was also reduced as a function of selling some of our Marriott International (MAR, Financial) and all of Booking Holdings (BKNG, Financial) stakes.

We believe that the portfolio changes in the last year resulted in the exchange of less appealing risk-reward opportunities for more attractive ones. Ten new equities were added in 2021, including new positions in video game stocks Ubisoft Entertainment (XPAR:UBI, Financial) and Activision Blizzard (ATVI, Financial), which joined Nexon (TSE:3659, Financial) and Epic Corp (EPOR, Financial) to comprise our current sector exposure of 3.1%.

Unsurprisingly due to low yields, there were no new high yield positions and just one new private credit investment.

Crescent ended 2021 with net risk exposure of 74.8%, lower year over year by approximately five percentage points.

While the global stock markets remain at more elevated valuation levels, the potential for continued financial repression and its inflationary consequences is the reason why Crescent has a larger position in equities than has been typical (and less in corporate bonds). We believe that more “balanced” portfolios of stocks and bonds (e.g., the 60/40 equity/fixed income portfolios) are likely to generate weaker long-term returns, dragged down by the low yielding bonds – both investment grade and high yield, when compared to a more equity-centric portfolio. The poor performance of fixed income instruments last year, as shown in Exhibit C, and in stark contrast to the equity returns shown in Exhibit A, might just be a harbinger of things to come.

Wrestling with how much to own of stocks versus bonds doesn’t seem like much of a contest. The low starting yields of bonds in general, and corporate bonds more specifically with their additional burden of potential default, offered a negative real yield at quarter end and into the beginning of 2022. With such an anemic starting point, it appears that the earnings growth potential of stocks affords the better opportunity for those with a longer-term view despite higher-than-average equity valuations (Exhibit D).

The S&P 500’s estimated 2022 P/E is 21.5x, which in its inverse translates to an estimated earnings yield of 4.7%. Given lower stock valuations outside the U.S., the estimated 2022 earnings yield for the global MSCI ACWI is a higher 5.6%. Contrast this with a 1.5% 10-year U.S. Treasury yield or worse, the 0.07% and -0.09% yields for Japanese and German government bonds.⁷

Assuming positive economic growth over the next decade, we believe the total return potential of stocks should exceed that of bonds, albeit with greater volatility. While volatility satisfies the institutional definition of equity risk, we have a different view. More precisely, risk is losing money, or a permanent impairment of capital, and should not factor in episodic, yet temporary price declines. Crescent’s oft-stated goal is to deliver an equity-like rate of return while avoiding a permanent impairment of capital. The potential discomfort that comes with the ups and downs of the market must be borne if one is to achieve equity-like rates of return.

It is not a truism that more invested = more risk. There are different kinds of risk. We believe, for example, that being less invested in risk assets invites the greater risk of inflation eroding the value of your cash or “conservative” fixed income instruments.

The easy money environment since the great financial crisis set the stage for higher inflation. The pandemic has made things worse, impacting both size and availability of the labor pool and causing supply chain disruptions. While one can reasonably argue that domestic inflation in the future will be lower than 2021’s 7%, we believe that inflation will likely average higher in this next decade than the preceding one – something that is not currently expected just as last year’s rise was not anticipated (Exhibits E and F).⁸

We manage your capital to seek to provide an acceptable real rate of return over time — both in the absolute and factoring in the risk assumed to achieve it. This requires us to seek to protect our/your portfolio from the diminution of real return that inflation can cause. To accomplish this, we:

• Own more stocks than the historical average (Exhibit G), including the Fund’s holdings of lower priced overseas-based businesses that we believe offer better potential for risk-adjusted returns than their US counterparts.
• Hold good to great quality businesses at good prices. Owning shares in businesses that are both less expensive and growing faster than the stock market should help to achieve our goal (Exhibit H).

• Have avoided low-yielding bonds, particularly those with unappreciated credit risk (Exhibit G).

Hopefully, the Fund’s long equity exposure will continue to outperform global indices as it has done historically. Long equities held by Crescent outperformed the S&P 500 by 0.70% since 2007 and beaten the MSCI ACWI by 4.22% since 2011 when the Fund began to tilt more international (Exhibit I).

Closing

We wish we could tell you the Crescent portfolio is as cheap as it has ever been, but given the market and the Fund’s strong performance since Q1 2020’s market bottom, you know that cannot be true. We have repositioned the portfolio as a function of old opportunities that have come to fruition and new opportunities that we believe offer reasonable prospects for attractive risk-adjusted future returns. The portfolio is also built to withstand multiple potential outcomes: e.g., inflation, stagflation, and recession.¹⁴

We just watched Peter Jackson’s The Beatles: Get Back. Although a music documentary, we couldn’t help but appreciate how those four young men from Liverpool managed to focus on what they do best and what they wanted to accomplish, despite pressure from others to do some things differently. Your portfolio managers similarly come together to concentrate on the long-term, which means shutting our ears to the many cacophonous voices that whisper to us in the short-term.

Best wishes in the New Year and may you and your families be in good health.

Respectfully submitted,

FPA Crescent Portfolio Managers

January 31, 2022

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 December 31, 2021 was 74.8%.
3. Comparison to the indices is for illustrative purposes only. The Fund does not include outperformance of any index or benchma rk 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. 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.
5. Source: Bloomberg. As of December 31, 2021.
6. Source: Yardeni.com, I/B/E/S data by Refinitiv, FRED. Chart data covers the period December 31,1978 through January 7, 2022. *Year-ahead forward consensus expected earnings divided by S&P 500 stock price index. Monthly through March 1994, then we ekly. **Monthly through March 1994, then weekly.
7. Source: Bloomberg, FRED. US, Japanese and German 10-year government bond yields as of December 31, 2021.
8. Average inflation over the past 10 years (2011-2020) was approximately 1.9%.
9. Source: FRED. Chart data covers the period December 31, 1965 through December 31, 2021. CPI stands for Consumer Price Index.
10. Source: FRED. Chart data covers the period December 31, 2002 through December 31, 2021.
11. Source: FPA. Chart data covers the period March 31, 1996 through December 31, 2021.
12. 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 74.4% and 75.1% for Q4 2021 and TTM through 12/31/21, respectively. The long equity holdings average weight in the Fund was 75.2% and 71.6% for Q4 2020 and TTM through 12/31/20, 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 rep resentation 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.
13. As of December 31, 2021, which represents latest data available. Data shown from January 1, 2007 as that is when FPA began capturing this data. CAGR shown for period 1/1/2007 through 12/31/2021 for the S&P 500 and for the period 1/1/2011 through 12/31/2021 for the MSCI ACWI.

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.