Bob Rodriguez's FPA Capital Fund returned 18.33% for 12 months ended March 31, it outperformed all of the major indexes by substantial margins, despite carrying a very elevated cash and bond position. He is very cautious and the fund's liquidity level rose to nearly 44%. "Despite adding two new holdings and increasing our ownership in several of the Fund's other positions, portfolio liquidity is at a record level since we began managing your Fund in July 1984. This elevated liquidity level is not a statement that we feel the stock market is going to decline imminently, but rather that we are finding it difficult to uncover sufficient investment opportunities that meet our valuation requirements."
The market's valuation landscape is very flat. The stock market's flat valuation landscape is proving to be a challenge for us in the rational deployment of your capital. We should clarify one aspect of our investment methodology - it is based upon a process of absolute valuation rather than relative valuation. Because of this, we can be at odds with other value-style managers that use more of a relative valuation metric. This difference in methodology can show up in the construction of style indexes, as well. For example, During a period when high-expectation stocks, i.e., speculative-type stocks, are leading the way, your Fund is likely to lag in performance, even without its high liquidity level. It is our discipline that prevents us from participating in a stock market that has these valuation tendencies. Though we did have winners during this last quarter, we did not have enough of them to overcome the lagging performance of several of our holdings, as well as our high liquidity level. This same observation applies for your Fund's fiscal-year performance. Though it did underperform the Russell 2000 and the Russell 2500 for the fiscal year, it did outperform the Lipper Mid-Cap Value Fund Average and the S&P 500. We believe the Fund's lower relative return reflects both our selectivity and defensiveness, at a time when we perceive that investment risks are rising.
The Fund's two largest sectors are energy and retailing, with each at slightly more than 18% of the portfolio. Despite large price rises in several of our energy stocks, we continue to hold most of them since we do not believe their share prices fully discount the expected growth in profitability that we anticipate. If we are correct in our estimates, most of them are valued at a single-digit or low double-digit P/E ratio. Furthermore, we believe they will be able to maintain this level of profitability for several years. Should we get a decline in energy prices (reasonably likely), we hope to use any period of price weakness to add new energy holdings to the portfolio, since we consider this area to be a strategic one for us. As for retailing, we believe our investments are directed toward retailers that have strong competitive positions and provide an attractive value proposition. Should the economy weaken, as we will discuss shortly, our retail holdings will probably experience some price weakness. In several cases, should this occur, we may add to some of our existing holdings.
In our opinion, stock prices would initially begin to move higher but then they would likely be constrained by the negative effects of higher interest rates. As economic growth slowed in the second half, so would corporate profitability. We still hold this view.
We see pressures building that are likely to slow corporate profitability growth. The rising tide of interest rates and a flat yield curve are not positive for the profitability of financial institutions in general. To maintain their existing profitability level, they must accept either more credit risk or more interest-rate risk and in some cases, both. In either case, it results in a higher risk profile. This trend is likely to lead to a higher degree of profit variability for financial institutions. With the financial sector near an all time high percentage of the various stock-market indices, any profitability disappointments could lead to a higher level of stock-market volatility with a negative bias. Rising commodity costs pose a risk as well since, unless a corporation is able to pass along these increased costs or reduce their negative effects by efficiency improvements, its profit margins are likely to suffer. Finally, various measures of wage expense growth show that this area is rising at a rate of approximately 3.5%. We are entering the fourth year of an economic recovery and therefore, it is likely that productivity improvements should be harder to come by to offset this rising cost. Again, corporate profitability may suffer. With after-tax corporate profit margins at post-war highs, there is little margin for error going forward. This process may be more visible by the end of this year, when we expect that S&P 500 profit growth will have decelerated to an approximately mid single-digit growth rate.
Our sense that there is little margin for error is in stark contrast to measures of stock-market volatility and bullishness. As we mentioned before, stock-market volatility measures are near all-time lows. Several measures of stock market bullishness are at elevated levels while, at the same time, mutual-fund industry liquidity is at an all-time low. We have no idea what the future will bring, but we do know that rarely are so many confident people correct. This is our natural contrarian way of thinking. As I once was told, “You never know the value of liquidity until you need it and don't have it.” We hope to be a liquidity provider when others desperately need it. We will do so but at a very high price.
Read the complete report
The market's valuation landscape is very flat. The stock market's flat valuation landscape is proving to be a challenge for us in the rational deployment of your capital. We should clarify one aspect of our investment methodology - it is based upon a process of absolute valuation rather than relative valuation. Because of this, we can be at odds with other value-style managers that use more of a relative valuation metric. This difference in methodology can show up in the construction of style indexes, as well. For example, During a period when high-expectation stocks, i.e., speculative-type stocks, are leading the way, your Fund is likely to lag in performance, even without its high liquidity level. It is our discipline that prevents us from participating in a stock market that has these valuation tendencies. Though we did have winners during this last quarter, we did not have enough of them to overcome the lagging performance of several of our holdings, as well as our high liquidity level. This same observation applies for your Fund's fiscal-year performance. Though it did underperform the Russell 2000 and the Russell 2500 for the fiscal year, it did outperform the Lipper Mid-Cap Value Fund Average and the S&P 500. We believe the Fund's lower relative return reflects both our selectivity and defensiveness, at a time when we perceive that investment risks are rising.
The Fund's two largest sectors are energy and retailing, with each at slightly more than 18% of the portfolio. Despite large price rises in several of our energy stocks, we continue to hold most of them since we do not believe their share prices fully discount the expected growth in profitability that we anticipate. If we are correct in our estimates, most of them are valued at a single-digit or low double-digit P/E ratio. Furthermore, we believe they will be able to maintain this level of profitability for several years. Should we get a decline in energy prices (reasonably likely), we hope to use any period of price weakness to add new energy holdings to the portfolio, since we consider this area to be a strategic one for us. As for retailing, we believe our investments are directed toward retailers that have strong competitive positions and provide an attractive value proposition. Should the economy weaken, as we will discuss shortly, our retail holdings will probably experience some price weakness. In several cases, should this occur, we may add to some of our existing holdings.
In our opinion, stock prices would initially begin to move higher but then they would likely be constrained by the negative effects of higher interest rates. As economic growth slowed in the second half, so would corporate profitability. We still hold this view.
We see pressures building that are likely to slow corporate profitability growth. The rising tide of interest rates and a flat yield curve are not positive for the profitability of financial institutions in general. To maintain their existing profitability level, they must accept either more credit risk or more interest-rate risk and in some cases, both. In either case, it results in a higher risk profile. This trend is likely to lead to a higher degree of profit variability for financial institutions. With the financial sector near an all time high percentage of the various stock-market indices, any profitability disappointments could lead to a higher level of stock-market volatility with a negative bias. Rising commodity costs pose a risk as well since, unless a corporation is able to pass along these increased costs or reduce their negative effects by efficiency improvements, its profit margins are likely to suffer. Finally, various measures of wage expense growth show that this area is rising at a rate of approximately 3.5%. We are entering the fourth year of an economic recovery and therefore, it is likely that productivity improvements should be harder to come by to offset this rising cost. Again, corporate profitability may suffer. With after-tax corporate profit margins at post-war highs, there is little margin for error going forward. This process may be more visible by the end of this year, when we expect that S&P 500 profit growth will have decelerated to an approximately mid single-digit growth rate.
Our sense that there is little margin for error is in stark contrast to measures of stock-market volatility and bullishness. As we mentioned before, stock-market volatility measures are near all-time lows. Several measures of stock market bullishness are at elevated levels while, at the same time, mutual-fund industry liquidity is at an all-time low. We have no idea what the future will bring, but we do know that rarely are so many confident people correct. This is our natural contrarian way of thinking. As I once was told, “You never know the value of liquidity until you need it and don't have it.” We hope to be a liquidity provider when others desperately need it. We will do so but at a very high price.
Read the complete report
