Dear Fellow Shareholders,
The FPA Queens Road Small Cap Value Fund (“Fund”) returned -2.25% in the third quarter of 2023 vs. -2.96% for the Russell 2000 Value Index. Year to date, the Fund has returned 2.57% vs. -0.53% for the Russell 2000 Value Index. As a reminder, we expect to outperform in down markets and trail somewhat in speculative markets as a result of our diligent, disciplined, and patient process.
Market Commentary
We are fundamental, bottom-up stock pickers and spend our time researching companies one by one. We don't make macro bets, and we don't try to predict the short-term direction of the market. We do, however, consider issues that we believe broadly affect small-cap indices. Right now, the two most relevant issues for small-caps as an asset class are elevated profit margins and rising debt servicing costs. We think that these issues further the case for active management in small-cap investing.
Headline valuation ratios for small-caps are cheap relative to large-caps. 2 But, from our bottom-up perspective, valuations for most quality small companies are still full. As we discussed in our last letter, some of this valuation discount at the index level is compositional.3 Even excluding the large number of unprofitable companies in the Russell 2000, small-cap indices include many more financial companies (especially banks) that we believe deserve to trade at low multiples and fewer tech companies that tend to trade at higher multiples. And some of the small-cap discount can be attributed to a large number of small companies that appear to be overearning, pushing their headline valuations lower (home builders and housing materials, specialty retailers, trucking and shipping, et al.). As shown in the chart below from Ed Yardeni, small-cap profit margins are significantly elevated relative to history. But estimates for 2024 margins, the lower red line, are declining (Yardeni looks at the S&P 600 rather than the Russell 2000 Value Index, our benchmark. The companies in the S&P 600 are required to be profitable and tend to be larger and higher quality than those in the Russell 2000 Value Index, but the point holds).4
The second big picture issue we are monitoring is debt service. Interest rates are up significantly from a year ago and are starting to impact corporate interest costs, with the ripple effect of slowing the economy. Many small-cap companies are lower quality than large-caps. But, according to research by RBC Capital Markets, their debt profile also tends to be worse. Small-caps generally have more debt, a shorter weighted-average maturity (4.8 years for the Russell 2000 vs. 8.8 years for the S&P 500), and more floating rate debt (slightly more than 50% vs. slightly under 40% for the S&P 500).5 In the most-recent rate-driven market sell-off since the July peak, the Russell 2000 performed worse than the S&P 500, -11% vs. -7% respectively. The chart below, from a recent article in the Financial Times and data from Ned Davis and Capital IQ, shows the recent spike in small-cap interest expense. This will accelerate as low-cost fixed-rate debt continues to roll off company balance sheets.6
These factors help make an attractive case for active ownership of small-caps. When we look across our portfolio, we see a collection of higher-quality, smaller companies with strong franchises and constructive long-term outlooks. The companies we own have conservative debt loads and are in favorable industries. And while quality small companies aren't on sale as they were during the financial crisis, the depths of Covid, or even the taper tantrum at the end of 2018, we believe valuations on the companies we own are attractive.
Quality and the Four Pillar Process
Our investment process has four pillars:
- Balance-Sheet Strength –We seek companies with strong balance sheets. We are notcomfortable owning companies that have significant liabilities (e.g., debt, legal, regulatory, pension, or something inherent in their business models) that could cause insolvency concerns when there is an economic, financial, or any other kind of crisis. We want to make sure we are invested in companies that have staying power.
- Valuation –We normalize economic earnings over full market cycles, primarily using free cash-flow discount valuation models. We demand a margin of safety.
- Management – We evaluate management's track record oflaying out a long-term strategy andsuccessfully executing their stated objectives.
- Sector and Industry Analysis –We own companies in growing industries with stable competitivedynamics and favorable economics. We avoid commoditized or overly-competitive industries.
We have a preference for long-term compounders – i.e., high-quality franchises with strong balance sheets, proven management teams, and attractive industry dynamics that we hope to own forever. Compounders don't usually come cheap, and while we are always valuation-conscious, we are generally willing to pay a little bit more for higher quality companies.
So, what do we mean by quality? At the most basic level, quality means we can have confidence that a company's earnings and cash flows will be greater in three-to-five years than they are today. Different investors look at different metrics to describe quality. High returns on-capital, high operating margins, organic growth, high cash conversion, and low debt are all indicators of quality. But at the end of the day, we take a holistic look at our companies, identify their risks, try to remain conservative and judicious, and compare their current prices to our confidence in their futures. Our four pillars – balance sheet strength, valuation, management, and industry analysis – guide this process.
Historically, quality has been a large contributor to our outperformance during market downturns.7 Low leverage allows companies to survive and reinvest during downturns. Strong management teams can be trusted to shepherd their companies through headwinds and seek out new growth opportunities. Entrenched competitive positions and industries with favorable outlooks mean that the passage of time is our friend. In practice, it is never this easy. It is rare to find a company that sits cleanly atop each of our four pillars. But when things get complicated and the future seems uncertain, the four-pillar framework helps us keep a long term perspective.
1 As of September 30, 2023. Source: Morningstar Direct, FPA. Data shown for the FPA Queens Road Small Cap Value Fund – Investor Class (“Fund”). Inception of the Fund was June 13, 2002. The periods referenced above reflect Russell 2000 Value drawdowns 15% or greater and are calculated from that index's peak and trough dates, (i.e., 6/14/2002-10/9/2002, 6/5/2007-3/9/2009, 5/10/2011-10/3/2011, 6/24/2015-2/11/2016, 9/20/2018-12/24/2018, 1/16/2020-3/23/2020, 11/8/2021-9/30/22). Please see page 1 for net performance of the Fund since inception. Please also see the end of this presentation for Important Disclosures and Definitions of key terms. Past performance is not indicative, nor is it a guarantee, of future results.
2 Source: Morningstar; Small-Cap Stocks Are Really Cheap; December 2, 2022; https://www.morningstar.com/markets/small-cap-stocks-are-really-cheap; also; Market Brief: Fading Recession Fears, Cheap Valuations Have Small-Cap Stocks Looking Attractive; June 2, 2023 https://www.morningstar.com/markets/fading-recession-fears-cheap-valuations-have-small-cap-stocks-looking-attractive.
3https://fpa.com/docs/default-source/funds/fpa-queens-road-small-cap-value-fund/literature/fpa-qr-small-cap-value-fund-commentary-2023-06_final.pdf?sfvrsn=74749f9d_8
4Source: Yardeni Research, Inc.; Global Index Briefing: S&P 600; October 16, 2023; We like the chart packages from Yardeni, but the data on small-cap index valuations and margins are consistent with other authors and methodologies; https://www.yardeni.com/pub/int-sap600.pdf
5 Source: RBC; Small Cap Balance Sheet Fears – Transcript refers to the S&P 500; October 24, 2022; https://www.rbccm.com/en/insights/transcripts/small_cap_balance_sheet_fears.page
6 Source: The Financial Times; US small-cap stocks wilt in the heat of higher interest rates; September 26, 2023; https://www.ft.com/content/9de514d5-678b-4b52-91e1-86fd53794d13
