Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown. This data represents past performance and investors should understand that investment returns and principal values fluctuate, so that when you redeem your investment it may be worth more or less than its original cost. Current month-end performance data may be obtained by calling toll-free, 1-800-982-4372.
The Fund commenced investment operations on June 2, 1993. The performance shown for periods prior to March 1, 1996 reflects the historical performance of a predecessor fund. FPA assumed control of the predecessor fund on March 1, 1996. The FPA Crescent Fund's objectives, policies, guidelines and restrictions are, in all material respects, equivalent to those of the predecessor fund.
S&P 500 Index includes a representative sample of 500 leading companies in leading industries of the U.S. economy. The index focuses on the large-cap segment of the market, with over 80% coverage of U.S. equities, but is also considered a proxy for the total market. Barclays Aggregate Index provides a measure of the performance of the U.S. investment grade bonds market, which includes investment grade U.S. Government bonds, investment grade corporate bonds, mortgage pass-through securities and asset-backed securities that are publicly offered for sale in the United States. The securities in the Index must have at least 1 year remaining in maturity. In addition, the securities must be denominated in U.S. dollars and must be fixed rate, nonconvertible, and taxable. The Consumer Price Index is an unmanaged index representing the rate of the inflation of the U.S. consumer prices as determined by the U.S. Department of Labor Statistics. There can be no guarantee that the CPI of other indexes will reflect the exact level of inflation at any given time. The CPI shown here is used to illustrate the Fund’s purchasing power against changes in the prices of goods as opposed to a benchmark which is used to compare Fund’s performance. 60% S&P500/ 40% Barclays Aggregate Index is a hypothetical combination of unmanaged indices comprised of 60% S&P 500 Index and 40% Barclays Aggregate Index, the Fund's neutral mix of 60% stocks and 40% bonds. These indices do not reflect any commissions or fees which would be incurred by an investor purchasing the stocks they represent. The performance of the Fund and of the Indices is computed on a total return basis which includes reinvestment of all distributions. It is not possible to invest in an index.
Dear Shareholders:
The stock market declined in the third quarter of 2015, with the S&P 500 and the broader global index MSCI ACWI down 6.44% and 9.45%, respectively. The FPA Crescent Fund fell 4.73%, which was less than the overall market. For the nine-month period-to-date, Crescent declined 4.73%, while the S&P 500 and MSCI ACWI dropped 5.29% and 7.04%, respectively.
Crescent’s winners contributed 0.35%, while its losers detracted 1.62%. Generally speaking, in what was a difficult quarter, the more cyclical and more commodity-based companies performed the worst.
Value investors, in general, have it harder these days with value investing continuing to take a back seat to growth as growth indices again outperformed.1 In recent years, it seems there has been little need to own anything more than an index fund. Thinking – in the form of deep, fundamental analysis – isn’t worth the premium it once was. We are living in a world where beta has run over alpha – for now anyway.
Volatility has always been our friend and we’re wistful for its return. “Vol” has become a euphemism for something bad, like market declines (you’ll note that there’s not a lot of conversation around upside vol). For us though, bad can be good. Volatility can cause investors to sell and sometimes to do so indiscriminately. Being of sound(er) mind, we have captured some of that opportunity in the past and expect to do so again in the future.
So it shouldn’t come as a surprise that we haven’t been terribly excited about the pitches the market has been throwing us in the last couple of years. Although we step into the batter’s box every day, we haven’t taken many swings. We prefer the obvious and easy but this market makes it feel like Clayton Kershaw is on the mound. We had marginally reduced exposure coming into summer and then subsequently saw some good pitches in August and September, which allowed us to close the quarter with almost five points more exposure than at the start of the year. We were more active than we have been in quite some time. Total purchases accounted for 11.9% of average fund assets in the quarter and sales 9.3%, totaling 21.2%. In the first nine months of the year, we initiated eight new equity positions and exited five others. For the quarter, we initiated five and exited two. What we purchased was more inexpensive than what we sold. The average trailing Price/Earnings ratio (P/E)2 of companies purchased in 2015, including those initiated and increased, was 14.4x, compared to the P/E of those positions either reduced or eliminated, which was 19.4x.3 We also marginally increased our exposure to high yield in the quarter, initiating and adding positions in debt securities with an average yield of 11.6%.4
This is the off-quarter for our larger macro discussion on the economy and markets but we thought it as good a time as any to remind you why we offer that color in our year-end and semi-annual commentaries.
There are a couple of reasons. One, we live this every day and don’t want to take for granted that you know what’s been driving stock prices. If we are successful in paying a good or great price for good assets, it shouldn’t matter. Nevertheless, we have been told that these bigger picture views are helpful and therefore try to deliver accordingly.
Two, although we aren’t global macro traders betting on currencies, on the direction of interest rates or on something else, we do consider more global influences on the companies we consider for investment. We build our models with what we think are potential outcomes over the next two to three years in Low, Base and High cases. We aren’t good enough to consider what’s happening over shorter time frames.
An example of the big picture informing our judgement can be seen in our consideration of interest rates. Those companies that have more debt have benefited from interest rates bumping along all-time lows. When their debt matures, we’re not going to count on the fact that the level of rates and availability of capital will be the same as it is today. Therefore, in our Base case, we might normalize for a higher borrowing cost. We might be wrong, but in doing so we afford ourselves a larger margin of safety.
If companies can offer us a reasonable rate of return in the Base case while retaining some optionality on the High case, and if the Low case in that context isn’t too onerous, we’ll consider an investment – particularly if our research suggests that the Base and/or High cases are more likely than the Low case. We try not to be too precise. Precision can offer a false sense of security.
High Yield
High yield is an area in which we have recently been active and hope to be even more so in the future. High-yield bond prices have declined along with stocks – for the first time since 2008. The Barclays U.S. Corporate High Yield Index declined 4.86% in the third quarter, ending the first nine months down 2.45%. Although spreads (yields versus U.S. Treasuries) have increased, corporate high yield isn’t yet on sale.5 Most of the bump in spreads is due to the blow out of energy yields –now almost 1,100 basis points over Treasuries – as can be seen in the boxed area in the chart below. We haven’t yet reached a comfort level that energy high-yield bonds offer an appropriate margin of safety at our Low-case assumptions for the price of oil.
We have, however, made a number of other high-yield investments, moderately raising our exposure from 0.7% at year-end 2014 to 3.1% now. We are hopeful of increasing that further, markets permitting. Although prices have come down a bit, we’ve found that there hasn’t been much volume.
The bid/ask spread has traditionally been used to indicate at what price one can buy or sell. We find, however, that with such little volume on either side, that spread is portraying a false market – less an indication of two-way demand and more an invitation to begin negotiation.
One reason for this seems to be a by-product of increased financial regulation that accompanied Dodd-Frank, part of the financial reforms that followed the Great Recession. Corporate bond desks of brokerage firms and banks have largely stepped back from the market. U.S. primary dealers’ holdings of corporate debt securities have declined by more than 85% since peaking in October 2007, as reflected in the chart below.6 With more than $250 billion of market-making capacity gone, it’s no surprise that bonds are transacting at levels different than the bid/ask. If you really want to acquire a bond, you may have to accept an offer higher than indicated. If you really want to sell a bond, you may have to accept a lower bid.
Conclusion
We have taken some pride in not only the total return that we have been able to deliver over time, but also in the relatively tax-efficient nature of that return. Crescent’s pre-tax rank in Morningstar’s Moderate Allocation category has been good over time – note the 5, 10, and 15-year ranks below.7 Our after-tax performance holds greater importance to our taxable clients and you will note in each period that Crescent’s after-tax ranking is the same if not better.
Not only do our after-tax returns compare well over time, but the majority of our returns have been long-term capital gains. However, some years prove to be more tax-efficient than others. There is a time to reap and there is a time to sow. When we’ve taken a gain, it has generally been long-term. Fifty-seven percent of all fund distributions have been long-term capital gains.8 Eighty-five percent of Crescent's capital gains have been long-term. The balance has been taxed as ordinary income, the majority of which has been dividend and interest income.
Returns and capital gains are lumpy with some years higher or lower than others. You may now be able to guess where this is going. 2015 will not be our most tax efficient year. We currently estimate that the fund will pay a $1.74 dividend on December 15th. This level is not inconsistent with what has occurred at times in the past. However, being mindful of taxes has allowed us to move up the ranks when comparing post-tax to pre-tax returns. As taxable holders ourselves, we care greatly about after-tax returns and will continue to do so in the future.
We appreciate the trust and confidence that all our investors have in our strategy and strive each day to maintain it. We promise to always consider risk in the context of reward, recognizing that to do otherwise is antithetical to our nature. This leads us to generally err on the cautious side which, at times, may cause us to feel a bit lonely but we don’t know any other way.
Respectfully submitted,
Steven Romick (Trades, Portfolio)
President
October 28, 2015
1 As an example, the Russell 1000 Growth Index returned -5.29% in the third quarter, while the Russell 1000 Value Index returned -8.39%.
2. Price-to-earnings, or P/E is the price of a stock divided by its earnings per share.
3. We only use P/E as a proxy for valuation. It is not an end-all be-all. P/E uses income in the denominator, even though it can be vastly different from our preferred measure of free cash flow. In addition, trailing metrics may not be reflective of a businesses’ earnings power.
4. Yield-to-worst is provided. As of September 30, 2015, the Fund’s SEC yield was 0.78%. This calculation begins with the Fund’s dividend payments for the last 30 days, subtracts fund expenses, and uses this number to estimate your returns for a year. The SEC yield is based on the price of the fund at the beginning of the month. The income yield stated here reflects prospective data and thus assumes payments collected by the fund may fluctuate.
5. Barclays. Graph represents the Barclays U.S. Corporate High Yield Index and its energy sub-component spreads over U.S. Treasuries from 8/15/2000 – 9/30/2015.
6 New York Fed, CLSA.
7. Morningstar.
8. Includes current $1.74 distribution projection for December 2015, which is estimated as of October 23, 2015 and subject to change.
Also check out:
