Steven Romick (Trades, Portfolio) is the portfolio manager of the FPA Crescent Fund. According to his GuruFocus profile, the fund has delivered more than 11% a year on average over the past decade.Â
GuruFocus says Romick's portfolio consists of both long and short equity positions. He also has sizeable positions in short-term bonds and cash. In addition:
"He seeks value in all parts of a company's capital structure, including common and preferred stocks, as well as corporate and convertible bonds. The manager invests in securities 'that the consensus does not wish to own,' searching for stocks and convertible bonds that reflect low price-earnings ratios and trade at discounts to private market value. Corporate bonds with yields substantially higher than those of government securities are also considered."
Crescent just held an investor day with a very interesting presentation about their market view. I thought it was especially interesting because, although somewhat bearish, it conflicts with that of GMO, who is doubling down on emerging markets. Here are some of the highlights, followed by my commentary (emphasis mine).
Interest rates drive stocks
"If I had to pick one chart that has been the greatest driver of stock market returns, it would be the one here, which shows the decline of interest rates in the U.S. If I were to overlay the CAPE earnings yield for the U.S. market, you would see that as interest rates have fallen, the earnings yield of the market has also fallen. Said differently, when interest rates go down, stock prices go up. Earnings growth has not been the biggest driver of stock prices. In 1982, you can see on the graph above that the earnings yield was more than 15 percent, or about the same as the 10-year Treasury bond. And here we are today with earnings yield and interest rates still trading in lockstep."
This observation is utterly simplistic, but also extremely powerful. If you look at the chart below, you have to give central banks more credit than you might like to. Especially as they have embarked on the path of rolling back their extraordinary measures:
Global markets are expensive
Where FPA really clashes with the market views as espoused by firms like GMO are in that it's not just U.S. stocks that are overvalued. Pretty much everyone agrees U.S. stocks are extremely expensive as we are in the midst of one of the longest bull markets in history:
"This rally has truly been unprecedented. The S&P 500 had 15 consecutive months of positive performance, a streak broken in February. The longest previous streak was 10 months -- and that happened just once. Before that, the longest streak was 9 months, and that, too, also happened only once."
The S&P 500’s projected price-earnings ratios show the market is priced only slightly above average – but that average is terribly skewed by the 1998-99 period of hypervaluations. Also, forward price-earnings ratios have generally proven to be overly optimistic.
"...Valuations are high. U.S. P/E ratios are higher than either of the prior two market peaks... ....and so are price-to-sales ratios and price-to-book ratios..."
But where GMO is plowing massive amounts of money into emerging markets, FPA hesistates:
"There is a view that stocks are much cheaper outside the U.S., but that’s a view from 30,000 feet and inaccurate when you compare a U.S. company to a reasonable analog outside the U.S. Like-for-like companies are priced similarly around the world. For example, on a trailing twelve-month basis, Nike trades at 28.9 earnings, while Germany’s Adidas trades at 29.6 times. The insurance broker Marsh McLennan trades at 21 times, and UK’s Aon trades at 31.2 times. Proctor & Gamble trades at a 10 percent discount to Unilever."
While this is an interesting point, I think there are simply no reasonable analogs outside of the U.S. Tech makes up almost 25% of the S&P 500. In Europe, tech doesn't even make up 10% of the market. Tech also happens to be one of the "more overvalued" segments at very high multiples.
European high-yield bonds much worse
The European Central Bank has been aggressively buying bonds, which, I would argue, distorted bond markets. FPA thinks European high-yield bonds offer a return of just 0.3% after defaults. That's with inflation above 2%, turning it into a factual loss. Not to mention some Europeans will need to pay taxes on that yield as well.
"The U.S. high-yield market offers a 6.3 percent gross yield. E.U. high-yield bonds offer even less return, just 3.2 percent. One is unattractive, given the risk, and the other is downright scary. Remember, these are gross yields. If one were to reduce the gross yield by the net default rate and to assume that past default and recovery rates are a guide, as I have done here, then the net yield would be just 4.2 percent for U.S. high-yield bonds and 0.3 percent for the E.U. equivalent."
Although FPA disagrees with some of the other shops I follow, they do arrive at a similar conclusion; have some cash around to go shopping when the blood starts gushing through the streets (figuratively speaking, of course):
"We have been active buyers at all the large and small peaks. In the early Aughts, 2008 and 2009, 2011 and 2012, and most recently in late 2015 and early 2016 when we were buying financial stocks. We’re counting on a value resurgence but have no idea how long we will have to exercise patience."
Disclosure: No positions.
