Introduction
Dear Shareholders:
FPA Crescent Fund, or the Fund, returned -0.81% in the third quarter and 13.56% over the first nine months of 2019. This compares to -0.03% and 16.20% for the global MSCI ACWI and 1.70% and 20.55% for the S&P 500 over the same respective periods.
Long equities held by the Fund returned -1.33% and 19.47% in the third quarter and year-to-date, respectively. 1, 2
We previously exhibited contributors and detractors to the Fund’s performance for the most recent quarter and on a trailing twelve month basis. Quarterly price movements, however, are generally not much more than “noise,” frequently reversing in the coming months or quarters. It is therefore more informative to focus on what has happened in the most recent year, as shown below.
Developments in the Fund’s holdings can explain, in part, their stock price movement.
- Arconic has benefited from improved operating performance under new management.
- Comcast has continued to grow organically in the aggregate and begun to develop an over-the-top offering to deliver content streaming over the Internet as it repositions its legacy cable channel assets.
- Puerto Rico’s municipal bonds have benefited from favorable developments in the island's restructuring process. That, coupled with lower interest rates, has propelled the price of its bonds.
- Pacific Gas & Electric has suffered from devastating wildfires and a bankruptcy process that, to date, has evolved poorly for the company's equity. We remain hopeful that 2019 will not deliver any destructive wildfires and that the bankruptcy will result in a reasonable workout for all constituents.
- Owens Illinois reduced operating guidance for 2019 on account of adverse foreign exchange rates and near-term operational challenges. As of the end of the quarter, its stock trades at less than seven times its guidance for 2019 free cash flow and less than five times its average free cash flow over the past three years (adjusted for asbestos liabilities).
- Baidu, as discussed during the second quarter webcast, has lost market share in the Chinese online advertising market, with particular weakness seen in key verticals including healthcare and online gaming. Lower than expected revenue, combined with increased investments in ventures that are expected to produce profits only over the long term, has resulted in a demonstrable decline in profitability and led to a severe sell-off of the shares, resulting in what we believe to be is a very inexpensive valuation applied to its core search business.
- Mylan continues to face multiple headwinds including a challenging regulatory environment, pricing pressure on generic drugs in the U.S., and slower than expected regulatory approval of new products. We used the recent merger announcement between Mylan and the Upjohn division of Pfizer as an opportunity to trim into strength.
Continued market strength in the first three quarters of the year has delivered good and bad news. As noted above, the Fund’s long equity positions have increased in value along with, and slightly in excess of, the market. Market strength, however, has made most stocks more expensive -- and it wasn’t like they were being given away to begin with. With many companies priced as if bad news is a thing of the past only, we have found more opportunities to sell than to buy, thereby reducing the Fund’s net exposure to risk assets. The Fund’s net risk exposure was 66.1% at quarter-end versus 73.1% at the end of 2018. Adjusting for the soon-to-be-distributed cash from the Fund’s position in Altaba which has been selling down its stake in Alibaba, the Fund’s net risk exposure was even lower at 65.5%.
Threats to global equity markets abound. There are trade wars and negative interest rates that pervert asset pricing models, not to mention a rising tide of global populism, looming Brexit, and unprecedented global leverage. In the United States, during the quarter, we had an inverted yield curve, high valuations for risk assets, a president prone to tweets that spook the markets and, just around the corner, an election likely to produce a number of surprises.
Yet the equity markets, shrugging off such anxieties, continue to sustain and propel the longest U.S. economic expansion and bull market in recent history.4 Investors have generally bid up risk assets to the point that most offer less of a margin of safety than we like. With so much to ponder, we can offer little comfort as we don’t know what will happen.
So we will share our broader market views in our year-end letter. In the interim, we will continue to scout for opportunities that offer a better, more comfortable balance of risk and reward.
Respectfully submitted,
Steven Romick (Trades, Portfolio)
Co-Portfolio Manager
October 15, 2019
1 The performance of 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 exclude paired trades, short-sales, limited partnerships, derivatives/futures, corporate bonds, mortgage backed securities, and cash and cash equivalents. Please refer to the first page for overall net performance of the Fund since inception. The long equity performance information shown 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.
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.
3 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 TTM. 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. Past performance is no guarantee, nor is it indicative, of future results.
4 Source: National Bureau of Economic Research and JP Morgan Asset Management. There have been 123 months of economic expansion for the period June 1, 2009 through September 30, 2019, which bests the prior economic expansion of 120 months for the period March 1, 1991 through March 21, 2001. The current bull market has been ongoing since March 2009 through September 30, 2019.
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. 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 has 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 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 examples discussed. The portfolio holdings as of the most recent quarter-end may be obtained at www.fpa.com.
Investments, including investments in mutual funds, carry risks and investors may lose principal value. Capital markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. The Fund may purchase foreign securities, including American Depository Receipts (ADRs) and other depository receipts, which are subject to interest rate, currency exchange rate, economic and political risks; these risks may be heightened when investing in emerging markets. Foreign investments, especially those of companies in emerging markets, can be riskier, less liquid, harder to value, and more volatile than investments in the United States. Adverse political and economic developments or changes in the value of foreign currency can make it more difficult for the Fund to value the securities. Differences in tax and accounting standards, difficulties in obtaining information about foreign companies, restrictions on receiving investment proceeds from a foreign country, confiscatory foreign tax laws, and potential difficulties in enforcing contractual obligations, can all add to the risk and volatility of foreign investments.
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