As of September 30, the FPA Crescent Fund (FPACX, FPC1Z**) has had an annualized return of 9.38% for the last 15 years, the longest time period for which Morningstar presents data. That is 233 basis points ahead of its benchmark, the Morningstar moderate-target-risk total-return index. It also places it in the top 1% of its Morningstar peer group.
Steven Romick, CFA, is a managing partner of FPA, having joined the firm in 1996. He serves as a portfolio manager for the FPA Crescent Fund and Source Capital, Inc.
Steven was named a Morningstar Domestic-Stock Fund Manager of the Decade Nominee in 2009 and, along with Mark Landecker and Brian Selmo, Morningstar U.S. Allocation Fund Manager of the Year in 2013. Both awards were in recognition of his leadership with the FPA Crescent Fund.
I spoke with Steven on September 29.
** Schwab clients only.
In your June 2016 commentary, you remarked, “Value investing continues to be out of favor.” The underperformance during the past decade is nearly universal among value investors. Why do you think the style is having such difficulty, and what might happen to change that?
Growth sometimes wins, and other times its value. It goes through periods of time where one versus the other wins. Value did very well going up and into the great recession. But what generally happens when you go into a downturn and come out the other side, an economic recovery drives the market to higher and higher multiples the further you go into an economic cycle.
In any given year, we can’t figure out in advance which will outperform – growth or value. Looking over long periods of time, we are in the business of buying good businesses at good prices. That’s what value investing is to us, which means you’re investing with a margin of safety.
Although, I don’t think there’s a growth manager who would argue that what they own isn’t cheap. The same goes for value. But growth investors are willing to discount the future to a much greater degree than the traditional value investor, who wants more of a margin of safety in the here and now.
So as long as the market is good for a long period of time, growth can do better. But we’re in the eighth year of economic expansion. This is the weakest economic expansion we’ve had, relative to the size of the downturn, since the Great Depression. Cumulative GDP growth, relative to what we lost in GDP, shows that the recovery is punk by comparison to all other downturns since the 1930s.
What’s happened of late, in particular, is that people are paying up for yield. So PEs are going up, and the prices of a lot of high-quality, growing businesses are going up. But it defies gravity, to a degree, because we’re working on seven consecutive quarters of S&P 500 year-over-year earnings declines. It has never happened before that the market hits new highs at the same time bonds also hit all-time highs, and earnings are weakening. That’s an unusual combination.
So growth has outperformed value, as it has other points of time in the past. The reason it’s lasted as long as it has, I’d put firmly at the feet of central bank policies.
I’ll come back to central bank policies in a moment. But speaking of margin of safety, Seth Klarman, whom you quoted in a recent commentary, is on record along with Warren Buffett of warning of the dangers of using EBITDA in financial analysis. Do you use it in either debt or equity analysis and if so how?
EBITDA is just a number that’s calculated. We don’t use it by itself. We look at free cash flow.
If you look at the value of a company based on EBITDA, and compare it to some other company and value it on EBITDA, you’re assuming that the companies have equivalent cap-ex requirements.
Businesses have to be looked at based on the free cash flow they generate. That’s all it can spend. You don’t get to spend EBITDA. It’s cash flow you spend. I can go to the supermarket and buy my Campbell’s soup with my free cash flow. I can’t go there and buy my Campbell’s soup with my EBITDA.
I’d like to ask about some of your holdings. What is the value argument for owning Leucadia National?
We have a host of financials, in which we invested as the sector collapsed in price. Leucadia was one of those companies and is, in fact, a couple of different businesses. At a high level, we think there’s about $25 of net asset value there. When the stock was trading down in the mid-teens, it gave us a very large margin of safety.
It’s in the merchant banking and the investment banking businesses, and there’s some synergies between them and they’ve historically been good capital allocators. We are going to take advantage when good businesses trade at large discounts to their intrinsic value.
In investment banking it has Jefferies, and it also has a portfolio of owned businesses, which is the merchant banking part of the business. The most valuable of those businesses are National Beef Packing, Berkadia and Garcadia. There’s some publicly traded positions they have in the HRG Group and HomeFed Corp. They also own FXCM, which was in the press not long ago. It shows how Leucadia can be opportunistic and take advantage when things are in disarray. There’s also other assets, like, deferred tax assets, some cash and a number of other smaller operations.
When you add all these things up, conservatively we believe it gets you to a mid-$20s value, assuming it can continue to compound on its assets. It closed at $18.74 today. Versus a $25 net asset value, it is priced at $0.75 on the dollar. If it only grows at 5% annually, then we are getting a 6.7% return. If they’re able to grow the assets at a faster rate, call it at 8%, we’re getting a 10.7% return on our money, plus any narrowing of the discount.
We’re buying good assets at a discount with a good management team who we believe has the ability to compound the value of the company’s assets.
According to your commentary “Financials are currently our largest equity exposure at about 20%. Citigroup, as an example, traded down to ~60% of tangible equity at one point in the first quarter. We believe tangible equity is pretty solid, even after assuming a higher level of charge-offs.” How can one know the real capital structure or the tangible book value of a major bank when their derivative book is large and opaque?
That’s a fair question. You can’t. You have to count on the fact that the management team has the derivative book well in check.
If you look at issues that have gotten a lot of these banks into trouble, it’s generally on the loan side on-balance sheet, rather than the off-balance sheet derivatives. Some of the banks we own have derivative exposure and there is a certain opacity that exists. When we look at these businesses, we look how they’ve been priced historically as well as how we think they should be priced today. Banks in 2004-2005 were trading at 3 to 3.5-times book value. In our 2006 year-end shareholders letter, we talked about why different banks and investment banks didn’t make a lot of sense, given the valuations and prices that were being paid. Then prices dropped in the recession, and they were trading at 1x book or so. Then they dropped down even further in 2016, particularly in February, when they were bottoming. You would be able to buy banks at big discounts to book value. In our portfolio, at the end of June, the portfolio of different lenders that we own were trading, on average, at 0.7 times book, cheaper than they were in the great recession, in many cases. (I say in many cases because there were some subtle differences. Some of these companies were restructured, and we actually created securities as a result of that through the debt. But that’s an aside.)
In addition to being cheaper than they were in the recession, we would argue that their balance sheets are better than they were back then. Their loan books are better and they have far more equity capital supporting their assets.
Take Citigroup, for example, it was 3% tangible equity to tangible assets back in 2007 and it’s now three to four times that today.
Because of the risk that exists off balance sheet, there are things we truly can never know. We’ll never know exactly know what’s on the balance sheet either, admittedly, for example exactly the loans and how they might perform. We get all information with a time lag, at least in terms of nonperforming assets. For the derivatives, which are all off-balance sheet, it’s even more opaque, with less transparency than what’s on-balance sheet. Because of that, we know we can never hold too much in our portfolio. If these characteristics existed for a portfolio of industrial companies, our exposure would be 50% of the fund rather than 20%.
We feel that despite the unknowns and believing that so much of the risk is priced in at the prices we paid for these businesses, we were comfortable making investments in a host of different companies in this financial sector: like, Citigroup, Bank of America, CIT, AIG, and Leucadia/Jeffries. But they’re not out-sized positions given the inherent leverage and opacity you referenced.
To maintain our goal of delivering equity rates of return, while absorbing less risk in the market over full market cycles, we don’t want to be too oversized in this space.
You also stated in your commentary, “We strongly favor long-term, business-minded owners exercising influence and control over the companies in which we have an investment.” How does that statement comport with your 48% turnover rate?
I actually don’t think that’s a fair question because you’re looking at a turnover rate in one year and not looking at an average over time.
Let’s say we owned one stock for 10 years, and then we sold it and bought a new stock to replace it at the end of year 10. Our turnover rate would be 100%. You have to look at an average over time. I would argue that, if you look back over time, our average holding period ends up being five years for our core positions, if not longer. That’s pretty low. It correlates to a very low turnover rate of 20%.
But that gets up-sized by a few other factors. We had some shorter term bonds that were in the portfolio that matured. Shorter term bonds increase the turnover rate. Inflows and outflows have an impact on turnover rate as well.
We also took the opportunity to trade out of a lot of more expensive securities that had their move, and moved a lot of that capital into, for example, the financials. They were trading at much lower prices. We sold those businesses that were more in favor that had worked and then moved that capital into those companies that had not worked.
All you have to do is look at our fund over time and see that our average turnover rate is not as high as that 48%. Forty-eight percent was an unusually high year.
How does your practice of value investing differ from other value investors both within FPA and in the greater community of value investors?
That’s a great question. But that would require me to know how other people invest. Among the people whom we respect the most in the industry, I don’t think we differ substantively. We’re not that different from those managers who invest seeking a margin of safety, who wait opportunistically, and while they’re waiting don’t mind if they underperform, particularly in the latter stages of a bull market. Those value managers don’t mind if they sit with large amounts cash for periods of time, and are always working to understand businesses, so that when an opportunity arises, they are prepared.
There’s a lot of people who do it that way.
You spoke earlier about central bank policies. Do you believe the rates will remain low for a longer period of time? If so, wouldn’t that then justify a higher multiple being paid for businesses?
Although we have the lowest rates in history and have $11-12 trillion of sovereign debt trading with negative yields, we don’t know what comes next. But, we feel it is not a good bet to count on rates remaining as low as they are. It is not a good probability bet, with a good risk-reward tradeoff. That doesn’t mean it’s a bet that can’t be won. Bad bets are won all the time. But it is a bad bet, mathematically, with the asymmetry running the wrong way.
We’re not willing to count on the fact that rates are going to remain this low forever, or that central banks will continue to bail us out. We want to just analyze businesses and buy them at a discounted price, operate with a margin of safety, and hopefully, have some optionality that good things can happen. We strive for a good IRR over time, over full market cycles.
Read more articles by Robert Huebscher
As of September 30, the FPA Crescent Fund (FPACX, FPC1Z**) has had an annualized return of 9.38% for the last 15 years, the longest time period for which Morningstar presents data. That is 233 basis points ahead of its benchmark, the Morningstar moderate-target-risk total-return index. It also places it in the top 1% of its Morningstar peer group.
