FPA Crescent ("Fund") returned 3.33% in the second quarter and 14.49% over the first six months of 2019. This compares to 3.61% and 16.23% for the global MSCI ACWI and 4.30% and 18.54% for the S&P 500 in the same second quarter and year-to-date periods.
Long equities held by the Fund returned 5.03% and 21.16% in the second quarter and six months, respectively, besting the equity indices noted above.1 Including the small amount of other risk assets and cash the Fund held, the Fund generated 92% and 77% of the MSCI ACWI and S&P 500's returns with just 72% of its capital at risk in the second quarter.2
The Fund benefited from broad-based performance in the first half, with only two of its investments meaningfully detracting from the year-to-date return. But rather than a cause for celebration, we regard such favorable breadth as more of a reflection of this bull market than a credit to our competence as portfolio managers.
There was little in the way of news that drove individual contributors and detractors.
Interest rates have helped drive stock market returns over the past few decades, and now, while only marginally higher than thousand-year-plus recorded lows, rates are again expected to remain low -- and perhaps sink even more -- for even longer.
Low interest rates make stocks more valuable. We use the Dividend Discount Model, or DDM, as a simple proxy for valuing businesses to illustrate that principle.
In the DDM formula, P is the fair price of a particular stock; D1 is the expected annual dividend; r is its discount rate, and g is its dividend growth rate. Assume that the value of a business is equal to the sum of cash flows received by the shareholder over time. (Of course many companies reinvest their free cash flow and pay no dividend. We assume dividends and cash flow are interchangeable for this simple example.)
We will assume a dividend growth rate of 5% and set the expected annual dividend at $1 a share and leave them constant to isolate the effect of changes in interest rates. We will assign a discount rate based on a U.S. government bond plus an equity risk premium. In this example, we use the yield of a 10-year U.S. Treasury note in 2007, which was 5%, and the same note in 2019, when it was 2%, and then added a 5% risk premium for a discount rate of 10% and 7%.
In this case, the value of a business in 2019 that looks the same as one in 2007 would be worth 2.5 times as much, thanks to a discount rate that is 30% lower. In other words, low interest rates have added 7.9% to the return of the market since 2007, all else being equal; i.e., the rate of return from $20 to $50 over 12 years.
The beneficial impact of low rates on a highly leveraged equity would be even greater, in part because borrowing costs have declined so dramatically and in part because even more cash flow goes to investors.
The impact on a bond holder would be similar. In 2007, a 10-year U.S. Treasury note with a 5% coupon would be priced to yield 5% and therefore trade at $100. In 2019, a 10-year note priced to yield 2% would trade at $127 - or, 27% higher.5
Jim Grant of the eponymous Grant's Interest Rate Observer has called today's current low interest rate environment a "yield famine".6 Taking that thought a step further, a starving person will eat most anything put in front of him, and indeed, investors hungry for returns are replacing low yielding, conservative fixed income and cash-like investments with riskier assets, further fueling markets already running on high octane. In our opinion, features of those assets like low coupons, high leverage and weak covenants are more meal replacements than sustenance.
There is an aura of hopeful complacency floating around the stock market that, in part, finds need replacing want. Investors wanting a higher rate of return have often steered bull markets, and this bull market certainly has that characteristic. What's different today is that an investor cohort needing return also has a hand on the steering wheel in this market.
Let's say that before the Great Recession in 2007, you sought a conservative return, eschewing credit risk in exchange for a modicum of interest rate risk. You might have purchased a 10-year U.S. treasury note yielding 5.02%, and if you were fortunate enough to have $2.5 million to invest, you would have received an annual return of $125,450 for the next ten years.7 Today the 10-year Treasury yields a lowly 2.05% and that same investment would give you just $51,125 annually - a 59% decline.
What's more, the ravages of inflation have reduced the purchasing power of that relatively meager return by a further $8,840, so that its real value is an annual inflation-adjusted $42,285 - $83,165 less than it earned just a little more than a decade ago - a 66.3% drop in purchasing power!
That means a retired person investing today is left with three choices: curtail lifestyle, spend principal or take on more risk. As creatures of habit, changing how we live is difficult, particularly if it means consuming less. Watching your nest egg shrink is also discomfiting unless your corpus is unusually large or you are older so that it matters less (assuming you don't plan to leave much to your heirs). So it's not surprising that most people select the third option and assume more risk, perhaps without even realizing they have added risk to their portfolio. They may at first look for yield in vehicles that at least look and feel like conservative bonds, an exercise likely to lead them to high-yield bonds, utilities, master limited partnerships and, maybe, higher yielding common stocks. Eventually they may even find their way to stocks that pay no dividend at all.
This has led the average household to have 44% invested in common stocks -- the second-highest level in the past 18 years.8 Crowding into equities has been a prescription that cured most ailments for more than a decade now. We suspect that not everyone knows what is in their portfolio; not everyone understands that volatility will most likely recur at some point, and not everyone fully understands how they might react to a major and sustained market downdraft. Will they panic and reduce their exposure? Or will they ride it out and maybe even buy more? History suggests the former.
Larger equity ownership generally suggests lower future stock market returns. As noted above, household ownership of equities currently stands at 44%, falling into the highest quintile and suggesting dismal prospective returns.
Unusually, both risk-on and risk-off trades are working right now, allowing bulls and bears to win concurrently. Most global stock markets are trading at or near all-time highs, and gold and long-term U.S. Treasury bonds have also rallied. Thus, we have opposing sentiments existing and thriving in the same market.
Many investors have placed the fears that sank the market in the fourth quarter of last year aside, pushing global markets higher despite a rising tide of populism around the world; slowing economic growth; looming Brexit, and U.S. corporate debt proliferation that features low coverage ratios for this point in the cycle, not to mention, weak covenants, high sovereign debt, high state and municipal debt, trade wars - we could go on.
Some investors believe that economies and markets will eventually suffer from some combination of the aforementioned woes. Interest rates, they argue, should then decline even from current low levels, and U.S. Treasuries and gold should be a safe place to wait out the inevitable correction. Inevitability we can affirm, timing we cannot. We know not which path the market's mixed signals portend, thereby making any prognostication an unsavory exercise of futility.
There isn't anything, however, that suggests rates can't remain low for a long, long time. As we collectively drink from this trough of easy, cheap money, there is no reason to believe we will escape an unfortunate hangover, unless, of course, long-standing economic rules are up-ended and cycles abrogated.
The decline in interest rates over the last dozen years has benefited most risk assets and has certainly supported the Fund's returns. However, despite much lower interest rates, we have not meaningfully increased the multiple we have been willing to pay for companies, nor have we been comfortable allocating capital to junk bonds yielding single digit returns.
From the perspective of maximizing return, this decision has been a mistake as it has it led us to have less risk exposure and therefore more low yielding cash. Had we correctly predicted that interest rates would remain lower for longer and chosen to embrace the idea of free money as a long-term component of the market/economy, the Fund would have more invested in the markets and potentially performed even better.
Since your managers do not have such predictive capabilities, that would have meant taking unacceptable risks. A portfolio positioned perfectly for low interest rates and the attendant knock-on economic benefit, would likely result in a permanent impairment of capital in the event that interest rates were to rise or the economy to weaken. One, the other or both will change at some point, and so we consider the current upside/downside trade-off unrewarding.
A decade ago we didn't know what the markets, interest rates and the economy would look like today. Similarly, we don't know what things might look like ten years hence. If one believes in the status quo, then one should be willing to pay a high multiple for a stable stream of cash flow and a very high multiple for a growing stream. Many companies today are priced with that expectation.
But how often do things really turn out as anticipated? There's an old Yiddish adage, "Mann tract, un Gott lacht," or, "Man plans, and God laughs." Rates might rise. The economy might weaken. Valuation multiples might therefore contract, and the same math that drove markets higher could reverse, taking it lower.
The Fund will continue to adhere to its long-term mandate and manage prudently. If the status quo prevails and markets continue to spin higher, that will likely mean we miss out on some gains. On the other hand, the Fund is positioned to do reasonably well if markets take a turn for the worse and to take advantage of the resulting opportunities.
The Fund has an unusual ability to invest broadly. It can put money into equities of various market caps around the globe, both long and short; high-yield and distressed credits; private loans; derivatives; and more. Simply having an impressive collection of tools in our belt, however, doesn't mean they are consistently in use. If we moved into a newly constructed home, we would not likely remodel the kitchen. Today, the equity and credit markets are like new homes, offering us little opportunity to use our tools. Where you wield a hammer, everything can't be a nail.
And so for some time, the Fund's portfolio composition and, by extension its performance, has regrettably appeared relatively more ordinary than its entire history would suggest. That will continue to be the case until such point in time when we can pull tools from our belt to create real value.
The stock market currently still offers us occasional opportunities to own good businesses and other misunderstood assets priced to offer attractive prospective returns with limited downside. Still, we are presently in the eleventh year of the longest running U.S. bull market in modern history, and it is challenging to assemble a fully invested portfolio that meets our risk/reward hurdles.
With stocks trading on average at a 19.3x price-to-earnings ratios and high-yield bonds trading on average at 6.5% yields, our position should not come as a surprise to our long-time partners. An exemplar of pricing gone wrong are the fourteen Euro-denominated junk bonds that trade with a negative yield. As Bloomberg pointed out, "At the start of the year there were none (i.e., no negative yielding junk bonds). Cheap money policies since the last financial crisis have kept interest rates at, or near, all-time lows for the last decade. That's prompted many investors to buy riskier assets that yield enough for them to meet their liabilities, driving bond markets higher and yields lower."11
We have to decide whether a security trades at a price where the underlying business or asset is valued at a discount to some combination of its current or prospective value. In order to protect capital, that discount must be big enough to compensate for the risk that an investment negatively surprises.
The distinction between growth and value has blurred. That's partly a function of technological innovation that continues to impair the economics of many businesses and render others obsolete, as we discussed in our commentary. So we remain hyper-focused on the importance of price.
Our opinion is that stock and bond markets have borrowed from future returns. Admittedly, a dollar in our pocket today feels better than the promise of one tomorrow, but in this low interest rate environment, spending that dollar is risky because it might not be so easily replaced by future stock market returns.
Price matters. Just take a look at two hypothetical companies, one growth, and the other value. Their shares can be purchased for $10 apiece. Growth Inc. trades at 17 times earnings (its "price-to-earnings"), and its profits compound at 12% over the next five years. At the end of that period, however, expectations for the next five years might be more modest, and so an investor would pay a somewhat lower 15 times earnings for its shares. That would leave an investor with a 51% gain.
Value Inc., on the other hand, trades at a much "cheaper" 10 times earnings. If it grows 5% over the ensuing five years and its multiple expands just two turns to 12 times earnings, then an investor would make a 53% return. The difference in return on investment for Growth Inc. and Value Inc. after five years is therefore inconsequential, as shown in Exhibit A.12
We invest, however, with imperfect knowledge in a dynamically evolving world, and reality in Year Five of owning a stock can be dramatically different than when it was bought - and more likely worse, given that one generally buys a security with optimistic expectations.
Let's now imagine that Value Inc. performs as expected and Growth Inc. doesn't, or vice-versa. In either case, an investor's gain would be far more muted should earnings growth disappoint and the expected P/E lag expectations, as is the case in Exhibit B.
But what if these companies start with a much higher valuation than in either Exhibit A or B, but profit growth and ending P/Es are the same as in Exhibit B? A price decline of 39% and 48% for Growth Inc. and Value Inc., respectively, is likely a larger mark-to-market decline than most investors find comfortable.
High valuations are perishable, and we see the world tilting more towards the scenario in Exhibit C than Exhibit A. There are, of course, some who are nimble enough to exit overpriced equites before their sell-by date, but that is not our skill. To us, price matters.
As a result of strong performance across the portfolio, we have reduced the Fund's exposure to investments with risk-to-reward ratios that no longer justify the size of previous positions. The Fund's net risk exposure has declined since the end of 2018, ending the second quarter this year at 71.4% and down from 72.2% at the end of the first quarter.
With stocks and bonds trading at or near all-time high valuations, the market provides little downside protection for what will likely be a mediocre prospective return and we are therefore less than fully invested today.
Alfred E. Neumann, MadMagazine's fictitious mascot and cover boy, had a favorite catch phrase, "What, Me Worry?" Neumann embodied complacency, a similarity we see today in many an investor. Mad's publishers recently announced that the monthly magazine would cease publication with its August issue. Maybe now's the time for Mr. Neumann to worry. What about the rest of us?
Steven Romick (Trades, Portfolio)
July 29, 2019
- 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. Past results are no guarantee, nor are they indicative, of future results.
- 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.
- Reflects the top five contributors and detractors to the Fund's performance based on contribution to return for the quarter and year-to-date. 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 quarter. A copy of the methodology used and a list of every holding's contribution to the overall Fund's performance during the quarter is available by contacting FPA Client Service at firstname.lastname@example.org. 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.
- Source: FPA. These calculations are hypothetical and are for illustrative purposes only.
The 27% increase in bond prices has been a benefit for an investor interested in assuming interest rate risk. For investors such as ourselves, who prefer credit risk to interest rate risk, this has been a headwind.
Grant's Interest Rate Observer. May 17, 2019.
- 10-year US Treasury note yielded 5.018% at 2007 third quarter-end (September 28, 2007).
Source: Federal Reserve Economic Data, Bloomberg. Data as of December 31, 2018.
- Source: Federal Reserve Economic Data, Bloomberg.
- Data in table through June 30, 2019. The date of the '2016 Low' was February 11, 2016. Gold's all-time high price, as measured by the LBMA Gold Price PM Index, was 1895 recorded on September 5, 2011. The change in the price for the 30-year US Treasury bonds was calculated by comparing the price of two 30-year US Treasury bonds where coupon is held constant. The lowest 30-Year US Treasury bond yield (coincident with its all-time high price) was 2.11% recorded on July 8, 2011. The 30-year US Treasury Bond yield as of June 30, 2019 was 2.52%. Past performance is no guarantee of future results.
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.
See original with charts here.
This article first appeared on GuruFocus.