04 Feb 2012 Those afraid of fire should fear petrol cars more than electric vehicles
What is left unsaid in all this is the fact that conventional cars with a tank full of petrol are far greater fire hazards than electric cars will ever be. Some 185,000 vehicles catch fire in America each year, with no fewer than 285 people dying as a consequence. But, then, people have been living with the hazard of petrol for over a century. Irrationally, electric-vehicle fires are perceived as somehow more worrisome simply because they are new.

03 Feb 2012 Canada’s housing market
After years of lecturing America about loose lending, Canada now must confront a bubble of its own.

31 Jan 2012 U.S. recovering faster than its peers
If you look at the 10 largest developed economies in the world, the United States is the furthest along the path to recovery.

31 Jan 2012 Homeownership Rate Falls to Lowest Level Since 1997; The Homeownership Bubble Is Still Deflating
One of the primary reasons for increased homeownerhip rates above 68% was the deterioration of credit and lending standards, including significant increases in the share of home purchases with very low down payments.

29 Jan 2012 Greece and the euro
Despite a jobless rate that has risen to 18%, Greece still has a current-account deficit of 10% of GDP. For an economy to have so much slack and yet consume more than it produces is a sign of chronic uncompetitiveness. The IMF has said it will take more than a decade for Greece to become competitive.

29 Jan 2012 China's housing market is set for a hard landing
The numbers are grim: China's property bubble is heading for a spectacular burst, and its effect on the country's economy will be widespread.

27 Jan 2012 One Cure for Accounting Shenanigans
Auditors work for the same company for so long that instead of being independent, they end up co-dependent.

25 Jan 2012 Wells Fargo: The Bank That Works
Wells does what banks are supposed to do: take deposits  and then lend the money back out. Interest margin drives half its revenues. Fees from mortgages, investment accounts and credit cards generate the other half. “I couldn’t care less about league tables,” says Stumpf, throwing out a line ­custom-made for the Wells aphorism book. “I’m more interested in kitchen tables and conference room tables.”

22 Jan 2012 The High Price of Safety
Over the past three years, $172 billion has been withdrawn from U.S. equity mutual funds, while $628 billion has flowed into bond funds. Ten year U.S. treasuries yield less than 2%, and yields on six-month German sovereign debt are actually negative -- investors are willing to deliberately lose a small amount of money lending to Germany because they're so fearful of potentially losing even more.

22 Jan 2012 Falling prices fuel natural gas demand
Historically low natural gas prices, resulting from a glut in global reserves, have caused home heating bills to plummet to levels not seen in a decade. Experts anticipate the prices dropping further before they self-correct, with expectations that a long-term surplus could keep prices cheap for years.

04 Feb 2012 Video: Matthew McLennan of First Eagle on WealthTrack
On this week’s Consuelo Mack WealthTrack, one of the fund managers WealthTrack has identified as the next generation of Great Investors. Matthew McLennan, the hand-picked successor to legendary investor Jean Marie Eveillard, tells us where he is finding value with less volatility for the First Eagle funds now.

04 Feb 2012 Fairholme - Year End Letter
What a horrible year for performance! Market prices plunged in many of our Funds’ core holdings in spite of strengthening book values with huge reserving for legacy issues.

In more-normal times, we expect portfolio companies to generate 10% returns on book values, which would lead to much higher common stock returns with discounts to those book values. However, current events always reverberate much louder than the financial histories of past cycles; positive results and actions are now needed to swing market sentiment and prices toward more balanced views and values. AIG’s $1B common stock buy-back, Buffett’s transaction with Bank of America, CIT’s rapid debt refinancing, and MBIA CEO Jay Brown’s repeated stock purchases all point to improving fundamentals – the process has started.

AIG common stock and warrants are by far the largest issuer holding of The Fairholme Fund and the company is worthy of a Dickens novel. Started in Shanghai by U.S. citizen C.V. Starr in 1919, built into a shining example of how America can compete and win around the world by an imperial M.R. Greenberg, torn apart by a ruthless AG Spitzer, and now rising from the ashes of a great tragedy. The company’s book value of $45 per share is heading to $55 in the near future and yearly earnings power of $4 per share will further propel shareholder value. Yet, AIG’s market price plummeted to less than half of book value due to what we can only surmise as a belief that the United States Treasury will sell its 77% ownership stake below the Department’s $29 cost. Why this is negative for long-term investors we do not know.

Sears remains a large position in all of our funds, notwithstanding announcements in late December of falling sales and margins, rising expenses, and write-downs. Investors fled with this New Year’s greeting before Chairman Lampert purchased over $150 million of common for his personal account. For many reasons, including management, we continue to believe the assets of this iconic brand to be a multiple of values implied by its current stock market price and continue to see the beginning of a new Berkshire Hathaway.

ank of America was our worst laggard – even with results showing $20 per share of book value, $5 per share of reserves for bad debt and legal issues, and yearly pre-provision, pre-tax cash flows growing to $4 per share. Shareholders can find our analysis at fairholmefunds.com. If only BofA could buy back its stock at current prices that are near one-third of book value.

In great years, we asked shareholders not to be swayed by short-term performance. The same is true in a bad year. One circling of the Sun is too short a time to differentiate between good and lucky. Thus, we remain optimistic given our performance since inception and a belief that while history does not exactly repeat, it does rhyme. Unemployment is coming down and elections are near. Our favorite economist, Warren Buffett, is bullish on America. Year-end reports show continuing, positive trends. Our companies are strong and cheap. Shareholders have kept their courage and conviction under stress. Fairholme has kept its word to focus on value-based, long-term investments. We will stay the course.

03 Feb 2012 Longleaf - Year End Commentary
The Great Dichotomy
Never in our investing careers has the prospective return on corporate ownership so surpassed the return on long-term lending. Never has the risk of permanent capital loss from long-term lending been so great. Oft-discussed macro fears and the accompanying market volatility have driven investors from equities into the supposed security of U.S. government bonds and other highly rated sovereign and corporate debt. The January 5, 2012 USA Today headline, “Bonds Outperform Stocks over 30 Years,” highlighted this flight and was reminiscent of the 1979 Business Week “Death of Equities” headline that preceded the high stock returns of the 1980s. Unlike the double-digit yields that 10-year Treasurys offered in the early eighties, today’s below 2.0% government yields are meager competition for the S&P 500’s earnings yield of 7.9%, the Russell 2000’s 6.4%, and the EAFE’s 9.3%. Moreover, and surprising to some, equities are even more attractive vis-à-vis bonds today than at the end of 2008, the worst economic downturn and bear market in our lifetime. Because of the large and unprecedented spreads between “safe” lending and business ownership yields shown above, we believe it is almost certain investors will begin swapping low or no return debt instruments for the much higher returns that high quality equities offer. According to the Wall Street Journal story on January 13th titled “China Reserve Changes Weighed,” China has begun to reconsider its approach to investing its $3.2 trillion in foreign-exchange reserves. The chairman of China’s largest state-owned bank indicated that “China may invest more of its...reserves in stocks, enterprises, and other assets as it looks for ways to boost returns.”

Because our future returns will be determined by the companies in the Longleaf portfolios, we have summarized the investment case for the five largest holdings. These names are representative of the caliber of our portfolio components. The qualified merits of “business, people, price,” including the current free cash flow (FCF) yield at each, will illustrate why we are convinced we should deliver positive, excess performance over the next few years.

Dell: Based in Austin, Dell has transformed its business by offering a combination of servers, services, storage, and software to provide enterprise solutions which now dominate and complement the desktop and laptop computing segment. As the world becomes “unplugged,” demand for solutions to manage hardware, software, and security will grow. With Dell’s product mix change, the company has delivered substantially higher margins and earnings. Michael Dell, founder and CEO, is a multi-billion dollar owner and has been a major insider purchaser over the last year. The market continues to focus on the “dying” PC business even though it is only 35% of our appraisal value, and analysts persist in evaluating the company against the consumer market which represents only about 10% of revenues. In assigning a multiple to the earnings, most analysts also disregard the large net cash that generates virtually no earnings and equals over a quarter of the share price. As long as the market ignores the growing free cash flow coupon, Dell should continue to use much of it to repurchase shares and build value even faster. Using expected 2012 FCF, the company’s FCF yield is 16.2%, but adjusted for the net cash, is over 20%.

Chesapeake Energy: Based in Oklahoma City, Chesapeake has assembled at low cost the best set of natural gas assets in the U.S. and a rapidly growing portfolio of oil reserves and production. Aubrey McClendon, co-founder and CEO, has been controversial but has consistently monetized assets at far above cost through either joint ventures like the most recent Utica transaction in late 2011 or the full sale of the Fayetteville holdings in early 2011. The stock sells for less than half of our NAV in part because the market doubts McClendon’s willingness to spend less than cash flow on additional lease acreage, but mostly because natural gas has declined to under $3/mcf due to oversupply and the current warm winter. At these prices, drilling is unprofitable, and supply will eventually decline as gas drilling commitments are met and rigs move to much more profitable oil wells. Longer term, LNG (liquefied natural gas) facilities are preparing to export gas to Asia and Europe where prices are over $10/mcf and transportation, industrial, and electricity generation demand is accelerating. Natural gas assets continue to attract large offshore buyers at substantially higher prices than Chesapeake sells for in the market. The free cash flow yield with $3/mcf gas and flat production in 2012 is 7.6%, but if adjusted for a higher gas price a year or two out as the futures curve suggests, the yield is well into the double digits. These numbers are also before backing out $10-15 per share for assets such as drilling carries, oil service company investments, and pipelines that provide little in earnings today but will probably soon be monetized at good prices.

Loews: Based in New York, Loews is a diversified holding company sagaciously stewarded by Jim Tisch and his management team. In addition to $4 billion in cash available to deploy opportunistically, the company’s primary assets are CNA, a dramatically improved property/casualty insurer led by talented Chubb alum, Tom Motamed, Diamond Offshore, an offshore drilling rig operator with substantial cash flow and a history of acquiring, leasing, and disposing of rigs successfully in a volatile industry, and Boardwalk, a natural gas pipeline and storage company with a growing cash coupon. The Tisch family owns approximately 25% of the stock and has intelligently allocated capital and delivered value growth for investors over decades. The company sells for roughly half of appraised value, in large part due to the mispricing of publicly traded CNA and the resulting conglomerate discount on Loews. Not only does insurance remain out of favor, but the results of Motamed’s turnaround have not been given credit, and earnings are highly volatile with the unpredictability of insured events. CNA shares sell for half of book value. As long as Jim Tisch is making capital allocation decisions, whether for large share repurchases at these discounts or for high-return acquisitions, we believe value will grow materially. Using consensus 2012 earnings, the company’s current FCF yield is 9.0%, but adjusted for the net cash, is 11.6%.

Aon: With a planned headquarters move from the U.S. to London, Aon is the top global insurance broker in an oligopoly. The company also is a leader in the investment and benefits consulting business. CEO Greg Case and his team have increased margins substantially and gained share over the last six years. Additionally, they have reinvested the growing cash coupon into Aon’s discounted shares and several successful acquisitions. The stock sells below 70% of our appraisal because of both depressed earnings from low interest on premium float and a substantial difference in reported and cash earnings due to goodwill amortization from acquisitions. As long as the shares remain significantly undervalued, management expects to grow value-per-share by meaningful repurchase activity. Based on 2012 expected FCF, Aon yields 10.1%.

DIRECTV: Based in El Segundo, DIRECTV is the largest satellite broadcaster in the U.S. and has dominant market share in Latin America. Domestically the company offers unique technology and programming that attract high-end customers with little churn. In Latin America, most countries have no alternative because neither cable nor fiber have been or will be laid where there is minimal infrastructure. The market puts a low growth multiple on the entire earnings stream, not accounting for the more valuable emerging market growth. Additionally, SAC (subscriber acquisition cost) is counted against earnings rather than being treated as discretionary capex that provides a return via revenues over multiple years. The stock trades below 70% of our appraisal, and Mike White has done a tremendous job building value by using the substantial cash coupon to buy in shares aggressively at deeply discounted levels. The free cash flow yield based on 2012 expected FCF is 10.3%.

02 Feb 2012 FPA Capital Fund - Year End Commentary
The top four performers in the quarter were Amerigroup, Reliance Steel & Aluminum, Trinity Industries and Oshkosh Corporation, up 51.4%, 43.1%, 40.4% and 35.8%, respectively. We purchased Amerigroup earlier in 2011 when the stock price went from the seventies to the low forties, as investors sold the stock on lower than expected earnings results. We took advantage of this price dislocation to purchase the stock at 3.9x EBITDA, 8.2x earnings, 1.7x book value and 40% of sales. The buying opportunity presented itself due to margin compression that, after extensive research, we thought would be short-lived. Unfortunately, the stock has quickly moved up since our purchase, taking away the opportunity to add more. Reliance Steel & Aluminum and Trinity Industries performed well as investors became less worried about the U.S. economy in the fourth quarter and rewarded more cyclically exposed stocks, like these two. Oshkosh Corporation moved up for a number of reasons: the access segment has produced better results and the problematic defense program will reach profitability a quarter earlier than initially thought. In addition, Carl Icahn took a large position in the company and is working to get board representation.

Only four stocks had negative returns in the quarter, Veeco Instruments -14.7%, Federated Investors -13.6%, InterDigital Inc. -6.5%, and Newfield Exploration -4.9%. Veeco, which makes MOCVD (metal oxide chemical vapor deposition) machines which are used to make LEDs, softened as its customers slowed orders. We had been expecting this and built the position as the share price came down. Federated Investors fell as investors worried about the impact on profitability from fee waivers that result from continued low interest rates. We have a small position, less than one percent, in Federated. We like the yield we are getting, north of 5%, while we wait for a return to more normal profits as fee waivers in its core money market business subside. This is, however, not an investment with tremendous upside and there are risks to its money market business, so to add to our existing position we would want to be even more generously compensated. InterDigital declined as investors began worrying that the company may not sell itself to a strategic buyer. We added to our position as the stock came under pressure and the price fell far enough below our estimate of instrinsic value. Lastly, Newfield Exploration provided us with the opportunity to repurchase some of what we had sold at substantially higher prices in the last twelve months. Newfield reallocated some of its capital dollars to its highly economic Monument Butte field in Utah and reduced its Bakken investments. This will slow the volume growth rate somewhat, but it should improve the returns on capital. That’s a tradeoff we like, higher returns on invested capital versus a little slower volume growth.

Helmerich and Payne Incorporated (HP) was a new addition in the fourth quarter. HP is a leading U.S. land rig oil service company with a fleet of 324 rigs including 38 under construction. HP has the most advanced rig fleet in the U.S. and this allows it to benefit from the switch to horizontal drilling which requires more advanced equipment than traditional vertical drilling. As a result of this, HP commands a higher premium on its equipment versus the competition. The stock came down from the 70s earlier in the year and broke into the 30s at which point we bought into it. We paid 4.4x EBITDA, 10.2x earning, 1.2x book value, and 1.7x sales. HP has a strong balance sheet with only 10% Total Debt to Total Capital.

Our core screen that looks for companies having low ratios of Price to Book, Price to Earnings, Price to Sales, and Price to Cash Flow, and little debt on the balance sheet is signaling a moderation in opportunities. A recent run qualified 128 names. This is below the 150-200 qualifiers that reflect a more normal level.

Thevaluationoftheportfolioisattractivebasedonhistoricalmeasures. Forinstance,theP/Eratioisless than 13x, which is almost half the Russell 2000 P/E of 23.0x. The portfolio companies are performing well with a weighted return on average equity of approximately 13-14% versus 10.7% for the Russell 2000. In addition, these returns are achieved with substantially less financial leverage, with less than 30% Total Debt to Total Capital versus 37.2% for the Russell 2000.

Economic Commentary
Our investment strategy has always taken the macro-economic environment into consideration, but never as much as today. Over the past couple of decades, we consistently evaluated the prospects for higher or lower inflation and what impact the inflation rate would have on a company’s revenues and profits. We have always considered what the Federal or State government could do to disrupt an industry from a regulatory outlook, which is why, for example, we have stayed clear of the utility industry. The utility industry was a heavily regulated industry until the 1990s and then aspects of the industry were de-regulated. However, when Enron, Calpine, and others abused the system the industry once again became heavily regulated. We have always assessed monetary policy, regulations, fiscal policy and other macro-economic variables, but they played a less important role in our investment decisions than when we appraised a business’s operations, competitive position, return on capital, financial strength, and management’s capabilities. Unfortunately, we cannot say the same today.

Today, we do not have the luxury of just focusing on the bottoms-up fundamentals of a business. In our opinion, the macro-economic risks have increased to the point where the systemic risks are large enough to adversely affect all of our investments. The large macro risks we are particularly worried about, and which we have discussed over the past couple of years, are sovereign debt defaults and the domino-effect those defaults would have on the global economy.

Financial credit and energy are among the most important input factors that sustain our modern economy. Without credit, Boeing does not sell planes to Lufthansa. Without credit, Exxon does not sell oil to a French refinery. Without credit, real estate developers would not have the money to build a new retail complex to house Apple’s newest stores. According to the Bank Credit Analyst, European banks represent one-third of all global finance projects. Unfortunately, there are many European banks that have large exposures to European sovereign debt issued by the likes of Greece, Ireland, Portugal, Italy, Belgium, etc. Should one or more of these countries stop making interest and principal payments, credit from these banks will likely shrink. How much might credit shrink is anyone’s guess, but European banks are already backing away from previously announced deals and yet not one of the aforementioned countries has missed a payment thus far. Moreover, beyond inter-bank loans, European banks have entered into credit default swap (CDS), interest rate swap, and currency swap agreements with U.S.-domiciled banks and other financial institutions. In this game, the dominoes are both numerous and large.

We will try to provide some assumptions that directionally frame the risks posed by over-levered European countries. These assumptions are purely meant to illustrate the enormous amount of capital that may be destroyed should one or more European nation default on its debt obligations. The framework may also be used to calculate Japan’s and America’s potential write-off of debt as well, or any country for that matter. Although it is likely that Japan and the U.S. will eventually inflate away their growing debts.

To start: based on 2011 numbers provided by the International Monetary Fund (IMF) and the ratings company Egan-Jones, Greece’s estimated debt level is €330 billion and its tax revenues are roughly €46 billion. If one assumes Greece’s tax revenues remain unchanged (they are currently falling due to a ~15% contraction in its GDP) and investors require a 6% interest rate to buy and hold Greek debt, what level of debt can Greece support on a go-forward basis? The answer depends on what percent of the tax revenues the politicians would want to allocate to debt service versus paying for education, roads, sewers, police, fire, healthcare, and thousands of other demands for government services. We believe allocating 10% of tax revenues to debt service (interest payments only) seems reasonable, but one could easily argue for either a lower or higher percent. Thus, under our assumptions of a 6% interest rate and an allocation of 10% of tax revenues to interest payments, Greece could support roughly €76 billion in debt. This implies an approximate €250 billion debt write-off from Greece alone.

We have shared these numbers and estimates with our clients since the summer of 2011, when the heads of many European states repeatedly said Greece will not default. As the summer of 2011 dragged into the fall, European leaders tentatively suggested that private financial institutions “voluntarily” accept a 20% haircut on their Greek debt holdings. Then the haircut grew to 50% and today we are hearing that a 70% haircut may be required before another bailout package is offered and accepted.

We as investors see numerous problems in the way European leaders have mishandled this tragic set of circumstances and too many for us to outline in this letter, but we will highlight two issues that we see as very serious. The first is that European leaders seem to only want to focus on Greece and, in our opinion, are ignoring the default risks of Portugal, Ireland, Italy and Spain. If we apply the same logic and assumptions that we used for Greece, these countries combined could add another €1.6 trillion to the debt write-off bucket. Again, much of this debt is held by European banks. Of course, these estimates would be ridiculed by European leaders as outrageous and unreasonable, but we are not even including the potential losses on banks’ books for business or consumer loans should the European economy shrink, as the latest statistics indicate.

The second problem we see, and in some ways even more dangerous than not addressing the magnitude of the entire default risk, is that politicians have failed to recognize that their economic and political systems are no longer sustainable.

The Eurozone’s economic system has clearly benefitted the rich Northern countries in the Euro area that export products and services to the less-rich, less productive countries of the South. But in order to keep their economies growing, the rich export-oriented countries have had to recycle their trade-surplus revenues through their banks and then into the sovereign debt of countries running trade-deficits. Until recently, the effect was to lower interest rates in the Southern countries, thereby stimulating unsustainable real estate development and personal consumption.

At first, this system looks like a virtuous cycle as jobs in the north and south grow and people prosper, but it is really more akin to a Ponzi scheme where the last marginal producer in the north gets rich just as the tower of debt is about to topple over. It is similar to a Ponzi scheme because the debt eventually rises so high that all of the creditors cannot be repaid in full. Much of this increased debt has not only created an illusion of prosperity throughout the region, but also the ingredients for a combustible showdown amongst banks, politicians and the citizens they purportedly represent.

To illustrate the unsustainability of the current situation all one needs to do is look at the uncompetitiveness of the Southern countries versus Germany. According to the OECD and Capital Economics, Greece’s unit labor costs are approximately 40% higher than Germany’s. Italy’s and Spain’s costs are 30% higher, and even France’s are roughly 20% greater than Germany’s.

Instead of issuing more debt or imposing severe fiscal austerity measures, it would be advisable, from our perspective, if the politicians allowed market forces to recalibrate the different productivity levels of the various countries within the Eurozone. Thus, imbalances from issuing too much debt and disparate productivity levels would not be allowed to get out of control and jeopardize normal, sustainable economic activity. Of course, other measures would be required as well and we discussed those in prior letters.

Regrettably, the Eurozone’s political and economic systems do not allow for equilibrium in productivity to be reset periodically. That is wages in the South are not adjusted downward to reflect their lower productivity, and greater incentives are not provided to increase consumption in the North. Obviously, currencies in the North and South are not allowed to rise or fall to adjust for the imbalances because they both use the same currency. Thus, the competitive gap widens further as businesses have no incentive to invest capital in the lesser productive countries, which creates more imbalances.
Sadly, we have now reached a dangerous point where central bankers are facilitating this unsustainable game of musical chairs. The European Central Bank (ECB) is providing very low interest rates to banks so they can help the Southern countries rollover their Euro-debt at rates well below what the market demands. The ECB loans have led to a huge increase in the Central Bank’s balance sheet, which is now roughly €3 trillion. Helping to monetize an over-levered country’s debt is not sound monetary policy.

More puzzling is why Germany’s central bank, the Bundesbank, would lend the ECB nearly €500 billion for the ECB’s Target2 interbank payment system. The recipients have been not only Greece, Ireland, Portugal, Spain and Italy, but also France. Hans-Werner Sinn, President of a Munich-based economic research firm, Ifo Institute for Economic Research, was recently quoted in Bloomberg Businessweek as saying, “if the Euro breaks up then the whole claim [€500 billion] is under risk. This may be the largest threat keeping Germany within the Eurozone.” It is astonishing to us that the Bundesbank would enter into such a risky endeavor after rebuilding their credibility over the last several decades, and considering the history of previous German central bankers who twice destroyed their currencies over the past ninety years.

Currencies are merely a medium of exchange in an economy and investors require that the central bankers do not debauch those currencies. If currencies are diluted to prop up a failed system, investors lose the anchor on which they rely for purposes of valuing a security. Central bankers play a vital role in a well-functioning economy by allocating credit to banks to stimulate a sluggish market and holding reserves from banks to dampen excess lending. While controversial, central bankers may even be the lender of last resort, but only at a price that is fair and at a level which future players would not want to endure. Lending money out to banks at 1% or less does not seem fair to those who hold that currency for savings and investments, nor does it seem appropriately high enough to discourage future reckless behaviour.

Outlook
The above economic commentary plays a significant factor in our outlook for 2012. It is very possible that Greece defaults on its debts this year, which could trigger insolvency among several large European financial institutions that are highly levered and own a lot of Greek debt. What the ripple effects would be on the CDS market and the entire financial industry are difficult to predict, but it is clear to us that banks are going to be fearful of lending to other banks until the risks are better understood. Moreover, in the event of a Greek default, it is entirely possible that several European banks will be nationalized and recapitalized. All of this is a prescription for a substantial decline in credit underwriting by European banks and, thus, lower economic growth worldwide. The only good news is that there has been enough “foot dragging” to allow exposed banks to better prepare their balance sheets should Greece default on its debts.

We believe U.S. economic growth this year will remain sluggish, despite the decent momentum in the latter part of 2011. We also recognize that this year is an election year, so it is possible that politicians could surprise us by implementing a growth policy based on prudent tax reform including extending the Bush tax cuts another two years. However, because of varying political reasons, we believe the odds of Congress and the White House agreeing to a deal in time to boost 2012’s economic growth are very low.

Barring any rational tax and growth policies from Washington, we do not believe the consumer is in a position to ramp up their borrowing or spending. Consumer debt is still very high today at just under 100% of GDP, and many people have expressed a desire to continue to reduce their financial leverage.

Despite the recent encouraging signs that unemployment is declining, the U6 rate is still over 15%. The U6 rate includes the official unemployment rate plus those working part-time that want to work full-time and those who want to work but have given up looking for a job. This high U6 rate, low wage growth, and the ineffective government policy of trying to boost home prices, should encourage the average consumer to remain parsimonious.
The strong likelihood that Europe has entered a recession or will soon experience an economic contraction will have some negative repercussions on our economy, for no other reason than some of our exports to that region will suffer. For example, while the final statistics are not yet available, it appears that our exports to Europe fell roughly 7% in the fourth quarter. The Euro has continued to weaken and is now close to 1.25 to the dollar. The dollar’s strength and a European recession do not bode well for American exports to the Euro region.

If our major trading partners in Europe suffer an economic recession, the U.S. consumer remains sluggish, and the dollar strengthens, we do not see how corporate earnings will surprise on the upside. Unless one believes that Japan, China, and the emerging markets are going to buck the challenging economic conditions in the U.S. and Europe, one should expect continued stock-market volatility in 2012. Your portfolio has substantial liquidity that can and will be used strategically to purchase market-leading companies at attractive valuations should their stock prices exhibit the type of volatility we expect this year.

In summary, we expect the ECB and the Federal Reserve to continue to provide substantial liquidity to their respective banks and economies. The Central bankers hope that this liquidity will provide time for countries to get their fiscal houses in order and jump-start moribund economies. However, we believe we are getting near an inflection point when the music stops and someone is going to be left without a chair. The obvious candidate for such a predicament is Greece. But if Greece defaults, why would Ireland and Portugal want to continue suffering under the draconian austerity measures imposed on them? No European country is immune to the risks posed by the reckless leverage these governments have assumed, and have encouraged their banks to purchase. With today’s global financial system so intertwined, the risks to U.S. equity investors, from a sovereign default, are greater than anytime in the last quarter of a century. Hence, we are expecting more market turbulence this year, but positioned your portfolio accordingly and possess the liquidity required to pursue opportunities that may avail themselves to the patient, absolute-value investor.

02 Feb 2012 FPA Crescent Fund - Year End Commentary
We find investing especially challenging today—not that it’s ever been easy. We feel like we are forced to bet on policy, and how does one do that? Particularly when we believe we are betting that too many of the wrong people will make the right decisions. We feel a little like explorers, blazing new trails, learning about the new world we’ve come upon, charting a different path with new information, all while trying to avoid being scalped. We continue to seek the best path, even if it’s new, to both protect your capital (first) and to provide a return on it (second). It’s as the Scottish missionary and explorer David Livingstone once declared: “I am prepared to go anywhere, provided it be forward.” Along the way though, we sometimes feel a bit like Daniel Boone, who said, “I have never been lost, but I will admit to being confused for several weeks.” We’re left with the hope that selfish and uneducated views coalesce somehow to form appropriate policy. But we’re not seeing it, so we maintain our cautious positioning, with net exposure to risk assets at 70.5%, which includes 5.0% of corporate bonds that are largely lower risk. As a result, we are not positioned for the world being great, and our performance will lag should that prove the case. We continue prudently, however, aware that the metaphor of ‘kicking the can down the road’ is misleading because it implies a problem of a constant proportion instead of what we see as more of a snowball, rolling downhill and gathering momentum and size with each advancing yard. Volatility is our friend. We anticipate more of it, and will commit capital accordingly.

Consider the argument made at the beginning of this letter—that one company’s faster earnings growth does not necessarily mean that its stock will outperform a business whose earnings grow more slowly. In fact, we would argue that one can successfully invest in a shrinking business, even one that ultimately disappears, as long as that company, 1) generates free cash flow, 2) has a shareholder-friendly management team that’s returning that excess capital to its shareholders, and 3) was purchased at a price that takes into account the company’s ultimate net present value and deteriorating prospects, and still allows for an attractive return. It’s not that we seek such investments, but we do occasionally find and profit from them. Wang Laboratories, the now defunct manufacturer of mainframe computers, comes to mind as one such investment. However, there are others that can become value traps. We erred in making one such investment in 2011.

We purchased a small position in Hewlett Packard (HPQ) as part of a tech basket in 2011. Although the tech basket performed reasonably well, HPQ was a mistake – not just because we have lost money thus far, but also because we allowed rationalization to creep into our process. We established a small, toehold position at an average price just over $40, believing that the P/E was just 8x, that the printing business was an annuity, and that the services business had sustainable cash flow at current (or better) levels. Subsequent research revealed that neither business was as resilient as we thought. Instead of selling our stake at that time, though, we argued that the stock price remained cheap enough to stay in the basket. We were wrong. HPQ management made a series of reckless decisions, including a multi-billion dilutive acquisition; a publicly announced commitment to WebOS that was retracted within a month; and declaring their intention to sell their PC business without having a buyer lined up (leaving customers to worry about who would stand behind the products in the future, and undermining sales efforts aimed at IT departments).

Nevertheless, we do not believe Hewlett Packard is a Wang Laboratories. The stock ultimately declined to $21.50, but we added to our position at lower prices, and the stock increased to $25.76 at year-end.

We are mindful that when a big asset bubble finally bursts, the ramifications are large, and the time to resolution is usually long. Take housing for example. The drinking binge of easy money has created a five year hangover, and counting. The housing market remains weak, but does seem to be bumping along a bottom. We have made a number of investments exposed to the housing sector, e.g., Lowes, mortgage whole loans, and some small bank positions.

On the emerging economies front, economic growth has been reasonably good, but the performance of their respective bourses has not (they declined far more than their U.S. counterparts). It’s ironic that our debtor nation is still viewed as a safe haven, while the creditor nations are viewed as more risky. We suspect that such accepted wisdom of today will be turned on its ear tomorrow. In general, smaller domestic businesses don’t have much of a foreign footprint; as a result, faster growth overseas disproportionately benefits the larger, global companies, and it’s in those companies that we continue to maintain a greater concentration. We do not do much in emerging markets directly, but we do continue to seek those investments domiciled in more developed markets that have exposure to up-and-coming economies (typically, those are bigger companies).

In the second half of the year, Crescent established new positions in a few companies that have more such global footprints. We initiated investments in Google, as well as the advertising agencies Interpublic and WPP. The fortunes of all three are tied directly to the level of global advertising spend, and they all saw their shares prices decline due to concerns of a recession-related slowdown. At our purchase price, we believe we were buying each at roughly 11-13x our estimated earnings for 2012 should the fears of a macroeconomic slowdown prove correct. This strikes us as a very reasonable multiple to pay for asset-light global businesses that generate strong free cash flow across the business cycle and have the capability to grow earnings greater than GDP in a normal economic environment.
Of the three, we expect Google to grow revenue the fastest, IPG to demonstrate the greatest improvement in operating margins, and WPP to fall in the middle on each measure. Regardless, at the prices we paid, the market was according little progress to any of these prospects, and that allowed us to purchase each position at a price that provided an attractive margin of safety in all but the most pessimistic of outcomes. Should the valuations of any of these names retrace over the coming year we would expect to accumulate on weakness and increase our position sizes. In fact, at the right price, we would very much like to see this collection of companies account for a demonstrably greater exposure than where the weighting currently stands.

We continue to focus our long equity book on larger, higher-quality businesses that trade at reasonable valuations and that have great balance sheets, as well as attractive dividend yields (when possible).