28 Apr 2012 FPA Crescent Fund - Q1 2012 Commentary ( Portfolio ) Overview
FPA Crescent’s long-term, conservative approach to protect and grow your money did exactly both this first quarter, but we did trail the stock market’s big move, which was generally fueled by companies more economically sensitive and leveraged than we currently prefer. FPA Crescent returned 6.6% in 2012’s first quarter; the S&P 500 returned 12.6%. Our Fund’s performance was influenced by a variety of factors:
Quality: Companies in the Crescent portfolio are, on average, of a higher quality than the companies currently pushing the stock indices higher. Firms with the greatest operational and/or financial leverage have the greatest “torque” in an improving economy, and it was these companies that drove performance in the first quarter. Although our companies, on average, underperformed in the most recent quarter, we prefer a more conservative course given our ongoing conviction that the global economy still faces significant headwinds and that markets will exhibit continued volatility.
Europe: Currently, 22% of our total portfolio, and 34% of our long equity exposure consists of European domiciled companies doing business globally. Broad European indices underperformed the U.S. stock market in the quarter – the S&P Europe 350 returned 7.8% measured in dollar terms – and, emulating the U.S., the best performing companies were on average the more cyclical.
High Yield: Just 3.4% of the portfolio at the quarter’s close was made up of high yield debt (with nothing in distressed debt), a weighting that’s far lower than our average. High Yield performed well in the quarter, with the most commonly cited High Yield index increasing 5.2%.1 With rates so low, companies are wisely offering new debt issues to buyers starving for yield. We generally avoid a market that’s saturated with reckless buyers and savvy sellers. Instead, we prefer a climate plagued by an absence of buyers and an abundance of forced sellers.
Long-Term Holdings: Our longer-term, non-equity investments should benefit the portfolio over time, but are unlikely to keep up with a big stock market rally over any short time frame, e.g., the investments in sub-prime mortgage whole loans and farm land.
Cash: The cash in our portfolio can’t compete with a market in melt-up mode, but having it socked away makes sure we have enough capital available to deploy at those times when the demand for risk assets is at a low ebb – a time when we can buy good businesses at bargain-basement prices.
Microsoft added more to our performance than the top five losers detracted from it. Tesco’s share price has suffered lately because of weak sales over the Christmas holiday. We don’t expect a quick turnaround, but find solace in its attractive valuation, provided the company can hold serve in the UK, while continuing to expand internationally. We added to Tesco on weakness.
We also added to Canadian Natural Resources when its price sagged amid what we believe are temporary conditions: unanticipated downtime at a key mining operation and a delay in the narrowing of Canadian oil price differentials. The latter is thanks to a politicized debate over a proposed pipeline that would carry the company’s crude to the U.S. Gulf Coast.
The loss in Nissan Motor reflects just part of a paired trade with our long position in Renault, a trade we discuss further in the Investments section.
Investments
We have very little to show (over the short term) for the many hours our team has invested in analyzing businesses and industries, but we refuse to allow the securities markets to dictate our portfolio positioning. Importantly, we also make sure the time spent researching a company doesn’t become the justification for its inclusion in the portfolio. In these fallow periods, we add to the shelves of our research library with such analyses. Once volatility impinges on a business within our bailiwick, we pull the germane report(s) from the shelf, apply necessary updates and commit capital should an opportunity present itself.
We discuss below some investments worthy of mention.
Renault
Renault, the French auto manufacturer, owns significant stakes in publicly traded companies, including Nissan, Volvo and Daimler. One can effectively hedge out (i.e., short) Renault’s ownership interest in these entities and create a “stub” representing Renault’s own auto manufacturing operations. Given that the pre- tax value of Renault’s public stakes is worth approximately 130% of its own share price, one is effectively being paid to own Renault. Recently, we took advantage of our flexible mandate to create the so-called Renault stub and have the market pay us €5 billion to own Renault’s core operations, which earned pre-tax income in excess of €1 billion in 2011. Though Renault faces a tough operating environment in Europe, we believe its auto business is worth something. Therefore, we purchased Renault and shorted Nissan and Volvo. Over the past decade, the Renault stub has experienced periods of both positive and negative valuation in the market. We first executed this trade profitably in 2006 and now, given its healthier balance sheet, better geographic mix and improved profitability, we are happy to reestablish a position. We believe the value that is being given away has less financial risk than in the past. If the Renault stub trades up to just a zero value, the outcome would be nicely accretive.
Closing
Explaining short-term market moves is never easy and frankly, such fluctuations are irrelevant. Nevertheless, we do try to impart better information than the trust officer of a well-respected (and still solvent) bank who wrote to a client with two trusts under his purview: “...the Bank feels that the decline in the relative percentage between trusts had more to do with Trust 1 simply doing better then (sic) Trust 2 and not so much one account performing poorly.” He explained that the difference in holdings drove the performance delta, but failed to adequately explain why the holdings were different in the first place. This client may as well have been a mushroom – in the dark and fed a lot of manure. Although that’s a low bar to hop over, we strive to make our regular communication sufficiently robust, and hope we have succeeded – and will continue to succeed – in that regard.