01 Oct 2010 FPA Capital - Q3 2010 Commentary ( Portfolio )
Given the portfolio’s large out-performance last year, we are not surprised to fall somewhat behind this year. With the Fund’s higher than normal cash position, it remains a challenge for us to achieve better returns than the benchmark when the market is on an upward tear. Nonetheless, your portfolio continues to have a substantially lower weighted P/E ratio and leverage factor than the benchmark, so we believe the portfolio is in good shape to weather any meaningful downward surprises. That is not to say the portfolio cannot decline in a bear market, despite the large cash position; rather the investments in the portfolio are more cheaply priced and have stronger balance sheets than the companies, in aggregate, which comprise the benchmark. As we have noted so often over the past couple of decades, cash is simply a residual of investment opportunity. That is, the more opportunity we see to deploy capital using our investment strategy, the smaller our cash position.

Contrarian value investing is by nature a lonesome activity, but one that we relish because of the potential for outsized reward opportunities for those that embrace this enduring philosophy. We do not mean to give short shrift to other viable investment strategies, but merely to reinforce in the minds of our clients and shareholders that we will faithfully continue the practice of buying securities that are, in our opinion, absolutely cheap and have a good margin of safety. Being loyal to a strict valuation discipline also requires us to reduce or liquidate entire positions when security prices reach beyond fair value. Our investment strategy is timeless and one practiced by only a few other highly successful investment professionals; it is in a distinct minority amongst a plethora of strategy options for global investors.

We have our own thoughts on why so few emulate our regimen, with patience ranking high as a behavioral trait many investors fail to exhibit, but one that is essential to successfully replicating our strategy. Let’s take the past quarter and put it in our petri dish to test our hypothesis. What we discover is that there was a lot of trading volatility recently and investors alternated between bullish and bearish sentiment. For instance, in July the Russell 2000 was up nearly 7%, in August the Index declined roughly 7.5%, and finally in September the Russell 2000 rose approximately 12.5%. That is an incredible amount of movement for a major institutional benchmark during one quarter.

On the other hand, your portfolio did not purchase any new securities, quietly added to only one existing position, did not reduce any existing securities in the third quarter, but reduced three positions in the second quarter, and eliminated Seahawk Drilling, a very small position, which was a spin-off from an existing holding. Clearly, we continue to manage the portfolio with a steady hand on the tiller in choppy waters, while other investors spin themselves into a confused state in a compass-free world. Truth be told, we would have preferred to purchase more stocks at depressed valuations during the summer, but valuations for the vast majority of stocks in our fishing hole barely dropped to fair value, let alone down to the bargain-basement levels we require.

Patience and loyalty to absolute valuations are the signature virtues of our investment strategy. Investment managers often want to display how smart and knowledgeable they are versus other investors, so they rapidly move in and out of stocks based on the latest tidbit of information. Rather than stop to assess the significance of the information to the long-term valuation of a business, these traders and speculators quickly “pull the trigger” and buy or sell stocks if they believe the news is not yet discounted in the share price. This is why, according the New York Stock Exchange, the average holding period is now just seven months. As your portfolio managers, we do not measure our holding period in months but rather in years. We are fundamentally different than what our industry represents today, and our patience and discipline to absolute valuation has served your portfolio well over the years. We definitely will not out-perform every year, but over longer periods of time we have been able to achieve excess returns due to our adherence to the virtues of long-term value investing.

Turning back to portfolio activity, as we mentioned above, we did not purchase any new stocks during the most recent period. Nevertheless, the recent volatility has allowed a couple of stocks that meet our criteria, to be priced at attractive valuations. We are finishing up our due diligence on these potential investments to determine whether the risk- to-reward ratios are adequate to which we may allocate capital. Quite often we finish our due diligence and agree that a company meets all of our objectives except the stock price needs to drop another 5-10% before starting a position. This is where our patience for buying securities at attractive values comes into play.