22 Feb 2011 FPA Capital Fund - Q4 2010 Commentary ( Portfolio )
There are many factors that could negatively impact corporate profit margins, but higher inflation and lower consumer demand are among the more relevant risks we see today. Globally, commodity prices across many food, metal, and energy sectors are rising quite rapidly. If companies cannot pass on the higher costs to their customers, their margins should decline. Consumer demand in certain European countries has recently declined as those countries experience sovereign debt problems. Lower unit demand could also pose a risk to profit margins.

Normally, raising prices to offset higher input costs is what investors would expect from management. If all companies in a given industrial sector are seeing a parallel shift up in their respective cost curves, economic theory states that all companies in that sector are more likely to respond similarly and raise prices to maintain their returns on invested capital. The current dynamic of high unemployment in the U.S. and prospects for modest job and wage growth do not bode well for traditional economic theory playing out in text book fashion. That is, we would not be surprised to see the financially strongest companies in a sector hold prices down or not raise them as much as the weaker players, at least in the short run. The stronger companies would initially try to hold prices and squeeze the weaker players even further, in the attempt to gain more market share.

While we are not predicting that the recent spike in commodity prices will flatten out or even rise further, we are merely pointing out that many investors appear not to have taken this possibility into consideration, given the robust stock market gains over the last two years. At the same time, we readily admit that sluggish consumption from the rich, western economies could cause commodity prices to decline from the recent highs, particularly after new supply becomes available. We believe the strategy of not raising product or service prices in a temporary cost-push environment makes sense. However, being long-term value investors, we would appreciate any change in market sentiment toward discounting the possibility of a cost-push inflation environment.

As for our expectations for the equity markets in 2011, our comments are similar to those we chose last year. If you recall, we said “it is very unlikely that the stock market’s return in 2010 will resemble the nearly 30% return of 2009.” With the S&P 500 up roughly 15% in 2010 and other indices up between the high teens and the mid-20% range, we were fairly accurate with our expectation with respect to the equity markets as well. For 2011, we expect returns for equities to be lower than they were in 2010. The consensus 2011 earnings estimates for the S&P 500, according to Morgan Stanley, are expected to grow nearly 15% versus last year. As we mentioned earlier, profit margins are near historical highs, so we believe it will be a challenge for many companies to grow earnings at the consensus rate. Moreover, should interest rates gradually rise, it is reasonable to assume that P/E multiples will not expand much from current levels, and that they may even contract.