2013 q4 Crescent Conference Call

2013 Q4 Crescent Conference Call
Mark H:
Good afternoon, everybody, and thank you for your patience. My name is Mark Hancock, and Im Director of Client Service and Business Development here at FPA. We appreciate you joining us today for the FPA Crescent Funds 2013 fourth quarter webcast. It is our goal during these calls to give you, our stakeholders, a clear understanding of our current views. The team discusses the portfolio, the market, and the economy. It is our expectation that with the appropriate sense the audio, transcript, and video aspects of todays call will be posted on our website, fpafunds.com, over the coming days. Momentarily you will hear from Steven Romick, Brian Selmo, and Mark Landecker, the Portfolio Managers of our Contrarian Value Strategy, which includes the FPA Crescent Fund. Steven has managed the Fund since its inception in 1993, with Brian and Mark joining Steven as Portfolio Managers in June of last year. Following some recent news, on behalf of all of us here at FPA, I would like to take this chance to congratulate Steve, Mark, and Brian and the team on receiving Morningstars Allocation Manager of the Year award for 2013. Well done, guys. It is now my pleasure to hand it over to Steven Romick.
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Steven:
Thank you Mark. As always, we being at our philosophy page where We show this slide about our philosophy each call, and what we really want to highlight is that we are value investors who consider return in the context of risk. And in trying to generate equity rates of return, we have a lot of tools in our tool chest, so we can invest across the capital structure. And so were investing in stocks and bonds, and we invest in the U.S. and overseas in different industries and in different market caps. Weve executed reasonably well with respect to this philosophy over the last two decades and have been able to achieve our goals while running with about a quarter of the portfolio in cash. In 2013 we returned 22% for the year. And as been our case in our history, our conservative nature generally causes us to not fully participate in big bull markets, particularly that are due more to expanding multiples than earnings growth. In the fourth quarter of 2013, we lay out our winners and losers. And the winners added about 2.5% into the return in the fourth quarter, and losers detracted just 16 basis points. If only the winner/loser ratio were always that good. Now its not clear that really much can be gained from this table. Microsoft is a case a point. It was a top five winner in Q2 and a top five
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loser in Q3 and then a winner a gain in Q4. And we are confident that the value of Microsoft as a business did not move as much as a $100-billion stock swing in stocks valuation in 2013. In looking at the characteristics at the end of year, youll note that our market capitalization continues to be on the larger side. We have continued greater exposure to bigger, higher quality multinational businesses. P/E and price of books are slightly above our average but still less than the market, and our debt-to-capital is we have a generally more conservative manifesting itself in our debt-to-capital. Our balance sheets are the best balance sheets in our history in our portfolio. This debt-to-capital, the fact that its negative on this slide here that you see of 32%reflects that theres more cash than debt on the books of our portfolio companies. The next series of slides dont provide much in the way of conclusion, but they do serve to show, in additional to valuation, why we maintain our relatively cautious stance. That said, if prices break enough, youll find us investing despite this backdrop that Im going to speak to. If you look at the Federal Reserve balance sheet, you can see that the balance sheets increased now more than $3 trillion since 2008. And that succeeded in helping the market achieve new highs. Now this
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expansion of the Feds balance sheet had less of an impact on GDP than it did on the market. And you can see here that the market really is not gone up anywhere near the amount of GDP Im sorry. The debt has gone up a lot more than GDP. Now the total U.S. debt has increased more than $7 trillion since 2008. Thats a pretty big commitment for just a $2 -trillion increase in GDP from the 2008/9 lows. Now this trend in increasing U.S. debt and diminishing productivity has endured for decades. Debt increases with an increasingly steeper slope. And the incremental GDP gain offers a lower and lower return. Now one thing were confident about with debt continuing to rise, ongoing deficits, not seeing a clear path to what has become our addiction to quantitative easing and what has become the new high in corporate operating margins, the one call were willing to make is there will be more volatility, which is still below its historic average. Maybe some of the volatility will show up in some of these more speculative stocks. The Russell 3000 ended last year up more than 33%. But interestingly at the beginning of the year the most heavily shorted equities, if you look at that list, they increased 70%more than two times the index during the year.
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And Im going to turn it over to Brian to address allocations and a general portfolio overview. Brian: Thanks, Steve. On the slide in front of you, you see the exposures in the portfolio from a year agothe end of 2012 to end of 2013, this year. So a couple of takeaways for everyone would be (1) you can see that the equity, and importantly the net equitythe common stocks less the shortsexposure has come down about 10 points over the course of the year. In addition, you can see that corporate listed debt has come down a bit, and weve stayed relative static in the combination of mortgage and other category, which tend to be our illiquids. Youll also note on this page that the number of equities has come down by seven. Now that was accomplished by selling 16 positions, buying eight new positions. And for those of you adept of math, you might wonder how we only came down seven. One of our high yield issues went through a bankruptcy process, converted, and became common stock. So this is a background. Id like to take you through a couple of slides that hopefully depict whats going on in the market. So the next slide shows you that the vast majority of the return from the S&P and other indexes over the course of 2013 was driven by multiple expansion. The slide following that, 14, shows you that the general level of P/Es in
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the market is fairly expanded when looked at over a long-term period of earnings. This is a Schiller P/E ratio. The next slide shows you that markets in the U.S., specifically relative to GDP, are at a very high level relative to historical peaks and averages. And the next slide shows you that the absolute level of yields on a high-yield bond is trending right around as low as has ever been recorded, or at least has been recorded in the last 25 or so years. And so with that as a backdrop, it should be no surprise that weve had a more difficult time finding absolute value opportunities on the equity or the debt side. And with our flexible mandate and our absolute standards, you can see that thats been reflected in less allocation or less exposure to equities and debt. Also to keep in mind the number of positions in the portfolio has come down over the course of the year. We would expect that to continue going forward. We think long term our top ten positions will be larger in terms of percentage of the total portfolio than they have been over time. Now a common question that that we get is: what are the areas of opportunities? How are you spending your time? Is this a difficult environment to invest in? And I think that, as weve shown in the previous three slides, yes, this is a difficult environment. Absolute multiples are
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relatively stretched; absolute yields are relatively slow or Im sorry, relatively low, which means this is not a target-rich environment for our strategy. But whats important to keep in mind is that we do stay busy in two primary activities of research. So when you think about what were doing, there are two things in the research team that were doing constantly. The firstand this is really something that Mark and I spearhead is that we have built and maintained a universe of good and great businesses that were waiting to buy, if only at the right price. And so this is a universe of 500800 companies where we have some level of understanding of them. We like to think of ourselves as maybe a week out, meaning a week from being ready to buy them. We monitor them regularly, whether thats reading conference calls, initiations, visiting with management teams when they come through Los Angeles. And were biding our time in the hopes that we can buy these long-term compounders. Mark will talk about one in a moment. The other activity thats going on in the research side is what we call live commercial opportunities. And so this is just classic value investments where something deeply out of favorwhether thats at a low P/E, a low price-to-book, and industry thats undergoing a restructuring, or
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it could be a company with some specific self-help. These tend to be more trade-oriented investments for us, and that means we probably have a three-year outlook on them, and we think about them from a risk/reward perspective. So in terms of things that weve been spending time on in the, call it, value for value sake category, is some commodity asset producers, specifically raw materials; some manufacturers that serve the coal industry. And then more generally would be emerging markets, and there were looking at all different companies that are trading in the emerging markets. Specifically, Mark and I spent time at a Brazil conference last year, and weve recently begun buying an Asian emerging markets company. With that, Ill turn it over to Mark, who will take you through an example of an investment in the portfolio. Mark L: Thanks, Brian. So before we go into the discussion, wed just like to say we truly feel privileged youve chosen us to act as stewards of your capital. Now unfortunately we dont get a chance to interact directly with most of you. So were dependent on the feedback you provide to your Client Service Group, that being Mark Hancocks team, with respect to what you do and dont want to hear on these calls.
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Now Steve, Brian, and I have always been of the opinion that listeners would like us to keep our prepared remarks short and the Q&A long. But Mark Hancock and his team have recently told us otherwise. With that in mind, Im going to spend the next five or so minutes discussing Oracle, which for some of you might be a perfect time to go grab a snack or take a walking break ahead of the Q&A that will immediately follow afterwards. Now many of you have probably heard of Oracle. But because the companys products are focused on large- and medium-size enterprises, few of us have actually interacted with the companys products directly. So what does Oracle actually sell to these large companies? Most importantly, Oracle provides databases catalog information related to revenues, costs, assets, people. It then complements these databases with software that enterprises employ to integrate, manipulate, and manage that data. Lastly, Oracle sells hardware that provides infrastructure to help make all of the above happen. So how does Oracle make money doing this? Well, the on-premise softwarethat being databases and softwarecounts for roughly twothirds of revenue and 80% of operating profit. Over half of the companys revenue is of a recurring nature, which stems from very lucrative
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maintenance streams with mid to high 90s renewal rates. According to IDC, Independent Data Consultant, Oracles database market share is 45%. Thats more than two times that of the next largest competitor, which happens coincidentally to be Microsoft, another holding in the Crescent Portfolio. Now weve already told you that Oracle targets medium - and largesize enterprises. But to put the companys global span in perspective, Oracle has over 400,000 customers across 145 countries. This includes 100 of the Fortune 100 and 97% of the Global Fortune 500. Why is this a good business? the secret to Oracles success is that Larry Ellison initially developed and subsequently sold this highly profitable database to companies all over the world. However, he didnt stop there. His next act of ingenuity was to utilize M&A, as well as organic development, to offer these same customers mission-critical software to even further entrench the Oracle ecosystem amongst developers, consultants, and of course customers. Now as you can imagine, as organizations became reliant on using multiple Oracle products, which often involve some level of customization, Oracles strategic importance, as well as pricing power, increased over time.
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Now lets move on to management. We spoke on prior conference calls about our preference for owner-operated companies given the natural alignment of incentives between management and shareholders. In the case of Oracle, Larry Ellison, the company CEO, owns 23% of the company, making this the vast majority of his net worth. With respect to how Larrys done over the past decade leading Oracle, the chart on this slide highlights some key achievements. For example, software revenue has grown from $7.2 billion in 2003 to $27.5 billion in 2013. Moving down the income statement to the bottom line, non-GAAP EPS has increased from $0.43 a share in 2003 to $2.68 in 2013, which equates to a 10-year CAGR of 20% a year. Now the company has historically redeployed free cash flow in a shareholder-friendly manner. As an example, Oracle returned 90% of its free cash flow in 2013 to shareholders in the form of dividends or buybacks, which includes a doubling of the dividend this past year. For those of you interested in learning more about Larrys psyche, weve included a link to a recent Charlie Rose interview. That we personally found both informative as well as entertaining. Perhaps the quote we liked the most was when Larry looked in Charlies eyes when asked, What drives you, and Larry said, Charlie, I just like to win.
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So what are the risks? Firstly, relating to databases, competition from large players such as Microsoft and SAP has increased, and there are also open source alternatives that have emerged. As an investor in Oracle, a key element of our thesis is that databases provide a missioncritical service to customers and, while there will be attrition, itll be over decades rather than years. The second major risk stems from oracle losing market share in applications and software to SaaS competitors. SaaS stands for software as a service and, to put it simplistically, if you think of Oracle as historically selling on-premise software that customers own, SaaS companies sell software that customers rent. SaaS alternatives generally have lower upfront costs than on-premise solutions and are very popular among small organizations and new startups. On this risk, our thesis is that Oracles growth opportunities have dimmed, but the company can hold serve with medium- and large-size enterprises, which remind you of the companys target market, by developing its own SaaS applications and also utilizing M&A when necessary to complement existing products. Given we originally viewed Oracle as a potential compounder addition to the portfolio, the natural question we had to ask before purchase was: how can we get comfortable with the thesis that Oracles
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earning power was not going to diminish over the coming years? To do this, we spoke to competitors, customers, consultants, independent IT research and advisory firms. While we couldnt include what everyone had to say, weve taken some selected excerpts from a few of the more interesting calls. For example, the Senior Manager at a global competitor told us, The companys built a loyal base of customers who are trained on Oracle products and are reluctant to shift. Programmers are comfortable writing code for Oracle databases Rewriting code is a huge, time -consuming, and risky undertaking. The CIO, Chief Information Officer of a North American regional bank said, Dont expect open source to shake up the database market in the next five years because todays application developers are already geared to one infrastructure platform or another, and skills are not readily transferable. The VP Technology of a large North American defense company you wouldve heard of said, Switching from Oracle databases would probably cost a few million dollars, require a lot of human effort testing for six months, and could only be justified if Oracle suffered a technology
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failure or tried to strong arm clients through force bundling of databases and applications. A North American consultant told us, Switching costs can be astronomical, particularly for customers that have been using the product for many years and made customizations. And lastly, a Senior Manager at a large European-based global system integrator said he doesnt believe open source, unstructured database systems will cannibalize Oracles business because Oracles products maintain security and availability advantages that best enable them to analyze the data after its been collected. So now that weve reviewed the qualitative aspects, you know that were self-described valued investors. It goes without saying we want to buy things at what we consider to be an attractive valuation. So looking at Crescent, we have an average purchase price of approximately $30 per share, which compares to a current price of roughly $3637. Oracle currently has net cash of roughly $1.50 a share after adjusting for repatriation taxes, assuming that cash is brought back onshore. If you were to look at Bloomberg, youll see that the adjusted EPS estimate is $2.91 for the fiscal year ending this coming May and $3.18 for the year ending May 2015. We of course have our own estimates.
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Nonetheless, the implication is that Oracles trading at a high single or low digit earnings yield, which will assume as a proxy for cash, given the very cash-generative nature of the business, on a share price ranging from $3037. So whats our upside? Well, if we look out over the next three or so years, we believe Oracle will have a very stable earnings profile, which gives us a high degree of confidence in both their low-end and base case that earnings are unlikely to rapidly diminish in the immediate future. Now in our high case, we think were getting free optionality in the form of opportunistic share repurchases, improvement in sales force productivity related to a companywide reorganization, and lastly sales growth from deeper penetration into existing verticals to which Oracle has recently committed capital, which would include advertising and telecommunications, to name a few. So hopefully youve done your snack, youre back from the washroom, and we can get into the Q&A. Steven: Thank you, Mark. Were going to take this Q&A in two parts. First there were some questions that were sent to us in advance, and were going t o address those first, followed by questions that are going to come over the
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transom that get emailed to our Client Service Department. And where are we going to see those coming through? Mark H: Steven: Into the system. Into the system. So please submit your questions if you think you have more to ask well round out the remaining portion of the hour with Q&A. So first question that was posed to us was The question was asked about Janet Yellen. The next one is about the Federal Reserve Board and the impact of all that on the equity market. Other than to say, from where we sit, it seems to be more of the same, we have no view. Next question was: after such a banner year, what now? Will the increased rates pour cold water on the stock market? Since we didnt know in advance that the market would rise like it did in 2013, the first question might be better posed to someone with a better ability to prognosticate. With respect to interest rates, a lot will depend on how much rates might rise, if they rise, how quickly they might rise, and why did they rise. For example, was it due to the Fed tempering inflation or a strong economy? We dont have an answer, but to say we suspect that higher rates dont help the stock market. Gentleman asked the question: do you agree that small cap U.S. stocks are overvalued and that emerging market and high quality U.S.
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stocks are undervalued? And you may want to queue up that small cap versus large cap chart from the chart book please. On average, we see large cap stocks being cheaper than small cap stocks. Th ats really merely a relative statement. Neither are undervalued from where we see things today. And in a moment youre going to see a chart thats going to come up thanks to the Leuthold group. Its a ratio of ratios which shows P/Es of small cap stocks divided by the P/Es of large cap stocks. And let me just try and get that up. Do we have it there? There we go, right there. Pull it up. And so that top chart you can see, as the lines trending up, large caps are relatively cheaper when compared to small caps. On the chart its trending downward. Small cap stocks are inexpensive by comparison. So clearly today, at least by this measure in very general terms, large cap stocks are slightly less expensive than small cap stocks. But this does not speak to the overall level of the market. And as weve mentioned, were not finding great opportunity to commit our capital. Mark, theres a question here for you. The U.S. outperformed foreign markets in 2013. Are you finding more value abroad? How do you
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assess foreign companies and their safety given that reporting requirements in many countries are loose? Mark L: So to start with, are we finding more value abroad? If we do an informal survey on what members of the team are working onI just took a quick peekits two European companies, a couple of Asian companies, and one South African company. So that would suggest without having a formal answer, were finding more value internationally because thats where were currently spending our time. As for the reporting requirements, well say that generally it hasnt posed a problem to us in the past. The U.S. is maybe known historically for having excellent levels of disclosure, but that probably applies more to the world of 10 or 15 years ago than it does to the present. Steven: Mark L: Steven: Mark L: Want to follow up with a second question as well? I got one just as a Technical difficulty. Hold on one second please. Okay, yeah. So there was another question about updated thoughts on Ensco. So Enscos actually not held in the portfolio, and we make a habit of not talking about names we dont currently own. That said, Ensco was a portfolio holding for many years. So we think makes sense to actually recap what we did in the drilling space.
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So if you go back in the portfolio a few years ago, we wouldve owned several drillers. And if you think about the buckets of types of investments we make, one is category that we call 3:1s, and the drillers will line up dead center in that category. Theyre the type of businesses that earn an average return on capital over timenot awful, but not exceptional. And so the key to doing well on a drilling investment is to buy it when its getting priced like a cheap mass of steel and sell it when it starts trading on earnings. So with that in mind, we think that we bought the companies generally cheap, and we think sold them when they were getting priced as businesses with a more rosy future. Hence we no longer own any drillers in the portfolio. It doesnt mean theyre not still good investments from here; it just means you have to have more enthusiastic view of the oil sector. Steven: (@25:25) Theres a question, Mark, as long as you mentioned
Ensco. Today do we find offshore drilling rig companies attractive? The Group seems to be drifting lower. Mark L: So the Groups drifting off highs, and what we will think Think about it this way. If there were prices where we didnt have exposure to the sector, and things are drifting down 5%, 10%, generally speaking, our Group
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doesnt play 5% to 10% moves. So we would like to see names significantly lower to capture our interests once again. Steven: There was a question posed on Canadian Natural Resources, their position in the portfolio, and just asking for general thoughts. So offering some general thoughts, Canadian Natural Resources has the largest acreage position in the oil sands of Western Canada and the lowest operating cost. The stock trades at a good discount to what we believe are the value of its assets. And, I mean, these are good assets with a long life and are of a very high quality in a geopolitically stable country. So Im going to speak a little bit about We have a constant question with this inflation/deflation argument, and so this gives us some optionality in the event of higher inflation. Canadian Natural Resources has been hurt in recent year by a ramp-up in unconventional production in the Lower 48. This has created effectively an infrastructure bottleneck and has crowded out the delivery of Canadian production. And this in turn has caused them to have to sell that production at a pretty sizable discount to WTI, West Texas Intermediate. It widened out whats called the light/heavy differential, and its wide and its $42. And also since 2009 U.S. dollar until relatively recently has been weak relative to the Canadian dollar, and thats hurt the company because
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the revenues are in U.S. dollars and yet their costs are in Canadian dollars. And also the company shot themselves in the foot a bit due to behind planned implementation of expansion projects. Now things are looking somewhat better now. Theres an easier path to market for their oil. New pipelines are coming on in 2014some anyway. The rail/barge supplys actually running now about 10X what it was a year ago. And the light/heavy differentials come down to about $18, and I wouldnt be surprised to see it say something around that level. Thats about the incremental transport cost. And in addition, theres new product capacity coming online, which gives them another place to sell their oil. For example, theres a new coking facility in Illinois, which is a place to sell their product right through to. And recently the Canadian dollars been weaker versus the U.S. dollar, and every penny change in the exchange rate in favor of the U.S. dollar adds about $100 million or so to cash flow. And thankfully they no longer seem to be shooting themselves in the food with respect to their expansion projects. And Im going to turn it over to Brian for a question that came in on an update on the potash discussion that we had a couple quarters ago in response to a question that was asked. And the question is: I take it the
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investment did not make it into the portfolio, but we would like to hear about what analysis was done, what the issues were, and how you came to the conclusion. So, Brian? Brian: Sure, thanks, Steve. So we mentioned potash on earlier calls, and its a good example that, when things fall apart when stocks are down 20% or 30%, we take a quick look at them to see if they make sense and conduct further research. With regard to potash, we tried to determine what we thought a long-term price for the commodity was, and thats generally based on what we think the incentive price is for new capacity. After having done that, we applied that sort of estimate to the cost structures of the existing potash companies that traded. And that suggested a certain normalized earnings level. And given where we came out with those estimates, it was not attractive at the trading prices of the stock. And if those trading prices were to change or our thoughts about normalized earnings were to change, we would revisit potash again. Steven: Thanks, Brian. Post 2008/9 macro events, have your stock selection criteria changed, especially with respect to corporate leverage? Weve never had much exposure to highly leveraged companies. Im talking stocks, not bonds. And that continues to be the case. So not much has changed.
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Next question, Brian, why dont you take that? Brian: Next question is: many companies including Morningstar have been using lower discount rates when bringing future cash flows to the present. How are you handling discount rates for your valuations, and do you see a risk to the overall market? Steven: So I think when a question is posed with respect to Morningstar, Morningstar has go the Mutual Fund Ranking Division, and they also have their own Research Division that researches companies, for those of you not familiar. And this questions referring to the latter. Brian: Yeah. So I think this gets at two things: (1) are the currently low interest rates causing us to change our standards or our approach? The short answer on that is no. And then the second question that I think this is getting at is: how do we analyze companies or how does a discount rate come to impact our research? So first we tend to be scenario analysis people. And when thinking about values in most scenarios, we use multiples, which are of course a shorthand for a discount rate. And our multiples havent changed in terms of where we think businesses might trade or could trade in the future. And for different companies we use different multiples, and those tend to be governed by the economics of those underlying businesses.
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Now with regard to compounders, we tend to think about them a little bit differently, and there we look for a current free cash flow yield as Mark pointed out with Oracle, being in the high single low double digits. And then we add to that what we think is a long-term sustainable growth rate for the business giving the current capital spending used to support the free cash flow yield. And from that we get to what we think is a long-term owners yield or owners return, and were looking for that to be attractive low to mid teens rates for us to make an investment in. So our process really is the same despite what others might be doing with discount rates. Steven: Thank you. Theres a question that speaks to some certain liquid investments that we have made, so were going to lump a couple of these together. But to continue to examine investments outside traditional public markets, due to the lack of opportunities including real estate partnerships, does FPA have real estate expertise? Our concernthe questioner is that this lack of opportunities is pushing managers to invest in areas in which they are less familiar. Thats a fair question, and a reasonable concern. We see both professional managers and individuals reaching out the risk curve. We do not believe that this is the case with respect to our team and this Fund in
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particular. And although we do not claim to be real estate experts, we certainly arent naifs either. We have studied and invested in real estate through the public markets for more than two decades. And analysis isnt any different, public versus private. Also these less liquid loans that weve made that we have in the portfolio arent that new for us in Crescent. And from a real estate perspective, Crescent has invested in real estate partnerships since 2011. One of the significant benefits in size is that were able make certain investments that are more off-limits to smaller funds such as these real loans that youre referencing, but also includes our investments in subprime home loans, farmland, and shipping vessels, and more. And this also speaks to a question about special purpose vehicles in general, and more specifically with investing in shipping vessels. Whats the investment or value-added thesis behind that decision, Brian? Brian: So, yeah, the specific question is: whats our experience with SPV? So we have experience as an investor in the mortgages, farmland, and different debt structures. We have experience as a structurer in distressed and in mortgages, and we have experience as a manager in terms of a special purpose distressed pool that we once managed.
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And the next question would be: whats our experience in shipping? And so this is both personally and as a fund. We were involved in the restructuring of a U.S. barge company a decade or so ago, and FPA has a long history investing in offshore oil rigs, which is similar in terms of investment thesis to the current shipping investment that we had. So Id like to spend a minute and talk about this as a general genre of investments. And so when we think about cyclical commodity assets, we want to invest in them when they have a long-term demand for the underlying assets that we think is growing or going to be greater than what it is today. And the reason thats important is because it allows us to think about the replacement cost for that asset as being a relevant economic factor in the long-term earnings of the assets that currently exist because, if the world needs more of a given asset down the road, the economics for the existing fleet are going to have to support new build prices. And so if we can determine what it costs to re-create the asset and what someone might reasonably expect to earn on that, we can make a guess at what the normalized earnings power of the given commodity asset is. And so thats exactly what weve done with shipping.
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And a year or so ago, we were pitched an opportunity to invest in container ships at around scrap value. We thought that was very interesting, and so we sent some time trying to pursue that investment thesis in the public markets by making private investments into public companies and by purchasing bonds and bank debt. We did make one bank debt investment at the time, which is in Crescent, and we also decided that the best way to pursue this investment would be through a partnership in a private vehicle where we could have ultimate influence or control over the allocation of capital or the spending to buy ships. And thats led to our current shipping investment, which is very small and in some ways immaterial to the Fund at this time, but where we hope to have a much larger presence if the prices remain attractive. Steven: But interestingly when you look at our ability to transact in a space that has less liquidity, were able to frequently pick up assets at discounts to where they otherwise are trading in public markets. So, Brian, do mind speaking to that for just a second with respect to this specific investment, which was on a look-through basis? Brian: Absolutely. So as I mentioned, we considered making this investment in shipping in many other shipping investments through more publicly traded bonds and bank debt. And what we quickly found was that the bank debt
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trades at anywhere from a 2030% premium to were the underlying vessels trade in the secondary market. And that seemed a little nutty to us to pay that kind of premium for what is really no difference in terms of underlying asset quality. And so because that premium was required because of the, Ill call it, liquidityprobably more I think its because there are many funds out there that have mandates to own liquid assets we decided to pursue this particular investment in a private vehicle. And the next questions for me also. These are two questions on bonds, and essentially they are questions getting at with low yields on bonds and not much going on in common stocks, where is Crescent looking for opportunities, and is this a difficult investment environment? So as we talked about in the beginning, it is a somewhat difficult investment environment. And as Steve and I have spoken about in the last two answers, were looking both in illiquid and off -the-beaten-path type of investments, whether that be real estate or shipping, and then also more broadly, more publicly. And I think Mark mentioned this: were looking at a number of international investments and a number of emerging market opportunities currently. Steven: A question with respect to our geographic allocation. And with 16% in Europe, is it an accurate reflection of the geographic exposure of the
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common stock portfolio? Is there a particular emphasis on Europe for some specific reason? Its important to take a step back when one considers geography. We think about where revenues are sourced rather than where a country is domiciled. Its far more relevant. For example, to speak to two investments in our portfolio, WPP Group, the advertising public relations company is based in the United Kingdom but has less than 50% of its sales from there. Meanwhile they have about a third or so from North America and Asia, and close to 25% in Continental Europeclearly not a UK company despite being based there. Another good example would be Aon, the insurance consulting company also based in the UK. Aon used to be a U.S. company, but move offshore to gain a lower tax rate. Despite a London office and the sponsorship of Manchester United, they are hardly a UK company. They have very little in the way in the way of business coming from England and have 60% of their revenues coming from here in the U.S. A number of questions Im going to lump together with respect to our cash holdings. Discuss why you hold a lot of cash. And if one thinks the markets overvalued, shouldnt that translate into a greater confidence to be short at some point in the market cycle? What were your plans for
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cash? How much longer do you feel high levels of cash will be necessary to continue to preserve our risk/reward value in the portfolio? Steve : So kind of lumping all of these together, Ill address thes e questions. Our goal is to put cash to work when the opportunity presents itself. Its important to understand that we do not define an investments upside without similar consideration as to its downside, as one accompanies the other. Cash is a byproduct of our investment process, building when we do not find investments that meet our risk/reward goals. It should not be taken as a broader market view. Further, we do not know now nor do we ever now where we are in the market or economic cycle, and therefore we cannot tell you when the cash will be drawn down. We try to make our portfolio robust to a host of outcomes without relying totally on one scenario. We have written about the inflation/deflation debate and admit to now knowing whats going to happen, let alone when. If theres a lot of inflation, our stock should participate, but our cash will be a drag. If theres deflation, our cash will benefit us, but our stocks will likely decline. We are sitting here with a middle-of-the-road portfolio without a clear view over the horizon. If one believes more in the inflation argument or in a strong U.S. economy, that
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person would be best served in a more fully invested portfolio run by some other manager. Brian, why dont you take the next question? Brian: Sure, this is sort of tied to cash also. Should we continue to expect the Fund to be in the 50s in terms of equity exposure with more allocation of cash given your view that there are not many attractive opportunities across the various asset classes? So if what youre talking about is next week or next month, yes, that would be my assumption. But keep in mind that we can move in a hurry. And whether its an industry, whether its a country, whether its a company from our investment universe, or whether its a high yield market cracking, we think that we could very quickly deploy significant amount of assets in any number of either individual opportunities or in asset classes. And with that, Mark and maybe, Mark, you could help because I forgot to mention this in the discussion of our cash position in the beginning of the call. We have diversified some of our cash holdings and this is a question that gets at that. Mark L: So I think we actually wrote about the diversification in the letter thats posted on the website, which some of you may not have had a chance to read yet. We highly recommend you do. Within our holdings, youll see
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that we started to accumulate some Singapore government bills as cash equivalent instruments. And the question is: whats the thesis behind that? So we actually have made a conscious decision to diversify our cash equivalent holdings away from domestic U.S. government issues. With respect to the Singapore government bills that the questioner asked about specifically, weve hedged out the currency exposure, but we still think these are an attractive investment. The country runs one of the healthiest current account balances in the world. And the fiscal balance that being the governments revenue less its spendingis in a surplus position, much different no doubt than the United States, which runs a deficit. We should also note we view the political situation favorably both in terms of stability and intelligent decision-making, which well suggest is more than can be said for many other developed countries. Lastly and perhaps most importantly, these are very liquid issues that allow us to maintain flexibility and ensure that we have cash accessible to spend when we need it. And I should add, when we say an attractive investment, we mean simply from preservation of capital. We earn next to nothing on these government instruments, just as you do when you buy a U.S. shortterm piece of paper.
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Brian:
And to round that out with some of the things I forgot to mention earlier, weve also made investments in commercial paper, senior rated asset backed bonds, and high grade corporate bonds.
Steve:
Short dated. Short dated a year or less maturities there. Were treating it as cash equivalent in an effort to have diversification in our cash holdings.
Brian:
The last pre-submitted question is a question on capacity, and Ill roll this into a number of questions that have come in also regarding if weve seen any impact from Morningstar award and capacity in general. So in terms of impact from Morningstar and thoughts on, weve not seen any impact on flows subsequent to the Morningstar award. And then secondly, as we talked aboutthis is more generally and this addresses sort of capacity in totalas we mentioned in the fourth quarter 2012 letter, theres really three criteria that were looking at to think about closing the fund. One would be a disruption to the team, so anything to me, Mark or Steve that made us think that our universe or opportunity set was different. To remind you, when we think about our opportunity set, we think about U.S. large and small cap, we think about international large and small cap, and we think about U.S. high yield and distressed, so fairly broad investment menu. Secondly would be if there were to be overwhelming Fund inflows. And as I mentioned, weve not
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seen anything on that front with regard to Morningstar. And then lastly and this is sort of a combination pointis if we were having current difficulty getting the portfolio positioned in a manner that we liked and/or we didnt think there were likely to be significant opportunities in the future. And so as Steve pointed out and mentioned with a number of the slides on government debt, were probably of the idea that volatility is apt to be higher in the future, not lower. So that makes us think that there will be more and better opportunities. And then secondly, the portfolio is very much positioned the way it would be if we had half the assets in the Fund right now. So there are a number of questions that kind of largely try to make the point of, if you have so much cash, perhaps if the Fund were smaller youd have less cash. Thats just not the case. The cash position is there because there dont seem to be great absolute bargain opportunities, and we think that this creates a robust profile. But whats important to add or at least emphasize, as weve said in a number of different ways, is that, as cash comes in, were able t o buy more of what we own and maintain this exposure that we have today. So when the opportunity really shows up, well be able to allocate that capital
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to whatll hopefully be the profitable investment ideas. So whats interesting is that our cash is or the cash we have in our portfolio would be this size regardlessif we were managing this amount of money or something less than that. And thats a very important consideration. Brian: And theres one question that came in on buying mid cap stocks, and I even extend this to small cap stock. You would absolutely anticipate having a significant amount half or more of the portfolio invested in small and mid cap stocks. Thats not where were finding a lot of value now. The one thing that might happen in that case is that we would have more names in the portfolio, not less. It could also happen that we would have very large positions in mid cap stocks and individual names. Steven: Right, thats particularly true of small cap. .At mid cap, I mean, given our size today, we could still put a 3% position in a $6-billion company and still own well less than 10% of that company. So theres still plenty of opportunity to invest in mid cap space. The smaller cap space in particular is one where we would have to have more positions. But generally speaking, with small cap stocks, our cheap mid cap stocks are usually cheap, too. They move up and down together. Mark, is there something you wanted to add? Mark L: No, I was going to jump into the Q&A.
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Steven: Mark L:
Oh, okay. So go ahead then. No, it was just its in the letter, but I dont think weve add ressed it on the call. Theres a number of names that we keep hidden as we accumulate them during the year. Weve got 12 months over which period we can do that. So theres a number of questions. For example, you bought Qualcomm during fourth quarter. It looks like it was trading up in that quarter. Qualcomm was actually purchased, I believe, in Q1 of 2013. We got an average purchase price of $60. So a number of the names that have been revealed in this quarter werent necessarily purchased in the quarter, and we encourage you to look at our filings where all the holdings are disclosed. And you can see the average purchase cost just in case youre curious as to trying to figure out exactly when these names were purchased. Theres another technology question about: are various tech names compounders at 3:1? Without going through the entire tech portfolio within Crescent, well just say that companies that skew to be more software-oriented, generally the Investment Committee views as to have a more compound-type nature simply because theyre typically more entrenched in their customers, such as the discussion we went through with Oracle. With respect to hardware, the investment Committee feels
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theres less stickiness at the customer level and theres more risk of disintermediation such that these companies represent investments that take more of a 3:1 nature. Brian: Great. Theres a question on where were spending time in emerging markets, and I would say emerging markets in general. Mark and I mentioned we went to a Brazil conference in particular. Mark spends a good amount of time on Asian markets generally. And the one thing I would say that we have been spending some time on is: what is the right price or how does one thing about sovereign or government ris k. Were contemplating some emerging markets with less than stellar central governments. Mark L: And we control that risk through sizing, we should add. So it doesnt mean these type of names are non grata in the portfolio. It does mean you wont see them show up as 3% or 5% holdings individually. Steven: Theres a question on: any comments on senior bank loan valuations and risk? And theres, I think, another question in there some place around corporate bonds or high yield, so Im going to lump those together. But right now if you look at bank loans, the largest amount of bank loans that are in issue, their covenant life is who they are today, at almost 50%. Its like 4550%. So its as risky at least as its ever been on that basis.
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But in terms of cash flow coverage valuations, these companies are smart to go out there today and term out their debt. Theyre not dumb. And as you see in the last four years, just the lumping together of not just bank loans but also high yield loans, high yield bonds, in the last four years, theres been over a trillion dollars of high yield bonds issued, which is larger than any four-year period in history. The last two years are larger than any two-year period in history. And of that trillion-dollar-plus, you have like $220, $230 billion or so thats actually triple-C and non-rated. So people are willing to accept a level of risk today thats pretty unparalleled versus any other point in time in history, at least relative to how much capital theyre willing to put out there. We believe thats going to be the fodder for future opportunity, although we dont have any idea when thats going to manifest itself. And spreads today are relatively average-ish, but the starting yield is so low. So you can take an average spread at a very low yieldtwo or three quarters in a ten-yearbut youre not getting much yield to justify the equities-like risk that we think were assuming in most of these high yield bonds. Brian: Maybe scroll to the question yeah. Theres a question talking about I think it was useful for everyone. How does a portfolio turnover look during
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a strong bull market letting winners run turning a portfolio more? So I think this was alluding to Marks comments about Ensco and some of the rig companies. And when we think about the 16 businesses that were sold, something that I would observe is that we think of them as generally lower quality. And if I think about the businesses added this year or the businesses held, I would think about them as generally higher quality. And so if you think about the makeup of the portfolio adjustments over the year, that would be my takeaway is that weve held onto or added to high quality businesses and sold those 3:1s that have sort of reached price targets. Mark L: And theres a question in here: are you avoiding consumer stocks due to price of the individual securities or macro view? So Brian just said weve had the portfolio moving up in quality. Weve got a couple consumer stocks in there. Unilever would be an example. We actually did add to our Unilever position a little prior to them reporting results. We thought the valuation was getting to just reasonable enough to justify topping it up. But generally speaking, we have notand Ill repeat, notbeen committing capital to new names over this period because we see valuations as generally lacking a margin of safety.
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Steven:
Thank you. Theres a question about Given our reviews and our conservative bent in the portfolio, theres a question about shorting. And are your short positions primarily hedges to specific longs? Are any short positions outright bearish company debt? And given the dearth of long opportunities, do you expect to increase the number of short positions? Most of our shorts have actually been relative to specific longs. We do have a few outright bearish company bets. We do not discuss them publicly. And the reason you dont actually see more shorts in the portfolio today is because of the, we feel, relatively barbells in our portfolio as it stands with the equities on one side and cash on the other. Given we dont know how much the market will move and when, we really dont mind increasing our shorts when we have a larger long book. And shorting by definition is not tax advantageous, and there is a negative asymmetry to the trade because your losses are theoretically infinite. So were very cautious in the way we short, but shorting is part of what we do, and you will continue to see it in the future. Its just not a very large portion of the book today. Theres a question with respect to margins being historically high, do you believe your portfolio companies to be well shielded from margin
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pressures. And I think that I dont know that our portfolios any better shielded from margin pressures than any other company. Theres been a huge Obviously Im speaking generally, but theres been a tremendous tailwind from low input prices the last couple of years. And the question remains: how long can you continue to get price as these companies, including companies we own, havent been able to get price in excess of input cost? Steven: Yeah, I would just add that on a more micro basis, you should assume that the margins in each individual company and the characteristics of the companys economic competitive position and business strategies that might either support those margins or lead to pressure down the road. Steven: Mark L: Im sorry. Go ahead, Mark. Maybe Ill just add: if you think about the positioning of the portfolio over the past yearand we talked about pruning names that we felt were slightly more commercial in nature, more 3:1sthey generally have business models that perhaps dont lend themselves to taking pricing and putting through strong increases to their customers over time. Th ats what makes them 3:1 investments because they have a little less sustainability, if you will, into what theyre going to look like as businesses five, seven years from now. So if you think about the portfolio and the upgrading
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thats gone on with the pruning and whats left, we probably feel we have a better quality portfolio with respect to margin protection than at any other point over, lets say, the past five years at least that Brian and I can speak to. Brian: Yes, and I also think that when we look at businesses and when we look to do the research that we do, we do, as been mentioned, a scenario analysis. And we look at our low case, our base case, and the high case. And when we look at our base case, were looking at normalized margins. So a company we own today very well might have higher than average margins at this moment in time, but were valuing a company on what we view is normalized margins. And we recently just completed work on one of these companies thats used, but like Brian reflected, its a week out where we could potentially own this if the stock broke. Its a company were not going to mention by name or by industry, but its a company that where we feel that most analysts and most investors are not paying the appropriate attention to what a normalized level of interest rates might mean to this company. Its a very capital-intensive business. And since theres a lot of leverage in this business, itll be very negatively impacted by a higher level of interest rates. In addition, there would be some higher level of
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depreciation. So a shout-out to Sean Korduner on our team, who did some very good work in identifying these issues. So its a company we dont own today because of that kind of higher margin risk relative to what we think consensus is. But its something we very well could own in the future once it gets priced in. Mark L: Theres a question here if you had to estimate, guess even at your seven-to-the-year real return, what would it be? Im thinking of GMO asset class return assumptions. So were probably not the type of shop that GMO is. So they spend a lot of time, I think, writing about the macro, contemplating it. Wed probably describe ourselves as more bottom -up stock pickers with a macro overlay or backdrop, if you will. Its not primary forefront of the type of research were doing. And because of that, anything we say wouldnt be worth the air that comes out of my mouth. Brian: And theres a second question thats sort of seems to be related to that, and that is: what if 6% real is no longer the reasonable guess if equilibrium returns to the U.S. equities, if equity returns are more like 3.5%? There was an article in Financial Analyst Journal, Paradox of Wealth, which supports that. Sorry, Ill get closer to the mic. What are your thoughts?
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So I guess to Marks point, we dont form 50-, 100-year outlooks for asset classes. We think its important to remain opportunistic and to look across the board. I think that our confidence would be that markets will go to excess and that humans will remain irrational and that, as long as they do, being flexible will provide us opportunities for compelling returns going forward. But certainly we dont have a seven-, ten-, or any other year estimate of that. Steven: Let alone, six-month, one-year, three-year. I mean, investors, thank god, are emotional. And that emotion makes its way into the markets and creates opportunity at various points in time. Thats what gives us confidence to argue for higher volatility in the future. Question here on we were actively expressing our concerns to the Oxy board of directors. Are you happy with the way OxyOccidental PetroleumOxy is progressing? We are. I mean, its still early in the process. But after the chairman left the company, a number of strategic alternatives were sought and are being considered today, whether it be spinning of Middle Eastern assets or potentially dividing U.S. assets or for that matter actions that have already been taken selling at a significant gain their general partnership interest in the Plains Pipeline business. So were happy with the way it progressing, but its still early.
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Theres a question about any chance the butt whacking Apples taking in the aftermarkets would cause us to take a look at it? Weve gone back and forth about Apple. Im sure Brian and Mark are going to chime in on this. We just dont have a strong view as to what the business model looks like in the future, so we have not participated to date. Brian: I think we can craft a bullish thesis, and we can craft a bearish thesis. We just dont know which one is ours. And so with that I mind, weve chosen at the moment to stay on the sidelines. That said, everything has a price. Time will tell. Steven: Do you hedge currency when buying foreign stocks? Yes, periodically. It depends on the company. It depends on whether or not a I mean, it could be a foreign stock that, as I mentioned in the case of Aon, 60% of the sales are in the U.S. It could be a foreign company thats already hedging their currency back into theirs, and we dont know exactly what theyre doing. So we could be hedging something thats being hedged, and it gets very complicated. Certain companies are more obvious. We do participate and we do some hedging. Steven: I think its fair to say thatlike everything else, were not rules-based that we hedge currencies when we think its appropriate, and then we take currency exposure when we think its appropriate.
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Steven: Mark L:
Just reviewing the questions. There was a question earlier about emerging markets. So just to reiterate, there has been a slight sell-offnot enough to really get us jumping up and down. But as an example, just last night we wouldve had three buy orders that were filled. So there is activity going on in the portfolio. We are actively reviewing names. Im tentatively off to India in a couple months with a list of companies to visit. As always, we never know what the world will bring over the next few weeks, months, or even years for that matter. But rest assured were ready to go if things hit our price targets.
Steven:
Well take one more question. Theres a few questions that are left outstanding, but were past the hour mark. So if its very important that question be answeredtheres a small number of questions that are left please address it to our Client Service, and we will make sure that you get every question answered.
Mark L:
The next call well try and devote more time to Q&A and perhaps less to the investment examples.
Steven:
Theres a question here about thinking through the Feds financial repression. Understanding investors dont always behave rationally, can we use the word normal anymore when describing markets, the economy, or even company earnings? We dont describe normal. When
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we think about normal, we dont describe it to be in terms of the economy. When we think of a company, we just use it as kind of a base casekind of as a fulcrum point under which we can observe kind of what could happen on either side. Its not meant to be terribly precise. Its meant to consider a normal level of unit volume if an industrys being hit by a bad economy or a normal cost of money if interest rates are unusually low. I mean, but that said, we dont ever know how many units a company will sell or what interest rates will go to or when. Mark L: So a great example would be the home improvement store Lowes, which was in the portfolio until early this year when it was sold. When the name was purchased, sales were at a cyclical low, and so we didnt buy thinking sales would stay that way forever. We thought we had a free option that sales would improve to some normal level. The last sales have improved, expectations have improved even more, and weve chos en to exit stage-left. So that speaks to the fact that we were really doing a bottoms-up analysis on Lowes rather than a high level macro study of the U.S. economy. Mark H: Well, thank you, Steven, Mark, and Brian. That wraps up our conference call for today. Thank you, our listeners, for participating in Crescents fourth quarter 2013 webcast. We invite you, your colleagues, and clients
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to listen to the playback and view the slides from the webcast today. It will be available on our Funds fpafunds.com over the coming week. We urge you to visit the website for additional information on the Fund, such as complete portfolio holdings, historical returns, and after-tax information. You will have the opportunity to provide feedback after todays call, and we take it seriously. And please, if you have any constructive feedback, wed like to hear from you. Please visit our website, fpafunds.com, in the future for future webcast information including replays. We post the date and time of the prospective webcasts during the latter part of each quarter and expect the calls, as in the case today, to take place three to four weeks after each quarters end. We hope our shareholder letters, commentaries, and these conference calls will help to keep you, our investors and advisors, appropriately updated about the Fund. We do want to make sure that you understand that the views expressed on this call are as of today, January 27th, 2014, and are subject to change based on market and other conditions. These views may differ from the other portfolio managers and analysts of the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Any
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mention of individual securities or sectors should not be construed as a recommendation to purchase or sell such securities, and any information provided is not a sufficient basis upon which to make an investment decision. The information provided does not constitute or should not be construed as or an offer of solicitation with respect to any such securities, products, or services. Past performance is not a guarantee of future results. It should not be assumed the recommendations made in the future will be profitable or will equal the performance of the security examples discussed. Any statistics have been obtained from sources believed to be reliable, but the accuracy and completeness cannot be guaranteed. You may request a prospectus directly from the Funds distributor, UMB Distribution Services LLC, or from our website, fpafunds.com. Please read the prospectus and the Contrarian Value Policy Statement carefully before investing. FPA Crescent Fund is offered by UMB Distributors LLC. Again thank you all for participation in todays webcast, and this concludes the call. Thank you. [END FILE]
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