FPA Crescent Fund Inv (MUTF:FPACX) Q2 2022 Earnings Conference Call July 27, 2022 4:00 PM ET
Company Participants
Ryan Leggio – Partner, Lead Client Relations
Steven Romick – CFA, Managing Partner
Brian Selmo – CFA, Partner Portfolio Manager
Mark Landecker – CFA, Partner Portfolio Manager
Conference Call Participants
Operator
Hello, and welcome to today’s webcast. My name is Sarah, and I will be your event specialist today. Please not that today’s webcast is being recorded. During the presentation, we will have a question-and-answer session. [Operator Instructions] It is now my pleasure to turn today’s program over to Ryan Leggio. Ryan, the floor is yours.
Ryan Leggio
Thanks so much and good afternoon everyone. Thank you for joining us today. We would like to welcome you to FPA Crescent’s Second Quarter 2022 Webcast. My name is Ryan Leggio and I’m a partner here at FPA and Lead Client Relations. The slides, audio, visual replay, and transcript of today’s webcast will be made available on our website FPA.com in 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 FPA Crescent Fund since its inception in 1993, with Brian and Mark joining Steven as portfolio managers in June of 2013. We include performance information on your screen for disclosure purposes.
At this time, it is my pleasure to turn the call over to Steven Romick. Steven, over to you.
Steven Romick
Thank you, Ryan. As I’m sure everyone is aware, the equity markets have been trending lower with many formerly high flying stocks down dramatically. From the January peak, the global equity market declined more than 20%. During the same period, with its 75% average net risk exposure, Crescent captured 64% of the average market decline.
While net risk exposure remained relatively flat in the quarter, there was certainly activity below the service. We continue to upgrade the quality of our equity holdings and are seeing early signs of potential opportunity in credit, thanks to higher interest rates and credit spreads particularly in busted convertible bonds.
We use a flexible approach in order to deliver our shareholders and their equity rate of return while seeking to avoid permanent impairments of capital. Most of you appreciate that Crescent maintains unique ability to invest across asset classes in different parts of the capital structure and around the world.
Breath of opportunity does not mean that we will always be invested in all asset classes that are available to us. An attractive risk reward guides us. Paying a good price for a good asset should translate into good performance over time. Rising interest rates, high inflation, and fears of a weakening economy have driven the broad based decline in global equity index’s, leaving little unscathed.
Crescent declined 9.3% in the second quarter of 2022 and declined 10.7% for the trailing 12-months, holding up better than the market and the illustrative indices thus far in 2022. While market declines can be psychologically difficult, they are expected and can be used to allocate capital towards repriced and newly attractive opportunities.
We are genetically predisposed to lean into price weakness by adding to quality businesses at increasingly attractive prices, acquiring debt, and equity like rates of return, building positions in long admired franchises, and occasionally, [bumps through] [ph] diving and distressed and deeply out of favor situations.
The S&P 500 Value Index has led the charge in the trailing 12-months declining just 4.9%. Value stocks have benefited from the energy sector being one of the few bright lights in the market. Despite energy’s strong performance in the last couple of years, including the S&P energy ETFs having increased 39% in the last 12 months, the sector has dramatically underperformed over the last decade.
We prefer in general to own higher quality businesses with higher returns on capital and better [management teams] [ph]. Growth stocks have been the greatest drag on the stock indices, including their disproportionate impact on the MSCI Emerging Market Index shown at the far right. The worst performers, which we’ve largely avoided, have been the many money losing companies with unproven business models.
The most expensive stocks have declined the most. Using price to sales as the valuation metric, this chart shows the year to date performance of the most expensive 10% of the S&P500 as compared to the remaining 90%. The top decile and valuation have declined almost 30% in the first half, while the remaining 90% have declined far less, around 14%. While the most expensive have become less so, they are still far from cheap as exhibited in the table at the bottom of the slide.
At the end of June, the top 10% traded about 40x earnings down from 72x. The remaining 90% traded in [easier to stomach] [ph] 17x earnings. In equities, more traditional value stocks are no longer as inexpensive as they recently were as reflected in this chart. Unlike March of 2020 when [value spreads] [ph], the cheapest 20% of the market versus the market average, got to 2008 levels of cheapness. The spikes in this chart reflect valuation disparities in the market and tend to be a good time to focus our attention and allocate capital.
With stocks generally trading more in-line today, we have spent more time considering and adding to faster growing, better quality businesses, many of which are both less expenses in the market today and where they have historically been valued. We will remain flexible taking advantage of opportunities that present a margin to safety whether they are perceived as value or growth.
The Fund’s stock selection has historically exceeded that of the equity indices most significantly outperforming the MSCI ACWI by 4.2% since 2011 and 2.5% year to date. Going back to the [7] [ph] when the S&P was the more pertinent index, equities held in Crescent have exceeded the S&P by 0.9% and 2.3% in the first half of 2022. In the last 12 months, Crescent’s Top 5 performance contributed 3.4% to its return, while its Bottom 5 detracted 5%.
We believe that some of these ups and downs might prove ephemeral, but we address where our thesis is being validated and where it might be broken. Let me highlight a few. For a host of reasons, we don’t believe that investing in public equities in the shipping industry is the best way to take advantage of its 7x extreme cyclical swings. We prefer to buy vessels at below replacement cost, operate them with minimal leverage and then exit when higher values drive new vessel construction.
Acting in this contrary fashion can lead to attractive, less correlated, long-term equity like returns with modest risk of permanent impairment, consistent with our investment philosophy and goals. Container ship values were extremely depressed in 2013, which allowed us to begin to make direct ship investments in partnership with industry operators via sound holdings and FPS LLC.
In the ensuing years, we’ve also bought and participated in loans to container dry bulk chemical and oil service vessels. Because our investments are direct and we control the equity, we make the purchase, sale, and capital distribution decisions ensuring that we buy at attractive prices, finance conservatively, and exit opportunistically.
With the rebound in the global economy combined with boats being scrapped, supply and demand has once again tipped in favor of container vessel owners, allowing us to exit our spot container positions at meaningful premiums to our acquisition costs, resulting in gains recognized by the fund.
We expect distribution of sale proceeds in the third quarter to reduce our sound holdings position, FPS’ increase in price caused it to become a Top 10 [fun holding] [ph], but since FPS is primarily comprised of oil service vessels and given the supply demand dynamics for oil service vessels today, we are cautiously optimistic.
Glencore is one of the largest globally diversified commodity companies operating both industrial and marketing businesses. We believe Glencore operates in a genuinely shareholder oriented manner. Crescent purchased Glencore often on from 2018 through 2020 and what we believe was a single-digit multiple of normal earnings power.
The opportunity presented itself when most investors were less willing to own commodity sensitive businesses in a period of low inflation regardless of its inexpensive valuation. Net of distributions of extraordinary cyclical profits likely to be earned this year. We believe the company still trades at an attractive valuation relative to its long-term earnings power, justifying its continued presence in the fund, although we have taken some money off the table given the rise in its share price.
While our investment thesis and the names that have detracted from performance have not materially changed. I’ll highlight three. Processes stock prices declined along with the value of their investment portfolio. Our thesis has somewhat improved as management recently announced a share repurchase program that will be funded in part by periodic and partial sales of its Tencent Holding.
Given that its stock price trades at a greater than 35% discount, to its estimated net asset value, share repurchases will be accretive. Its stock has appreciated 26% since the announcement. Charter and Comcast, our investment in the U.S. cable industry, are examples of us leaning into fear. These investments have underperformed in the last year, but still trade well above our cost.
The industry has been plagued by fears of video cord cutting and competition from 5G and fiber-to-the-home. This allowed us to buying and to continue to hold both Comcast and Charter Communications. These businesses trade at reasonable valuations and should have tremendous growth in free cash flow over the next decade.
We expect we will allocate that free cash flow in the best interest of shareholders given that they are controlled by owner operators. Crescent had net exposure at the end of the second quarter of 75.5%, marginally higher than this exposure at the end of the first quarter. With the stocks haven’t declined as much as they have, the 1% increase and exposure belies the greater activity when you scratch below the surface.
We added seven new positions, and exited three in the quarter, including some recent bond additions that I’ll speak to. High yield exposure in Crescent reached an all-time low of just 0.2% in Q4 of last year, below the Fund’s five-year average of 4% and long-term average of 9% and certainly way below its peak in the great financial crisis in the thirties.
We explained at the time that this was because of historically low yields and spreads to treasuries. Since year-end, the high yield index has declined 10% as both treasury yields have increased and credit spreads have widened. We have begun to see some compelling risk adjusted opportunities in convertible bonds for the first time since 2000. Many stocks have seen a tremendous decline in price, particularly those companies that are still in their earlier stages with business models that have yet to be optimized.
Some of these companies had raised money to fund their growth via convertible bonds that were issued with yields of 1% and lower. With the conversion price now well out of the money to the decline in the stock prices, many converts have traded down and now offer attractive yields to intermediate term maturities, it leaves some optionality should these businesses succeed.
Should the market reward them with higher stock price, that should translate to a higher bond price, and an outside chance that the convertible feature pays off prior to maturity. The unweighted average yield to maturity of these bonds in the fund is currently 11.5%, 310 basis points better than the 8.4% yield offered in the high yield market.
The allocation to these convertible bonds is small for now, but we are hopeful a combination of a further increase in interest rates and continued stock market volatility may allow us to increase the funds exposure. You can find additional detail on the portfolio activity in the first half of 2022 in our Q1 and Q2 shareholder commentaries available at FPA.com.
The equities held in the fund, both continue to trade less expensively than the market and are expected to grow faster. The average PE of Crescent’s portfolio companies based on consensus estimates looking-forward one-year is 11.8x. 15% to 25% less expensive than the MSCI ACWI and S&P500 respectively.
Crescent’s portfolio companies trade at 1.5x price to book, about 40% to 60% cheaper than the ACWI and the S&P. The Fund’s portfolio companies delivered 3-year trailing earnings per share growth of 32% better than either the ACWI’s 9% or the S&P’s 12%, and analysts expect these companies to grow earnings at a rate more than triple the market in the aggregate in the next three years.
Relatively speaking, markets continue to trade at lower valuations outside the U.S. Given that one might expect more non-U.S. companies in the portfolio. However, we would argue the U.S. has more of the higher quality growing companies and bigger most than any other country, owning a slower growing European company, for example, that trades at a lower valuation than, say, a Google would not be interesting to us.
Nevertheless, we continue to find attractive opportunities outside the U.S. and have 37.5% of our capital invested offshore. The company’s treated less expensively outside the U.S. is supported by this chart that reflects international stocks traded at 27% discount on forward earnings when compared to U.S. stocks. Of course, this chart does not take into account quality and growth differentials when contrasting companies based in the U.S. versus other regions.
We are often asked about our outlook, which is kind of funny because we have never made a market forecast and like everyone else are regularly surprised by world events. While there is always plenty to worry about, we agree with Jamie Dimon who on JPMorgan’s Q2 call in response to a question about pending economic hurricanes observed, and I quote, “going through a storm, and that gives us opportunities too. I always remind myself the economy will be a lot bigger in 10 years. We’re here to serve our clients through thick or thin”.
There always be a place in our portfolio for good businesses and good prices and you’ll see the funds risk exposure increase should those prices become great. As always, we will be conservative in our underwriting and that price PR guide. Despite our new market prediction philosophy. We do think it’s useful to observe current conditions and pricing for financial assets in order to avoid potholes, focus, the research attention of our team and calibrate risk appetite.
In bonds, we mentioned the initial fruits of our labor in convertibles, stepping back, we would observe that high yield is approaching 2016 and 2020 yield levels, but credit spreads are still below the 800 plus basis point spreads seen in both of these periods and despite there being no official recession, since 2016.
We are living through what is not our first volatile period. While we cannot tame volatility, we have learned to make friends with it. A decline in price can afford us the opportunity to buy as much as an increase can offer the chance to sell. Our hyper focus on price and business quality should allow us to successfully navigate this current turbulent moment in time.
Well, that concludes our prepared remarks. We have Q&A. As a reminder, we won’t be discussing companies where we are currently engaged in transacting, whether it be a buyer sell, or those positions that are so small as to not be terribly relevant as to Crescent’s performance. We won’t be speaking to companies that are not in the portfolio or in those of which we have no opinion or for that matter any macro questions to which we only bring our ill-equipped view.
So turning to Q&A. The first question, we’ll take the ones that we received in advance first, and then we’ll have some currently coming in over the transit.
Question-and-Answer Session
A – Steven Romick
Morningstar shows that nearly 4% of the fund is invested in other and classified. Can you talk about what kinds of investments they are?
The majority of the other/classified category or the Fund’s investments and partnerships, including the sound in FPS holdings I mentioned earlier, as well as the small derivative exposure held in the Fund.
Your SPAC portfolio appears to be nothing more than a bunch of lottery tickets. How can you just provide a time and energy to research those entities?
The SPAC investments are indeed like lottery tickets to the extent that they will are unlikely to win big, particularly now. However, they are quite different from lottery tickets and that the SPAC portfolio doesn’t share a lottery tickets likely 100% loss. We have been getting paid, while earning these, while retaining an option that some good act – some acquisitions could be good, which would allow the equity and warrants to trade up.
Importantly, there has been very little time invested. We bought a broad basket that totals 3.8% of the fund that was purchased on average at a discount to the trust value, setting up the opportunity to make a small amount of money at the minimum and potentially much more in the event of a successful acquisition.
We had suggested in prior communications that we expected this portfolio to return better than the high yield index, which it has given that our portfolio is increasing value from cost in the last year, although high yield index has declined in that same period about 9%. I’m going to share the wealth of questions with my partners, Brian, and Mark, and Mark?
Brian Selmo
Tag that into the other SPAC question, where there’s a question about SPACs price to [indiscernible] up. I think just to reiterate what Steve was saying, we bought the SPACs a discount to trust value and got the warrants for you or less than free. And so that would be consistent across all of the SPACs that we purchased. And some have de-SPAC’d, in those cases, we’ve redeemed for the trust value or sold the shares at a premium to trust value in the event they traded there, and we’ve held on to the warrants, which again, we wouldn’t have paid anything before.
Mark Landecker
And if you go back to the Q2 2021 commentary, we wrote about the SPAC investment for following it. So, for those of you who want to refresh, you can review the investment thesis if you go back one-year again to Q2 2021.
Steven Romick
And there’s another question that come across the [trends] [ph] as well, which was we all know we’ve talked about convertible bonds, what implied volatilities in the convertible bonds are implied to get to 11% yields. I mean, the volatility calculation is what the consideration what the option value is. These option values are so deeply out of the money. We’re looking at these as bonds. And their ability to repay, you know, get that principal repaid at maturity. You are going to add something, Brian.
Brian Selmo
I was going to say, yeah. The 11 is just the straight yield to maturity with no consideration for option value. So, it’s a strictly the bond yield. Maybe what Steven was talking about.
Steven Romick
And so now I’m going to, you know Mark, there’s a question. And Brian’s here sitting next to me in the office and Mark is operating remotely. Mark, it was a question. What happened to downside protection?
Mark Landecker
Steve, I appreciate you as always giving me the [softball] [ph] questions. So, we think about downside protection over a full market cycle. If one thinks about what we’re trying to accomplish, it’s to deliver equity type returns over a multi-year period while avoiding a permanent loss of capital at the portfolio level. The caveat, however, is that over the short-term, one must accept some short-term volatility in the quest for equity type returns It’s just part of the package. We’ve never tried to suggest otherwise.
If we examine our performance in this most recent downturn, so we would always prefer to do better and that goes for markets that are either up or down, our recent results are not out of line with what we would expect during a market sell-off. And while historical performance is no guide to future performance, if you look back over the past 20 or so years of the fund, we’ve never taken you off a cliff and failed to get you back to higher ground as the market recovered. Steve?
Steven Romick
Why don’t you – if you have a list in front of you, Mark and Brian, why don’t you curate the next few?
Brian Selmo
Okay. Should S&P earnings receive a 17, 18 or different multiple and what price level would Crescent be fully invested in equities?
I think, in terms of what price level the S&P should trade at, I don’t have and I don’t think Mark or Steve really have an opinion on that. I think the very long-term average is something around 16. I think I’m just going to observe some historical facts. That’s all dependent on interest rates and growth and everything else, but we don’t spend any time thinking about or discussing that.
And then that kind of rolls into what price level would Crescent be fully invested? You know, it’s really a combination of price for individual businesses, their quality, and their similarities or differences in terms of risks and opportunities to other businesses we’re finding, because as Mark mentioned, we don’t want to take you off a cliff and not get you back. And sometimes, you know, individual industries might be incredibly attractively priced, but if one were to be entirely exposed to them, you are facing the risk that you may have that industry wrong and that you would be off the cliff.
And so, we want to both remain adequately diversified and invested in businesses that we think are at prices that the math around their valuation, compared to their business prospects suggest that the portfolio on a portfolio level will move ahead over time in a regular way. And so, what I will then say is, what does that mean in terms of being fully invested in equities?
What’s a combination of the opportunity set that currently exists in equities versus credit versus say cash or versus our sense of opportunities that might come in the future. And so, I don’t think there’s a particular level of equities that I would say we would or wouldn’t be fully invested, you know, in.
Okay. Next question. Given Crescent’s view on the stock market overall being expensive, [I know] [ph] shorts at the end of June, how is this SPAC bucket which we spoke about when performing relative there’s more inter-relative history is there more interest in a purchase list?
I think, again, I don’t – I think we have a particular view that the market is or isn’t expensive and you get into composition of market and different weights of different holdings. And so, I think, again, Steve shares a number of charts that just, sort of give you, you know, perspective on where things are, it doesn’t necessarily mean we have a particular view on where the market should or shouldn’t trade because we don’t.
SPAC bucket we spoke about, and then relative to historic, are there more or less interested purchase list? I’d say we’re always building and maintaining a purchase list trying to get familiar and comfortable with new companies or companies that we haven’t been as familiar with in the past? And that work goes on, I think, at a steady pace.
Steve mentioned that in this quarter, there were a number of new purchases, and so that would, you know, indicate that there has been a fair amount of things that have fallen into the range where we think they were worth buying. But I would, I guess, to specifically answer, yeah, it’s probably slightly better than average opportunity set right now. It’s certainly not terrible like it was in, you know, maybe late 2021.
I think that’s it for submitting questions.
With so many growth stocks down, considerably in the convertible bond market down a lot, would you be adding to your convert exposure to 11% yields? What are the concerns on these coming late month, make it to bond maturity?
A few things. Would we add to these? Yes. We are, you know, without being specific, we bought bonds since the close in the second quarter and continue to work on a number of different bond issues. In terms of what’s the concern that they don’t make it? I mean, similar to really all of our credit investments, we make the assumption we kind of analytically say, okay, let’s say they don’t make it, what is our cost into the underlying business through the restructuring? How do we feel about that cost into the business? And how do we feel about our particular credits, rights, and position if it were to be a court restructuring?
And I would say so, with that in mind, we’ve bought, you know, credit instruments that I think we’d be very, very excited to convert into equity at the implied enterprise values that we’re creating in the underlying companies, like, extremely excited. And so what you should hear from that is, one, we think they’re well, well covered by the, you know, long-term enterprise value of the business; and two, for our converts, I think bankruptcy is actually the best case scenario.
Has the team’s watch list pipeline grown substantially over the past four months?
Again, no. Not because things aren’t closer to buy prices. I think things are closer to buy prices if I try to take the question in that direction, but the watch list, the pipeline, the universe is pretty constant whether markets are high or markets are weak. It’s just that you’re closer on a number of names, maybe you’re dusting them off, you’re getting, you know, tighter on your model as prices come your way.
Mark Landecker
And maybe speaking, like, the quality of those names when the world tends to correct and say the quality of those names on average ended up being that they were just enough to really work it on tend to be on average higher?
Brian Selmo
Yes.
Mark Landecker
Here’s a broad market question on valuations [indiscernible] indicator. I don’t actually have those current numbers in my head, but it’s important to understand that, you know, any of those indications that you see in those valuations, it’s all the companies. And then we’re finding host of opportunities within the universe. And we always have even in more expensive environments as generally something out there, you know, worth doing, and that continues to be the case.
So that concludes our prepared remarks and all the questions that have been addressed. So, I’m going to turn it back to you, Ryan. Thanks.
Ryan Leggio
Yeah. Thank you. Thanks, Steve, Mark, and Brian. And if we missed your question or if you have additional questions, please feel free to reach out to your FPA relationship rep or email us at crm@fpa.com. We try to be responsive to all inquiries within 24 hours. Thank you everyone for listening to FPA Crescent’s second quarter 2022 webcast. And again, the replay will be on our website in the next few days. We now turn it back over to the system moderator for closing comments and disclosures.
Operator
Thank you for your participation in today’s webcast. We invite you, your colleagues and shareholders to listen to the playback of this recording and view the presentation slides that will be available on our website within a few weeks at FPA.com. We urge you to visit the website for additional information about the Funds, such as complete the portfolio holdings, historical returns, and after-tax returns.
Following today’s webcast, you will have the opportunity to provide your feedback and submit any comments or suggestions. We encourage you to complete this portion of the webcast. We know your time is valuable, and we do appreciate and review all of your comments.
Please visit FPA.com for future webcast information, including replays. We post the date and time of upcoming webcasts towards the end of each current quarter, and webcasts are typically held three to four weeks following each quarter end. If you did not receive an invitation via email for today’s webcast and would like to receive them, please email us at crm@fpa.com.
We hope that our quarterly commentaries, webcasts, and special commentaries will keep you appropriately informed on the strategies discussed today. We do want to make sure you understand that the views expressed on this call are as of today, and are subject to change without notice, based on market and other conditions. These views may differ from other portfolio managers and analysts at the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results, or investment advice.
Past performance is no guarantee, nor is it indicative of future results. Any mention of individual securities or sectors should not be construed as a recommendation to purchase or sell such securities, or invest in such sectors, and any information provided is not a sufficient basis upon which to make an investment decision.
It should not be assumed that future investments will be profitable or will equal the performance of the security or sector examples discussed. Any statistics or market data mentioned during this webcast may have been obtained from sources believed to be reliable, but the accuracy and completeness cannot be guaranteed.
You should consider the fund’s investment objectives, risks, and charges, and expenses carefully before you invest. The prospectus details the fund’s investment objective and policies, risks, charges, and other matters of interest to a prospective investor. Please read the prospectus carefully before investing. The prospectus may be obtained by visiting the website at FPA.com, by emailing at crm@fpa.com, tollfree by calling 1-800-982-4372, or by contacting the Fund in writing. FPA funds are distributed by UMB Distribution Services, LLC.
This concludes today’s call. Thank you and enjoy the rest of your day.
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