From the November 2007 issue of Investment Advisor • Subscribe!

November 1, 2007

Balanced Contrarian

Steven Romick achieves high risk-adjusted returns by finding out-of-favor companies and investing across the capital structure--and sometimes shorting

When it comes to investing during turbulent times, it can be very difficult to justify to clients that staying with an asset mix that works well in normal market scenarios is still the right course to take while equity indexes reach new highs at the same time as some financial companies are taking multi-billion-dollar write downs, commercial-paper market snarls are threatening runs on banks, and nobody can say for sure whether valuations for certain structured securities on financial firms' balance sheets are accurate.

Times like these might provoke advisors to consider an allocation to funds that have come through difficult markets before and done well for investors, such as the no-load $1.4 billion FPA Crescent Fund, FPACX, which reopened to direct investors on October 2. The fund had a down year in 1999 during the height of Internet and tech froth, but posted positive returns in 2000, '01, and '02, when the S&P 500 showed substantial losses. "We treat this capital carefully," says the fund's President and Chief Investment Officer, Steven Romick, who is a partner at First Pacific Advisors, LLC, in Los Angeles.

FPA Crescent gets Standard & Poor's overall three-star ranking, and returned an annualized average of 10.08% compared with 6.12% for peers in S&P's Hybrid U.S. Balanced style for the 10 years ended September 30; and 14.22% versus 11.36% for five years.

What are the characteristics of your fund?

Volatility is the enemy of many investors. Fear drives people in and it shakes them out. [It's] a gross generalization...but Morningstar has terrific data to show that most people do invest that way. I felt that having a fund that could generate equity-like rates of return with less risk than the stock market would be a good product for many investors. The goal of the Crescent Fund [is], by investing across the capital structure, whether it be common stocks, preferred stocks, convertible bonds, junior notes, senior notes, bank debt, that it would be a very good way to create those kinds of lower volatility returns that were still equity-like in their nature. We've been able to accomplish that.

I noticed that in those years after the Internet bubble burst Crescent had years of good returns when [the equity market] did not, [2000, '01, '02].

And notice the one year when I lost money, which is 1999.

Was that a value fund issue?

The three different areas where I prefer to have focus, high-yield bonds, [and] small-cap stocks lost money in 1999, and value--the lower the P/E, the worse you did in 1999. Half the market declined in 1999, the lower P/E stocks as broken out by deciles declined in value. I wasn't willing to play the Internet game; I felt there was a bubble and it takes awhile sometimes to be proven correct.

Your bond sector is small at this point; cash is high?

Of the bonds that we own, the corporate bonds [are] the most germane portion of our strategy, currently [sitting] at about 4% of the portfolio.

We own the debt of Sally Beauty Holdings--the 10.5% Senior Notes due in 2016. At current prices, the bonds trade at about a 10.6% yield-to-maturity, a yield we believe will exceed the average stock market return in coming years. Sally Beauty operates [about] 2,600 beauty supply stores around the country plus another [approximately] 800 locations distributing primarily to hair salons. They are the dominant player in the business. The enterprise value of the business is [around] $3.4 billion, with the debt representing [about] 55% of that. So the equity value would have to disappear for our debt to be in trouble, i.e., $1.5 billion. We find that highly unlikely because they generate good free cash flow. They were even able to increase earnings through the last consumer recession of the early 1990s, so we don't think an economic downturn would be too punitive.

[Going back to] high, risk-adjusted performance, which is really our goal: we have had, since inception, about three-quarters of the upside in an up market, and about half the downside in a down market. We should underperform in an up market; it's expected, given our history, and it should also be expected that we will outperform in a down market given the way we invest.

If you look at the spread between the average up month versus the average down month, in the average up month, we've returned since June 1993 about 2.6%, so when we're up we make about 2.6% historically. That's lower than the stock market, using the Russell 2000 as a small-cap index, Russell 2500 as a mid-cap index, and the S&P 500 as a large-cap index--we average about three-quarters of what the return has been. In a down month we lose 2% and the stock market is double that for those three indexes, so our range between the two is, we're lower highs and [less-severe losses]; our range between the two is about 4.5% and the stock market range is from 6.5% to over 8% for those three indices, so our standard deviation is much, much lower. Since we not only have lower volatility but in fact our performance from inception is greater than the stock market, we end up with a much higher Sharpe Ratio. It's a value-driven process to begin with from the equity side, and by investing across the capital structure we're able to accomplish this.

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How do you find the companies that you are interested in investing in?

We're looking for bad news, things that fall out of favor. The energy sector was largely out of favor in the early part of this decade, and we've built a good stake in energy and we still maintain that stake because we happen to believe it's one of those few industries where you've got declining supply over the years and increasing demand. That's our largest exposure.

The same thing will apply [to] a company that's out of favor. ConocoPhillips [COP], our largest position, is a very large, integrated oil company with a very large refining business as well. We spent a lot of time analyzing that company and felt that the stock was down at, and in, the low 60s; we felt we were getting a normalized basis in earnings. If earnings had remained just where oil was at the time--this was the summer of 2006--we felt we were buying the stock at a very, very low single-digit P/E. If that's normal, that's great, but even if it wasn't normal and oil went down we felt we were going to be very well positioned for the future. Given the price of oil and gas at that time we felt it was a great place to be and so we took a good-size slug of that company and it certainly worked out in our favor.

So when you say 'over time' how long are you looking?

Five, 10 years. I think that's a good place to commit capital for extended periods.

I noticed that you're low on the financial sector allocation.

Again, we look for bad news, and until this year there hasn't been any bad news in financials. Financial services stocks have had a tremendous run: P/Es have gone up; earnings have grown at a terrific rate. The biggest reason is the economy's been great; you had a recession in the early part of this decade but that recession was corporate-led rather than consumer-led. The consumers held up exceptionally well.

Does that mean that now that there has been some bad news in the financial sector you'd consider it?

The financial sector bad news has been focused on companies that we don't have a tremendous amount of interest in--I'm generalizing now--the subprime space we think was fraught with risk and that blew up, and we talked about the issues in subprime going back in our shareholder letters...the subprime space is not the kind of [financial] we're wiling to touch at any price; doesn't mean it's bad for somebody to bottom fish, [it's] just not our strength; we don't have conviction in that area. The bigger companies where we think there's opportunity, financial services where we'd like to own are just not cheap enough, they haven't come down enough in price to make it attractive.

So, not a sector quite yet for you, not enough bad news coming out?

No; we have one financial services stock in the portfolio, an insurance company; nothing on the lending side.

What else makes Crescent different from other balanced funds?

Most balanced funds, I would guess, are invested in Treasuries, and more invested in large-cap stocks. We're invested more in large-cap, mid-cap and small-cap stocks. Our preference is small-to-mid-, though we've found a lot larger-[cap stocks] more recently. I would imagine we have, historically--not necessarily today--a lower average market-cap. We invest across the capital structure [and that] is a big, big, big difference because we're not doing the Treasuries as a focal point of our investment strategy. We also will do some shorting, which is different.

Would you tell us about that?

The shorting is something that dampens the volatility. We generally short a stock because we believe that stock will go down on its own, not because it's some kind of paired trade; largely it's specific companies where we see some kind of opportunity for downside there and it's a reasonable hedge for the long portion of our portfolio.

Is there a stock that's worked out better than you anticipated?

AGCO [AG], manufactures farm equipment, and the stock is now $51, a terrific winner. Our average cost in the stock is around $18. We look at businesses that are very much out of favor and we bought this company at a point when the business for farm equipment was at a low ebb. This company doesn't have, in most of its segments, the market share that most of its competitors have. It was a rollup strategy, growth-through-acquisition for a number of years under a prior management team. New management came in and is trying to operate the business instead of just acquire, acquire, acquire, and we felt there's a good chance that he could operate this much better than it's been operated in the past because it's never really been operated. We did feel the cycle was going to come around and that the next farm cycle was going to be advantageous to all farm-related suppliers. What we didn't anticipate was just the magnitude of the farm cycle, and some of the tremendous success that farmers are having today is actually as a result of what's happened to inflation with commodities: grain, corn, etc., with ethanol. Rising oil prices have certainly helped drive that.

Is there one that didn't work out as well as you'd hoped?

We owned a position in Finish Line [FINL], which is a shoe retailer. The shoe business has been tough of late for athletic shoes. Partly it's a fashion shift--people go out there and buy flip flops for $10 [versus] $75 for athletic shoes--let alone $150. As a result it's made that business a little bit tougher. We like that--these cycles come and go. What we found was that the management team wasn't entirely patient for the business strategy they had been operating under for many years [and it] all of a sudden shifted dramatically on one fateful day when they decided they were going [acquire] another company, Genesco. All of a sudden they were going to take this company that had a great balance sheet, leverage it, and we just decided that this was unacceptable, outside our realm of comfort, and we were just going to punt until we sold our position out. We lost money; the stock has just gotten decimated further since.

You use a blend of the Russell 2500 Index (60%) and the Lehman Brothers Government/Credit Index (40%) as your benchmark?

Figure that over time we'll have 40% in bonds and 60% in stocks.

Your March 31 Annual Report says that the duration for that Lehman Index was 5.1 years, while Crescent's was much lower, at 1.7 years, and the yield on the Lehman was 5.1% while the yield for Crescent's was much higher at 5.6%?

Yes but we're taking on less interest rate risk and more credit risk.

Will you be looking at anything in the housing/materials realm?

Yes, absolutely, we've been invested in that space in the past, we were short some companies in that space, and we're looking to be involved in that space once again, but we think we're early. The housing market has declined for the first time since the 1930s on a nominal basis, house prices. This is not going to end like this with this whimper. The market started trading down this summer but we believe that the consumer will be impaired, that it will have a greater effect than what we've seen so far in the stock market.

I want to be clear about one thing: the cash we have in the portfolio is a byproduct of our investment process--it's not because we're looking for Armageddon.

If we don't see companies that meet our risk-reward [we are not going to invest the cash until we see companies that do.]

Who would be the ideal candidate to invest in the fund?

If you look at the performance on a risk-adjusted basis, it's met our expectations and what we've laid out for people over the years, so if you believe that either you as the investor, or your clients, have a problem with fund volatility and still want to generate equity-like rates of return this is the perfect product. One other way to look at it would be maybe to call it a hub in a hub-and-spoke strategy.

The fund has been closed to new investors but [reopened narrowly October 2].

It's not a broad reopening and it won't be until we get our invested position up higher. It's a narrow channel--anybody can buy the fund if they go direct to our transfer agent as opposed to Schwab or Fidelity.

What else do advisors need to know about the fund?

That we treat this capital carefully, and as cautious as we are in thinking about investment ideas, and the research and due diligence that we do on various investments, if we don't find them we remain committed to just staying on the sidelines, and when we do find them we will put the capital to work. By that same token there's no guarantee we're going to make money right at that point. If we find something attractive, stock markets tend to go up a little bit too high or down a little bit too low. We can't pick either the top or the bottom, so as we start buying and really build the portfolio and get it more invested, I would expect that we're not picking the bottom and therefore if things decline a little bit further we'll be able to put more capital to work, which is what we want to do, but what we own won't necessarily be performing that well. It's important that whoever invests with us, or with any fund, they really understand the fund manager's strategy, [and] people understand what they own. The last thing we'd like is to see people start panicking either one way or the other--I don't want to see people panicking into our fund or see them panicking out. People got very panicked back in 1998 and 1999 and there were a lot of fund redemptions in this fund, and we looked pretty stupid for a couple of years; and as you've already pointed out, we looked pretty smart in the ensuing years. All those people who sold out probably put their capital not with a fund like mine but in something with a lot of Internet or technology exposure and probably performed quite poorly unless they put it in cash. Know the manager well enough so that you can trust them; if you can't, then don't invest. We care about a stock price twice: the day we buy it and the day we sell it. Everything in between is noise.

Do you own this fund in your own account?

I believe our SAI reflects that I have greater than $1 million invested in Crescent.


E-mail Senior Editor Kathleen M. McBride at kmcbride@investmentadvisor.com.

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