Balanced Contrarian

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.

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.