You are on page 1of 15

FPA Crescent Fund

Quarterly Commentary

2nd Quarter

Dear Shareholders: Overview The second quarter exhibited a bit more volatility than the first, with the stock market declining 6.4% from peak to trough intra-quarter and ending the period on a flat note. The S&P 500 increased 0.10%, while the Crescent Fund rose 0.50% in the period. We have provided a more detailed performance summary at the end of this letter. The contribution from the top three winners was almost entirely offset by the losers, but it was stock price movement without significant news. Quarterly Winners CVS Corporation Wellpoint, Inc. Petsmart, Inc. Quarterly Losers Ensco Plc Owens-Illinois, Inc Hewlett-Packard Company

We enjoy the flexibility to invest in various asset classes; yet having the ability to go anywhere loses its advantage if theres nowhere to go. Thats the position we find ourselves moving closer to today, given that many stocks arent particularly cheap. Few industries, countries, or asset classes are out of favor, and even fewer meet our strict risk/reward parameters and fall within our circle of competence. Its starting to feel like our strategy is merely going to give us more ways to find frustration. Economy We pay attention to the macro environment because it sometimes allows us to identify significant opportunities and, at other times, to avoid or limit catastrophic risk. From 2005-07, we worried about unsustainable home prices, the over-levered consumer, and fragile financial institutions. Our anticipatory and conservative stance helped protect the portfolio when those fears proved well-founded as the panic of 200809 viciously punished the excess of the earlier era. We still find ourselves worrying today, particularly about unreasonable government budgets that have helped foster unmanageable burdens. Over the past three years we have witnessed a shift in financial obligations from the personal to the public (governments) that has done nothing to enhance the solvency of the overall system, although the optics appear favorable to some. A country can be viewed as a proxy for the collective economic production of its populace, but if that society finds itself unable to shoulder the debt burden necessary to finance its lifestyle, then simply shifting its financial obligation to the government will eventually bankrupt the nation. We currently bear witness to such a shift. However, its easier to determine if an individual or business is bankrupt than to determine a nations insolvency (particularly those with access to an established printing press). Many countries walk a fine line that separates the solvent from the bankrupt. Those that tip to the latter will be forced to default and/or dramatically cut programs and services. We expect such action will likely have a significant negative impact on that countrys GDP, and to a lesser degree, on that of its larger trading partners. Companies that do business in those countries will find themselves similarly harmed. The day of reckoning may not come quickly, as there exists more than one way to default: you can stop paying, or just let inflation erode what you owe in real terms. For example, for the $14.3 trillion dollars the U.S. owes today (ignoring any future borrowing), a 3% inflation rate would reduce the purchasing power of that debt to $10.6 trillion dollars in ten years, but at 5% inflation, the real debt would be just $8.8 trillion,

and at 10%, it drops to $5.5 trillion. Inflation benefits debtors at least as far as paying it back is concerned. The ancillary effects can prove dramatic though, as attendant higher interest rates can crowd out spending. How many of you have already seen fewer police on the street, or had your local fire station or library close? Its terrible; but make no mistake, it can get worse. Much can be done to avoid default but, unfortunately, we see little progress being made as we anxiously observe global leaders continuing to make decisions meant to address the problems of today, without regard for tomorrow. In the process, they are rewriting economic law based on need rather than common sense. As Stephanie Pomboy of MacroMavens writes, the Fed remains steadfast in the conviction that there is no problem money cant solve.1 Until we gain confidence in our elected officials, we will work under the assumption that eventual default (outright or inflationary) and the commensurate austerity will prove the most likely outcome. President Obama emphatically stated in a recent speech, "We have to live within our means."2 Different views abound as to what means means. We cannot agree on where we are trying to go, let alone how to get there. Our representatives in Washington, D.C. are performing something less than their civic obligation, whiling away the time playing Neros lost fiddle and dancing around their respective political third rails. The result: the successful avoidance of constructive consensus. Democrats dont want to cut spending, and Republicans dont want to raise taxes, so together they avoid imposing the shorter-term pain thats required to ensure solid economic footing in the long run. Such narrow-mindedness saps the marrow from our bones, leaving us with the osteopathic challenge of an infrastructure too fragile to withstand shocks or support our future needs. We have expected little from Washington in the way of bipartisan action. Sadly, they have lived up to expectations. Even now, party ideology trumps appropriate and compromising resolutions, and its evident in Congress inability to reach an agreement on a higher debt threshold. Ultimately, Republicans must recognize the need to increase revenues; Democrats must accept spending cuts, especially with respect to previously untouchable entitlement programs. We see no alternative. Waiting for an improved economy and better employment picture to boost tax revenue may be like waiting for Godot a prospect thats both uncertain and interminable (if foisted upon you by your high school English teacher). An organic increase in tax revenues certainly helps, but it wont solve the problem. As we have often discussed, government spending continues unabated federal, state, and loco (oops, we meant local). We have learned that one can spend what he doesnt have, thanks to the munificence of others. Or, maybe its not generosity that motivates Treasury purchasers, but their hopeful belief that 3.16% (for 10-year Treasuries) represents good value.3 Current squabbling over raising the debt ceiling and who will make what concessions aside, our nation will continue to borrow more money from our trading partners. The real question is will we repay it with U.S. dollars that retain their value in the future relative to our kind lenders currencies? In a word, no, which begs the earlier question, who the heck would lend us money at such low rates? Lenders to the U.S. are watching our current debt level as well as our deficit-driven need for future increases in debt. Unfortunately, theres no easy prescription for curing a $1.6 trillion deficit. Returning the highest marginal tax rate to pre-Bush tax cut levels would raise just $700 billion dollars over ten years, or call it $70 billion per year for simplicity sake.4 Lets say we could also cut federal spending by 20%. We would then raise an additional $767 billion, but at just less than half this years deficit, that still wouldnt be enough. Thats an impossible expectation anyway. Since 1950, the government has successfully cut the federal budget year-over-year only twice and that was back in 1954 and 1955, for an average cut of just 5.2%. In other words, we wont see a balanced budget for many years.
Stephanie Pomboy, Perma Schmucks, MacroMavens, April 18, 2011. Barack Obamas speech at George Washington University on April 13, 2011. 3As of July 17, 2011, the 10-year Treasury yield had declined to 2.93%. 4 For want of a better number, we have used an optimistic estimate from an organization whose goal is to increase the highest marginal personal income tax rate to pre-Bush tax cut levels. The group, Wealth for the Common Good, believes the move would yield $700 billion in revenue a figure that would still leave a revenue gap.
1 2

Spending cuts wont come easily, particularly given whats considered mandatory versus discretionary government expenditures. Mandatory spending includes social programs, defense, and interest expense on our national debt. Whats left over is just 14% of our budget. We wont solve the problem by addressing such a small slice.
Mandatory vs. Discretionary Spending (% of total spending) Composition of Federal Spending

(% of total spending, in constant 2009 dollars)

We have to address the mandatory spending. We can keep trying to bring interest expense down by buying our own debt (particularly longer maturities), but that suicidal solution would be overwhelmed by the higher debt balance anyway. If one considered the defense of our nation to be necessary, but not the support to so many others, we could eliminate the annual cost of multiple wars, and save $168 billion5 still not enough. Sure, defense spending has bloat, but note it has already fallen more than 50% as a percent of the federal budget since 1970, from 42% to 20% today. Inevitably, we must address the high cost of our social programs. It seems it might be some time before personal tax receipts recover enough to help narrow the budget deficit. In his July 13 Congressional testimony, Federal Reserve Chairman Ben Bernanke pointed to decelerating growth expectations. Fed forecasts for 2011 real GDP have dropped from 3.3-3.7% to 2.7-2.9%. As we projected, the stimuli ended and economic growth slowed. Surprised? Apparently, the Fed was. Its scary that government action hasnt gotten traction after opening the money spigots. By this point, we would have thought someone would have drowned, but instead, the money has either been spent without long-term benefit or just lies dormant on bank balance sheets. The Fed has gone from blowing on a string to sticking that string in a wind tunnel to no avail. Although inflation tinder on the one hand, it does point to serious deflation consequences should Chinas economic luster tarnish. So now were back to square one, or maybe were too pessimistic and its back to square two. At least the stock market found temporary comfort in Mr. Bernankes hint at more stimulus; after opening down that morning, the market rallied 0.6% during his prepared remarks. If he can keep that streak going, we might just wish him to speak ad nauseam. When considering stimuli, the question too often posed is have we spent enough? rather than have we spent wisely? We have argued that putting money directly into our wallets via all sorts of transfer payments provides nothing more than an ephemeral boost. The vicious circle of borrow, give, borrow, give leaves us indebted and without the necessary investment for self-sustaining growth. The preferred path of borrow, invest, borrow, invest apparently lacks the feel-good sensation of being able to walk into the Apple store and buy the iPad2. We know people who have done just that instead of putting the money in their childs college fund or paying down their mortgage. We make the distinction between the government providing the immediate necessities of food, shelter, and health care, and the more the superfluous needs that many Americans feel is their right. The lack of investment in areas that could yield long-term benefits, such as education and scientific research, is appalling. Its therefore no surprise that consumer confidence remains
Fiscal 2011 amount for Iraq and Afghanistan wars, according to The Cost of Iraq, Afghanistan, and Other Global War on Terror Operations Since 9/11, a March 29, 2011 report by the Congressional Research Service.

low and companies arent creating jobs at the rate that you would hope at this stage in a recession. Of the 8.5 million jobs lost during the recession, only 1.75 million or just 21% have been replaced.6 Although theres plenty of blame to go around, we regrettably have to point to Washington for its fair share. We are long past the days of having our political leaders perform a civic duty as an interlude in their private lives as philosophers, lawyers, soldiers, scientists, or businesspeople. Its now a profession, and not a bad job at that. Members of Congress earn more than four times the pay of the average American and, amid massive job losses, they have seen their wages increase 5.3% since 2007.7 Interestingly, in FDRs time, Congress took a pay cut when the going got tough.8 Does QE2 by necessity beget QE3? If U.S. stimulus spending is unsustainable (no doubt), or ineffective (possibly), then interest rates can easily spike because of higher inflation expectations and/or because foreign buyers of our debt view our fiscal position as tenuous and fear default.9 This wont bode well for the U.S. dollar down the road, but its a long road. For example, consider the once-mighty British pounds two centuries of erosion. The pound averaged north of $5.00 dollars per pound during the nineteenth century, but was worth 32% less on average in the twentieth century ($3.38). Thus far in the twenty-first century, its averaging another 50% less ($1.69). At first glance at the next chart, its easy to conclude that the pound is worth a heck of a lot less versus the dollar over the last couple hundred years. A hotel stay for a Brit visiting New York would cost 3x more today than it would have two hundred years ago. However, please also note that the pound didnt decline in a straight line, but instead had decade-long periods of stability and shorter periods when its value spiked. We continue to expect the U.S. dollar to weaken versus a basket of global currencies over time. The chart for the U.S. dollar versus a basket of global currencies wont look exactly the same over the next two centuries, but it will also have periods of stability and price spikes.
U.S. Dollars per British Pound
(yearly average)
$10 $9 $8 $7 $6 $5 $4 $3 $2 $1 $0


We arent alone in our currency challenges. We would even take our dollars over Euros because we question the long-term success of the European Union (EU), particularly as it faces the Herculean challenge of reconciling the competing interests of a central monetary authority and independent fiscal fiefdoms. Xenophobic Europeans still swear greater allegiance to their own country than to the EU. The UK had its doubts from the beginning and declined to join. Now it seems to rest on the shoulders of the stronger European countries such as Germany to continue supporting the unkindly (but not entirely inappropriately) termed PIIGS (Portugal, Italy, Ireland, Greece, and Spain. We dont know how the Euro will play out.
Alexandra Frean, Fed Floats QE3 as a Cure for Persistently Weak Economy, The Times of London, July 14, 2011. Members of Congress currently earn $174,000 ( Recent BLS data reports that median weekly earnings of the nation's 100.6 million full-time wage and salary workers was $756 (seasonally adjusted), or $39,312 annually( 8 In 1932 and 1933, Congressional salaries were cut a combined 15%. 9 We do not see default as a likely course when as much can be accomplished through high rates of inflation, as discussed on page 2.
6 7

Germany has offered its support thus far, but will it continue? The German economy has clearly benefited from its place in the EU. Had Germany gone the way of the U.K. and remained independent, its strong economy would likely have dictated a stronger Deutschemark, making their goods more expensive and curtailing their exports thus negatively impacting their economic output. Weakness or fear in other regions can cause others to seek refuge in the dollar, just as during the U.S. Civil War, the British pound doubled in value versus the dollar. Maybe China temporarily rolling over could cause such a flight. Theres a certain lack of data integrity coming out of the PRC, and they cant continue to invest in infrastructure at the same pace ad infinitum, particularly when their spending on (fixed) assets is now equal to 70 percent of its GDP, a ratio no other nation has reached in modern times.10 As with every developing economy, there will be hiccups. The only questions are when, from what level, and how bad? Investments Central banks have succeeded in a coordinated effort to drive asset prices higher, thereby creating wealth but eliminating opportunity. When committing capital, we have a high tolerance for uncertainty, provided the prospective investment offers a sufficient margin of safety something thats becoming less and less the case today. In general, stocks presently trade above their historic average. Although low interest rates contribute to this, we believe that risk is above average. We have, in effect, borrowed from our future returns, and we therefore continue to find less to get excited about in the equity markets.
Historic P/E Ratio 10-Year Average Earnings

Source: Shiller, Robert J. Online Data Robert Shiller.

Quality larger-capitalization companies remain attractively priced and, given our macro uncertainty, if we are to bend, it will be more on price than quality. We own more such high-quality businesses than in the past, since the market has priced them in a way that has allowed us entry making good businesses available at average prices, as opposed to our more typical investment in average businesses at good prices. These opportunities have emerged because investors have taken current fears and projected them into the future. Take Johnson & Johnson and Microsoft as examples.


David Barboza, Building Boom in China Stirs Fears of Debt Overload, New York Times, July 6, 2011.

Johnson & Johnson ~ Media Perspective

Why J&Js Headache Wont Go Away Johnson & Johnsons Quality Catastrophe
Bloomberg Businessweek April 4, 2011 Fortune Sept. 6, 2010

J&J Needs More Than a Band-Aid

Barrons Oct. 19, 2010

We were able to purchase Johnson & Johnson (JNJ) at an 8%+ free cash flow yield, giving no consideration to the companys cash position, in part because of negative stories caused by the companys consumer recalls. Although the consumer business is a terrific asset, it generates less than 25% of the companys free cash flow and is almost certain to recover from recent missteps. Occasionally, the medias undue focus on one division will allow us the opportunity to acquire the entire business at an attractive price. When we look at JNJ, we worry about many things (long-term health care spending, unusually low tax rate, and very high margins), but JNJ is one of the worlds great franchises, with over 50% of sales derived internationally, plus tremendous product/business diversification, a AAA balance sheet, and compelling long-term demographic trends benefiting each of their businesses. The combination of business franchise and low price attracted us to the company. JNJs shares were as inexpensive as theyd been in thirty years, giving us another of what we consider to be infinite-duration bonds with rising coupons, i.e., 8% plus the growth.
Microsoft ~ Media Perspective

Microsoft has gotten its share of not-entirely-undeserved bad press in recent months. During our Q1 2011 letter we disclosed that, The greatest negative impact in the quarter came from Microsoft (down 19bps), a holding we have increased to take advantage of price weakness, given the current low expectations of a P/E of just 10x. Despite the modest recovery this quarter, we still think the shares are attractively valued, as reflected by an equity multiple that remains at roughly 10x earnings, and an enterprise value of about 7x operating profit. Irrespective of the stocks lowly valuation, we actually have some enthusiasm for Microsofts earning

prospects. As measured by operating profit, Microsofts fiscal 2011 earnings may actually be more than 50% higher than five years ago. Though the company clearly faces challenges, we can point to a number of opportunities that suggest earnings five years hence should exceed todays though by what amount is open to debate. We like that the market appears to have priced its business as one in permanent decline. We believe the market has therefore handed us a free option on the possibility for future growth. Rather than provide an exhaustive list of the levers available to Microsoft to improve earnings or discuss the tremendous market share in its various business segments, we instead use an example to reflect how little credit Microsoft gets by comparing it to a current tech darling., a leading cloud player with $2 billion in revenues and valued at greater than 100x forward earnings, is forgive us a cloud company trading in the stratosphere. Microsoft is already a leading cloud player, as measured by number of users and revenue, and yet the market seems blind to this fact, awarding it just one-tenth the P/E. To secure Microsofts place in the cloud, Jean-Philippe Courtois, president of Microsoft International, said earlier this year that the company would spend 90% of the companys annual $9.6 billion R&D budget on cloud strategy (more than 4x revenues).11 With Microsofts R&D staff of 40,000 and a portfolio of product offerings that touches almost every organization in one way or another, we give Mr. Softee at least a fighting chance at remaining relevant in the world of corporate cloud computing. As for the legacy Windows franchise, the recently introduced Version 7 had the fastest take-up in the companys history. We recognize, though, that many of you may read this commentary on a computer running a predecessor, Windows XP which continues to have the largest global installed base of any operating system. Come April 2014, we regret to inform you, Microsoft will no longer provide XP support (e.g., no more maintenance updates). We suspect this will drive another strong cycle of upgrades, contrary to what Microsofts valuation would suggest is a business in steep decline. Microsoft isnt the only large-cap technology company to be viewed so negatively, as can be seen in the following chart. Large-cap tech stocks are as cheap as weve ever seen them, both on an absolute basis and relative to the broader market and historical sector multiples. We have therefore invested in a basket of other such companies that we find inexpensive.
Technology Bellwethers vs. S&P 500 Enterprise Value/Trailing EBIT
25x 20x 15x 10x 5x 0x

Tech Bellwethers
Sources: Capital IQ, FPA.

S&P 500

We sometimes opt for such a basket approach when we have greater conviction on the prospects of the group and its attendant risk-reward than we have on individual companies. Some of these investments are smaller in size than is typical, but that is not to say that our research has similarly shrunk. The baskets come about through bottom-up work and are only created after we complete significant write-ups of each potential company. One of the benefits of having a big team is that we dont have to compromise on the depth of our research on even our smaller investments.

Aydan Eksin, Microsoft Says to Spend 90% of R&D on Cloud Strategy, Bloomberg News, April 7, 2011.

The select universe of technology bellwethers charted above trades at less than half the valuation of a decade ago.12 Low overall expectations for the group have caused the current EV/EBIT multiple to contract to 8.4x, an unprecedented ~28% discount to the S&P 500, versus an average 4% premium over the past decade. While company-specific issues vary, there are two commonly perceived risks for tech incumbents: 1) capital allocation, particularly given current large cash positions; and, 2) business disruption brought on by the emergence of cloud computing models and related mobile device proliferation. We believe current valuations provide a healthy margin of safety given the bulletproof balance sheets, strong continuing cash flow, and leading market positions for many of the most out-of-favor tech stalwarts. Ravi Mehra, our analytical lead on technology investments, worked for Cisco in a prior life and brings with him a mix of relevant industry, consulting, and investing experience. As of June 30, Crescent had 5.6% of long exposure to large-cap technology. We would expect to increase that basket position should individual companies and/or the sector allow us entry at lower price levels. Financial services companies also seem inexpensive. Given the bad news surrounding financials these past few years, we have recently reengaged in the sector by assembling a host of companies in a basket that now represents 4.0% of the portfolio. Just a few years ago, financial service companies had overstated book values, high valuations, and the companies seemed to be doing great. Since then, many companies have ceased to exist, and most of the rest had the stuffing knocked out of them. Write-downs have driven book value lower, valuations have come down, and prospects look dim. Two industry subsectors, banks and property & casualty (P&C) insurance, now trade cheaply by any historic measure. While valuations are now low, lack of transparency and balance sheet risk remain. As the table below illustrates, it seems that every 510 years, one or more of the large financial services companies gets into trouble and incurs large write-downs. This last period, 2008-09, was obviously the worst of these episodes. By taking a basket approach, we minimize the idiosyncratic risk to future unforeseen crises, while exposing the portfolio to the historically cheap valuations in these two subsectors.
2008-09 2005 2001-02 1998 1994 1990-91 1982-84 1973-74
Source: FPA.

Huge losses from exposure to residential and commercial real estate

P&C Insurance
Massive write-downs to investment portfolios due to the decline in value of mortgage-backed securities and corporate bonds Hurricane Katrina renders several insurance companies insolvent Asbestos lawsuits explode out of control

Losses from dot-com & telecom exposure Asian and emerging market currency crises cause losses at large international banks Mexican peso crisis Savings & loan crisis due to: change in goodwill accounting as well as weakness in commercial real estate and junk bonds. Losses in Latin America: Continental Illinois fails

Rapid drop in interest rates from Paul Volkers Fed causes industry pricing crisis Over-invested in common stocks. A 45% drop in the S&P 500 index causes several insolvencies

As the chart below illustrates, we are currently near an aggregate 1.0x price/book ratio for banks in the S&P 500 a level not seen since the savings and loan crisis concluded back in the early 1990s.13 We have begun investing small amounts of capital in select banks and are actively looking for more opportunities. To date, our investments have been in the larger-cap banks, where the valuations are the lowest. We are looking for opportunities among regional banks, but their valuation levels have not come down as much as the large-cap banks.


Tech bellwethers: Cisco, Dell, EMC, Hewlett Packard, IBM, Intel, Microsoft, & Oracle. Bloomberg data.

Price/Book Ratio of S&P 500 Banks

3.50 3.00 2.50 2.00 1.50 1.00 0.50 1993 1995 1997 1999 Source: Bloomberg, FPA. 2001 2003 2005 2007 2009 2011

We have recently established a small position (just 1.3%) in three large banks. Though each company is unique, the group has some similar attributes, namely:
Strong operating franchise Significant market share Exposure to the global financial system Much stronger capital position than during 2006-07 Robust reported capital strength (based on traditional measures) Unusually low price to current tangible book value Low valuation to prospective normalized earnings power
Source: FPA.

Diminished (but lingering) credit issues from 2008-09

Increased regulatory pressure Balance sheet leverage Exposure to the global financial system Unknowable balance sheet and derivative exposure

Although our position is currently small, we have spent a great deal of time considering the merits of each company, as well as the group as a whole in the context of our entire portfolio. From a strictly bottom-up perspective, each of the banks merits a much larger portion of our portfolio. Our investment (or lack thereof, depending on ones perspective) is a result of the intersection of our bottom-up approach with our consideration of the macroeconomic environment. The situation today is quite different from the environment we discussed in our Q4 2006 and Q3 2008 shareholder commentaries, when we explained why we refused to own financials (and had, in fact, not owned them for much of the last decade) as we believed that any potential upside to the stocks could not be justified by the risk assumed.14 At the time, we pointed out the elevated level of ROE (18-22%) being earned by financials, the extreme amount of balance sheet leverage (26x equity in the case of the investment banks), and the pricey multiple to book value (2-3x) and earnings (12-15x) at which financials traded. At our purchase price, our basket now trades at an average 85% of tangible and recently scrubbed book value and 7x our best estimate of normalized earnings power. It is rare to find leading franchises available at such prices. Not only does each company have its strongest balance sheet in a least a decade, but we are also cognizant that a strategy of buying leading financials at a discount to tangible book after a recession/credit dislocation has repeatedly produced outstanding results over the past thirty years. If the world doesnt fall apart, our basket
Crescent Q4 2006 commentary:,%202006.pdf . Crescent Q3 2008 commentary:,%202008.pdf.pdf.

could double over the next 2-3 years, based on conservative business results and exit multiples. Although there are no guarantees, on a bottom-up basis, we really like the opportunity. However, our appreciation for the macro-environment causes us trepidation, leaving us with a relatively small position. Our concerns about the functional insolvency of Western governments, the potential real estate bubble in China, unnaturally fixed currency exchange rates, untrustworthy official data, and highly manipulated interest rates, create the fear that the oasis of bottom-up bargains we see could prove a mirage. While we worry about the macro, we also appreciate that we dont know what will happen. On one hand, the unsustainable increases in government obligations could lead to default and a second crisis (one thats perhaps worse than that of 2008-09), as governments might prove incapable of providing a backstop. On the other hand, it appears to be in everyones interest for responsible officials to cut spending, increase revenue (in part though the resulting economic strength), and tweak certain entitlement programs to put developed economies on solid footing. If we could place a higher probability on the likelihood of officials making necessary the adjustments, we could then envision a larger position in banks. Our financial basket also includes property & casualty insurance. The sector is historically cheap, with aggregate valuations near 1.0x. We believe the industrys underwriting cycle has bottomed and that current valuations fail to reflect a more normal environment. To date, we have invested in several insurance companies. One of our investments, Transatlantic Holdings, is currently the target of a bidding war between two suitors. We are evaluating the competing proposals and working with Transatlantic to maximize shareholder value.
Price/Book Ratio of S&P 500 Property & Casualty Companies
2.25 2.00 1.75 1.50 1.25 1.00 0.75 0.50

Source: Bloomberg, FPA.

High Yield / Distressed High yield is distressing. Higher yielding corporate bonds just dont really exist, certainly not with enough yield to justify the twin risks of interest rates and credit. We have been sellers, either through maturity or in reduction of position size. Our exposure is a frustratingly low 6.9% and that doesnt even tell the whole story, because we believe there is very little risk to our book. Companies, on the other hand, have been issuers. High yield originations hit an all-time high in 2010, and 2011 is on track to handily trump that as both yields and credit spreads remain low.


Merrill Lynch High Yield Index (YTM) vs. 5-Year & 10-Year U.S. Treasury Yield
25.0 20.0 15.0 10.0 5.0 0.0

Merrill Lynch High Yield Index (% YTM)

10-Year U.S. Treasury Yield

5-Year U.S. Treasury Yield

Current High Low Average

High Yield 7.7% 21.7% 7.3% 11.0%

5 yr UST 1.8% 9.5% 1.2% 5.1%

Spread vs 5-Yr 5.9% 19.8% 2.8% 6.0%

10 yr UST 3.2% 9.3% 2.2% 5.6%

Spread vs 10-Yr 4.5% 18.8% 2.8% 5.5%

Sources: Bloomberg, Bank of America Merrill Lynch.

As can be seen in the table below, the average credit quality of new high yield bond issuance has been deteriorating, with 17% of the issues either Caa or unrated. Although this is down from 2007-08, when 24% of the issuance was Caa or unrated, it is 29% higher than the 17-year average. But the percentage of lowerquality issuance fails to tell the whole story. The dollars issued in the Caa and unrated totaled $47.6 billion in 2010, and in 2011's first half, $28.6 billion has been issued, 60% ahead of last year. Note that in the prior peak years of 2006-07, Caa and unrated issues totaled just $56.2 billion. The total for the past 18 months $106.2 billion is almost double that peak. Lest one challenge our conclusion by saying that refinancings account for most of this, we counter with the argument that refinancings are 53% of new issuance today, as compared to 92% in 2007-08.
High Yield New Issuance 1995 - 2011 1995 2011
Ba B Caa NR Total Caa +NR % 9.6% 10.8% 11.8% 18.9% 4.8% 17.9% 3.0% 2.9% 7.1% 16.2% 14.6% 15.0% 25.2% 22.8% 10.2% 18.1% 17.0% 17.0% $Caa+NR % Redeem $ % 3,901 7,807 15,524 25,947 4,419 7,922 2,356 1,690 9,278 21,835 13,623 21,328 34,899 11,335 15,524 47,618 57,112 28,556 20.3% 19.9% 24.2% 19.0% 47.9% 74.9% 46.3% 58.5% 45.7% 64.0% 62.4% 50.8% 68.6% 114.5% 68.8% 51.2% 54.7% 54.7% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Annualized 2011 2011 15,001 23,928 44,406 38,570 26,648 12,784 31,492 17,421 33,323 34,468 25,142 50,113 27,607 13,263 49,731 63,933 97,007 48,504 21,681 40,819 71,814 72,787 60,217 23,655 45,800 39,435 87,712 78,100 54,698 70,927 75,862 25,142 87,345 151,102 181,668 90,834 1,790 1,336 6,091 12,309 1,875 3,205 1,543 1,435 7,446 21,291 13,213 19,821 33,136 10,214 14,063 43,409 53,599 26,800 2,111 6,471 9,433 13,638 2,544 4,717 813 255 1,831 543 410 1,508 1,763 1,121 1,461 4,210 3,513 1,756 40,583 72,554 131,744 137,304 91,284 44,361 79,648 58,545 130,313 134,403 93,462 142,368 138,368 49,739 152,599 262,654 335,787 167,893

High Yield New Issuance

Sources: Barclays Capital, FPA.

Source: Barclays, FPA.



High yield bonds are easily sold when alternative yields are low and, easier still, when a company gets all gussied up. Its easy to sell something that looks good, but is it as good as it looks? Who buys a new car and thinks theyll ever have a problem with it? There will be some wrecks on the road, and well be there to pick through them. So while were without high yield opportunities today, were expecting them tomorrow. Until then, cash will continue to be the residual of investment opportunity.
U.S. High Yield Originations (in billions of dollars)

2000 $44.4











1H 2010 1H 2011 $108.4 $167.9

$79.6 $58.5 $130.3 $134.4 $93.5 $142.4 $138.4 $49.7 $152.6 $262.7

Source: Barclays Capital. Artwork copyright 123RF Limited, used with permission under license.

Closing We manage per the equation Portfolio = Investment Opportunity + Cash. The rules of algebra therefore dictate that Cash = Portfolio Investment Opportunity. Cash will be invested only when the risk/reward of a given investment dictates its deployment. You dont know how valuable cash is until the day you need it. It is important to note we lived by this equation when the fund had $100 million in assets under management, when it had $5 billion, and we continue to do so today. Slow economic growth and high unemployment can lead to further societal polarization, and yet, politicians lack the political will to do anything more than pay lip service to the larger issues. Candidly, were not sure they really understand either what to do or whats really going on. We see them, and their EU brethren, packing surfboards for a tsunami something that wont end well. We continue to wait and hope as we enjoy what we believe to be relative calm between two crises.15 We have a couple of introductions before we close. First, we are happy to have Chris Lozano joining our analytical team, bringing our current number of professionals to ten. Chris comes to us with a law degree and five years of finance experience that includes his most recent stint as an associate in Oppenheimers Restructuring Group. We expect that Chris will help us in the next round of restructuring. We hope he wont have to wait long. Second, wed like to introduce our new, improved (and much overdue) website,, coming in early August to a browser near you. You will be able to easily navigate our site and find past commentaries and speeches, more details on your Fund, as well as information on other products FPA offers. You might also notice that the First Pacific Advisors name is not present. Weve come to realize that most investors

Steven Romick, Wait and Hope (Speech given at the Value Investing Congress in Pasadena, California, May 3, 2011).


know us simply as FPA, and that Pacific really doesnt convey the breadth of the firms offerings. Heretofore, we will only be using FPA. Respectfully submitted, Steven Romick President July 20, 2011

The discussion of Fund investments represents the views of the Funds managers at the time of this report and is subject to change without notice. References to individual securities are for informational purposes only and should not be construed as recommendations to purchase or sell individual securities. FORWARD LOOKING STATEMENT DISCLOSURE As mutual fund managers, one of our responsibilities is to communicate with shareholders in an open and direct manner. Insofar as some of our opinions and comments in our letters to shareholders are based on current management expectations, they are considered forward-looking statements which may or may not be accurate over the long term. While we believe we have a reasonable basis for our comments and we have confidence in our opinions, actual results may differ materially from those we anticipate. You can identify forward-looking statements by words such as believe, expect, may, anticipate, and other similar expressions when discussing prospects for particular portfolio holdings and/or the markets, generally. We cannot, however, assure future results and disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. Further, information provided in this report should not be construed as a recommendation to purchase or sell any particular security.


FPA Crescent Fund

Contrarian Value Strategy
FPA Crescent Fund
Managed By Ticker Symbol NAV Initial Min. Inv. Firm Assets Strategy Assets Fund Assets CUSIP
*Charles Schwab only

2nd Quarter

FPA FPACX/FPC1Z* $28.12 $1,500 $16.8 billion $6.8 billion $6.7 billion 30254T759 The FPA Crescent Fund endeavors to provide, over the long-term, an equity-like return with less risk than the stock market.

Absolute value investors. We seek genuine bargains rather than relatively attractive securities. Alignment of interests. We invest our money alongside yours, and we act as stewards of our shared capital. Broad mandate. We invest across the capital structure, asset classes, market caps, industries, and geographies. We are willing to hold cash. Long-term focus. We believe the best way to accomplish our goals is to accept short-term underperformance in exchange for long-term success. Macroeconomic view. We incorporate an understanding (sometimes limited) of the economic environment. Volatility. If we have performed our research correctly, volatility creates opportunity, not risk. Downside protection / Risk minimization. We aim to protect capital first and create longterm equity-like returns second. We cannot eliminate risk, but we conduct ourselves by hoping for the best, while preparing for the worst. Please reference FPA Contrarian Value Policy Statement for additional information.

Portfolio Management Team

Steven Romick, CFA, Portfolio Manager Brian Selmo, CFA, Director of Research Dennis M. Bryan, CFA Rikard B. Ekstrand Elizabeth A. Douglass Mark Landecker, CFA Christopher Lozano Ravi R. Mehra Gregory R. Nathan

Average Annual Returns (%)

Through 06/30/2011

FPA Funds 11400 West Olympic Blvd., Suite 1200 Los Angeles, CA 90064 Phone 800-982-4372

FPA Crescent S&P 500 Russell 2500 Index 60% R2500/40% BCGC

Since YTD 1 Year 3 Years 5 Years 10 Years Inception* 5.0 19.9 5.2 6.4 9.7 11.1 6.0 30.7 3.3 2.9 2.7 8.1 8.1 39.3 8.2 5.2 7.4 10.2 5.9 24.3 8.3 6.3 7.3 9.1

* Annualized return since inception of FPA Crescent in June 1993

Annual Performance (%)

FPA Crescent S&P 500 Russell 2500 Index 60% R2500/40% BCGC 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 12.0 28.4 -20.6 6.8 12.4 10.8 10.2 26.1 3.7 36.1 15.1 26.5 -37.0 5.5 15.8 4.9 10.9 28.7 -22.1 -11.9 26.7 34.4 -36.8 1.4 16.2 8.1 18.3 45.5 -17.8 1.2 19.1 22.5 -21.4 3.9 11.2 6.0 12.7 28.1 -6.6 4.8

Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. The Fund can purchase foreign securities, which are subject to interest rate, currency exchange rate, economic and political risks. The securities of smaller, less well-known companies can be more volatile than those of larger companies. Value stocks can perform differently than other types of stocks and can continue to be undervalued by the market for long periods of time.

Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown. Performance has been calculated on a total return basis, which combines principal and dividend income changes for the periods shown. Principal changes are based on the difference between the beginning and closing net asset values for the period and assume reinvestment of all dividends and distributions paid. All applicable expenses such as advisory fees have been included in calculating performance. Total return calculations are based on a $10,000 investment. This data represents past performance and investors should understand that investment returns and principal values fluctuate, so that when you redeem your investment it may be worth more or less than its original cost. Current month-end performance data may be obtained by calling toll-free, 1-800-982-4372. You should consider the Funds investment objectives, risks, and charges and expenses carefully before you invest. The Prospectus details the Fund's objective and policies, charges, and other matters of interest to the prospective investor. Please read this Prospectus carefully before investing. The Prospectus may be obtained by visiting the website at, by email at, toll-free by calling 1-800-982-4372 or by contacting the Fund in writing. S&P 500 Index includes a representative sample of 500 leading companies in leading industries of the U.S. economy. The index focuses on the large-cap segment of the market, with over 80% coverage of U.S. equities, but is also considered a proxy for the total market. Russell 2500 Index is an unmanaged index comprised of 2,500 stocks of U.S. companies with small market capitalizations. Barclays Capital Government/Credit Index is an unmanaged index of investment grade bonds, including U.S. Government Treasury bonds, corporate bonds, and yankee bonds. Balanced Benchmark is a hypothetical combination of unmanaged indices comprised of 60% Russell 2500 Index and 40% Barclays Capital Government/ Credit Index, reflecting the Fund's neutral mix of 60% stocks and 40% bonds.

FPA Crescent Fund

Contrarian Value Strategy
Portfolio Information
Portfolio Inception Actual # of Positions Expense Ratio*
(1.16% excl. short dividend expense)

2nd Quarter

Portfolio Characteristics
June 1993 123 1.28% 20%
FPA Crescent Russell 2500 S&P 500 Barclays Capital Gov't/Credit

Price/Earnings TTM Price/Earnings 2011 est. Price/Book Dividend Yield Average Weighted Market Cap (billion) Median Market Cap (billion) 15.8x 12.9x 1.7x 1.9% $64.2 $25.5 0.9 1.0 2.2% 6.4% 23.8x 16.5x 2.1x 1.3% $2.8 $0.8 15.9x 13.2x 2.2x 2.0% $90.1 $11.9 5.5 7.8 2.4%

Turnover* Dividend Frequency

*As of most recent report


Portfolio Exposure
Asset Allocation

Historical Range

Duration (years) Maturity (years) Yield-to-Worst Yield-to-Worst (corporate only)

59.0% 40-65% Common Stocks, Long 3.7% 0-10% Common Stocks, Short 0.7% Other 0-1% 7.1% 4-25% Corporate Fixed Income 2.6% Mortgages 0-5% US Govt Bonds & Agencies 13.8% 0-20% 27.1% 10-45% Liquidity*
*Cash and high quality, liquid, limited term securities (net of shorts and collateral).

Portfolio Statistics
FPA Crescent 60% R2500/ 40% BCGC 367.7% 99.5% -198.4% 82.7% 2.6% -2.7% 5.3% -13.9% 9.3% 11.14% 0.37 Russell 2500 S&P 500

Gain in Up Months - Cumulative Upside Participation Loss in Down Months - Cumulative Downside Participation Up Month - Average Down Month - Average Delta between Up/Down months Worst Month Best Month Standard Deviation Sharpe Ratio (using 5% risk-free rate) 366.0% -164.1% 2.6% -2.2% 4.8% -13.9% 12.6% 10.58% 0.58 567.3% 64.5% -354.3% 46.3% 4.1% -4.4% 8.5% -21.5% 15.4% 18.48% 0.28 464.7% 78.8% -300.4% 54.6% 3.3% -3.9% 7.2% -16.8% 9.8% 15.31% 0.21

Geographic Allocation
United States Europe Other 59.2% 15.9% 4.3%

Top 10 Holdings
Aon CVS Wal-Mart Stores Ensco plc Covidien Occidental Petroleum Microsoft Stanwich * Omnicare Pfizer Total
*Various issues

FPA Crescent Fund (NAV)/ S&P 500: 10-Year Growth of $10,000

3.5% 3.5% 3.4% 3.2% 3.1% 2.9% 2.7% 2.5% 2.0% 1.7% 28.5%
Date: 7/1/200106/30/2011

$27,500 $25,000 $22,500 $20,000 $17,500 $15,000 $12,500 $10,000 $7,500
S&P 500 $13,076 FPACX $25,180

2002 2003 2004 2005 2006 2007 2008 2009 2010

*Past performance is no guarantee of future results. The return shown is at net asset value (NAV) and does not reflect the deduction of the sales charge, which if reflected, would reduce the performance shown.