Fpa Crescent Fund Q2 2013 Webcast Transcript

7/27/2019 Fpa Crescent Fund Q2 2013 Webcast Transcript

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FPA Funds2013 Q2 Crescent Funds Webcast

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Mark Hancock: Good afternoon everybody. Thank you for waiting. My name is Mark

Hancock . Im Director of Client Service & Business Development here

at FPA. We appreciate you joining us today for the FPA Crescent

Funds 2013 second quarter webcast. It is our expectation that with

the appropriate consent, both the audio, transcript and visual aspects

on todays call will be posted on our website fpafunds.com over the

coming week or so. Momentarily you will hear from Steven Romick,

our Managing Partner here at FPA, Portfolio Manager of our

Contrarian Value Strategy, which includes the FPA Crescent Fund.

Brian Selmo and Mark Landecker who s Co-Portfolio Managers on the

strategy, as well as other members of the team. Steven has managed

the FPA Crescent Fund since its inception in 1993. And Id like to

congratulate Steve and the team as they recently celebrated the

funds 20 th anniversary on June 3 rd of this year. Its our goal during

this course and review of stakeholders a clear understanding of our

current views as the team discusses the portfolio, the market, the

economy and fields a bunch of questions that have come in prior to

and during the call. Joining Steve today, as I said, are Steves co -

managers on the strategy, Brian Selmo and Mark Landecker. As well

as key members of the team, Andrew August, Greg Crouch, Sean


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Korduner, Chris Lozano, Greg Nathan and Ravi Mehra. Now over to

you, Steve.

Steven Romick: Thank you very much, Mark. And thank you all for joining us today.

We start with always at the first with our philosophy just to make sure

this is truly engrained in your mind as much as it is engrained in ours.

Our goal is either to provide equity rates of return and avoid

permanent impairment of capital along the way, so invariably it usually

ends up meaning less risk in the stock market. We do this by

investing across the capital structure buying common stocks,

preferred stocks, convertible bonds, junior debt, senior debt, bank

debt and various sundry other types of special purpose vehicles we

may have invested in the past or may invest in in the future. The

Fund Overview, this shows the hypothetical growth of $10,000. We

never really spend much time on this, and notice Im going to spend

more time on this today. Its just that in the secon d quarter we

actually had a relatively seminal event. Theres a question that just

came through that says that people cant hear. So we marked our 20 -

year anniversary in the second quarter. And were very proud to

deliver on our specific goals these past two decades. And the very

least we can do is promise that we will work just as hard in the future.


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And Im very confident that we will do quite well overtime because we

have a process that we feel that we can replicate over many years

with the wonderf ul people involved on our team, and Ill talk about

team in a moment. Performance, most recently, has given our

continuous cost of spend. The point is to perform quite well. And the

investment committee and investment team hasnt changed much

over time I mean, in the recent year recent six months, actually. I

apologize. But the theme remains unchanged in composition, except

for one factor. But as Mark Landecker and Brian Selmo now the

added title of Portfolio Managers. Mark and Brian have been

affectively serving in this capacity for the last few years, and now they

have the title to go with the role. And I wanted to thank them publicly

and let everybody know that were quite honored to have them

alongside of me. Now theres also been one small addi tion to the

family, Mark Landecker and his wife Kim had a baby boy, Nate, during

the second quarter. Congratulations to the Landeckers. Mark is

smiling a little bit, not a lot. I want that on the record. The FPA

Crescent winners and losers for the second quarter are actually quite

interesting. Because theyre notable for the reason that it really just

shows you how much noise there is in quarter to quarter performance.


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The biggest impact in Q1, which is Covidien, declined so much in Q2

that it topped the losers chart. And as of today, Covidien has made

back all of its losses in the second quarter, which mark to market only

didnt transact. And in the second quarter decline has made back as

it approaches its all time high as we speak. Microsoft led the charge

in the second quarter and now seems to be pulling Covidien as its

leading the early third quarter charge for poor performance. Again,

this is really all just noise and nothing reflects that more than

Omnicare that you see on this page, which at numerous periods of

time of inter-quarter declines over the last few years, along the way to

doubling from our cost. The FPA Crescent allocations, when you look

at risk asset exposure, has declined somewhat from the prior quarter.

And we continue to maintain a very conservative posture in the fund.

The stock price has continued to offer little in the way of margin of

safety, a nd given the continued risk in the market, one shouldnt be

Im sorry the continuing rise in the market, one shouldnt be too

surprised to see the fund s exposure to risk assets to continue to

decline. So its declined by a few percent since the first quarter. The

portfolio characteristics slide you have in front of you now, this reflects

that things arent particularly cheap as th e P/E can certainly reflect


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which is slightly higher than where its been over our 20 years.

Price/Book is in line, Return on Equity is relatively in line. And we

continue to see better value, at least relatively speaking, and were

trying to think of ourselves as absolute, value investors. So I do

recognize that Im making a relative statement, that the larger

companies are relatively more attractive and that is reflected in our

higher market cap at $76 million. We also own a number of

companies that have important off balance sheets with more cash

than debt, and this pushes the debt to capital numbers solidly into the

negative, which means far more cash than debt, and thats the

weighted average across the portfolio. Now the reason for our

continued conservative posture can be seen in this slide of

unemployment. Y oull see three lines here . One is the red line at the

bottom, which is the lowest number. I ts the government number for

unemployment. And the other two lines reflect Th e gray line

reflects a broader level of unemployment in U-6, and then the blue

line is actually one firms opinion , John Williams opinion and

ShadowStats, that this is really where we see true unemployment

number, and basically arguing that the government number is all wet.

Now were not showing this slide to advocate that the ShadowStats


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number is the correct number. But directionally we certainly agree

with the idea that government statistics dont really show the whole

story which would be for inflation, or in this case unemployment.

Unemployment showing at 7.6% is misleading for lots of reasons and

Ill give you just one simple reason. If the same number of people

wants to be employed in the United States, the same percentage of

the population as five years ago, unemployment would be 3.5. So

unemployment wouldnt be 7.6%, it would be 10.6%. And if the same

number of people in the U.S. as a percentage of the population

wanted to work today, were seeking work five years ago. So people

give up and dont want to work, and they come out of the civilian

institutional population, they come out of the denominator, and the

unemployment number goes down. Earnings arent what is driving

the stock market, certainly not in the recent 12-month period. And

you can see that in this slide where multiple expansion is still the

predominant driver of returns. And at some point were going to need

earnings growth. And this chart is reflective of both the U.S. and

Europe, is also true of emerging markets. It doesnt happen to be true

of Japan at this point in time. And things are somewhat challenging if

you just look and one of the reasons why see the economy not


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having such terrific growth today is always to just look at the real

median household incomes. This is income adjusted for inflation.

And this number has been on its longest slide since the depression.

Now this chart only goes back to the late 1960s , but its not going to

have an inconsequential impact on spending if you have your real

income declining for years on end. N ow the economys had some

bumps some improvement along the way. It doesnt look so terrible

for lots of different reasons, not the least of which is government

involvement. But the US savings rate has been declining, and this

chart here shows you that. Now as savings rates come down, you

end up with more conservative spending. People pull it down to go

and make ends meet or buy something special, whatever the case

may be. But clearly its not something that can continue to go down in

velocity as it has been. There are some positive points in the world

today, and obviously we ve mentioned these before. Natural gas

prices remain relatively low, which is great for our manufacturing

capabilities in the country that are located close to natural gas

facilities. And we have auto sales that are still well below their peaks.

So as these things, as natural gas prices Im sorry the auto sales

move back towards a norm, revert to a mean, thats some benefits to


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the economy. Housing starts same thing. Housing starts still remain

well below where theyve been historically. Now were not arguing to

go back to peak, but it should go back to some normal level that will

still be higher than where we are today. But stocks and price, most, if

not all of this in. So, if you look at the historic P/E on this Shiller chart

that you see here, you can see that the current P/E is smoothed out

over ten years is 23.6x earnings. And that is much higher than its

been at any point in time in the past on an average basis. I mean, not

the highest point, but its well above average, I should say. And one

of the reasons you get there is because the treasury yield is so low

and Im going to argue, artificially low at just 2%. And the reason

that we like this Shiller methodology is it looks at earnings as a

denominator averaged over ten years, so it really smoothes out those

big peaks and valleys that you have in earnings. And another reason

we like it, looking at it on a trailing basis, is that we dont place a lot of

stock in projected earnings. If you look at this chart here that is titled

Wall Street Blind Optimism , you see 18 data points. These are 18

years worth of projections, and in each year you see, in these

squiggly lines, you have, at the beginning of the year, the expected

earnings over the course of the year. They are coming down to what


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the actual earnings end up being. So they start high, to the left, end

up low, to the right. Now, thats true in 15 of the 18 cases. So in 15 of

the 18 data points, in 15 of the 18 years Wall Street was overly

optimistic, and we dont expect that to be any different in the future.

Its nice to be optimistic and its a wonderful way to live your life, but

its not necessarily the way to make money. Were more on the

pragmatic side and take this realistic approach. And the reality is

theres less fuel out there for equity valuations. And you look at this

chart that showed the G7 average 10-year government bond yield,

you can see that 13 years ago that the yield was 5.5% and now were

down here at under 2%. Now that is thats federally declining level

of interest rates, and around these developed economies has been

fuel for risk assets around the globe. So, at some point interest rates

are going to change and when that does and when interest rates end

up going back up, its not going to be good for the same risk assets

that have benefitted from this downward sloping chart. Turning to

high yield bonds, high yields are equity and these arent cheap either.

And this chart shows you the S&P 500 versus junk spreads on an

inverted scale. So as junk spreads are going our yields are going

down and spreads are getting tighter, you see the line actually going


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up. And you can see how the stock market and high yield bonds are

so closely correlated. Covenant-lite levered loans are a pretty darn

good indicator as to what the risk is. And in an environment where

people are perceiving risk, lenders are more willing to just capture the

yield and get what they can for the loan that theyre m aking and not

worry about any kind of covenants or worry less about them. As a

result, theres actually more risk in a lot of loans out there, whether it

be in high yield bonds, or in this slide that you see in front of you,

covenant-lite levered loans. Because covenant-lite levered loans

show you that this chart shows 25% of these levered loans are

covenant- lite. That is to say, that they dont offer a great deal of

protection, or as much protection as it had in the past for the lender,

which is obvious ly good for borrowers. Now were going to, over time,

take advantage of opportunity when it shows up, and thats going to

be where theres market volatility. And volatility shows up for a host of

different reasons at times that we cant predict. So we j ust sit there

and wait for there to be that kind of negative volatility which creates

fear in the individual company, and therefore stock price; creates fear

in the market as a whole or industry group or an asset class, or

something of that nature. So you can see in this chart that you have


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in front of you that the VIX in this is the measureable utilities, the red

line. And as that line tends to go up over time, our cash which is on

an inverted scale, on liquidity, tends to be pulled down. So as the

index comes down, then as volatility comes down, you end up with

periods of time where theres complacency, and you see longer, flatter

periods like the period of 2004 to 2007. And in that timeframe there

was just a lot more complacency, as we all know now with hindsight,

and that kind of thing shows up in the VIX index. I want to make it

very clear, we dont manage to a volatility index. We dont think about

it at all. This just happens to be the case where it shouldnt be any

great surprise that where there is bad news, where there ends up

being fear, where theres fear there ends up being volatility , and thats

where theres the opportunity. And just to give you some idea of how

our liquidity kind of ebbs and flows over time. Im going to turn it over

for a large cap view a large cap technology view that Mark

Landeckers going to walk you through to give you a perspective on

process and how we think about and work through things at FPA. So,

Mark, Im going to turn it over to you.

Mark Landecker: Sure. So weve never branded ourselves as tech investors at FPA .

But if you were to look at sectors fully here at the moment, youd


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actually see that tech makes up the largest portion of the portfolio. So

before we get into Tech, the three names were going t o talk about

here, and there are others in the portfolio, some of which you can see

in our holdings. Others, which actually we continue to hide because

theyve purchased them in the last 12 months and dont want to

disclose the names as of yet. But if we think about Microsoft, Cisco

and Oracle, and you just look at this slide here, we like to say, if it

wasnt for bad thered be no news at all , as it relates to these three

companies. But surprisingly while we want to invest in Tech, it is

probably dangerous to look in the rear windshield. Nonetheless, if

you look at the performance of these three companies, on average,

over the past ten years, or even from 2007 to 2012, you can see that

in terms of revenue growth and EPS growth, each has actually

exceeded the S&P 500 Median. And you can see the numbers for

yourself from this slide. If we go past revenue and EPS and we

actually look at Return on Equity, you can see the same trend. Each

of Microsoft, Oracle, Cisco generate higher ROEs than the S&P 500

on average. And as a group, they were actually almost doubled from

2002 to 2012. And over the last year 2012 on a loan, 22% versus

15%. And we should not e that that ROE is negatively impaired by


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the fact that each of Microsoft, Oracle and Cisco maintain large cash

balances that effectively act as a lead weight when one calculates

through channel and equity ratio. But, nonetheless, still exceeding the

S&P. Now if we go forward to Enterprise Value/EBIT, many of us

were probably back when we had the dot com days. And even after

the dot com fizzled out, if you looked at Microsoft, Cisco, Oracle in

2002, the valuations traded at an enterprise value of high teens in

terms of pre-tax earnings of EV to EBIT as you can see on what I

believe is the red line on this chart. Now as we go forward over the

next decade, you can see that at present just by the fact these

companies have grown revenue, EPS and generate return capital that

all exceed the S&P, the companies now actually trade at a discount to

the S&P as it relates to EV to EBIT with the group on average now

coming in less than ten times versus the S&P which would be above

ten. If you go to another earnings metric, which would be the P/E

ratio, you can once again see the same trend from 2002 to 2012.

These three companies were once very expensive as it relates to

valuation and theyre now firmly entrenched in value category trading

at a discount to the S&P. Lastly, another popular metric to look at

would be the dividend yield. Back in 2002 these companies actually


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didnt even pay a dividend full stop, yet alone trail the S&P. Now we

roll forward to today, each of the companies has more disciplined

capital allocation program, and even excluding buy-backs that all

were doing on a regular basis simply as it r elates to dividend yield, all

were yielding above the S&P average. So while there are no

guarantees that these tech companies as a group will provide

excellent returns, we do think from our purchase price we have a

tremendous margin of safety, and Ill ca ll it cautiously optimistic that

well be able to achieve equity -type returns from our cost during the

three to five year holding period.

Steven Romick: Thank you, Mark. Im going to we have a number of questions that

has come in over the transom in the last few weeks, and we have

some additional questions that are coming over the transom as we

speak. And well do our best to get to them in the allotted time . And if

questions arent answered, please call Mark Hancock or Brand e

Winget in our client servi cing team here at FPA and well make sure

that every question does get answered even if it isnt getting

answered live on this call today. So the first questions that I have is a

number of questions from one person regarding Google, is it frothy, is

there a catalyst for Apple, should we swap out Hewlett Packard, plus


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in the biotech space, and issues or thoughts regarding committing

natural resources. We own a few of these companies. I just

mentioned Google, we do own in the portfolio today. Look, I think if

they could go back to that slide that I showed earlier about what our

valuations are in the market, where valuations are for our portfolio.

Ca ndidly, we dont think our portfolio is real cheap. We cant sit here

and tout our book today and tell you, well, were really excited about

the companies we own and their valuations. We like the companies

we own, dont get us wrong, but the valuations are not particularly

cheap across the portfolio, and one can speak to that on a host of

different companies. And with respect to Google specifically , theres

other questions about that, Mark, as well. Do you want to speak to

Google specifically?

Mark Landecker: Maybe if we just step back from a broader basis. So we like to think,

we would never ask anyone to give us all their money to manage, but

we act like they have. And with that in mind, we have to construct a

portfolio thats essentially robust to any environment. What that

means is, we want to do okay if theres a deflationary outcome in the

world. We want to do okay if theres an inflationary outcome. These

are both scenarios that we worry about. So if you look at the portfolio,


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theres a number of names which we will say are just not outright

cheap. And we can put Google in there as an example. But what we

think they are, are fantastic hedges against inflation. If you think

about the business model of Google and some of the other

companies Im thinking of such as AB Inbev, for example, the

headline P/E is not classic value guide territory. But what they offer

an excellent opportunity to do is protect ones purchasing power over

time by basically allowing us to clip coupons on the earnings yield

thats reasonable given the high quality of the business and the fact

that each of the companies in question are very well protected against

inflationary environment. But of course that protection doesnt come

cheap, and at present, it reveals itself in a P/E ratio that we have to

pay. As for Google, it falls into the fact that we think its a great

manag ement team thats allocated capital , incredibly well. Brian could

probably talk about the Toothbrush Test for Google and why we think

theres embedded optionality that doesnt reveal itself at first glance.

Brian Selmo: I guess what Marks referring to is Google projects that they would

pose to themselves that have to be in common use the way someone

would use a toothbrush every day. And so Google has a few blue sky

opportunities in front of it that probably arent in the stock currently. I


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think Mark and I would say were very impressed clearly from the

outside, but with the organization and the types of opportunities that

they tackle. And its not inconceivable that there could be additional

large businesses within Google. If you rewind five, six, seven years,

there wasnt an Android operatin g system. I think now theres 900

million people on it this is just from the Google s second quarter call

and I think a million-five are signing up every day. And so if you think

about the kind of opportunities that theyre seeking to address, thats

an example of success. Well have some failures along the way, but

we think its still an interesting business. And probably the valuation

isnt quite as stretched if you were to try to peel back and tease out

what you were paying for just the core search function.

Mark Landecker: A lot of cash on the balance sheet as well. So if you were to tax the

foreign cash, bring it back in, the valuation gets a bit more reasonable.

And of course with a company like Google, we expect it to be larger,

rather than small over the years. It falls into our compounded

category. And because of that, we probably look at what the

company will be worth a few years out, not necessarily on trailing

earnings.

Brian Selmo: And maybe just to think in terms of our strategy, in an environment


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where there are lets say less absolute bargains to go around, I thi nk

were more comfortable to hold the higher quality businesses at

stretched valuations and are probably going to be quicker to exit

positions that fall under sort of the 3:1 or trade-oriented categories of

the portfolio. And if you watch over time, youll notice that in the

turnover of the names.

Mark Landecker: And, in fact, even if you look at our holdings next quarter once they

come out, so not for Q2, but for Q3 , youll see theres some names

that are going to be out of the book. We wont talk about which ones

yet because some are still being sold.

Steven Romick: Theres a number of questions about asset classes we find fully

valued and a number of questions about high yield bonds and some

of those just merge a number of these questions together. Theres a

number of areas we do find specifically unattractive, and specifically

that would be any area that is most directly impacted by the artificially

low level of interest rates that exist today as a result of quantitative

easing. And so when we look at some of those specific areas, that

would be any of those kinds of businesses, industries or asset classes

that are tied closely to interest rates. So thatd be master limited

partnerships, real estate investment trusts, and then of course high


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yield bonds. So this is not to say that any of these asset classes go

down. All we mean to say is that the yields at which these companies

trade, some of which traded in the case of a number of reasons,

above their NAV, net asset value. Or high yield bonds are going to

trade at very, very tight yields tight spreads rather with a low starting

yield. These are investments that were n ot willing to make. We want

to buy from those people who are foresellers of something, and we

dont want to be in the mi dst of a stampede where people feel the

need to buy because their yield that theyre getting on their fixed

income investments or what they may have had in cash is so low. So

those are the kinds of things that we do truly try and stay away from,

and that just gives you a little bit of a flavor for some of the fully

valuated asset classes. Any other areas or sectors that we find

unattractive that we care to talk about?

Brian Selmo: Unattractive? No, I think that

Steven Romick: And so the question actually came up specifically about high yield

bonds is, what would make it sort of larger allocation high yield

bonds? I mean, when the yields S imply when the yield is higher.

Weve always tended to look at the last couple of decades. Lets get

yields north of 10%. Again, go back to our goal. Equity rates of return


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with less risk in the market. And if we can accomplish that goal with a

bond, we will do it. That doesnt mean we want to buy a bond with a

slightly lower yield, but the lower the yield, the less risk were willing to

assume the further away we get from an equity rate of return. And

so as that point in time, we get aggressively invested in high yield

bonds as we did in late 2008 and early 2009 when yield spreads were

blown out to 20%+. And we were having yields in a number of

investments that were north of 20%, north of 30% for a number of

different bonds that we own. Tha ts not where we are today. We

admittedly sold some of our bonds a little bit early, and a lot of the

bonds we did own were short of maturity and they termed out and we

had the cash delivered to us at that maturity. So what next? We dont

know when next, because right now its not attractive and we cant tell

you exactly when its going to be attractive. We can tell you theres a

trillion dollars in the last three and a half years of new debt issue. We

can tell you that theres a larger amount of tripl e C and non-rated debt

thats eve r been issued in any point in time in history. And that will be

fodder for future opportunity, but its not where we are today. There is

a question I think from one individual who doesnt understand the way

we think about our fixed income set of our portfolio. And the question


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is, is given the long bear market for bonds, please talk about how the

fixed income side of your Fund will be managed where you minimize

the drag that bond losses could incur, and then target profits on both

sides of the portfolio. I dont really know what the latter part means,

so I ll address the first part. Our fixed income portion of our portfolio is

largely a credit-based portfolio. That is to say we assume more credit

risk. That does not mean there is an interest rate risk on the portfolio

at points in time. It does not mean that were not going to go and buy

bonds that mature in 10 or 15 years. We will at points in time. We

just want to make sure were getting paid with the yield to just ify any

credit risk or interest rate risk for that matter. But by and large, what

were doing in our portfolio of fixed income securities is invest in

companies buy bonds of companies that have higher yields. At a

point in time when those high yields are not so high, we end up on the

sidelines. And thats really where the largest portion of our cash

comes from today. Theres a question about...

Brian Selmo: Maybe highlight that, Steve, because we dont really have a bond

portfolio right now. Were 2% i n bonds. And so if you think about the

Fund, the Fund moves dynamically in response to opportunity or lack

of opportunity. So, Mark mentioned there wasnt Tech in the fund 13


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years ago when it was expensive. Right now, we think bonds are

expensive and we find it difficult to see absolute opportunity, so we

dont have them. So rates go up, were not going to have a direct loss

on a bond portfolio because we dont have a bond portfolio.

Steven Romick: That doesnt mean we cant find yield investments, but theyre harder

to come by. We find them in different ways. As the high yield market

was at troughed and we found other op You know, we were

reducing the portfolio, we found other opportunities in subprime home

loans, but that was more of a risk-based asset than a yield-based

asset. But we also made an investment theres a question on this

today about I cant find the specific question at the moment, Ill find it

in a minute but about an investment we made in an Atlanta office

building. It was actually a Florida office building , it wasnt Atlanta. We

actually lent money to complete an office building in South Florida,

and we had hoped to get an 11.8% IRR in the money that we lent to

this building, which was it was a much higher yield than we would

have gotten in high yield bonds at that point or most other any other

that we found at the point in time, fixed interest investment to offer

that kind of asset coverage that this investment did. Well, Im

unhappy to report that that the IRR on that investment was actually


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closer to the mid-teens rather than just sub-12 as we had hoped. And

the reason why we express negatively is that the reason why you end

up with a higher IRR is that we got paid back sooner, so the

commitment fee that we got upfront ends up becoming a larger

portion of our higher IRR. We also didnt get everything drawn down

that we wanted, so we ended up making a higher return on less

capital committed for a shorter period of time. Now theres other

opportunities that come up and were actually in the process of

working with the same partners we worked with on that prior Miami

office building investment to underwrite another building thats being

currently constructed in Florida and that yield will also be a

reasonable yield for us in the low teens really 11%. As our target,

whether it ends up being there or not or higher or lower, we dont

know. So we do find some of these one-offs, but these are not whole

portfolios of fixed income securities to Brians point. And a point in the

future that we will reinvest in there, in bonds when spreads are wide.

High yield bonds are like vacation homes. You go there and visit

when the weathers nice. Well, the weathers not so nice the

weathers not so great right now for us, which means its ac tually

attractive to other people I guess. Theres a question that I love


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FPA CX, but Im worried. The strategy has been superseded by

events, at least for the foreseeable future. I would welcome

comments on any of the following on your upcoming conference calls.

How can absolute value funds flooded with so much liquidity that all

asset prices are inflated? Lets start with that one first, and then Ill

just turn it over to Brian.

Brian Selmo: I mean, I think hearing the tone of the call that we find the world

challenging. But the way we respond to it is by, one, holding cash, so

letting that build up if we dont find bargains. And two, maintaining

positions in stocks, some of which might be a little bit more expensive

than where wed find it attrac tive to buy, but respecting the fact that

there could be a dramatic inflation. And so thats been our approach

to do it. I mean, time will tell how correct that approach has been.

Mark Landecker: You can see theres a number of questions up on the scre en about

bonds, interest rates, the like. I think Steve largely probably address

them. And so if you see treasuries on the holdings, these are very

short- term treasuries, essentially cash substitutes. So were not

taking what we call interest rate or duration risk with those securities.

And even the potential real estate loans Steven mentioned that were

looking at funding, these are all short duration investments, meaning


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under three years and actually maybe possibly under two, such as our

last Miami or Florida investment, if you will. So just to nip it in the bud,

because we see all these questions popping up, we dont have

duration risk in the portfolio. Were not holding bonds of extended

maturities and we dont think were subject to a wood saw effect in the

event that rates kick up on our fixed income portfolio. And thats just

sort of it.

Steven Romick: Theres also some que stions about specific shorts and we dont

answer questions regarding our short book. We may periodically

proffer a view in a pion on a company were short, or in either a naked

basis. Usually not on a naked basis. Usually if its edge against

another long we have in our books. So, just so youre aware for the

future, shorts are a very, very small percentage of the portf olio and its

not something that we comment on.

Brian Selmo: There s a couple of questions on size and sort of flexibility and impact

on the portfolio. I think Id refer everyone to the fourth quarter letter,

first of all, and as a brief overview I thin k we discussed that theres a

very broad mandate for the Fund, so its not just an equity fund, its

not just a debt fund, its not just a U.S. fund, its not just an

international fund. Its really a go anywhere, do everything fund, so


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the very broad markets that we participate in. A nd then next its a

matter of having a broad and deep team. That in part is the three of

us but its also everyone else doing the research and working with us.

And then there are two conditions that we think the size of the fund

might impact us. One is on flows, if we were to get dramatic. In flows,

wed certainly have to consider stopping that. That hasnt been the

case. And then second, our expectation for the future or for the

existing opportunity set, I think whether its due to very low rates,

whether theres concerns about liquidity in government bond buying

programs which theres a handful of questions on. That sort of has

left us thinking that there will be significant opportunities in the future.

You know, I th ink Steves alluded to some charts on volatility. We

think volatility will be much greater, and so we think that it will be

manageable to deploy the capital in a responsible way and in some

attractive absolute opportunities. Thats sort of it on that.

Steven Romick: Just to shift gears because theres actually a question 21. Could you

recommend a recent book you like? I mean, Brian, Mark and I read

different kinds of things. But, go ahead.

Brian Selmo: I have a book. Some on the call may or may not know, weve been

trying to buy ships for a period of time. Theres a book called The


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Shipping Man which I would recommend to everyone to read.

Mark Landecker: Short read, beach read, entertaining.

Brian Selmo: Its a summer read.

Mark Landecker: And its not based on Brian. He does not wear Gucci shoes, he wears

Prada, just for the record.

Steven Romick: Theres a book called Pride of Carthage, which I read earlier this

summer to which I think was actually quite interesting. And it seems

like when you deal with governments, you look at what

governments how they can affect outcomes for economies and

societies, and you looked at what This is about Hannibal

Carthage and you look how the governments, the Carthaginians,

how they handled what would happen in their empire. How, basically,

if they had done things differently, the Mediterranean would look

completely different than it does today. And its just interesting to see

how governments act, and they acted irrationally. Theres a lot of that

in that bo ok as well. So I thought that was interesting. Its not as light

a read as The Shipping Man , but I would recommend that none the

less. Theres a question about Tesco. Lagging in the fund in the

quarter. Do you still believe in its management order to improve its

situation in the managements capability to improve the situation?


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Mark Landecker: So Ill be brief here, because the answer is probably similar to the last

two or three calls. Tescos transforming from what previously believed

themselves to be a growth company to more of a cash flow return

company, return on capital focus. So youve seen theyve exited the

U.S. or at least announced their intention to exit the U.S. They

havent actually extricated themselves from the debacle y et. Theyre

pairing back CapEx forecast which takes them time, because when

you open a new store it goes through a formal planning process with

the local regulatory bodies. Its actually a number of years in the

making. But needless to say, theyre pulling back on n ew store

openings in their home market of the U.K, as well as other markets

such as China. So if we just look at the business in the U.K. and

some of the other nice markets: Thailand, Korea, etc., it a pretty good

business. Were buying Tesco as a whole. Lets call it somewhere

between 10 and 12 times earnings depending if earnings are a little

good or a little bad. Its got about a 4% dividend yield, and

management is incented through the bonus scheme to increase return

on capital, which is why youve seen them do things like exit Japan

and the likes. So, we hope theres more good news on the way as it

related to capital allocation, and from what we can tell, looking at


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customer surveys and the like, theyre improving the shopping

experience in the U.K., which hopefully should flow through to

operating margins as well as same store sales, and a pickup in the

U.K. economy would help as well, at least as it relates to the U.K.

market. So, I think if you go back to our Investor Day, we probably

said Tesco sort of towed the line between a compounder and a 3 to 1

we thought when we bought it. Its now more firmly entrenched in the

3 to 1 camp and its probably where it will stay for the rest of its life

whether we own it or not, which means that were a pr ice sensitive

buyer of Tesco. We dont think its going to grow forever. Were more

price sensitive, but at the current valuation were a happy holder.

Steven Romick: Were a price sensitive buyer for everything. I mean, thats what we

do. Theres a lo t of questio ns that are already here. Were going to

kind of take about ten questions and merge them into one. These

questions about whats happening to margins and have they peaked.

Whats the S&P 500 going to do for the second half of this year?

What s going to happen to the interest rates when are they going to

go up? How much are they going to go up? How is the stock market

going to react when interest rates do go up? The answer to all these

question is, is we dont know. Were in the business of buying


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business, were in the business of buying assets. Were in the

business of buying businesses and assets when they are trading out

of favor. When theres kind of the arbitrage between perception and

reality where we believe that the future is much better than what is

perceived to be today in the present. And so we dont know the

answer to all these questions. I think that realistically that we think

were pretty good at what we do at finding these assets and doing our

work and digging deep on them. And when the market throws up

good pitches and theres strikes and we hope are hopeful to hit them.

And once in a while, admittedly, we miss a strike. Were working on

something and it doesnt get into the portfolio because its gone up too

fast. I mean, its very difficult for us, the way we invest, to invest in a

market where the chart is steeply upper- sloping to the right. Thats

just not a world where we excel never have and never will. Where

we do think we do quite well is buying those assets and buying

businesses where people perceive that theyre going to be challenged

for a longer period than we think, or that they are declining and we

view that with this new management team are going to be better in the

future. Or a business like Tesco where Tesco had some of its market

share taken from them from local competition. Theyve not been the


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greatest allocators of capital in recent years, but that seems to be on

the mend. And so we dont think that the good news that can happen

at Tesco is in the stock. And as Mark likes to say, you know, Good

things can happen in cheap stocks. Theres also another question

about, again, speaking broadly, and what will Obama Care do to the

market? We dont know. I mean, I dont think Obama Care knows

what Obama Care is yet and exactly how it will be implemented.

Theres been a number of head fix along the way in terms of

implementation. Its going to certainly affect some healthcare

companies when it does finally get implemented, and could it in turn

have some impact on the economy? Sure. When exactly that will be,

we dont have any idea. Theres a question about our views on cash

as well as where weve been on cash historically. Let me find that

question.

Mark Hancock: Were down.

Steven Romick: Wer e down. Oh, were down.

Mark Hancock: We would need the 2008.

Steven Romick: What number is this? Well, while we find that question Im going to go

turn to the slide. Turn that slide, Elliott. So, I think this is going to

answer the other question that was out there on cash. And cash, we


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have a very flexible approach to cash. But the headline, actually, the

title of the slide actually makes it sound like we are actually making a

conscious decision about cash . Were not. Were making a

conscious decision about businesses and assets and the prices that

we trade in. And if they are attractive and they provide that margin of

safety, we will buy those businesses. We will buy those assets

regardless of what the backdrop looks like. When the world didn t

look great in 2007 we were nervous. When the world didnt look so

great in 2008 and 2009, we were still nervous. Maybe we were

always nervous, but we were able to take action and invest your

portfolio for you. Its our average liquidity at different p oints of time.

You can see these points of time with that peak liquidity. And the

peak liquidity are returns from those peaks were just less than 6% in

the ensuing two years. But from trough periods we actually where

we pulled liquidity out of the single digits, you actually had the

compounded growth rate for the fund, and the next two years was

mid-teens. So the average liquidity in those returns in the earlier chart

that we showed you going back to the inception of the Fund in June of

1993, the average liquidity has been about 26%. And I wouldnt be

surprised, and Ill put this to Mark and Brian as well, if they have a


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different spin on this. But our liquidity in excess of that today, but over

time I wouldnt be surprised if our average liquidity is lower in the

future than where its actually averaged to start with, but its going to

be in and around its going to go up and down. And one of the

reasons for that is we do have a long return view of what governments

are doing in central banks in developed economies around the world.

Its going to be more like an inflationary than not, and stocks will end

up being better than cash in that event one. Two, this is a product

that is to be run by me alone, and as the team has gotten bigger, as

theyve bui lt the team and then other people who are here around this

table have helped build this team and have become integral to the

process, we have a greater ability to invest more broadly. To own a

few more companies than we did before because we have the skill set

to do it. To invest in industries that werent otherwise invested in, to

invest in asset classes that werent otherwise invested in. So I

wouldnt be surprised in the future that cash isnt averaging less than

it has averaged historically. Brian, Mark?

Brian Selmo: I think I would agree with that. I would say that I would expect the

cash balance to swing around quite a bit. So I would expect there to

be perhaps lower lows and highs probably around the level were at


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now. I think thats all of ou r working assumption. I think I would point

out on the cash side, it just goes kind of for everyone to think about

what were doing, right? Looking at the question, were not predicting

where the 10- year is, were not trying to figure out if high yield i s going

to do great or not next year. Were just saying, hey, if theres nothing

to buy were going to let cash pile up. So we run the risk of under -

performing in a really strong up market. Thats kind of something part

and parcel of what we do. Were very comfortable with. Were also I

think Steves chart shows and were glad to stand on Steves

credibility that, yeah, when we do decide to buy stuff, sort of the track

record of identifying good opportunities and good times to buy things,

its worked out over time and wed expect it to work out over time also.

Steven Romick: Theres a question here, Mark, for you, since youre our on -point

person on WPP, asking here our thoughts on Omnicom and Publicis

and the recent announcement.

Mark Landecker: You know, its probably good for the industry as a whole

Steven Romick: But on the basis of WPP was the question.

Mark Landecker: Yeah, so its probably good for the industry as a whole. For those of

you who dont follow the advertising agencies as closely, theres been

some talk in the market lately about some of the larger customers like


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-35-

Proctor and Gamble, for example, pushing the advertising agencies to

basically stent payment and almost acted like a bank in funding their

working capital. So Proctor and Gamble says, hey, instead of taking

45 days to pay you, I want to pay over 90 days, for example, and

youll pay for my median and Ill pay you back. By Omnicom and

Publicis getting together, its definitely gives them more heft in

pushing back against customers like that with WPP can benefit from,

because no doubt, they will be pushing back as well. It, I think, helps

on pricing. Generally, if youve looked at markets that tend to

consolidate with a fewer number of competitors over time, they often

have higher margins than very fragmented markets. Here the number

of large real critical mass agencies is shrinking by one, but if you think

about that as a percentage of the participants the big guys are IPG,

Omnicom, WPP and Publicis, so essentially youre r educing it by 25%

because one out of four is essentially gone. So we think its a benefit

for the industry as a whole. WPP will get to piggyback on them, and

look, there might be some ancillary benefits such as good people who

become available because th ey dont like the fit of the new

Omnicom/Publicis. There could be trying conflicts, which historically

is the management in the industry, but nonetheless, I think Publicis


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and Omnicom represent both Coke and Pepsi, if Im not mistaken.

And thats just an example. Were not saying one of those will go, but

you can take that through the auto industry and any other consumer

facing or business industry.

Brian Selmo: There will be bids.

Mark Landecker: Yeah, therell be opportunities. If nothing else it will probably force

some customers to put some things up for tender, which just gives

WPP a chance to win.

Steven Romick: But also, interestingly, its not just a question of what it means to

WPP, and the question was asked in the context of WPP, and it can

posed in the context of IPG. Brian?

Brian Selmo: I mean, noting that, it probably means its more likely that IPG gets

bought.

Mark Landecker: Exactly.

Brian Selmo: I think that IPGs been thought to be an acquisition candidate for a

while, but this probably increases the odds.

Mark Landecker: And theyll benefit from the same things we just discussed. So,

favorable for the industry as a whole, and we actually think, you know,

well be watching Omnicom and Publicis that much closer as well. It

makes that a potentially interesting name if theres an opportunity,


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perhaps, to get involved there in the future. We already watch them

closely.

Steven Romick: There is a couple questions asked regarding our investment in the

farming partnerships that weve invested in, and why the second Fund

was so much smaller compared to the first investment that we made.

And it was just because our mutual fund was larger and we just re-

upped in the investment to gain more exposure. We have an illiquid

bucket in these funds. We have a number of different illiquid

investments that we make. And when we make a illiquid investment

we have to be conscious about how much of that bucket is filled at a

point in time as were very careful of that with the idea that, if the Fund

were to decline 75%, that these investments could still be a

manageable position to fund. And in the case of the farming, the

farming investment is a longer term investment. And the farming, too,

investment that you questioned about is still in the---the capital

commitment is larger than the position size, as you actually mentioned

in your question, because its still in drawdown mode.

Mark Landecker: So theres 20 questions left10 minutes. Im going to tackle two at

once. Theres a question how Brian and Mark work with the team,

and theres a question about Potash. So, just as an example, Brian


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leads a Tuesday meeting where all the analysts get together. We talk

about what were working on, anybody have ideas, anybody seen

anything interesting, specific company names schematic. At

yesterdays meeting two analysts were both chomping at the bit to

look at Potash after its decline, and theres a question here, Would

you look at Potash? So we will announce formally here, for the

analysts listening to the ca ll, were staging a final death battle

between Sean the Snake Korduner, Chris the Lionheart Lozano to

see who gets to look at Potash. People like to look at it. So yes, well

look at Potash and

Steven Romick: Just to be clear, these are monikers Ive ne ver heard.

Brian Selmo: Mark came up with those on the fly.

Steven Romick: And theyre going to stay here.

Brian Selmo: Lets expand those answers. Theres a handful of questions on

natural resources in emerging markets. Would we invest in them?

Are we interested? Do we have thoughts? Yes, we would invest in

them. On a couple we have thoughts. No, were not going to discuss

them right now. And that kind of addresses

Steven Romick: But we also do invest in emerging markets. We already have. We

have investments in a casino in Malaysia called Genting. And so we


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do, in the portfolio today, do not have a large exposure. I mean,

emerging markets clearly have underperformed more recently, but the

higher quality businesses have not declined to those kinds of prices

that we find attractive. A lot of the companies that are really down

and out are those kinds of companies that are more leveraged and/or

more cyclical.

Mark Landecker: These are 3 to 1s that are out of favor right now, but we dont think as

of yet they offer sufficient return for the risk we take. And as it relates

to the international compounders, theyre not at the right valuation.

But if you look at the portfolio, Elliott, you can go to the slide that has

the geographic revenue breakdown, if you know which one.

Steven Romick: Yeah, its not on this slide. Its not on this one.

Mark Landecker: Yeah, you just go past that.

Steven Romick: Yeah, go back, sorry.

Mark Landecker: So you can see, just as an example, so the portfolio, if you were to

look at the invested portion, roughly half of the revenues will be

derived from outside North America. And you have companies in

there like AB Inbev whose got a big Brazilian portfolio, theyre big in

China, youve got the WPPs of the world, youve got the J&Js of the

world. So we have exposure. We have some direct exposure


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through Genting Malaysia, for example. But were watching this

space closely. We would opportunistically like to increase our

exposure to what the world generally calls faster developing markets

but we want to do it on a price sensitive basis. So we need that

margin of safety. And historically, if you follow the emerging markets

over time, you basically dont have to pay up for growth. Youre going

to get chances every five, seven years to get these companies at the

same type of valuation, the same sort of margin of safety as you get

with classic sort of developed market companies. So were not going

to pay high multiples just because theyre in a country with a fancy

sounding name.

Steven Romick: Theres a question and I think its a really good question, and it

speaks to profits. How much time, roughly, do you spend in face to

face meetings with management groups representing companies you

buy? And I think what wed lik e everybody to take away from our

research process is, we really try and understand the businesses we

invest in, and really try and gaining a realistic sense of that business.

And speaking to the management teams face to face is certainly a key

part of wh at we do, but its not the majority of what we do. To

understand a business is to spend time reading about where that


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industry has been over time, or that business operates within. Where

in the case of farming, reading the book Cadillac Desert: An

Emergence of Grain or with the auto industry reading the book by

David Halberstam called The Reckoning. And so that actually takes

up a lot of time is to get that grounding. And then we, obviously, are

reading all the financials of the companies and reading the financials

and reports of their competitors as well. Im not referring just to Wall

Street reports, by the way, Im talking about industry studies and

looking at a consulting firm study of the Paris-based business, etc.

And so, thats a lot of what we do. And then we also do a lot of work

trying to interview the current employees and/or ex-employees and

talk to the vendors and talk to customers and trying to understand the

business from kind of from the inside out, bottoms-up and top down.

And thats what we try and do. So yes, management teams are very

important to what we do, but its certainly not the most important thing

we do.

Mark Landecker: We spend a lot of time, though, on that respect, interacting with

management teams. Theres a question about would bewere

activists. And well say referring to that, well, theres a portfolio

holding. Its one of our larger nameswe wont say which. We talk to


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the company on a quarterly basis, and its a larger Fortune 500

company. And we said, hey, rates are really low. It would be nothing

but the best thing in the world if you issued 30-year debt. And we sort

of get on that with them every quarter. We might call our friends and

say, Hey, do you mind calling management and say, hey, issue 30 -

year debt. Its the best thing youll ever do. Maybe the next quarter

when we talk to management they say, Hey, we got a lot of calls from

your friends that we should issue 30- year debt. Yeah, its not that bad

of an idea. Were basically going to sell a s much 30-year debt into the

market as itll stomach. So theres subtle

Brian Selmo: And now their 30-year debt is already trading down 15 points. So

were happy to report that they successfully tattooed the bond market.

Mark Landecker: And in other instances weve talked about this on calls last year we

are willing to take a more activist bench when needed. We dont

necessarily seek out these opportunities, but if we stumble upon them

we will

Brian Selmo: Yeah, theres a question, if we dont like whats going on will we be

active? And the answer is yes.

Steven Romick: And we have been most recently. In the first quarter, beginning of the

first quarter, we really became quite active on one of our portfolio


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positions that we were fairly public on. And as a result of, in part, our

efforts and the efforts on the part of our team, you know, Greg

Crouch, was a terrific help in that regard we were able to gain a very

clear view of what an appropriate thing was to recommend to the

company and recommend to the board and then talk to other

shareholders about. And we were very happy in the end that we

accomplished what we set out to do. I think just to highlight what

Mark was saying about speaking to companies, we want to, especially

for these core businesses, the businesses we love, we really want to

understand the businesses and we also really want to help if we can.

And we dont pretend we can manage the business, but we want to

help if we can be of some service. And theres an example of a

company that we used to own that was an automotive dealer that we

owned a number of years ago, that we help to avoid bankruptcy

because we urged them to do certain things with the balance sheet

close to the 11 th hour at the fourth quarter of 2008. And so when we

can offer that counsel and do that, youre not going to get there. Its

just a place where the companies will actually listen to you, and

unless youve actually gained their trust first and shown that youve

done the work to understand their company.


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Steven Romick: We have time for just a couple more questions, and again, theres a

number of questions that are left and were not going to be able to get

to but all the questions stay in the call. But if theres something that

you feel wasnt answered an d you want to make sure that it is

answered, please resend that email to Mark Hancock. Mark, to your

email, or to Elliott. Who does it go to?

Elliott: [email protected].

Mark Hancock: Again, [email protected].

Steven Romick: So send your question repeated, if you wouldnt mind. Send another

follow-up question if you have that, and well make sure that you do

get the answer because our goal is to educate our shareholders. We

think the best educated shareholders are the best kind of

shareholders to have and we view it as our obligation to you to

provide that. Any questions that jump out at you guys?

Mark Landecker: I mean, someone asks you, look, we realize what weve said on this

call, that were not talking up our book, and theres a question,

Whats the better long term investment decision continuing adding

to Crescent now, in the future, or hold more cash? Wait for the

decline and better entry points for additional purchases? So what

weve essentially tried to do is take that decision out of your han ds.


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Were not telling anyone to put more money into the Fund now, but for

those who have, weve got to make that same choice each day when

we wake up. And it just speaks to the fact, again, what we said earlier

in the call, we want the portfolio to try and be robust to any

environment. Not optimized to a particular outcome, but just robust

because the future is an uncertain place. And so were all waking up

and weve got the same problems with our own savings. We actually

are all invested in the Fund o urselves, and so you can imagine its

something were thinking about on a daily basis.

Steven Romick: And I think thats a really great way to wrap it up. We are committed

to this Fund as shareholders as you are, and we thank you for your

time and continued commitment. And we will continue to do what we

have done for the last 20 years, well into the future. Thank you very

much. Mark, Ill turn it over to you.

Mark Hancock: Thanks gentlemen, and thank you our listeners for listening and

participating in our second quarter 2013 Crescent webcast. We invite

you, your colleagues and clients to listen to the playback and view the

slides and read the transcripts from todays webcast that will be

available on our website: fpafunds.com, over the coming week or so.

We urge you to visit the website for additional information on the Fund


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such as complete portfolio holdings, historical returns and after-tax

returns. Following todays webcast you will have the opportunity to

provide feedback. We take it seriously and appreciate any

constructive either positive or negative feedback that you happen to

provide. Please visit our website: fpafunds in the future for future

webcast information. We will post the date and time of the

prospective webcast during the latter part of each quarter, and expect

the calls, as is in the case today, to take place three to four weeks

following each quarter end. We hope that our shareholder letters,

commentaries, these conference calls and special commentaries help

to keep you, our investors and stakeholders, appropriately updated

about the Fund. We want to make sure that you understand that the

views expressed on this call are as of today, July 31, 2013, and are

subject to change based on market and other conditions. These

views may differ from other portfolio managers and analysts of the

firm as a whole and are not intended to be a forecast of future events,

a guarantee of future results, or investment advice. Any mention of

individual securities or sectors should not be construed as a

recommendation to purchase or sell such securities, and any

information provided is not a sufficient basis upon which to make an


48/48


investment decision. The information provided does not constitute or

should not be construed as an offer of solicitation with respect to any

such securities, products, or services discussed. Past performance is

not a guarantee of future results. It should not be assumed that

recommendations made in the future will be profitable or will equal the

performance of the security examples discussed. Any statistics have

been obtained from sources believed to be reliable, but the accuracy

and completeness cannot be guaranteed. You may request a

prospectus directly from our Funds distributor, UMB Distributor

Services, or from our website: fpafunds.com. Please, read it carefully,

and our Contrarian Value Policy statement before investing. FPA

Crescent Fund is offered by UMB Distribution Services, LLC. Again,

thank you for your participation today, and this concludes todays

webcast.

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