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FPA Crescent Fund 2Q17 Letter – Markets, Naspers/Tencent Arbitrage, Financials, Sears Canada

FPA Crescent Fund 2Q 2017 Commentary, July 28, 2017

  • Returned 1.84% in 2Q17 compared to 3.09% S&P 500; YTD, 5.27% compared to 9.34% S&P 500

Markets and Economy

  • Despite the turbulent changes to the political terrain in the US and Europe, global economy continues to putt-putt along much as it did before Brexit and US elections
  • US is now in year 9 of its economic expansion – the 3rd longest since 1900
    • Despite its long duration, the rate of GDP growth has fallen well below past expectations
  • Low interest rates and absence of bad news have been the twin pillars underpinning stable markets worldwide
    • S&P 500 is in its 99th month of a bull market – 2nd longest since 1926 – and hasn’t corrected more than 20% since 2009
  • Other parts of the world are less expensive (not to be confused with inexpensive)
    • Asia and Emerging Markets are trading closer to their median valuation
    • At best, one can argue that parts of the world are relatively cheap
  • Part of our historical bread and butter has been finding opportunities in the high yield sector but today we find the bread burned
    • YTW of the US high yield market is a paltry 5.7% while the EU high yield sector offers a pathetic 2.7%
    • If one were to look at the US as a proxy over the past 35 years with an average default rate of 3.7% and recovery of 40.9%, the US gross yield would be reduced to a net yield of 3.5% and in Europe, return would be negative

Naspers/Tencent Arbitrage

  • Have been long Naspers and short Tencent – Naspers, a South African holding company, made a prescient investment in Tencent, a technology business with a market cap among the top 10 globally
  • Naspers’ $34 million investment in 2001 is now valued at $113 billion – a 63% IRR
  • Passion to own Tencent shares has caused it to be valued at 40x current year’s earnings and dwarfs investor interest in Naspers
  • Its Tencent stake now exceeds its $86 billion market cap by $28 billion
  • Naspers profitably operates a Pay TV business in South Africa and has made successful investments in other valuable technology investments such as Allegro, Avito and Ibibo
    • Yet, market insists on paying us to own Naspers
    • Unfortunately, we’re being paid far more today than when we initiated the trade – Naspers ‘stub’ was trading at negative $1.5Bn but is now trading at negative $27Bn
  • Similar thought process led us to invest in Renault at 2 different times, while shorting its ownership stakes in Nissan and Volvo Truck – whose combined value exceeded Renault’s enterprise value
    • Market was paying us to own Renault but its stock price appreciated slower than that of its equity stakes, creating unrealized losses in our portfolios
    • This lasted for 1.5 years but eventually the market appreciated that Renault was worth more than zero and profitably unwound our trade
  • Anticipate the same could be true of Naspers/Tencent

Financials

  • Earnings have improved and book value has increased but the largest driver has been an increase in valuation – in 2016, price/tangible book ratio of our portfolio of financials has increased from 0.73x to 1.04x
  • More than a year ago, we thought it was reasonable to expect equity-like returns in all but extremely negative scenarios
  • Our companies still trade at a discount to historic norms based on tangible book value but can no longer be viewed as “dirt” cheap
  • Current investment case for these financials to continue to perform well increasingly relies on a continued favorable regulatory climate, our avoiding a recession, increasing capital return and in some cases, higher interest rates and/or a steeper yield curve
  • If our portfolio companies can improve ROTE to an average of 12% and trade at 1.25x their TBV, our positions would offer decent returns over the next 3 years
    • Note, however, that a little more than a year ago, when these institutions were trading at just 0.75x book, we believed we were well-protected on the downside
    • We don’t have that same protection today
  • We aren’t finding much of anything that’s so statistically inexpensive which is why we maintain a significant position in financials although we have taken some money off the table

Sears Canada Loans

  • Its existential challenges were similar to many other brick-and-mortar retailers and it could very well go bankrupt at some point
  • Since we underwrote the loan predicated on liquidation value, remain comfortable that we will be paid in full in the next couple of months
  • We expect that our 2% commitment fee will now be amortized over a shorter maturity, resulting in a higher-than-budgeted IRR
  • Process of seeking to fund the DIP loan that will allow the company to conduct either its restructuring or its liquidation in an orderly manner
  • Prospective DIP loan should afford us somewhat better asset coverage with a higher starting yield and a shorter expected duration

Closing

  • Business of investing is harder than investing itself because one must ably manage both the capital and the high expectations of others
  • Can only speak to a present dictated by price and with that in hand, always query: does an asset price today afford us an acceptable rate of return after taking into account the good, the bad, and the ugly?
  • Should we find a good business, and should winning offer a return well in excess of what might be lost in our downside case, and should chance to win be more likely than the chance to lose, then we’ll be buyers
    • Until such time, we exercise patience
  • “Markets are only lived forwards, but only understood backwards”

Image Source: FPA Crescent Fund

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