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Uncovering 'Absolute Value'

An absolute value approach has led FPA Crescent's Steve Romick to large-cap global growth names and away from high yield.

Esther Pak, 10/28/2011

FPA's Steven Romick, CFA, managing partner and portfolio manager, recently answered our questions on FPA Crescent's FPACX portfolio holdings, absolute value approach, and the prospects for future inflation.

1. Currently, the fund is invested in a private construction loan backing an office building in the southeastern United States. What is your rationale behind investing in this illiquid private investment? Is this an opportunistic investment or a defensive move? How much of the portfolio would you invest in such securities? How is the loan valued on a daily basis, since it doesn't trade on the open market?
We expect an 11.8% internal rate of return for this three-year note. It is both opportunistic and defensive. Opportunistic because the yield is attractive and defensive because we are lending to complete an office building that is one the nicest new buildings in the area at 50% of the replacement value. If we could find more such deals, we could envision having a few percent. We are obviously limited given the open-end nature of our fund. The loan is valued at cost.

2. Your investment philosophy states that you are absolute value investors--seeking genuine bargains rather than relatively attractive securities. In a market where it's hard to find companies that are cheap in absolute terms, how do you avoid falling into value traps?
When we analyze a company--its business, its industry, their financial statements, and its valuation--we try to make sure that the company has the ability to grow its revenues. So-called "value traps" are usually found in those companies that do not have the ability to increase their top line. We believe that this focus will limit (but not eliminate) our mistakes.

3. Management invests in securities "that the consensus does not wish to own." What's an example of a misunderstood holding in your portfolio? What is Wall Street missing about it?
Omnicare OCR, the institutional pharmacy company, is a good example. The company has been so horribly mismanaged in the past that investors seem to take a wait-and-see attitude. We think that this company, with about 50% market share and a new management team, is well-positioned to capitalize on a number of opportunities, including: more volume from an aging population, better customer service driving improved customer retention, a shift from branded to generic drugs, and more.

4. In your May 3 "Wait and Hope" speech at the Value Investing Congress, you mentioned that FPA's investments take inflation into consideration--more for protection than opportunity because "sometimes returns are generated not by what you own, but by what you don't." What's your current outlook for inflation, both in the near and long term? What investments are you avoiding because you think they could be vulnerable in a period of rising rates? Do you buy the current mantra that dividend-growth companies are a good place to invest in an inflationary environment?
Longer term, we find it hard to understand how coordinated efforts to reflate won't translate into inflation; however, over the near term, deflation seems to be holding the upper hand. As a result, we are not making directional bets one way or another. Instead, we are seeking the best possible companies with global franchises to own in this uncertain environment.

We continue our disinvestment of high-yield bonds with exposures down from the 30s to the mid-single digits.

We refuse to own long-dated bonds of any ilk, particularly U.S. Treasuries. We cannot understand a world where people are willing to lend to the U.S. for 1.8% for 10 years or 2.8% for 30 years.

We think owning good, large-cap, global, and growing businesses are a good place to invest today. Those of which cannot adequately reinvest their capital should pay higher dividends. Wal-Mart WMT is an example of that. Its dividend growth far outstrips its earnings growth, and we expect that to continue into the future. As to whether these companies end up being good inflation hedges depends more on a particular company's ability to get price increases such that margins will not be negatively impacted, as well as how inflation might impact the demand for that company's product.

Esther Pak is an assistant site editor of Morningstar.com.

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