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What Makes FPA Crescent Tick?

A mix of conviction and caution has paid off for this 5-star fund.

Greg Carlson, 01/24/2012

FPA Crescent FPACX resides in the moderate-allocation category, but it's far more distinctive than its category name implies. FPA Crescent aims for equitylike returns, but it invests in companies of all sizes across the globe through stocks, traditional bonds, and convertibles. It will often hold a hefty stake in cash and sells stocks short as well--although the latter strategy is done in small increments and is used primarily to mute volatility. Steve Romick, who's managed the fund since its 1993 inception, is a highly selective stock-picker: That portion of the portfolio, which typically comprises more than 50% of assets, usually contains 20-40 long positions.

An Unconventional Value Strategy
Romick is a dyed-in-the-wool value investor, but he doesn't stick with a single set of metrics. He does tend to focus on cash flow, but he isn't wedded to either troubled, deeply cyclical companies or growth darlings trading at a modest discount. And unlike most value managers, in addition to looking at company fundamentals Romick also uses macroeconomic analysis to help limit risk in the portfolio. For example, in the mid-2000s, he examined the skyrocketing housing market, the spread of subprime debt, and the overuse of leverage and pricey valuations and then decided to avoid financial services firms. (The fund did sell short a few of those stocks, such as Capital One Financial COF and HSBC Holdings HBC.) That decision paid off in the financial-crisis-fueled, October 2007-March 2009 bear market, when the fund lost a relatively modest 27.4%--12 percentage points less than its typical moderate-allocation peer and only half as much as the S&P 500 Index.

Top-down analysis helps shape the portfolio in other ways, too. Convinced that consumer spending would weaken, Romick has at times shorted firms heavily affected by discretionary spending such as Tiffany TIF and Amazon.com AMZN. In the depths of the bear market in late 2008 and early 2009, he believed high-yield bonds were pricing in a depression (a scenario he found too dire), and the fund amassed a double-digit stake in them. The bonds rebounded sharply later in 2009. More recently, because of Romick's expectations of strong growth in developing markets and a weak U.S. dollar, the fund has sported a sizable stake in sturdy blue-chip companies that do a lot of business overseas, such as Johnson & Johnson JNJ.

The fund isn't a one-man show; FPA's investment professionals largely share the same macroeconomic view and sometimes place emphasis on the same sectors. For example, the fund had a well above-average weighting in energy stocks for years, as did small-blend fund FPA Capital FPPTX (the latter still does). Furthermore, Romick is assisted here by four analysts and confers with the other funds'managers. However, as firm CEO and former longtime FPA Capital manager Robert Rodriguez has stepped away from portfolio management and focused increasingly on macroeconomics, Romick has played a larger role at the firm. But this is the only mutual fund he manages. (He does run a hedge fund and separate accounts.)

Going Where the Cheap Stocks Are
Romick typically tries to stay off the beaten path when constructing the equity portfolio. For most of the fund's life, it has primarily owned small- and mid-cap stocks, a tilt that usually provided a performance tailwind compared with its category peers and the S&P. More recently, though, as valuations for large caps have come down on a relative basis, behemoths such as Microsoft MSFT, Wal-Mart WMT, and Cisco CSCO have not only crept into the portfolio but also are among the fund's top holdings. The fund's recent average market capitalization of $31 billion was near the category norm and 5 times higher than it was five years ago. As Romick stated in the fund's third-quarter commentary, "The businesses we currently own are of a higher quality, with larger market caps, more robust balance sheets, stronger competitive positions, and lower-than-average valuations." Indeed, the average debt/market capitalization ratio of the fund's holdings was recently well below the moderate-allocation norm and that of the S&P 500 Index.

Two of the fund's most recent purchases reflect Romick's interest in higher-quality stocks. He bought U.K. retailer Tesco TSCO and home improvement store Lowe's LOW because they have rock-solid balance sheets and real estate holdings that give them a leg up on rivals and they face only modest challenges from Internet-based retailers. Tesco is the third-largest retailer in the world and controls 30% of the grocery market in the United Kingdom (where it derives two thirds of its revenues). Romick also points out that it's a strong number-two player in faster growing economies such as South Korea and Thailand. Lowe's, the second-largest home-improvement retailer behind Home Depot HD, is a more-known quantity in the United States, but Romick believes the housing industry is near a historic bottom and notes that the firm is aggressively buying back stock. Both companies trade at or below 10 times owner earnings (essentially net cash flow) in his estimation.

The fund's equity weighting has bounced around over time, but it's telling that at the end of October the always-cautious Romick had boosted it to 66%--near the fund’s all-time high and more than double its weighting in the middle of the 2007-09 bear market. That doesn't mean he’s bullish on stocks in general, by any means. Instead, he's enthused about the current holdings' valuations and also believes their high quality means the fund isn't taking on more risk in the equity portfolio than it typically does. He also notes that the fund's stake in high-yield bonds is now well below-average following their rally from the March 2009 market bottom. And the fund still holds a 20% slug of cash.

Strong Performance and Stewardship
Romick's mix of strong conviction in his picks and aversion to losses has resulted in a superb long-term record. The fund has beaten all but one of its 70 moderate-allocation peers that have been in operation since the fund's 1993 inception through Jan. 22, 2012, and is more than an annualized 3 percentage points ahead of the S&P 500 over that span. (The fund is also in the category's top 2 percent over five, 10, and 15 years through Jan. 22, 2012.) It's been less volatile than the category and the index as well.

Greg Carlson is a fund analyst with Morningstar.

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