It's hard to know if the United States will actually fall off the much-discussed fiscal cliff. Will relatively low tax rates expire at the end of 2012? Will there be sharp spending cuts to the military and domestic programs? Will gross domestic product shrink by 4% as the Congressional Budget Office has predicted?
No matter what kind of deal Beltway politicians hammer out, however, the managers at FPA - the Los Angeles firm formerly known as First Pacific Advisors - believe that this year's uncertainty just underscores what a dire fiscal situation the U.S. finds itself in.
"It's pretty clear that no country can run a budget deficit of 8% to 10% of GDP year after year," says Dennis Bryan, co-manager of $1.2 billion FPA Capital Fund (FPPTX).
But fixing U.S. financial woes will require a shakeout of government excess, Bryan argues - and that will bring a lot of pain to the populace, at least in the short term. "We need to bring down the deficits, restructure the entitlements, change tax policy to be more transparent," he adds, echoing the firm's chief executive officer, Robert Rodriguez, who ran FPA Capital until 2010 with Bryan and co-manager Rikard Ekstrand. "In the short run that could be disruptive," he concedes.
FPA's grim view of the country's fiscal health affects the way they see risk - and has led them to demand more of the companies that they include in their portfolios. For now, that means FPA Capital runs a concentrated portfolio of just 20-odd names and a 30% cash hoard. Companies need lower valuations and higher net cash on balance sheets in an effort to gird against the coming fiscal storm, Bryan argues.
FPA has a good track record of pinpointing oncoming crashes. Rodriguez, in particular, was outspoken about the Internet and financial bubbles long before they popped. Now the firm has turned its attention to the problems of an overextended federal government.
Sometimes potentially being right long term isn't a winning strategy, and FPA Capital has struggled recently, while the market has soared. For the 12 months ended Nov. 1, the fund is up 6%, but trails the S&P 500 by more than eight percentage points. It's in the bottom 3% of its mid-cap value competitors, according to Morningstar.
Why? Bryan wanted to know as well, so he and his colleagues did a little digging. Looking at the stocks in the Russell 2000, the fund's benchmark, they noticed that 219 of them (about 10%) had appreciated by more than 50%. But of that group, half had negative earnings growth in 2011. And the companies that were profitable had price-to-earnings ratios of 36, price-to-book of 5.5 and leverage of 42%. Basically, Bryan says, what's been driving the index are companies with declining profits and others that are "richly priced."
Longer term, things look better for FPA. Over the last three years ended Nov. 1, the fund is up an annualized 12.8% a year, in the 43rd percentile of its category. For the last five years, it's up an average 4.7% a year annualized, in the category's top 4%.
The fund's huge cash position can insulate it from market turmoil, but the portfolio does sometimes miss out on stocks' upside. "It's a reflection of the fact that we can't find anything to buy," Bryan says. "We'd love to have 35 names in the portfolio, but we're just not finding enough of them."
What makes it so hard to gain entry into FPA Capital? Bryan and Ekstrand have set the bar exceedingly high. At a minimum, they are looking for companies with dominant market positions, ironclad balance sheets and strong management teams. Moreover, they refuse to pay up for that quality, keeping the P/E ratio at no more than 14; the current holdings average a P/E ratio of about 11.
While the portfolio's assets were once dominated by the energy sector, over the last year FPA Capital has been taking profits; Bryan and Ekstrand loaded up on the sector in early 2009, in the midst of the financial crisis, and share prices for a number of the fund's energy holdings have multiplied several-fold.
Now, looking for more modest valuations, they have turned their attention to technology. One example of the way FPA invests: Rather than betting on the dominance of Apple or Samsung in the smartphone space, Bryan prefers to focus on supporting technologies. Among their holdings is InterDigital (IDCC), which creates patents for the wireless industry. Though not a household name, InterDigital's technology is used by virtually all handset manufacturers, with the company getting a royalty for each phone sold. "It's a pure play on patents," Bryan says.
What's more, InterDigital is expected to renew its contract with Apple in 2014 at a higher rate. And the firm won a lawsuit against Nokia on appeal recently; profitability is expected to rise as a result. Also, the 1,700 patents the firm sold to Intel for $375 million bolstered earnings in the third quarter. The stock is down 5.3% for the 12 months ended Nov. 1.
Another of FPA's holdings is Veeco Instruments (VECO), which makes the tools necessary to produce light-emitting diode, or LED, lights. As more consumers shift from incandescent light bulbs to the more-efficient LED lights, demand should increase for Veeco's machinery. "There are only two companies that make the equipment and Veeco is one of them," Bryan explains.
He started buying the stock late last year, when the price was in the low to mid-$20s, attracted by Veeco's dominant position in its industry and the cash on its balance sheet. Shares closed at $31.45 on Nov. 1, up 24.5% over the last year.
Some energy names still have a place in the FPA Capital portfolio. The FPA team has a bias toward oil as opposed to natural gas, believing that limited supplies of the commodity will drive prices higher in years to come, while the latter is plentiful enough in North America that prices are unlikely to move as much.
The fund has shied away from exploration and production firms in favor of oil services; two that make the cut are Rowan (RDC) and Ensco (ESV). As more oil is found in shale and deepwater location, Bryan argues, drillers will need to lease more equipment to get the job done. "Those companies own big offshore oil rigs," he says. "They don't just benefit from drilling activity that's occurring in the Gulf of Mexico, but also in Asia, Australia and the North Sea."
Rowan is up 0.2% for the 12 months ended Nov. 1; Ensco is up 28%.
On a different front, Bryan dove into the contentious for-profit education sector this past spring and through the summer, loading up on shares of DeVry (DV). For-profit schools have come under fire for overcharging tuition and pushing students into pricey loans, but DeVry is considered one of the better players in the industry. "They have a very solid curriculum in their core education," Bryan says.
Known for technical colleges that focus on information technology and accounting, DeVry also has a string of medical and nursing schools that are less known. In fact, more than a quarter of DeVry's revenues come from these schools, helping to shore up enrollment. "Obviously the nursing field is tight and there is more demand than supply," Bryan says. DeVry shares are off 28.7% for the 12 months ended Nov. 1.
Ilana Polyak,aFinancial Planning contributing writer, has also written forThe New York Times, MoneyandKiplinger's.
FPA Capital Fund
Credentials: B.S. in Finance, Cal Poly; MBA, USC
Experience: Portfolio manager, FPA Capital (2007-present); portfolio manager for small/mid-cap absolute value investment strategy, FPA (1993-present)
Inception of fund: July 1968
Assets: $1.3 billion
Three-year performance as of Nov. 1:12.83%
Five-year performance as of Nov. 1:4.65
Expense ratio: 0.84%
Front load: 5.25%
Alpha: -1.38 vs. S&P 500
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