Thursday, July 28, 2011

FPA Crescent Fund Q2 2011 Letter to Shareholders

We enjoy the flexibility to invest in various asset classes; yet having the ability to go anywhere loses its advantage if there’s nowhere to go. That’s the position we find ourselves moving closer to today, given that many stocks aren’t particularly cheap. Few industries, countries, or asset classes are out of favor, and even fewer meet our strict risk/reward parameters and fall within our circle of competence. It’s starting to feel like our strategy is merely going to give us more ways to find frustration.


We pay attention to the macro environment because it sometimes allows us to identify significant opportunities and, at other times, to avoid or limit catastrophic risk. From 2005-07, we worried about unsustainable home prices, the over-levered consumer, and fragile financial institutions. Our anticipatory and conservative stance helped protect the portfolio when those fears proved well-founded as the panic of 2008-09 viciously punished the excess of the earlier era.

We still find ourselves worrying today, particularly about unreasonable government budgets that have helped foster unmanageable burdens. Over the past three years we have witnessed a shift in financial obligations from the personal to the public (governments) that has done nothing to enhance the solvency of the overall system, although the optics appear favorable to some.

A country can be viewed as a proxy for the collective economic production of its populace, but if that society finds itself unable to shoulder the debt burden necessary to finance its lifestyle, then simply shifting its financial obligation to the government will eventually bankrupt the nation. We currently bear witness to such a shift. However, it’s easier to determine if an individual or business is bankrupt than to determine a nation’s insolvency (particularly those with access to an established printing press). Many countries walk a fine line that separates the solvent from the bankrupt. Those that tip to the latter will be forced to default and/or dramatically cut programs and services. We expect such action will likely have a significant negative impact on that country’s GDP, and to a lesser degree, on that of its larger trading partners. Companies that do business in those countries will find themselves similarly harmed.

The day of reckoning may not come quickly, as there exists more than one way to default: you can stop paying, or just let inflation erode what you owe in real terms. For example, for the $14.3 trillion dollars the U.S. owes today (ignoring any future borrowing), a 3% inflation rate would reduce the purchasing power of that debt to $10.6 trillion dollars in ten years, but at 5% inflation, the “real” debt would be just $8.8 trillion, and at 10%, it drops to $5.5 trillion. Inflation benefits debtors – at least as far as paying it back is concerned. The ancillary effects can prove dramatic though, as attendant higher interest rates can crowd out spending. How many of you have already seen fewer police on the street, or had your local fire station or library close? It’s terrible; but make no mistake, it can get worse.