META - FPA U.S. Core Equity Fund Inc. Second Quarter 2022 Commentary
- First Pacific Advisors (FPA) is a Los Angeles-based institutional money management firm practicing a disciplined approach to value investing, prudently seeking superior long-term returns while maintaining a focus on capital preservation.
- In the second quarter of 2022, the FPA U.S. Core Equity Fund, Inc.’s (“Fund”) performance was -18.92%.
- I believe secularly growing mid- to large-capitalization companies trading at compelling valuations will continue to be a favorable place to invest for the long term.
| Average Annual Total Returns (%)* |
| As of Date: 6/30/2022 |
| QTD |
| YTD |
| 1 Year |
| 3 Years |
| 5 Years |
| 10 Years* |
| FPA U.S. Core Equity Fund, Inc. (‘Fund’) |
| -18.92 |
| -28.85 |
| -23.25 |
| 6.54 |
| 6.09 |
| 8.81 |
| S&P 500 |
| -16.10 |
| -19.96 |
| -10.62 |
| 10.60 |
| 11.31 |
| 12.96 |
| You should consider the Fund's investment objectives, risks, and charges and expenses carefully before you invest. The Prospectus details the Fund's objective and policies and other matters of interest to a prospective investor. Please read the Prospectus carefully before investing. The Prospectus may be obtained by visiting the website at www.fpa.com , by calling toll-free, 1-800-982-4372, or by contacting the Fund in writing. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown. This data represents past performance and investors should understand that investment returns and principal values fluctuate, so that when you redeem your investment it may be worth more or less than its original cost. Current month-end performance data, which may be lower or higher than the performance data quoted, may be obtained at www.fpa.com or by calling toll-free, 1-800-982-4372. The FPA Queens Road Value Fund (“Fund”) commenced operations on June 13, 2002. Periods greater than one year are annualized. Fund performance is shown net of all fees and expenses and includes reinvestment of all distributions. Fund performance does not reflect the deduction of taxes that a shareholder would pay on Fund distributions or the redemption of Fund shares, which would lower these figures. An investor cannot invest directly in an index. * Prior to November 1, 2020, the performance shown reflects the historical performance of the Fund when Bragg Financial Advisors, Inc. ("BFA") served as investment adviser of the Fund. Effective November 1, 2020, FPA became the investment adviser of the Fund and BFA transitioned to serving as the sub-adviser. BFA continues to be responsible for the day-to- day management of the Fund, subject to FPA's oversight. No changes to the Fund's principal investment strategies were made in connection with these changes in management of the Fund, and Steve Scruggs, CFA, Director of Research and Senior Portfolio Manager for BFA, continues to serve as the portfolio manager for the Fund. From inception of the Fund to December 31, 2004, BFA and its affiliates voluntarily absorbed certain expenses of the Fund and voluntarily waived its management fee. Had BFA not done this, returns would have been lower during that period. Effective January 1, 2005 through October 31, 2020, BFA charged a single unitary management fee and contractually agreed to pay all operating expenses of the Fund except for brokerage, taxes, interest, litigation expenses, and other extraordinary expenses. The Fund's Total Annual Operating Expenses (as of the most recent prospectus) before reimbursement is 1.69%. The adviser has contractually agreed to reimburse the Fund for operating expenses in excess of 0.65% of average net assets of the Fund, excluding interest, taxes, brokerage fees and commissions payable by the Fund in connection with the purchase or sale of portfolio securities, fees and expenses of other funds in which the Fund invests, and extraordinary expenses, including litigation expenses not incurred in the Fund’s ordinary course of business, until October 31, 2023. These expense reimbursements are subject to possible recoupment by the adviser from the Fund in future years (within the three years from the date when the amount is waived or reimbursed) if such recoupment can be achieved within the lesser of the foregoing expense limits or the then current expense limits. This agreement may be terminated only by the Fund’s Board of Trustees, upon written notice to the adviser. Prior to November 1, 2020, the Fund had a unitized fee structure that limited annual operating expenses to 0.95%. Market Cycle reflects the most recent market cycle (peak to peak) defined as a period that contains a decline of at least 20% from the previous market peak over at least a two-month period and a rebound to establish a new peak above the previous one by Russell 2000 Value Index. The current cycle is ongoing and thus is presented through the most recent quarter-end. Once the cycle closes, the results presented may differ materially. Please see important disclosures at the end of the commentary. |
Introduction [1]
In the second quarter of 2022, the FPA U.S. Core Equity Fund, Inc.’s (“Fund”) performance was -18.92% (-18.59% before fees and expenses), which compares to the -16.10% total return of the S&P 500 Index (“Index” or “S&P 500”).
The Fund’s underperformance in the second quarter, like the first quarter, is mostly attributable to having none or less than average exposure to outperforming sectors during the quarter such as Utilities (-5.73%), Consumer Staples (5.23%) and Energy (-6.13%) coupled with having greater than average exposure to underperforming sectors such as Consumer Discretionary (-26.32%), Communication Services (-20.87%) and Information Technology (-20.44%).
The 10-year U.S. Treasury yield had another rapid rise in the second quarter following the first quarter’s similar jump in magnitude, increasing from approximately 2.3% to 3.0%--and reaching as high as nearly 3.5% intra-quarter. 2 While interest rates remain near historical lows, the rate of change has impacted how the market values higher multiple stocks to a greater degree than lower multiple ones. In the short term, this kind of multiple contraction, which impacted the Fund’s return in the second quarter as well as the first quarter, can be frustrating.
However, if you are investing for the long-term, multiple contraction or expansion historically has had the least amount of impact to equity returns. Rather, it is earnings per share ((EPS)) growth that has the greatest impact on a stock’s total return over the long run and that is what we are most focused on getting right with our portfolio companies.
I believe secularly growing mid- to large-capitalization companies trading at compelling valuations will continue to be a favorable place to invest for the long-term—especially relative to U.S. Treasuries and other investment alternatives.
Portfolio Commentary
During the second quarter, I continued to make some changes to the Fund’s portfolio to best position it for future success. To that end I eliminated 21 positions that made up 10.0% of the March 31, 2022 portfolio, decreased the weighting of the 57 remaining positions by 3.2% to 86.6%, and added 10 new positions representing 6.3% of the June 30, 2022 portfolio. These new positions are in companies I have been following and that were on my wish list to purchase. Most are not at full position sizes yet, and thus I am prepared to add to them.
As of June 30, 2022, the Fund was invested in 67 companies (61 of which are disclosed), including 47 disclosed investments that are in the S&P 500, which made up 78.3% of the portfolio. Moreover, the 47 disclosed positions in common made up 39.1% of the S&P 500’s weighting as of June 30, 2022. A majority of the 47 positions were overweight in the Fund relative to the Index. The Fund’s remaining 14 disclosed investments were mostly large-cap U.S. and foreign companies. Combined, those 14 companies made up 11.0% of the portfolio.
In terms of geography, 89.1% of the portfolio was in U.S. companies, while 3.9% was in foreign equities, as of June 30, 2022. By market capitalization, 90.7% of the portfolio was invested in large-cap companies with market values above $10 billion, with about 51% invested in mega-caps (companies with market values above $200 billion). The Fund’s weighted average market cap was approximately $676 billion, while the Fund’s median market cap was approximately $76 billion.
Regarding portfolio concentration, the Fund’s top five positions made up 39.5% of the Fund compared to approximately 22.4% for the S&P 500. The Fund’s top 10 positions made up 49.9% of the portfolio versus 27.0% for the Index. Over time, the goal is to continue to increase the weighting of some of the Fund’s smaller positions as valuations become more compelling.
From an industry exposure standpoint, the portfolio had investments in eight of the 11 sectors in the S&P 500. Combined, those eight sectors made up approximately 91.4% of the S&P 500 and 93.1% of the Fund’s portfolio. Relative to the S&P 500, the portfolio was overweight information technology, communication services and consumer discretionary, and underweight financials, health care, energy, industrials, and consumer staples. At the end of the quarter, the Fund did not have any investments in utilities, materials, or real estate. Collectively, those three sectors made up approximately 8.6% of the S&P 500.
| Sector |
| FPA U.S. Core Equity Fund |
| S&P 500 |
| Information Technology |
| 27.5% |
| 26.8% |
| Consumer Discretionary |
| 21.7% |
| 10.5% |
| Communication Services |
| 18.4% |
| 8.9% |
| Financials |
| 10.0% |
| 10.8% |
| Health Care |
| 8.8% |
| 15.1% |
| Energy |
| 3.4% |
| 4.4% |
| Industrials |
| 2.5% |
| 7.8% |
| Consumer Staples |
| 0.8% |
| 7.0% |
| Utilities |
| 0.0% |
| 3.1% |
| Real Estate |
| 0.0% |
| 2.9% |
| Materials |
| 0.0% |
| 2.6% |
| Total |
| 93.1% |
| 100.0% |
| Cash and equivalents (net of liabilities) |
| 6.9% |
| Source: FPA, Capital IQ. As of June 30, 2022. Totals might not add up to 100% due to rounding. Portfolio composition will change due to ongoing management of the Fund. |
Compared to the broader market, we believe the Fund’s portfolio is of higher quality and has greater potential for revenue and earnings growth. 3
| FPA U.S. Core Equity Fund |
| S&P 500 |
| Large Capitalization Holdings % of Portfolio |
| 90.7% |
| 98.6% |
| Top 5 Holdings % of Portfolio |
| 39.5% |
| 22.4% |
| Top 10 Holdings % of Portfolio |
| 49.9% |
| 27.0% |
| Foreign Securities % of Portfolio |
| 3.9% |
| 0.0% |
| 12-Month Forward P/E 4 |
| 17.2x |
| 15.8x |
| Price/Book 5 |
| 4.9x |
| 3.7x |
| Return on Equity 6 |
| 28.5% |
| 20.9% |
| EPS Growth Forecast (2-year, median) |
| 17.5% |
| 9.1% |
| Revenue Growth Historical (2-year, $-weighted median) |
| 13.2% |
| 17.5% |
| Revenue Growth Forecast (2-year, median) |
| 11.3% |
| 9.9% |
| Debt/Equity 7 |
| 0.2x |
| 0.9x |
| Median Market Capitalization 8 (billions) |
| $76.2 |
| $27.3 |
| Weighted Average Market Cap (billions) |
| $675.9 |
| $477.4 |
| Source: FPA, Capital IQ. Data as of June 30, 2022. Fund statistics for ‘% of Portfolio’ holdings are based on net assets. Portfolio composition will change due to ongoing management of the Fund. |
Q2’22 Winners and Losers 9
| Winners |
| Performance Contribution |
| Losers |
| Performance Contribution |
| Humana ( HUM ) |
| 0.08% |
| Amazon.com ( AMZN ) |
| -2.71% |
| AutoZone ( AZO ) |
| 0.04% |
| -2.27% |
| Cigna ( CI ) |
| 0.03% |
| Microsoft ( MSFT ) |
| -1.81% |
| UnitedHealth Group ( UNH ) |
| 0.01% |
| Apple ( AAPL ) |
| -1.77% |
| Ulta Beauty ( ULTA ) |
| 0.00% |
| Meta ( META ) |
| -1.53% |
Three of the Fund’s biggest winners in the second quarter were health insurers, which the Fund has been invested in for several years. In a quarter where the market was hit hard in part due to recession fears, the healthcare sector was a relative outperformer since it is typically viewed by the market as more recession resistant. With unemployment levels low coupled with an aging U.S. population, we believe the wind is at the back of health insurers.
While there will likely continue to be political risk that the government tries to do something to reign in healthcare costs, which could directly or indirectly impact health insurers’ business, I believe the risk is low and resulting impact relatively muted. While the Fund’s exposure to the industry ended the second quarter at about the same as the first quarter at just over 4%, I am finding more attractive opportunities elsewhere in the market. So do not be surprised to see the industry exposure come down over time.
The five biggest detractors to performance were the Fund’s five largest holdings, with Amazon.com being the biggest loser. As interest rates rose further in 2022 during the second quarter, higher EPS multiple stocks such as Amazon.com fared relatively poorly. While Amazon’s AWS business is doing extremely well (growing fast and generating robust free cash flow), its retail operations are not growing nearly as fast nor are they as profitable.
That segment is being impacted by a host of issues—some self-inflicted such as overbuilding local warehouse capacity for faster delivery of more goods to customers and some more out of its control such as supply chain disruptions and higher than expected wage inflation. Amazon.com is discussed in our previous letters so please reference those for a more detailed view on the company. 10 The bottom line is my investment thesis remains unchanged.
I believe the moat around its businesses continues to grow as it makes further investments into its operations that very few companies are willing to or even have the capability to make. Unless there is new information that invalidates my investment thesis or there are better investment opportunities for the Fund’s capital, it will remain a patient, long-term shareholder.
Closing
We are optimistic that the Fund will generate good absolute and relative returns compared to the S&P 500 going forward.
We look forward to delivering value for our fellow shareholders. Thank you for your confidence and continued support.
Respectfully submitted,
Gregory R. Nathan, Portfolio Manager
Footnotes
| [1] Past performance in not a guarantee, nor is it indicative, of future results. [2] Source: Bloomberg. [3] The portfolio manager believes a high-quality company is one that is able to generate a return on capital in excess of its cost of capital for sustained periods of time. [4] The forward price-to-earnings (P/E) ratio is derived by dividing the price of the stock by the estimated one year of future per-share earnings and is used as a relative value comparison for a company’s shares. Forward P/E numbers are estimates and subject to change. [5] Price/Book ratio is the current closing price of the stock divided by the latest quarter’s book value per share. [6] Return on Equity measures a portfolio company’s profitability by dividing net income before taxes less preferred dividends by the value of stockholders’ equity. [7] Debt/Equity (D/E) Ratio is calculated by dividing a company’s total liabilities by its shareholder equity. These numbers are available on the balance sheet of a company’s financial statements. The ratio is used to evaluate a company's financial leverage. [8] Market Cap, short for market capitalization, refers to the total dollar market value of a company's outstanding shares. [9] Reflects top contributors and top detractors to the Fund’s performance based on contribution-to-return. Contribution is presented gross of investment management fees, transactions costs, and Fund operating expenses, which if included, would reduce the returns presented. This is not a recommendation for a specific security and these securities may not be in the Fund at the time you receive this report. The information provided does not reflect all positions purchased, sold or recommended by FPA during the quarter. A copy of the methodology used and a list of every holding’s contribution to the overall Fund’s performance during the quarter is available by contacting FPA at crm@fpa.com . The portfolio holdings as of the most recent quarter-end may be obtained a t www.fpa.com . It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities listed. For a full list of holdings and weights by percentage of total assets please view the holdings report at the end of this Commentary. [10] Please refer to the commentary archive at https://fpa.com/funds/fpa - u - s - value - fund - quarterly - commentary - archive
|
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
For further details see:
FPA U.S. Core Equity Fund, Inc. Second Quarter 2022 Commentary