ValueInvestor

July 31, 2013

The Leading Authority on Value Investing

INSIGHT

Discerning Taste

If youre curious how smart equity managers with a dreary macro outlook are allocating capital, who better to ask than the brains behind FPA Capital?
INVESTOR INSIGHT

mong the many traits of marketbeating investors, First Pacic Advisors CEO Bob Rodriguez ranks having a thick skin among the most important. We have to have far more patience and discipline than our clients do, he says. Such resolve has served even the impatient clients of $24 billion (assets) FPA exceedingly well. Just one example: the small/ mid-cap FPA Capital Fund that Rodriguez ran for 25 years prior to ceding day-to-day responsibility to Dennis Bryan in 2010 has earned a net annualized 14.6% since 1984, vs. 9.9% for the Russell 2000 index. While theyre nding bargains to be rather few and far between, Bryan and Rodriguez do see value today in such areas as for-prot education, contract drilling, disk See page 2 drives and specialty retail.

First Pacic Advisors

Robert Rodriguez (l), Dennis Bryan (r) Investment Focus: Seek companies whose long-term competitive strengths are being overshadowed by short-term operating, cyclical or secular concerns.

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I N V E S T O R I N S I G H T : First Pacic Advisors

Investor Insight: First Pacic Advisors

FPA Capitals Robert Rodriguez and Dennis Bryan describe how the markets gaming mentality can create opportunity, what inexpensive sectors have not piqued their interest, how they play technology without having to pick product winners and losers, and why the see unrecognized value in DeVry, Rowan, Foot Locker and Western Digital.
FPA has absolute value and quality smaller-cap strategies. How you dene your absolute-value opportunity set? Dennis Bryan: If you think about what causes permanent loss of capital, it tends to be because a companys business is fundamentally awed, its balance sheet wont allow it to survive inevitable downturns, its management poorly allocates capital or is otherwise inept, or you just paid too much for the stock. What were looking for is the ip side of all that: market-leading companies trading at depressed valuations with strong management and strong balance sheets. Theyre proven competitors with a history of good protability and with assets that can produce a reasonable return for shareholders. Robert Rodriguez: Notice that he says reasonable. Some managers focus only on companies with very high returns on equity or on assets, and are willing to pay a price for that. Were looking at a universe of companies with reasonable returns on capital and assets and very depressed prices. The highest-quality companies with all the attributes Dennis mentioned rarely trade at extremely depressed prices. What situations are companies in that make their stocks cheap enough to buy? DB: The rst thing Id say is that it doesnt happen that often, so our strategy requires a lot of patience. It could be a company facing a secular issue where we have a differentiated view on the impact of that secular trend. An example of that would be Western Digital [WDC], the disk-drive maker that the market seems to believe is more susceptible to challenges in the personal-computer business than we do. It could be a company in a cyclical industry at what we believe is the low end of the cycle. We were buying Trinity IndusJuly 31, 2013

tries [TRN], for example, when its railcarmanufacturing business was weak because industry sales of tank cars were running at an annual rate of around 15,000, versus a normalized level of 40,000 to 50,000. Our conclusion was that the cycle would turn and that Trinity remained well positioned to benet from that, so we were willing to buy when the short-term outlook and therefore the stock price was depressed. There also can be events that create uncertainty that the market hates. In the middle of last year we were able to buy into Alliant Techsystems [ATK] at less than 6x trailing 12-month earnings because in our opinion investors were overreacting to the impact sequestration would have on its defense-related businesses. We obviously didnt know exactly how sequestration would play out, but when the stock got down below $45 we thought the risk-reward ratio was extremely attractive. [Editors Note: ATK shares recently closed at around $92.] RR: The advantage we have is time frame. When I came into the business the average holding period for a mutual fund was seven years. Today its less than nine months. If turnover ratios are that high, that means managers have more of a gaming mentality and are looking for the more instantaneous payback. With a longer time frame and patience, we can look at opportunities such as struggling tank-car companies that arent at the forefront of other managers selection processes. Describe the core valuation screen you use to help generate ideas. DB: Were looking at companies with roughly $1 billion to $4 billion in market cap, trading for less than 14x trailing 12-months earnings, less than 2.2x book value, less than 7x trailing EBITDA on an enterprise value basis and less than 1x
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Robert Rodriguez, Dennis Bryan

Go Your Own Way

Bob Rodriguez had many personal goals in mind when he decided to take a yearlong sabbatical in 2010. In stepping aside as First Pacic Advisors CEO and lead manager of the rms FPA New Income and FPA Capital funds, he wanted to see the world, read, pursue his passion for car racing and improve his health. Exhibiting the same energy that made him one of the most celebrated equity and xed-income managers of his generation, he traveled extensively in South America, Russia and Southeast Asia. He nished off 10 books, including The Theory of Money and Credit by Ludwig von Mises. He competed in 12 American Le Mans sportscar races. Last but not least, he lost 20 pounds and lowered his blood pressure. His time away was also meant to prepare FPA for the future. He temporarily ceded all administrative duties to managing partners Richard Atwood and Steven Romick, and permanently left his lead portfolio responsibilities to hand-picked successors. So often in our business a well-regarded manager leaves and everything falls apart, he says. This was meant to prove to everyone that the rm would thrive whether I was here or not. I couldnt be happier with how its worked out.
Value Investor Insight 2

I N V E S T O R I N S I G H T : First Pacic Advisors

sales. Total debt to capital should be no more than 40%. To give you a sense of where the market is today, Bob recently ran his version of this screen and came up with around 50 names. The low I can remember, in June 2007, was 40, while the high in March 2009 was about 450. Why target $1 to $4 billion market caps? DB: These are big enough companies to have proven themselves, and while not as inefciently priced as microcaps, they tend not to have the binary risk of success or failure that we want to avoid. At the same time theyre not so big that there are 12 to 15 analysts following the company. Fairly typical for us is to nd the $3 billion market-cap company that before it ran into some issues was worth $10 billion. Are there sectors you tend to either favor or avoid? RR: For the most part well go wherever the value is, but what will make something that passes our initial screens uninteresting is a chronically bad business. To give an example, gold-mining companies are showing up as quite cheap right now, but over my career Ive watched mining companies snatch defeat from the jaws of victory with great regularity. Thats not to say well never buy one, but its typically been a good area to avoid. We have in recent times not been active in nancials to the detriment of our relative performance because we perceive the risk elements to have changed. The regulatory environment is extremely uid, to the point where there are questions about the sustainability of nancial-company profits and what constitutes normal. Thats particularly an issue when we have such blatant manipulation of the nancial thermometer called interest rates. Our concern is that unintended consequences from such manipulation can get buried into balance sheets for extended periods and will only surface at the worst possible times. DB: Industry-related themes do often crop up in the portfolio, typically due to a cyJuly 31, 2013

cle or other trend we nd compelling for multiple companies. For example, weve owned for some time now both Arrow Electronics [ARW] and Avnet [AVT], the big global technology-distribution companies. We trade around them as the stocks go up and down, but we consider them core ways to play the better-than-GDP growth in technology without having to

On Mining StoCKs: Over my career Ive watched mining companies snatch defeat from the jaws of victory with great regularity.
gure out specic product winners and losers. With more than two-thirds of their business outside of North America, we also get to ride emerging-market growth while still being able to communicate well with management and fully understanding the accounting. Why the high current portfolio exposure to energy? DB: At a more macro level, oil is a global commodity and we believe demand for it will incrementally benet as growth in developing countries exceeds that of developed ones. High production-decline rates in many parts of the world make it difcult to grow global oil supply. We also very much like that oil in the ground and the assets used to produce it should provide a store of value against potential future monetary ination. What about contract driller Rowan [RDC] and E&P company Rosetta Resources [ROSE] make them your preferred ways to play those macro trends? DB: Well talk more about Rowan later, but the crux of our interest is that while we believe the company has smartly repositioned its assets to focus on high-end drillships and jack-ups, the market isnt giving it adequate credit because most of
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the payoffs from that repositioning are still a ways off. With Rosetta, the stock took a hit in recent months because the market didnt like it having to raise capital to acquire assets in the Permian Basin from Comstock Resources, but we generally believe the company has been very well run in shareholders interest and that there are multiple avenues for value creation out of its asset base. After your holding in healthcare-services rm Amerigroup got bought out by WellPoint late last year you bought shares in one of its competitors, Centene [CNC]. How did that one idea lead to the next? DB: We obviously look at all the players when we study a business and this was a case where we still wanted exposure to what we believe is an attractive business, called Medicaid Managed Services. States that have traditionally run their own programs to provide health services to their poorest residents are increasingly outsourcing to companies like Amerigroup and Centene, who can provide higherquality care at lower cost. Contract rates reprice every year, typically at average levels that afford the most-efcient competitors a nice prot cushion. Our view is that demand for what Centene does is in the early stages of a long growth phase and that it has the balance sheet and management to take advantage of it. How generally do you look at valuation? DB: We take a historical look at how the business has performed through cycles, adjust for how the asset base and opportunity set have changed, and arrive at downside, base, and upside cases for revenues and cash ow two to three years out. We then apply a comparable range of estimated multiples and want to see roughly $3 in potential upside for every $1 in downside. Our base case is what we consider normalized intrinsic value, built from conservative assumptions. Its rare that we would buy anything at less than a 35% discount to that intrinsic value.
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I N V E S T O R I N S I G H T : First Pacic Advisors

Your portfolio today has fewer than 30 positions. Is that typical? DB: Generally speaking, we have 20 to 40 positions, with 40-50% of the portfolio in the top ten. That level of concentration is simply a function of wanting every position to potentially be a difference maker. Philosophically we would have no problem with concentrating even more, but clients often have a problem with the volatility that comes with having fewer holdings. RR: I actually have an experiment going on this front since June 30, 1984. I have an IRA account that was set up then and over that period has only been invested in stocks that the Capital Fund has owned, but with never more than ve holdings at a time. Ill buy a stock only after the fund buys it and sell only after the fund sells it. From June 30, 1984 to December 31, 2009, when I stepped down from lead management, the Capital Fund had compounded at approximately 15% per year. But this IRA account had a compound rate of return of 24%. I attribute that premium to the higher concentration and to the fact that at no point has this account been affected by the inows and outows resulting from others emotional decisionmaking. I was the only investor. Does the effort to avoid emotional decision-making explain the Capital Funds relatively low turnover? RR: The turnover ratio has averaged 20% since 1986. Part of that is a function of investing with a long time horizon in companies that dont get better or realize hidden value overnight. Sticking with your conviction in such cases can certainly require patience and discipline that many investors might not have. Low turnover is also related to the fact that were slow to transition from companies we own and know intimately to those whose stocks were looking to buy and dont know as well. Theres a transition risk there that we usually address by taking a long time to both scale into something as well as to scale out of it.
July 31, 2013

Walk through your more-detailed thesis for offshore driller Rowan. DB: By selling off its manufacturing arm and its land-based rigs, Rowan is now focused on the high end of the offshore contract-drilling market with a eet of jack-up rigs and drillships. Its investing around $2.5 billion in four new drillships that have yet to be delivered, but two of those have already been leased out at very attractive $600,000-plus day rates. The technology is amazing. These drillships, for example, have dynamic-positioning motors synced up with a GPS system that
INVESTMENT SNAPSHOT

can literally keep a boat from moving no more than a couple inches in rough waters and swells. All of that is important as so much of the unexploited oil reservoirs that still exist in the world are in deep water and deep underground. Once these drillships go online, the company will have among the youngest and highest-quality eets out there. That positions it well in a market, after the Gulf spill, in which oil and gas companies require higher drilling standards and greater rig capabilities. Premium rigs also command longer contracts, which should result in less cyclicality in earnings.

Rowan

Valuation Metrics
(@7/30/13):

(NYSE: RDC)

Business: Global provider of offshore oil and gas contract-drilling services, with a focus on premium rigs that can drill deeper wells and perform in deeper water. Share Information
(@7/30/13):

P/E Forward P/E EV/EBITDA (TTM)

(@3/31/13):

RDC 21.3 9.5 9.6

S&P 500 18.6 15.1

Largest Institutional Owners

Price
52-Week Range Dividend Yield Market Cap

34.26
30.05 39.40 0.0% $4.26 billion $1.45 billion 20.4% 13.7%

Financials (TTM):
Revenue Operating Prot Margin Net Prot Margin
RDC PRICE HISTORY 50 50

Company Vanguard Group First Pacic Advisors State Street Franklin Templeton Neuberger Berman
Short Interest (as of 7/15/13):

% Owned 6.3% 5.8% 5.1% 4.1% 3.9% 2.8%

50

Shares Short/Float

Clo

40 40

40

30 30

30

20 20

2011

2012

2013

20

THE BOTTOM LINE

Due to a prot lull caused by the companys selling of revenue-producing assets in order to buy yet-to-be-delivered high-end drillships, the market appears not to correctly value the potential upside from those new assets, says Dennis Bryan. Putting a 12x multiple on his 2015 earnings estimate of at least $5 per share, the stock would trade closer to $60.
1.0 0.8 0.6 0.4 0.2

Sources: Company reports, other publicly available information

0.0

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I N V E S T O R I N S I G H T : First Pacic Advisors

The issue today for the stock is that the company is in a prot lull, having sold revenue-producing assets to buy new assets that arent yet generating revenue and prot. The rst new drillship wont deploy until next year, with all four scheduled to be up and running by the end of 2015. In a what-have-you-done-for-me-lately market, thats impacting the share price. How are you valuing the shares, now trading at $34.25? DB: We have an extensive model estimating the protability of each rig over time. When we roll it all up in our baseline case, we expect revenue to increase from roughly $1.5 billion this year to $2.3 billion by 2015, and for EPS over that time to go from a range of $1.50 to $2 to at least $5. With what we consider a reasonable 12x multiple, youd have a $60 stock price. What are your oil-price assumptions? DB: Weve tried to be conservative, assuming prices long term of roughly $80 per barrel. Thats against a WTI [West Texas Intermediate] price today of $103. How big is the risk that supply overshoots demand in the premium end of the market where Rowan is focused? DB: It certainly can happen, but given long lead times and limited shipyard capacity for building drillships, for example, it wont happen quickly. Particularly after Macondo, we also dont believe this is an easy market to enter even if you happen to have the capital. Customers shelling out this kind of money to lease drilling capacity are not likely to want to deal with untested suppliers without a proven regulatory, safety and quality track record. Few sectors have been more troubled than for-prot education. Describe why you think DeVry [DV] can rise above the fray. DB: Theres no question for-prot education companies face challenges. Prospective students are asking, more so in the
July 31, 2013

current job market, if increasingly expensive post-secondary degrees are worth it. Competition has increased from not-forprot colleges that are expanding their more vocational curricula and their online offerings. The public perception of the industry has also taken a hit as a result of well-publicized misdeeds by its less-honorable players. As a result of all this, forprot enrollment levels are down. Our case for DeVry rests on a few basic ideas. First of all, the company gets roughly half of its $2 billion in annual revenues from areas other than the DeVry University franchise that is under enrollment
INVESTMENT SNAPSHOT

pressure. It owns high-demand schools of medicine, veterinary medicine, nursing and healthcare services. Its Becker Professional Education division is the top provider of CPA-exam prep courses. Its also expanding in Brazil, which has a well-established for-prot educational sector. More generally, we think the drumbeat of negativity around for-prot educators has been indiscriminately applied to even the higher-quality players like DeVry. The knock on the industry is that it hasnt delivered value, but DeVry actually has a very good track record. Within six months of graduation from DeVry University,

DeVry

Valuation Metrics
(@7/30/13):

(NYSE: DV)

Business: For-prot education and training services through a number of branded institutions; curricula focus primarily on business, healthcare and technology. Share Information
(@7/30/13):

P/E (TTM) Forward P/E (Est.) EV/EBITDA (TTM)

(@3/31/13):

DV 13.3 12.1 4.8

Russell 2000 48.8 18.7

Largest Institutional Owners

Price
52-Week Range Dividend Yield Market Cap

29.95
18.32 34.51 1.1% $1.88 billion $2.00 billion 11.9% 7.3%

Financials (TTM):
Revenue Operating Prot Margin Net Prot Margin
DV PRICE HISTORY 80 80 70 70 60 60 50 50 40 40 30 30 20 20 10 10 2011 2012

Company Baron Capital Fidelity Mgmt & Research Ariel Investments International Value Advisers Vanguard Group
Short Interest (as of 7/15/13):

% Owned 6.9% 6.6% 5.3% 4.5% 4.5% 11.3%

80 70 60 50 40 30 20

Shares Short/Float

Clo

2013

10

THE BOTTOM LINE

While the market appears indiscriminately negative on for-prot education, the companys diversied revenues, technological prowess and better student outcomes warrant more optimism, says Dennis Bryan. At the low end of the valuation range he believes a privateequity buyer would pay, the shares on his 2014 estimates would trade above $50.
Sources: Company reports, other publicly available information

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Value Investor Insight 5

I N V E S T O R I N S I G H T : First Pacic Advisors

85% of its students get a job within their eld of study, at an average starting salary of more than $42,000. We also believe the DeVrys of the world stand to gain market share in an overall industry in which productivity gains have been almost non-existent. DeVry has aggressively shrunk its cost structure and can offer far more sophisticated online programs, night or weekend classes and convenient locations, all at annual tuition costs that are well below what even instate public schools charge. As prospective students continue to look for convenience and more bang for their buck, that should pay off in incremental demand. You havent mentioned the rise of massive open online courses [MOOCs] as a competitive threat. Are they? DB: Companies like Coursera and edX that offer such courses today are still looking for a business model, and while its something to watch, we dont envision a big overlap in the potential students. If a couple hundred thousand people are attending the online course of a Stanford Robotics professor, we dont see that having a big impact on DeVry. The fact that the for-prot companies tend to be light years ahead of public universities in terms of technological prowess could open up new revenue streams for companies like DeVry. Theyll have to be smart about how they do it, but we could imagine them offering technology products and services to the not-for-prot schools that are looking to diversify their own offerings. DeVrys shares at a recent $30 trade at less than half their level of two years ago. What upside do you see from here? DB: The stock today is trading at around 5x trailing EBITDA on an enterprise value basis. Assuming only modest growth from the non-DeVry branded businesses and a stabilized low-double-digit EBITDA margin from the branded DeVry University division, we estimate EBITDA next year could come in at around $400 million,
July 31, 2013

up 20% from todays run rate of around $330 million. If we use on that 2014 estimate a 7.5x EBITDA multiple the low end of the 7-12x range we believe a private equity rm would pay for a business like this and add back around $280 million in cash, we arrive at a share price of around $52. That would provide a nice return from today, but would still be more than 20% below the share price two years ago. Despite being demonstrably cheap, Western Digital stock has been hitting all-time highs. Whats going on?
INVESTMENT SNAPSHOT

DB: Western Digital is one of three big players in the disk-drive storage business, where it and Seagate Technology each control roughly 40% of the global market, with Toshiba having most of the rest. Over the past 30 years the industry has gone from a cut-throat, price-war type of business to one where the biggest players have won and now compete less on price and more on technology, availability and service. Western Digitals returns on capital and returns on equity are consistently above 20%. The headwind for the business and what has dampened investor enthusiasm

Western Digital
(Nasdaq: WDC)

Valuation Metrics
(@7/30/13):

Business: Designs and manufactures hard disk drives used in personal computers, consumer electronics, enterprise servers and for stand-alone storage. Share Information
(@7/30/13):

P/E (TTM) Forward P/E (Est.) EV/EBITDA (TTM)

(@3/31/13):

WDC 9.6 8.0 3.7

S&P 500 18.6 15.1

Largest Institutional Owners

Price
52-Week Range Dividend Yield Market Cap

65.09
32.25 70.61 1.6% $15.36 billion $15.35 billion 13.6% 10.8%

Financials (TTM):
Revenue Operating Prot Margin Net Prot Margin
WDC PRICE HISTORY 80 80 70 70 60 60 50 50 40 40 30 30 20 20 2011 2012

Company Vanguard Group State Street BlackRock Commonwealth Bank of Australia LSV Asset Mgmt
Short Interest (as of 7/15/13):

% Owned 6.3% 3.8% 2.9% 2.3% 2.3% 2.4%

80 70 60 50 40 30

Shares Short/Float

Cl

2013

20

THE BOTTOM LINE

Dennis Bryan believes the market is short-changing the companys ability to prot from the rise in cloud computing and to diversify into other faster-growing disk-drive end markets than the personal computer. At what he considers a conservative 12x multiple of his 2014 earnings estimate, plus cash, he pegs the intrinsic share value at closer to $90.
Sources: Company reports, other publicly available information

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I N V E S T O R I N S I G H T : First Pacic Advisors

is the sales decline in personal computers. Unlike your PC, your tablet or smartphone doesnt have a hard disk drive, which some have considered a potential crushing blow for companies like WDC. That view misses a couple things. One, when youre on your iPad or smartphone, youre accessing information over the Internet from a cloud that is stuffed with hard disk drives, which by the way tend to be three times the price of a PC drive. Two, it shortchanges the ability of WDCs management to smartly allocate capital to non-hard-disk-drive businesses, such as to solid-state drives, which are much more expensive but are taking share from hard drives for applications requiring very fast retrieval and processing speeds. The stock has done well because the company has performed much better than expected as it has shifted its product mix. Two years ago 80-90% of units and revenues were coming from PCs and notebooks, while today some 50% is tied to the enterprise market. Its not huge in absolute terms, but the solid-state-drive business is generating $600 million in annual sales and growing rapidly. The valuation remains quite low less than 10x trailing earnings and less than 4x EV/EBITDA because of secular concerns over hard disk drives in PCs. Were not saying those are not real, just that they are overdone. How are you arriving at an intrinsic value for the shares, now trading around $65? DB: Assume the bears are right, and annual revenues which grew more than 20% in the latest scal year decrease slightly to $15 billion. If that happens youd expect EBIT margins to go up given that the loss of business is at the low end, but assume they stay at around 15%. The majority of the prots are generated overseas, but assume its all repatriated and they pay a 30% overall tax rate. With all that, we estimate the company should earn about $6.60 per share in net income. Whats a fair P/E on that? For a company with these levels of returns on equity and capital, we dont think its less than
July 31, 2013

10x. Were using 12x, which after adding back $9 per share in cash would give us a share price of $88 using very conservative assumptions. One material item of upside that we havent included is the potential for the company to more fully integrate its 2011 purchase of Hitachis hard-drive business. Chinese regulators have thus far kept WDC from fully integrating the two businesses, particularly the marketing and sales forces. Were those restrictions to be relaxed, we think the resulting savings would add another dollar per share of pretax earnings.
INVESTMENT SNAPSHOT

You appear to have taken some prots in Western Digital of late. Why? DB: We had a strong contrarian case at $30 per share last year, but at $65 the risk/ reward has changed and we didnt think it was prudent to let the position size get to 7-8% of the portfolio. Even after cutting back, its still one of our biggest holdings. What do you think the market is missing in specialty retailer Foot Locker [FL]? DB: Foot Locker is the dominant athleticfootwear retailer in the U.S., selling some

Foot Locker
(NYSE: FL)

Valuation Metrics
(@7/30/13):

Business: Retailer of athletically inspired footwear and apparel, operating more than 3,300 stores in North America, Europe, Australia and New Zealand. Share Information
(@7/30/13):

P/E (TTM) Forward P/E (Est.) EV/EBITDA (TTM)

(@3/31/13):

FL 21.9 9.6 9.6

S&P 500 18.6 15.1

Largest Institutional Owners

Price
52-Week Range Dividend Yield Market Cap

36.47
31.07 37.70 2.2% $5.50 billion $6.24 billion 10.2% 6.5%

Financials (TTM):
Revenue Operating Prot Margin Net Prot Margin
FL PRICE HISTORY 40 40 35 35 30 30 25 25 20 20
15 10

Company Vanguard Group BlackRock Fidelity Mgmt & Research Harris Assoc ING Inv Mgmt
Short Interest (as of 7/15/13):

% Owned 5.4% 5.2% 4.1% 4.0% 3.2% 2.5%

40 35 30 25 20 15

Shares Short/Float

Clo

15 10 2011 2012 2013

10

THE BOTTOM LINE

The company has done right by focusing on prot margins rather than top-line growth, but there is more to do in improving the product mix and increasing sales productivity, says Dennis Bryan. With a 200-basis-point improvement in normalized operating margins, he believes the shares at a less-than-market multiple could increase into the low-$50s.
Sources: Company reports, other publicly available information

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Value Investor Insight 7

I N V E S T O R I N S I G H T : First Pacic Advisors

20% of all sneakers sold. That allows it special relationships with suppliers like Nike, who provide it with models and colors that customers cant get elsewhere. The company has done a lot right in recent years by focusing on prot margins, not the top line. It has recongured its store base, moving away from large combined Foot Locker, Lady Foot Locker and Kids Foot Locker stores that were a dismal failure. It changed the product strategy for its Champs Sports stores, putting more emphasis on branded logo apparel. It has been investing in technology and systems, which has improved inventory management, responsiveness to sales trends and worker productivity. All of this has helped take operating margins from less than 3% three years ago to around 10% today. Theres still work to be done. The company overall expects to signicantly increase capital spending this year to remodel stores and put somewhat more emphasis on clothing, which carries higher prot margins than shoes. Lady Foot Locker is a particular emphasis, as it has been struggling to respond to female athletic apparel trends that have driven the success of retailers like Lululemon. Some 30% of the companys stores are in Europe. Is that a drag as well? DB: Theres certainly room for improvement if the economy improves there, but the European business is doing ne. Operating margins are in the low double digits and the company has been investing into a downturn that has hurt many competitors. It recently bought a sport retailer in Germany called Runners Point Group, which management is optimistic about and wants to expand. At a recent $36.50, how inexpensive do you consider the shares? DB: Primarily from better performance at Lady Foot Locker and product-mix improvements overall, we believe the company can generate over the next couple of years 12% operating margins on roughly $6.5 billion in annual sales. With a 36%
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tax rate and 150 million shares outstanding, that would result in $3.30 in EPS. Even with a less-than-market multiple of 14x, plus $6 per share in cash, the share price would be in the low-$50s. Bob has been an outspoken pessimist on the economy. Whats your latest thinking? RR: I laid out some economic expectations in late 2008, in mid-2009 and then before I went on sabbatical at the end of 2009. I basically expressed a view that the economic recovery would be sub-standard, resulting in sustained high levels of structural unemployment. I expected s-

Are there any glimmers of hope? RR: A meaningful scal restructuring in the U.S. would be a positive, but I fear were running out of time. When Congress reconvenes in September, youre already into the 2014 election cycle and theres a risk that very little gets done. Then comes the beginning of the next Presidential election cycle and, again, theres a good chance no one is willing to make any hard decisions. How does all that get reected in your portfolio? DB: Even with all Bob just said, we could be fully invested. The great equalizer is valuation we invest when we believe were being adequately compensated for the risks were taking. Right now we believe the stimulus of lower interest rates has propped up the economy, which props up prots, which props up stock prices. So in our modeling work were not taking today as normal and going from there. Were building in the potential impact of interest rates rising, say, and the resulting lower level of economic activity. That type of conservatism in setting our intrinsic values explains why we have 30% of the portfolio today in cash. RR: You dont know the value of liquidity until you need it and dont have it. Thats when people are selling what they can, not what they want to, and valuations get highly depressed. We certainly didnt have a good 2008 in FPA Capital [down 35%], but our having cash to put to work in late 2008 and early 2009 set us up for being up 54% in 2009 and up 24% in 2010. People today say, I cant afford to earn zero return on my cash. But if youre a contrarian value investor, you should be used to deploying capital into an area that no one loves and where the consensus cant understand why anyone in his or her right mind would invest. I would argue that is how people are thinking about holding cash today, which makes us glad we have it. VII
Value Investor Insight 8

On LiQUiDitY: You dont know its value until you need it and dont have it, when people sell what they can, not what they want to.
cal policy responses to the crisis to prove inadequate and misdirected. I considered the Federal Reserves quantitative easing to be an experiment of major proportions with severe potential negative repercussions. I also warned that if the unsound scal policies of the U.S. government persisted, there was a material risk that wed face another nancial crisis of equal or greater magnitude to the last one. The short answer to whether Id reconsider any of those statements today is no. The prospects for economic growth remain weak, as real personal incomes are stagnant, corporations are sitting on cash and productivity improvements are minimal. At the same time you continue to have a buildup of liabilities in the system here and elsewhere that are like rubber bands that keep getting stretched ever tighter. You dont know when theyre going to snap, but when they do things can go from OK to bad very quickly. You dont want to think about what would happen to the scal condition of the U.S. government if interest rates moved quickly to more historically normal levels.
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EV (Enterprise Value) - a measure of a company's value, often used as an alternative to straightforward market capitalization. Enterprise value is calculated as market cap plus debt, minority interest and preferred shares minus total cash and cash equivalents. EBITDA (Earnings before Interest Tax Depreciation and Amortization ) is essentially net income with interest, taxes, depreciation, and amortization added back to it, and can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions. Price/Earnings ratio (P/E) is the price of a stock divided by its earnings per share. EPS (Earnings per share) is the portion of a company's profit allocated to each outstanding share of common stock. Basis point (bps) - A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. Exploration and Production (E&P) - An E&P company is known to be in a specific sector within the oil and gas industry. Companies involved in the high-risk/high-reward area of exploration and production focus on finding, augmenting, producing and merchandising different types of oil and gas. The views expressed and any forward-looking statements are as of the date of the publication and are those of the portfolio managers and author. Future events or results may vary significantly from those expressed and are subject to change at any time in response to changing circumstances and industry developments. This information and data has been prepared from sources believed reliable. The accuracy and completeness of the information cannot be guaranteed and is not a complete summary or statement of all available data

You should consider the Funds investment objectives, risks, and charges and expenses carefully before you invest. The Prospectus details the Fund's objective and policies, sales charges, and other matters of interest to the prospective investor. Please read this Prospectus carefully before investing. The Prospectus may be obtained by visiting the fund literature tab on this website, by email at crm@fpafunds.com, toll-free by calling 1-800-982-4372 or by contacting the Fund in writing.
In comparing the performance of the FPA Capital Fund to the performance of an IRA account, please consider the following: FPA Capital Fund Objective: Growth/Income Costs Fluctuating share price and income distributions 2.00% redemption fee Expense ratio is 0.83% as of the most recent prospectus IRA Account (individual securities) Fluctuating share price and usually fixed income payment Commissions on purchase or sale

Management Liquidity Market Risk

Professionally managed Daily liquidity Market conditions constantly affect the funds value, although the diversification inherent in a fund generally reduces the market risk of any one issuer. Mutual funds invest in many individual securities, providing diversification for a relatively small investment minimum.

Investor managed Generally liquid, however liquidity can be at a cost Market may be higher or lower than you paid for the security

Diversification

Tax features

Price may be higher or lower leading to a capital gain or loss

Investor must purchase many securities to achieve diversificationwhich means it may require a significant investment to achieve diversification. Price may be higher or lower leading to a capital gain or loss

Investments in mutual funds carry risks and investors may lose principal value. Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. The Fund may purchase foreign securities which are subject to interest rate, currency exchange rate, economic and political risks; this may be enhanced when investing in emerging markets. Small and mid cap stocks involve greater risks and they can fluctuate in price more than larger company stocks. Groups of stocks, such as value and growth, go in and out of favor which may cause certain funds to underperform other equity funds. The return of principal in a bond investment is not guaranteed. Bonds have issuer, interest rate, inflation and credit risks. Lower rated bonds, convertible securities and other types of debt obligations involve greater risks than higher rated bonds. The FPA Funds are distributed by UMB Distribution Services, LLC.

FPA Capital Fund, Inc.

Portfolio Holdings

06/30/13
% OF NET ASSET VALUE 0.37% 2.52% 1.12% 7.17% 1.22% 6.65% 1.68% 0.61% 0.61% 1.03% 2.67% 4.15% 1.29% 2.03% 1.05% 3.49% 2.20% 3.48% 1.32% 1.45% 5.20% 6.52% 1.74% 1.19% 1.15% 0.89% 5.32% 68.11% 31.89% 100.00%

CUSIP 018804104 037604105 04269Q100 042735100 050095108 053807103 057224107 127097103 15135B101 171798101 251893103 29358Q109 314211103 344849104 423452101 45867G101 651290108 688239201 703481101 759509102 777779307 779382100 78454L100 G81276100 896522109 922417100 958102105

TICKER ATK APOL ARRS ARW ATW AVT BHI COG CNC XEC DV ESV FII FL HP IDCC NFX OSK PTEN RS ROSE RDC SM SIG TRN VECO WDC

SHARES / PRINCIPAL 52,400 1,673,700 918,100 2,120,600 277,206 2,332,000 428,772 100,600 138,200 186,000 1,015,000 842,600 554,943 682,400 197,400 920,648 1,087,200 1,081,800 803,600 261,508 1,441,302 2,257,000 341,900 208,000 353,600 297,600 1,009,800

SECURITY ALLIANT TECHSYSTEMS INC. APOLLO GROUP INC.- CLASS A ARRIS GROUP ARROW ELECTRONICS ATWOOD OCEANICS AVNET BAKER HUGHES CABOT OIL & GAS CENTENE CORPORATION CIMAREX ENERGY DEVRY, INC. ENSCO PLC FEDERATED INVESTORS INC- CLASS B FOOT LOCKER HELMERICH & PAYNE INC. INTERDIGITAL, INC. NEWFIELD EXPLORATION OSHKOSH TRUCK CORPORATION PATTERSON-UTI ENERGY RELIANCE STEEL & ALUMINIUM ROSETTA RESOURCES ROWAN COMPANIES ST. MARY LAND & EXPLORATION SIGNET JEWELERS TRINITY INDUSTRIES VEECO WESTERN DIGITAL TOTAL EQUITIES: CASH & EQUIVALENTS (NET OF LIABILITIES): TOTAL NET ASSETS: NO. OF EQUITY POSITIONS

MKT PRICE ($) 82.33 17.72 14.35 39.85 52.05 33.60 46.13 71.02 52.46 64.99 31.02 58.12 27.41 35.13 62.45 44.65 23.89 37.97 19.35 65.56 42.52 34.07 59.98 67.43 38.44 35.42 62.09 $

MKT VALUE ($) 4,314,092.00 29,657,964.00 13,174,735.00 84,505,910.00 14,428,572.30 78,355,200.00 19,779,252.36 7,144,612.00 7,249,972.00 12,088,140.00 31,485,300.00 48,971,912.00 15,210,987.63 23,972,712.00 12,327,630.00 41,106,933.20 25,973,208.00 41,075,946.00 15,549,660.00 17,144,464.48 61,284,161.04 76,895,990.00 20,507,162.00 14,025,440.00 13,592,384.00 10,540,992.00 62,698,482.00 803,061,814.01 376,080,989.74 $ 1,179,142,803.75 27

Portfolio Holding Submission Disclosure Except for certain publicly available information incorporated herein, the information contained in these materials is our confidential and proprietary information and is being submitted to you for your confidential use with the express understanding that, without our prior written permission, you will not release these materials or discuss the information contained herein or make reproductions of or use these materials for any purpose other than evaluating a potential advisory relationship with First Pacific Advisors.

You should consider the Funds investment objectives, risks, and charges and expenses carefully before you invest. The Prospectus details the Fund's objective and policies, sales charges, and other matters of interest to the prospective investor. Please read this Prospectus carefully before investing. The Prospectus may be obtained by visiting the website at www.fpafunds.com, by email at crm@fpafunds.com, toll-free by calling 1-800-982-4372 or by contacting the Fund in writing. Investments in mutual funds carry risks and investors may lose principal value. Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. The Fund may purchase foreign securities which are subject to interest rate, currency exchange rate, economic and political risks; this may be enhanced when investing in emerging markets. Small and mid cap stocks involve greater risks and they can fluctuate in price more than larger company stocks. Groups of stocks, such as value and growth, go in and out of favor which may cause certain funds to underperform other equity funds. The return of principal in a bond investment is not guaranteed. Bonds have issuer, interest rate, inflation and credit risks. Lower rated bonds, convertible securities and other types of debt obligations involve greater risks than higher rated bonds. Portfolio composition will change due to ongoing management of the fund. References to individual securities are for informational purposes only and should not be construed as recommendations by the Funds, Advisor or Distributor.

The FPA Funds are distributed by UMB Distribution Services, LLC, 803 W. Michigan Street, Milwaukee, WI, 53233.