FPA Crescent Fund

Quarterly Commentary

2nd Quarter
06/30/2011

Dear Shareholders: Overview The second quarter exhibited a bit more volatility than the first, with the stock market declining 6.4% from peak to trough intra-quarter and ending the period on a flat note. The S&P 500 increased 0.10%, while the Crescent Fund rose 0.50% in the period. We have provided a more detailed performance summary at the end of this letter. The contribution from the top three winners was almost entirely offset by the losers, but it was stock price movement without significant news. Quarterly Winners CVS Corporation Wellpoint, Inc. Petsmart, Inc. Quarterly Losers Ensco Plc Owens-Illinois, Inc Hewlett-Packard Company

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. Economy 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 200809 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,

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Democrats don‟t want to cut spending.16% (for 10-year Treasuries) represents good value. we have used an optimistic estimate from an organization whose goal is to increase the highest marginal personal income tax rate to pre-Bush tax cut levels. Or. our nation will continue to borrow more money from our trading partners. We would then raise an additional $767 billion. How many of you have already seen fewer police on the street. are performing something less than their civic obligation. Unfortunately. Barack Obama‟s speech at George Washington University on April 13. they are rewriting economic law based on need rather than common sense. Returning the highest marginal tax rate to pre-Bush tax cut levels would raise just $700 billion dollars over ten years. Ultimately. The group. The real question is will we repay it with U. We have expected little from Washington in the way of bipartisan action. government spending continues unabated – federal. believes the move would yield $700 billion in revenue – a figure that would still leave a revenue gap. party ideology trumps appropriate and compromising resolutions.93%. As Stephanie Pomboy of MacroMavens writes. thanks to the munificence of others.6 trillion deficit. the 10-year Treasury yield had declined to 2. and it‟s evident in Congress‟ inability to reach an agreement on a higher debt threshold. “Perma Schmucks. as attendant higher interest rates can crowd out spending. let alone how to get there. that still wouldn‟t be enough. Republicans must recognize the need to increase revenues.and at 10%. An organic increase in tax revenues certainly helps. Stephanie Pomboy. In the process. Our representatives in Washington. Wealth for the Common Good. Sadly. "We have to live within our means. 1 2 2 . so together they avoid imposing the shorter-term pain that‟s required to ensure solid economic footing in the long run.S.3 Current squabbling over raising the debt ceiling and who will make what concessions aside.S. whiling away the time playing Nero‟s lost fiddle and dancing around their respective political third rails. no. We have learned that one can spend what he doesn‟t have. In other words. Since 1950. there‟s no easy prescription for curing a $1. 4 For want of a better number. President Obama emphatically stated in a recent speech. Democrats must accept spending cuts. Waiting for an improved economy and better employment picture to boost tax revenue may be like waiting for Godot – a prospect that‟s both uncertain and interminable (if foisted upon you by your high school English teacher). they have lived up to expectations. or had your local fire station or library close? It‟s terrible. but make no mistake. 3As of July 17. 2011. are watching our current debt level as well as our deficit-driven need for future increases in debt. unfortunately. we meant local). for an average cut of just 5. it drops to $5. Even now.”1 Until we gain confidence in our elected officials. The ancillary effects can prove dramatic though. Inflation benefits debtors – at least as far as paying it back is concerned. That‟s an impossible expectation anyway. maybe it‟s not generosity that motivates Treasury purchasers. or call it $70 billion per year for simplicity sake. We cannot agree on where we are trying to go. D. but their hopeful belief that 3. the Fed remains “steadfast in the conviction that there is no problem money can‟t solve. „who the heck would lend us money at such low rates?‟ Lenders to the U. especially with respect to previously untouchable entitlement programs. We see no alternative. without regard for tomorrow. we won‟t see a balanced budget for many years. The result: the successful avoidance of constructive consensus. Much can be done to avoid default but. the government has successfully cut the federal budget year-over-year only twice – and that was back in 1954 and 1955. it can get worse. but it won‟t solve the problem.2%.C.” MacroMavens. 2011."2 Different views abound as to what “means” means.4 Let‟s say we could also cut federal spending by 20%. which begs the earlier question. we will work under the assumption that eventual default (outright or inflationary) and the commensurate austerity will prove the most likely outcome. dollars that retain their value in the future relative to our kind lenders‟ currencies? In a word. leaving us with the osteopathic challenge of an infrastructure too fragile to withstand shocks or support our future needs. but at just less than half this year‟s deficit. state. 2011. and Republicans don‟t want to raise taxes. April 18. we see little progress being made as we anxiously observe global leaders continuing to make decisions meant to address the problems of today. and loco (oops.5 trillion. Such narrow-mindedness saps the marrow from our bones. As we have often discussed.

from 42% to 20% today. in constant 2009 dollars) We have to address the “mandatory” spending. So now we‟re back to square one. but instead. it does point to serious deflation consequences should China‟s economic luster tarnish. invest‟ apparently lacks the feel-good sensation of being able to walk into the Apple store and buy the iPad2. At least the stock market found temporary comfort in Mr. we must address the high cost of our social programs. The vicious circle of „borrow. It seems it might be some time before personal tax receipts recover enough to help narrow the budget deficit. is appalling. we would have thought someone would have drowned. Discretionary Spending (% of total spending) Composition of Federal Spending (% of total spending. Surprised? Apparently. we could eliminate the annual cost of multiple wars. Afghanistan. and health care. according to “The Cost of Iraq. We make the distinction between the government providing the immediate necessities of food. the market rallied 0. Sure. Mandatory vs. Bernanke‟s hint at more stimulus.Spending cuts won‟t come easily.” a March 29. The preferred path of „borrow. after opening down that morning. By this point. defense. particularly given what‟s considered mandatory versus discretionary government expenditures. Mandatory spending includes social programs. shelter. the question too often posed is „have we spent enough?‟ rather than „have we spent wisely?‟ We have argued that putting money directly into our wallets via all sorts of transfer payments provides nothing more than an ephemeral boost. Inevitably. the money has either been spent without long-term benefit or just lies dormant on bank balance sheets.3-3. we might just wish him to speak ad nauseam. but note it has already fallen more than 50% as a percent of the federal budget since 1970. The lack of investment in areas that could yield long-term benefits. 5 3 . the Fed was. but not the support to so many others. give‟ leaves us indebted and without the necessary investment for self-sustaining growth. borrow. Federal Reserve Chairman Ben Bernanke pointed to decelerating growth expectations. If one considered the defense of our nation to be necessary.7-2. If he can keep that streak going. Although inflation tinder on the one hand. invest. We know people who have done just that instead of putting the money in their child‟s college fund or paying down their mortgage. As we projected. In his July 13 Congressional testimony. and Other Global War on Terror Operations Since 9/11. such as education and scientific research. the stimuli ended and economic growth slowed.6% during his prepared remarks.7% to 2. or maybe we‟re too pessimistic and it‟s back to square two. give. but that suicidal solution would be overwhelmed by the higher debt balance anyway. When considering stimuli. Fed forecasts for 2011 real GDP have dropped from 3. defense spending has bloat. and save $168 billion5 – still not enough. 2011 report by the Congressional Research Service. It‟s therefore no surprise that consumer confidence remains Fiscal 2011 amount for Iraq and Afghanistan wars. It‟s scary that government action hasn‟t gotten traction after opening the money spigots. What‟s left over is just 14% of our budget. borrow. The Fed has gone from blowing on a string to sticking that string in a wind tunnel ‒ to no avail. We can keep trying to bring interest expense down by buying our own debt (particularly longer maturities). We won‟t solve the problem by addressing such a small slice.9%. and the more the superfluous needs that many Americans feel is their right. and interest expense on our national debt.

38). particularly as it faces the Herculean challenge of reconciling the competing interests of a central monetary authority and independent fiscal fiefdoms. The chart for the U.69). It‟s now a profession. Of the 8. then interest rates can easily spike because of higher inflation expectations and/or because foreign buyers of our debt view our fiscal position as tenuous and fear default.gov/news.nr0.S. dollar to weaken versus a basket of global currencies over time. please also note that the pound didn‟t decline in a straight line. it‟s easy to conclude that the pound is worth a heck of a lot less versus the dollar over the last couple hundred years. “Fed Floats QE3 as a Cure for „Persistently Weak‟ Economy. The pound averaged north of $5. 6 7 4 . A hotel stay for a Brit visiting New York would cost 3x more today than it would have two hundred years ago. Alexandra Frean.release/wkyeng. and not a bad job at that. Members of Congress earn more than four times the pay of the average American and. consider the once-mighty British pound‟s two centuries of erosion. we regrettably have to point to Washington for its fair share. it‟s averaging another 50% less ($1.cfm?pid=%27%2A2%404P%5C%5B%3A%22%40%20%20%0A).” The Times of London.7 Interestingly.S. 2011. Members of Congress currently earn $174.low and companies aren‟t creating jobs at the rate that you would hope at this stage in a recession.S. Ireland.6 Although there‟s plenty of blame to go around. but instead had decade-long periods of stability and shorter periods when its value spiked. but it‟s a long road.312 annually(http://www. they have seen their wages increase 5.9 This won‟t bode well for the U.00 dollars per pound during the nineteenth century.senate. lawyers. dollar down the road. Now it seems to rest on the shoulders of the stronger European countries such as Germany to continue supporting the unkindly (but not entirely inappropriately) termed PIIGS (Portugal.6 million full-time wage and salary workers was $756 (seasonally adjusted). as discussed on page 2. We continue to expect the U. scientists.8 Does QE2 by necessity beget QE3? If U. July 14. 9 We do not see default as a likely course when as much can be accomplished through high rates of inflation. amid massive job losses.com. We would even take our dollars over Euros because we question the long-term success of the European Union (EU).gov/CRSReports/crspublish. Congress took a pay cut when the going got tough. Xenophobic Europeans still swear greater allegiance to their own country than to the EU.bls. For example. or ineffective (possibly).S. Thus far in the twenty-first century. or businesspeople.75 million – or just 21% ‒ have been replaced. stimulus spending is unsustainable (no doubt). in FDR‟s time. dollar versus a basket of global currencies won‟t look exactly the same over the next two centuries. and Spain. At first glance at the next chart.htm). but was worth 32% less on average in the twentieth century ($3. but it will also have periods of stability and price spikes.5 million jobs lost during the recession. However. Italy. We aren‟t alone in our currency challenges. Greece. 8 In 1932 and 1933.measuringworth. only 1. soldiers.S. Dollars per British Pound (yearly average) $10 $9 $8 $7 $6 $5 $4 $3 $2 $1 $0 Source: www. The UK had its doubts from the beginning and declined to join. Congressional salaries were cut a combined 15%. Recent BLS data reports that median weekly earnings of the nation's 100. U.3% since 2007.000 (http://www. or $39. We don‟t know how the Euro will play out. We are long past the days of having our political leaders perform a civic duty as an interlude in their private lives as philosophers.

its strong economy would likely have dictated a stronger Deutschemark. particularly when their “spending on (fixed) assets is now equal to 70 percent of its GDP. from what level. 5 . it will be more on price than quality. In general. July 6. making their goods more expensive and curtailing their exports – thus negatively impacting their economic output. the British pound doubled in value versus the dollar. We own more such high-quality businesses than in the past. 2011. we have a high tolerance for uncertainty. thereby creating wealth but eliminating opportunity. as opposed to our more typical investment in average businesses at good prices. given our macro uncertainty. if we are to bend. Online Data Robert Shiller. We have. we believe that risk is above average. These opportunities have emerged because investors have taken current fears and projected them into the future. and they can‟t continue to invest in infrastructure at the same pace ad infinitum. Weakness or fear in other regions can cause others to seek refuge in the dollar. Civil War. borrowed from our future returns. Historic P/E Ratio 10-Year Average Earnings Source: Shiller. Quality larger-capitalization companies remain attractively priced and. The only questions are when. and remained independent. Maybe China temporarily rolling over could cause such a flight. Had Germany gone the way of the U. When committing capital. Take Johnson & Johnson and Microsoft as examples. and how bad? Investments Central banks have succeeded in a coordinated effort to drive asset prices higher.K. provided the prospective investment offers a sufficient margin of safety ‒ something that‟s becoming less and less the case today. in effect. and we therefore continue to find less to get excited about in the equity markets.S. Robert J. a ratio no other nation has reached in modern times.” New York Times.”10 As with every developing economy.Germany has offered its support thus far. stocks presently trade above their historic average. Although low interest rates contribute to this. there will be hiccups. “Building Boom in China Stirs Fears of Debt Overload. since the market has priced them in a way that has allowed us entry – making good businesses available at average prices. just as during the U. There‟s a certain lack of data integrity coming out of the PRC. but will it continue? The German economy has clearly benefited from its place in the EU. 10 David Barboza.

in part because of negative stories caused by the company‟s consumer recalls. a AAA balance sheet. it generates less than 25% of the company‟s free cash flow and is almost certain to recover from recent missteps. 6. unusually low tax rate.” Despite the modest recovery this quarter. Although the consumer business is a terrific asset. giving us another of what we consider to be infinite-duration bonds with rising coupons. When we look at JNJ. as reflected by an equity multiple that remains at roughly 10x earnings. with over 50% of sales derived internationally. JNJ‟s shares were as inexpensive as they‟d been in thirty years. 2011 Fortune – Sept. and very high margins). and an enterprise value of about 7x operating profit. During our Q1 2011 letter we disclosed that.. the media‟s undue focus on one division will allow us the opportunity to acquire the entire business at an attractive price. and compelling long-term demographic trends benefiting each of their businesses. “The greatest negative impact in the quarter came from Microsoft (down 19bps). giving no consideration to the company‟s cash position. 19. 2010 “J&J Needs More Than a Band-Aid” Barron’s – Oct.Johnson & Johnson ~ Media Perspective “Why J&J’s Headache Won’t Go Away” “Johnson & Johnson’s Quality Catastrophe” Bloomberg Businessweek – April 4. plus tremendous product/business diversification. we actually have some enthusiasm for Microsoft‟s earning 6 . we worry about many things (long-term health care spending.e. The combination of business franchise and low price attracted us to the company. a holding we have increased to take advantage of price weakness. given the current low expectations of a P/E of just 10x. 8% plus the growth. i. but JNJ is one of the world‟s great franchises. 2010 We were able to purchase Johnson & Johnson (JNJ) at an 8%+ free cash flow yield. Irrespective of the stock‟s lowly valuation. we still think the shares are attractively valued. Microsoft ~ Media Perspective Microsoft has gotten its share of not-entirely-undeserved bad press in recent months. Occasionally.

2011. Come April 2014. Jean-Philippe Courtois. Though the company clearly faces challenges. As measured by operating profit. the recently introduced Version 7 had the fastest take-up in the company‟s history. April 7. Salesforce. president of Microsoft International. One of the benefits of having a big team is that we don‟t have to compromise on the depth of our research on even our smaller investments. S&P 500 We sometimes opt for such a basket approach when we have greater conviction on the prospects of the group and its attendant risk-reward than we have on individual companies. To secure Microsoft‟s place in the cloud. S&P 500 Enterprise Value/Trailing EBIT 25x 20x 15x 10x 5x 0x Tech Bellwethers Sources: Capital IQ. “Microsoft Says to Spend 90% of R&D on Cloud Strategy. contrary to what Microsoft‟s valuation would suggest is a business in steep decline. no more maintenance updates). we regret to inform you. As for the legacy Windows franchise. we give “Mr. We like that the market appears to have priced its business as one in permanent decline..000 and a portfolio of product offerings that touches almost every organization in one way or another. 11 Aydan Eksin. We recognize. We have therefore invested in a basket of other such companies that we find inexpensive. We suspect this will drive another strong cycle of upgrades. Windows XP – which continues to have the largest global installed base of any operating system. Microsoft is already a leading cloud player.11 With Microsoft‟s R&D staff of 40. Microsoft will no longer provide XP support (e. as measured by number of users and revenue. Some of these investments are smaller in size than is typical.g. Microsoft‟s fiscal 2011 earnings may actually be more than 50% higher than five years ago. though.com. Microsoft isn‟t the only large-cap technology company to be viewed so negatively.prospects. said earlier this year that the company would spend 90% of the company‟s annual $9.6 billion R&D budget on cloud strategy (more than 4x Salesforce.” Bloomberg News. We believe the market has therefore handed us a free option on the possibility for future growth. is – forgive us – a cloud company trading in the stratosphere. but that is not to say that our research has similarly shrunk. The baskets come about through bottom-up work and are only created after we complete significant write-ups of each potential company. Large-cap tech stocks are as cheap as we‟ve ever seen them. FPA. 7 . both on an absolute basis and relative to the broader market and historical sector multiples. Softee” at least a fighting chance at remaining relevant in the world of corporate cloud computing. we can point to a number of opportunities that suggest earnings five years hence should exceed today‟s – though by what amount is open to debate. a leading cloud player with $2 billion in revenues and valued at greater than 100x forward earnings. we instead use an example to reflect how little credit Microsoft gets by comparing it to a current tech darling. that many of you may read this commentary on a computer running a predecessor. Technology Bellwethers vs. Rather than provide an exhaustive list of the levers available to Microsoft to improve earnings or discuss the tremendous market share in its various business segments. and yet the market seems blind to this fact. as can be seen in the following chart. awarding it just one-tenth the P/E.com revenues).

4x. Given the bad news surrounding financials these past few years. IBM. there are two commonly perceived risks for tech incumbents: 1) capital allocation. and most of the rest had the stuffing knocked out of them. we have recently reengaged in the sector by assembling a host of companies in a basket that now represents 4. an unprecedented ~28% discount to the S&P 500. and. Bloomberg data.6% of long exposure to large-cap technology. We would expect to increase that basket position should individual companies and/or the sector allow us entry at lower price levels. Microsoft. & Oracle. was obviously the worst of these episodes. worked for Cisco in a prior life and brings with him a mix of relevant industry. 8 . Two industry subsectors. and the companies seemed to be doing great. and prospects look dim. As the table below illustrates.0% of the portfolio. Dell.0x price/book ratio for banks in the S&P 500 ‒ a level not seen since the savings and loan crisis concluded back in the early 1990s. Banks Huge losses from exposure to residential and commercial real estate P&C Insurance Massive write-downs to investment portfolios due to the decline in value of mortgage-backed securities and corporate bonds Hurricane Katrina renders several insurance companies insolvent Asbestos lawsuits explode out of control Losses from dot-com & telecom exposure Asian and emerging market currency crises cause losses at large international banks Mexican peso crisis Savings & loan crisis due to: change in goodwill accounting as well as weakness in commercial real estate and junk bonds. strong continuing cash flow. valuations have come down. Hewlett Packard.13 We have begun investing small amounts of capital in select banks and are actively looking for more opportunities. versus an average 4% premium over the past decade. where the valuations are the lowest. Since then. Financial services companies also seem inexpensive. To date. while exposing the portfolio to the historically cheap valuations in these two subsectors. we are currently near an aggregate 1. our analytical lead on technology investments. We are looking for opportunities among regional banks. now trade cheaply by any historic measure. consulting. Just a few years ago. and investing experience. While valuations are now low. 2008-09. it seems that every 510 years. lack of transparency and balance sheet risk remain. many companies have ceased to exist. 2) business disruption brought on by the emergence of cloud computing models and related mobile device proliferation. one or more of the large financial services companies gets into trouble and incurs large write-downs. high valuations. We believe current valuations provide a healthy margin of safety given the bulletproof balance sheets. EMC. While company-specific issues vary. our investments have been in the larger-cap banks. particularly given current large cash positions. As of June 30. 12 13 Tech bellwethers: Cisco. and leading market positions for many of the most out-of-favor tech stalwarts.12 Low overall expectations for the group have caused the current EV/EBIT multiple to contract to 8. but their valuation levels have not come down as much as the large-cap banks. This last period. Write-downs have driven book value lower. A 45% drop in the S&P 500 index causes several insolvencies As the chart below illustrates. financial service companies had overstated book values. Intel. Period 2008-09 2005 2001-02 1998 1994 1990-91 1982-84 1973-74 Source: FPA. Crescent had 5. we minimize the idiosyncratic risk to future unforeseen crises. Losses in Latin America: Continental Illinois fails Rapid drop in interest rates from Paul Volker‟s Fed causes industry pricing crisis Over-invested in common stocks. Ravi Mehra. banks and property & casualty (P&C) insurance. By taking a basket approach.The select universe of technology bellwethers charted above trades at less than half the valuation of a decade ago.

50 2. not owned them for much of the last decade) as we believed that any potential upside to the stocks could not be justified by the risk assumed. At our purchase price. but we are also cognizant that a strategy of buying leading financials at a discount to tangible book after a recession/credit dislocation has repeatedly produced outstanding results over the past thirty years.fpafunds. 14 9 . Neutral Diminished (but lingering) credit issues from 2008-09 Negative Increased regulatory pressure Balance sheet leverage Exposure to the global financial system Unknowable balance sheet and derivative exposure Although our position is currently small.com/downloads/crescent/September%2030. namely: Positive Strong operating franchise Significant market share Exposure to the global financial system Much stronger capital position than during 2006-07 Robust reported capital strength (based on traditional measures) Unusually low price to current tangible book value Low valuation to prospective normalized earnings power Source: FPA. Crescent Q3 2008 commentary: http://www. we have spent a great deal of time considering the merits of each company. each of the banks merits a much larger portion of our portfolio. If the world doesn‟t fall apart. 2001 2003 2005 2007 2009 2011 We have recently established a small position (just 1. when we explained why we refused to own financials (and had.50 3. as well as the group as a whole in the context of our entire portfolio. we pointed out the elevated level of ROE (18-22%) being earned by financials.pdf.50 1. Not only does each company have its strongest balance sheet in a least a decade. our basket now trades at an average 85% of tangible and recently scrubbed book value and 7x our best estimate of normalized earnings power.Price/Book Ratio of S&P 500 Banks 3. From a strictly bottom-up perspective. in fact. The situation today is quite different from the environment we discussed in our Q4 2006 and Q3 2008 shareholder commentaries.00 0.%202008.14 At the time.pdf . FPA.3%) in three large banks.00 1. It is rare to find leading franchises available at such prices. depending on one‟s perspective) is a result of the intersection of our bottom-up approach with our consideration of the macroeconomic environment.fpafunds. Though each company is unique.pdf.00 2.50 1993 1995 1997 1999 Source: Bloomberg. the extreme amount of balance sheet leverage (26x equity in the case of the investment banks).%202006. our basket Crescent Q4 2006 commentary: http://www. the group has some similar attributes.com/downloads/crescent/December%2031. Our investment (or lack thereof. and the pricey multiple to book value (2-3x) and earnings (12-15x) at which financials traded.

could double over the next 2-3 years. High yield originations hit an all-time high in 2010.75 1. Our exposure is a frustratingly low 6.9% and that doesn‟t even tell the whole story. Our financial basket also includes property & casualty insurance. The sector is historically cheap.25 2. On one hand. certainly not with enough yield to justify the twin risks of interest rates and credit. the potential real estate bubble in China. we have invested in several insurance companies.0x. as governments might prove incapable of providing a backstop. because we believe there is very little risk to our book. One of our investments. We are evaluating the competing proposals and working with Transatlantic to maximize shareholder value. To date.00 1. Price/Book Ratio of S&P 500 Property & Casualty Companies 2.00 0. based on conservative business results and exit multiples. is currently the target of a bidding war between two suitors. 10 . and highly manipulated interest rates. Companies. and tweak certain entitlement programs to put developed economies on solid footing. with aggregate valuations near 1. Although there are no guarantees. unnaturally fixed currency exchange rates. Higher yielding corporate bonds just don‟t really exist. However. on the other hand.75 0.25 1. High Yield / Distressed High yield is distressing.50 1. either through maturity or in reduction of position size. and 2011 is on track to handily trump that as both yields and credit spreads remain low. On the other hand. have been issuers. If we could place a higher probability on the likelihood of officials making necessary the adjustments. on a bottom-up basis. leaving us with a relatively small position. Transatlantic Holdings. the unsustainable increases in government obligations could lead to default and a second crisis (one that‟s perhaps worse than that of 2008-09). We believe the industry‟s underwriting cycle has bottomed and that current valuations fail to reflect a more normal environment. FPA. increase revenue (in part though the resulting economic strength). While we worry about the macro. create the fear that the oasis of bottom-up bargains we see could prove a mirage.50 Source: Bloomberg. We have been sellers. untrustworthy official data. we really like the opportunity. we could then envision a larger position in banks. we also appreciate that we don‟t know what will happen. it appears to be in everyone‟s interest for responsible officials to cut spending. our appreciation for the macro-environment causes us trepidation. Our concerns about the functional insolvency of Western governments.

5% Sources: Bloomberg.8% 2.712 78.875 3.2 billion ‒ is almost double that peak.655 45.9% 4.928 44.5% 18. Sources: Barclay‟s Capital.433 13.210 3.668 90.3% 19.6% Spread vs 10-Yr 4.335 15.403 93.618 57.0% 62.6% 114. as compared to 92% in 2007-08.284 44.492 17.821 33.0% $Caa+NR % Redeem $ % 3.217 23.0% 10 yr UST 3.9% 7.862 25. when 24% of the issuance was Caa or unrated. 5-Year & 10-Year U.8% 9.731 63.263 49.2% 5.2011 1995 – 2011 Ba B Caa NR Total Caa +NR % 9.6 billion has been issued.100 54.368 138.0% 5 yr UST 1.Merrill Lynch High Yield Index (YTM) vs.435 87.834 1.9% 19.0 5. Treasury Yield Current High Low Average High Yield 7.8% 18. Although this is down from 2007-08.323 34. But the percentage of lowerquality issuance fails to tell the whole story.784 31.313 134.744 137.1% 16.756 40. The dollars issued in the Caa and unrated totaled $47.9% 24.7% 54.S.001 23. As can be seen in the table below.2% 22. and in 2011's first half.142 50.0 20.681 40.7% 64.328 34. Treasury Yield 5-Year U.113 27.922 2.513 1.0 10.927 75. it is 29% higher than the 17-year average.368 49.698 70. Note that in the prior peak years of 2006-07.3% 11.345 151.136 10.570 26.6% 15.583 72. we counter with the argument that refinancings are 53% of new issuance today.2% 19.690 9.2% 5.5% 68.0% 2.421 33.278 21. FPA.800 39.7% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Annualized 2011 2011 15.648 12.554 131.9% 46.111 6.545 130.S.623 21.102 181.435 7.063 43.3% 2. Yearly 11 .8% 6.213 19.2% 18.419 7.142 87.1% 17.504 21.947 4.8% 68.8% 51. Treasury Yield 25.787 167.356 1.406 38.112 28.214 14.304 91.1% Spread vs 5-Yr 5.8% 17.5% 45.291 13.121 1.0 15.599 26.9% 74. 60% ahead of last year.763 1. Bank of America Merrill Lynch.336 6.524 25.S.933 97.790 1.7% 21.2% 54.2% 14.0% 17.0% 25.835 13.787 60.654 335.468 25.831 543 410 1.599 262.309 1.5% 1. with 17% of the issues either Caa or unrated. Lest one challenge our conclusion by saying that refinancings account for most of this. Caa and unrated issues totaled just $56.800 2.899 11.462 142.508 1.461 4.819 71.446 21.9% 3.556 20.807 15.2 billion.544 4.007 48.0 0.524 47.638 2.8% 10.4% 50. High Yield New Issuance 1995 .543 1.6 billion in 2010. The total for the past 18 months ‒ $106.901 7.814 72.205 1.0% 47. $28.2% 9. the average credit quality of new high yield bond issuance has been deteriorating.361 79.8% 2.739 152.607 13.409 53.0 Merrill Lynch High Yield Index (% YTM) 10-Year U.6% 10.893 High Yield New Issuance Source: Barclays.091 12.8% 11.471 9.648 58.7% 7.3% 58.717 813 255 1. FPA.8% 5.

6 $58. coming in early August to a browser near you.fpafunds.5 $130. we are happy to have Chris Lozano joining our analytical team. used with permission under license.4 $49. we‟re expecting them tomorrow.4 $167.6 $262.7 $152.4 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 1H 2010 1H 2011 $108. Until then.9 $79. U. more details on your Fund. Cash will be invested only when the risk/reward of a given investment dictates its deployment. when it had $5 billion.High yield bonds are easily sold when alternative yields are low and.S. politicians lack the political will to do anything more than pay lip service to the larger issues. when a company gets all gussied up. California. www. We hope he won‟t have to wait long. and we continue to do so today. and their EU brethren. Candidly. we‟re not sure they really understand either what to do or what‟s really going on. as well as information on other products FPA offers. High Yield Originations (in billions of dollars) 2000 $44. It is important to note we lived by this equation when the fund had $100 million in assets under management. 2011). and we‟ll be there to pick through them. First. You will be able to easily navigate our site and find past commentaries and speeches.4 $138. You don‟t know how valuable cash is until the day you need it. but is it as good as it looks? Who buys a new car and thinks they‟ll ever have a problem with it? There will be some wrecks on the road. and yet. We expect that Chris will help us in the next round of restructuring.15 We have a couple of introductions before we close.7 Source: Barclays Capital. So while we‟re without high yield opportunities today.5 $142. we‟d like to introduce our new. bringing our current number of professionals to ten.com. The rules of algebra therefore dictate that Cash = Portfolio – Investment Opportunity.3 $134. “Wait and Hope” (Speech given at the Value Investing Congress in Pasadena. cash will continue to be the residual of investment opportunity. Chris comes to us with a law degree and five years of finance experience that includes his most recent stint as an associate in Oppenheimer‟s Restructuring Group. May 3. You might also notice that the First Pacific Advisors name is not present. Second. Slow economic growth and high unemployment can lead to further societal polarization. We see them. Closing We manage per the equation Portfolio = Investment Opportunity + Cash. It‟s easy to sell something that looks good. We continue to “wait and hope” as we enjoy what we believe to be relative calm between two crises. improved (and much overdue) website. We‟ve come to realize that most investors 15 Steven Romick. packing surfboards for a tsunami – something that won‟t end well.4 $93. 12 . Artwork copyright 123RF Limited. easier still.

know us simply as FPA. one of our responsibilities is to communicate with shareholders in an open and direct manner. assure future results and disclaim any obligation to update or alter any forward-looking statements. or otherwise.” “may. You can identify forward-looking statements by words such as “believe.” “anticipate. Further. Insofar as some of our opinions and comments in our letters to shareholders are based on current management expectations.” and other similar expressions when discussing prospects for particular portfolio holdings and/or the markets. whether as a result of new information. 2011 The discussion of Fund investments represents the views of the Fund‟s managers at the time of this report and is subject to change without notice. actual results may differ materially from those we anticipate.” “expect. FORWARD LOOKING STATEMENT DISCLOSURE As mutual fund managers. 13 . we will only be using FPA. While we believe we have a reasonable basis for our comments and we have confidence in our opinions. however. future events. We cannot. information provided in this report should not be construed as a recommendation to purchase or sell any particular security. Respectfully submitted. they are considered “forward-looking statements” which may or may not be accurate over the long term. generally. Steven Romick President July 20. and that “Pacific” really doesn‟t convey the breadth of the firm‟s offerings. References to individual securities are for informational purposes only and should not be construed as recommendations to purchase or sell individual securities. Heretofore.

and geographies.2 5.9 24. Portfolio Manager Brian Selmo.2 8.fpafunds. by email at info@fpafunds. We aim to protect capital first and create longterm equity-like returns second.6 6.8 Stock markets are volatile and can decline significantly in response to adverse issuer. so that when you redeem your investment it may be worth more or less than its original cost.7 -22.1 26. We believe the best way to accomplish our goals is to accept short-term underperformance in exchange for long-term success.com . charges. equities. Russell 2500 Index is an unmanaged index comprised of 2.1 -6. Long-term focus. corporate bonds.1 15. Philosophy Absolute value investors.8 1. currency exchange rate.1 39.500 $16.5 15.4 10.12 $1.3 8.com FPA Crescent S&P 500 Russell 2500 Index 60% R2500/40% BCGC Since YTD 1 Year 3 Years 5 Years 10 Years Inception* 5.fpafunds.000 investment. market caps. Please read this Prospectus carefully before investing.9 28. economic and political risks. We invest across the capital structure. while preparing for the worst. Volatility. market.com www.S. companies with small market capitalizations. Inv.8 10.2 7. 1-800-982-4372. political.8 billion $6. We incorporate an understanding (sometimes limited) of the economic environment.0 30.9 2. industries. with over 80% coverage of U.7 8. Ekstrand Elizabeth A.9 26. Bryan.8 12.8 1. Government Treasury bonds.S.S..1 8.com. Macroeconomic view.1 3.FPA Crescent Fund Contrarian Value Strategy FPA Crescent Fund Managed By Ticker Symbol NAV Initial Min. over the long-term. Balanced Benchmark is a hypothetical combination of unmanaged indices comprised of 60% Russell 2500 Index and 40% Barclays Capital Government/ Credit Index. asset classes. CFA. This data represents past performance and investors should understand that investment returns and principal values fluctuate. You should consider the Fund’s investment objectives. which combines principal and dividend income changes for the periods shown. and other matters of interest to the prospective investor. risks.6 4. The Fund can purchase foreign securities. Barclays Capital Government/Credit Index is an unmanaged index of investment grade bonds. an equity-like return with less risk than the stock market. The securities of smaller.7 billion 30254T759 The FPA Crescent Fund endeavors to provide. Portfolio Management Team Steven Romick. We are willing to hold cash.4 9.3 8. reflecting the Fund's neutral mix of 60% stocks and 40% bonds. economy. Nathan Average Annual Returns (%) Through 06/30/2011 FPA Funds 11400 West Olympic Blvd.0 28. and charges and expenses carefully before you invest.1 18. Total return calculations are based on a $10.3 7.4 10. The Prospectus may be obtained by visiting the website at www. Broad mandate.7 36.1 6. The Prospectus details the Fund's objective and policies.3 45.3 9.2 5.1 -11. but is also considered a proxy for the total market. We cannot eliminate risk. and we act as stewards of our shared capital.1 22. If we have performed our research correctly. Director of Research Dennis M.5 -17. Suite 1200 Los Angeles. CFA Rikard B.7 34.3 2. 14 www. Value stocks can perform differently than other types of stocks and can continue to be undervalued by the market for long periods of time.com. Alignment of interests.0 12. but we conduct ourselves by hoping for the best. Performance has been calculated on a total return basis.9 5.2 26.2 19.7 3.1 * Annualized return since inception of FPA Crescent in June 1993 Annual Performance (%) FPA Crescent S&P 500 Russell 2500 Index 60% R2500/40% BCGC 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 12.0 5. toll-free by calling 1-800-982-4372 or by contacting the Fund in writing.fpafunds. Current month-end performance data may be obtained by calling toll-free.7 11. which are subject to interest rate.8 billion $6. CA 90064 Phone 800-982-4372 info@fpafunds.0 19.5 -21.9 11.4 -36. All applicable expenses such as advisory fees have been included in calculating performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.500 stocks of U. and yankee bonds. CFA Christopher Lozano Ravi R. Downside protection / Risk minimization.9 10.4 3. volatility creates opportunity. Mehra Gregory R.7 28.5 -37. We seek genuine bargains rather than relatively attractive securities. regulatory.S.4 -20.4 16. less well-known companies can be more volatile than those of larger companies.3 6. or economic developments. The index focuses on the large-cap segment of the market. CFA. Principal changes are based on the difference between the beginning and closing net asset values for the period and assume reinvestment of all dividends and distributions paid. We invest our money alongside yours. S&P 500 Index includes a representative sample of 500 leading companies in leading industries of the U.2 6. Firm Assets Strategy Assets Fund Assets CUSIP *Charles Schwab only 2nd Quarter 06/30/2011 Objective FPA FPACX/FPC1Z* $28. Douglass Mark Landecker. including U.2 6.8 4. not risk. Please reference FPA Contrarian Value Policy Statement for additional information.

Average Down Month .2x 2.8% 15.6% 3.6% Mortgages 0-5% US Gov’t Bonds & Agencies 13.5 0.48% 0.500 $25.8% -13.3% -3.5% 2.4% 3.3% Top 10 Holdings Aon CVS Wal-Mart Stores Ensco plc Covidien Occidental Petroleum Microsoft Stanwich * Omnicare Pfizer Total *Various issues FPA Crescent Fund (NAV)/ S&P 500: 10-Year Growth of $10.9% 9.7% 0-10% Common Stocks.180 $5.000 3.076 FPACX $25.8% -300.7% Other 0-1% 7.1 $11.3% -13.2 $25.28% 20% Semi-Annually FPA Crescent Russell 2500 S&P 500 Barclays Capital Gov't/Credit Stocks Price/Earnings TTM Price/Earnings 2011 est.9 1.000 $17.7% 99.fpafunds.8 15.9% $64.500 $15.000 $12. The return shown is at net asset value (NAV) and does not reflect the deduction of the sales charge.Cumulative Downside Participation Up Month .4% 82.9% 7. limited term securities (net of shorts and collateral). would reduce the performance shown.0% $90.37 Russell 2500 S&P 500 Statistics Gain in Up Months .9x 13.7x 1.4% 23.2% 4.1x 1.21 Geographic Allocation United States Europe Other 59.58 567.0% 1.3% $2.3% 4.2x 2.2% 3.5x 2.6% -2.8% 0-20% 27.6% -2.8x 16.000 $27. Short 0.4% Turnover* Dividend Frequency *As of most recent report Bonds Portfolio Exposure Asset Allocation Current Historical Range Duration (years) Maturity (years) Yield-to-Worst Yield-to-Worst (corporate only) 59.5% -354.5% 15.8x 12.7% 2.9 5.31% 0.0 2.1% 4-25% Corporate Fixed Income 2.000 2002 2003 2004 2005 2006 2007 2008 2009 2010 www.2% -16.14% 0.58% 0. Portfolio Statistics FPA Crescent 60% R2500/ 40% BCGC 367.000 $7.4% 8.5% -21.com *Past performance is no guarantee of future results.9% 2. short dividend expense) 2nd Quarter 06/30/2011 Portfolio Characteristics June 1993 123 1.28 464.500 S&P 500 $13.6% 10.5% 3.5% -198. Long 3. Price/Book Dividend Yield Average Weighted Market Cap (billion) Median Market Cap (billion) 15.Average Delta between Up/Down months Worst Month Best Month Standard Deviation Sharpe Ratio (using 5% risk-free rate) 366.0% 40-65% Common Stocks.9% 12.7% 28.7% 2.3% 11.4% 54.9x 1.5% Date: 7/1/2001—06/30/2011 $30.0% -164.1% 2.000 $22.7% 5.3% 46.1% 2.16% excl.2% 6.FPA Crescent Fund Contrarian Value Strategy Portfolio Information Portfolio Inception Actual # of Positions Expense Ratio* (1.3% 64. which if reflected.4% 18.500 $20. 15 .9% 4.5% 3.500 $10.Cumulative Upside Participation Loss in Down Months . liquid.8% 9.2% 15.7% 78.8 2.8 $0.5 7.1% -4.1% 10-45% Liquidity* *Cash and high quality.

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