FPA International Value Fund Conference Call

2013 Q4 FPA International Value Fund Conference Call

-1-

Ryan: Good afternoon, everyone. We will begin the conference call in just a few

minutes. Please stand by. Thank you.

Good afternoon, and thank you for joining us today. We would like

to welcome you to the fourth quarter 2013 webcast for the FPA

International Value Fund. My name is Ryan Leggio, and I’m a Senior Vice

President here at FPA.

The audio and visual replay of today’s webcast will be made

available on our website, fpafunds.com. In just a moment, you will hear

from Pierre Py, the portfolio manager of the Strategy, as well as Jason

Dempsey, and Victor Liu, both Senior Vice Presidents and Analysts on the

Strategy.

Today’s call will cover a few areas. First, we will provide a brief

overview of the Strategy. The team will then review performance, detail

certain aspects of the current portfolio, and spend some time to review

some holdings in the portfolio. Lastly, we will turn to Q&A.

Before we begin, we would like to highlight the key Fund attributes

for those of you who may be listening in for the first time. I will quickly

mention a few of these attributes, which you can see on your screen right

now. First, the Strategy is run with an absolute value philosophy. The


-2-

team’s starting position is cash, and they seek genuine bargains in the

equity markets rather than relatively attractive ones.

Second, the Fund has broad benchmark-agnostic mandate. The

team can invest in both developed and emerging markets, and can own

stocks across market caps and sectors. Finally, the Fund is relatively

concentrated, as the team focuses on only high-quality companies that

trade at a significant discount to the team’s estimate of intrinsic value.

For more detailed information regarding the Strategy, we strongly

encourage you to read the Strategy Policy Statement available at

fpafunds.com.

One other quick update since we usually receive many questions

regarding the Fund’s size and the Fund’s expense ratio: as of Friday, the

end of January, Fund assets are now at around approximately $325

million. In terms of the expense ratio, we expect that, if the Fund

maintains its current asset level in 2014—that is, above $325 million—the

total expense ratio for the Fund should be less than the expense ratio cap

of 1.32% on a going-forward basis.

And with that brief update at this time, it is my pleasure to introduce

Portfolio Manager, Pierre Py. Over to you, Pierre.


-3-

Pierre: Thank you, Ryan, for the introduction, and thank you all for taking the time

to be on the call today. Starting with performance, during the fourth

quarter, the Fund was 2.57% compared to the MSCI All Country World

Index gain of 4.77%. For the year, the Fund was up 18% versus the

index’s gain of 15.29%. And since inception on December 1st, 2011, the

Fund as appreciated 20.70% annualized versus 14.75% for the index.

At the end of the quarter, we were 63% invested versus 61% at

September 30, 2013. Over the past three months and year-to-date, our

cash stake averaged in excess of 38%. Since inception, our average cash

holding has been around 35%, growing steadily from low teens over the

past two years with the exception of a three-month period that started in

February 2012 when the market corrected, and we were finding more

rather than less opportunities for a short while.

The way we seek to generate superior returns over the long run is

by selecting good companies, buying them with a high margin of safety,

and building a benchmark-agnostic concentrated portfolio whereby we

deploy a greater portion of the Fund’s assets towards our best ideas.

What our experience tells us unfortunately is that there are times, no

matter how big our investment universe or broad our market cap reach,

when it is simply not possible to do this. There are times when there are


-4-

just no well run, financially robust, high-quality companies for sale at a

discount to intrinsic value in excess of 30%. And we visit more than 30

countries a year. We speak to well in excess of 500 companies a year—

mostly senior management representatives. We monitor a focus list of

more than 700 companies, and we price a so-called best-of-breed list of

close to 300 companies. What we end up with based on this research

work is around 50 companies that fit our investment criteria and trade at

more than 10% discount to intrinsic value. That to us is a margin of error;

it’s not a margin of safety. So what that means is these companies are

trading below fair value, but it doesn’t mean that they all have enough of a

margin of safety for us to invest in them. And within these 50 companies

that trade at some discount to intrinsic value, we are only happy to own

currently about 23 of those, with a greater concentration, as you would

expect, towards those that give us the greater discounts to intrinsic value.

We articulated an investment philosophy and elaborated a process

around that for a reason—primarily because it minimizes our risk of

permanent losses. The share prices of the companies we own may go

down, but the companies themselves will continue to exist, and over the

long run they will continue to create value, and more and more value. So if

we cannot find anything to buy—anything that would meet all of our


-5-

investment criteria—we don’t see why we would change our investment

philosophy and process just to populate the portfolio. We should do

nothing, which is what we do, and this is why our cash exposure remains

elevated. Just because we don’t see any opportunities, though, it doesn’t

mean that prices cannot continue to go up. As they do, we may

experience short-term relative underperformance like we saw in the fourth

quarter.

Even if we underperform on a relative basis in the near term, we

will not change course, however, as we have see this play out several

times before. We may find ourselves at odds with the market for awhile,

but we know how the story ends, and we trust that our approach is the

winning strategy in the long run. As this unfolds, as we have done

consistently over the past two years, we will remind our investors to

always judge performance (1) with a long-term horizon and (2) being

aware of the risk of permanent losses that’s being taken to achieve the

results. Or what the alternative history, to borrow from a famous investor

and writer of the investment might have been—how the investment

might’ve turned out differently and what the consequences of that

would’ve been then.


-6-

That consistency in our approach shows in our portfolio metrics for

the quarter. Not much has changed there. On a P/E basis, our companies

are trading slightly ahead of the index. As we pointed out in the past,

though, we don’t think that P/E is a very meaningful metric—for one,

because of how much distortion there is, or there can be, between

accounting earnings and the unencumbered free cash flow that a

business generates on a level playing field; also because the index

includes businesses that typically trade at lower multiples, and for a

reason, and to which we have little exposure, such as financials,

materials, or energy stocks.

On an equal footing, we think our companies are in fact cheaper

than the market even on a P/E basis. We also think that they have greater

staying power, stronger earning generation power per dollar invested, and

superior management teams. In fact they generate a return on equity of

an average 19% versus 14% for the index. On top of this, they do this

without much financial engineering, without much financial leverage, and

thus without taking on the additional financial risk to deliver compelling

returns. Their weighted average debt-to-equity ratio is 0.4 time versus 0.6

time for the index.


-7-

So if we wanted to do this—not that we would—but if we wanted to

do this and we were to put the same amount of leverage on our

businesses, their return on equity would be twice as high as that of the

index. This idea of quality and sustainability of the business, that’s the first

thing we look at rather than the multiple at which a stock trades. The

multiple to us is meaningless without being able to put it in the context of

the quality of the business.

Then what we prefer to focus on to assess whether the stock is in

fact attractively priced is the discount to intrinsic value. On that metric, the

weighted average discount to intrinsic value of our holdings was just 24%

at the end of the fourth quarter. That compares to 25% at September 30,

2013, which means that we were effectively able to keep it relatively

stable in a rising market, although the fact is that, despite our best effort, it

did come down somewhat over the past three months.

Our best performing holding in the quarter was Senior, which was

up 16.92% in U.S. currency. Based in the U.K., Senior is a leading

manufacturer of components of gas turbine engines, aircraft structures,

and fluid conveyance systems. We have been invested in the company

for some time, and we profiled it in our last quarterly webcast. We also

commented on it in the previous quarter, as it offered a good example of


-8-

how we are careful not to anchor investment decisions on previously

available valuations, and how we do not seek to pick the trough or try and

maximize the upside as long as the minimum 30% and above discount to

intrinsic value is there.

When we first bought Senior, the stock was trading at almost an all-

time high, and yet it is up another 66.23% in U.S. currency since then.

And for reference, we have included the Senior case study slide again in

this quarterly presentation. Very briefly, Senior is the type of business that

we like—the type of business that we’re familiar with. We’ve been

invested in some of Senior’s peers in the past, and we have similar

companies on our best-of-breed list.

The parts that Senior produces are unit value, and yet they are

critical parts with high cost of failures. They are designed into long-life

platforms and single sourced due to the low volumes. Customers are

focused on quality of execution and reliability rather than price as a result

of that. And that ultimately translate into low to mid teen margins return on

capital employed in excess of 35, and very high cash conversion rates.

While cyclical, Senior’s underlying markets deliver continued

growth and offer good long-term visibility. Management has proven

operationally strong, having positioned the group’s portfolio activities


-9-

toward the IO market and having consistently improved profitability.

They’ve created value through bolt-on acquisitions and are focused on

value creation, or so-called EVA-focused. They manage the balance

sheet well, with a leverage ratio currently below one time and historically

below 1.5 time net debt to EBITDA.

So in short, we think Senior is a well run, high-quality businesses

with limited financial risk, and therefore meet all of our investment criteria.

And as such, we remain interested in owning this company within the

limits of our valuation discipline.

Our worst performing holding in the quarter was G.U.D. Holdings,

which was down 9.42% in U.S. currency. But the position was newly

added to the portfolio towards the end of the period, and this is not very

relevant.

Our second worst performing holding, which we have owned for a

more meaningful period of time, was Danone, which was down 4.17% in

U.S. currency. To talk about this, I’ll pass it over to Jason Dempsey, who

specifically covers the stock as part of his geographic responsibilities.

Jason?

Jason: Thanks, Pierre. Danone is a French company that is the world leader in

fresh dairy consumer products, in addition to having a broad global


-10-

portfolio in branded water, baby food, and medical nutrition. The stock

declined during the period and made a prolonged recovery in its Chinese

baby formula business after what turned out to be a false contamination

scare. Continued weakness in Europe’s demand, increasing raw milk

inflation, and currency headwinds also had some short-term negative

impacts.

From a long-term view however, Danone is well positioned to

benefit from the structural tailwinds driving demand for its products in both

mature and emerging markets. Its current margins are also still somewhat

below a normalized level that we believe the company can sustainably

achieve. Based on these factors, we continue to see value in our

investment and have been adding to the position. Pierre?

Pierre: Thank you, Jason. In terms of portfolio activity now, as many of our

holdings continued to perform well throughout the quarter, we had to exit

another two positions during the period—Assa Abloy and Britvic. Based in

Sweden, Assa Abloy is the global leader in lock and security products.

This is a company that we’ve known for years and that we owned since

the inception of the Fund. Assa Abloy was our first case study in our

fourth quarter webcast back in 2011, and for reference we have included

the case study slide in this presentation.


-11-

Based in the U.K., Britvic was also one of our longstanding

holdings. We presented the company in a case study in our second

quarter 2012. We also used Britvic twice as an example of how

disconnect between volatility and business values and volatility in market

prices can create repeated opportunities for long-term value investors to

buy high-quality businesses at large discount to intrinsic value. And both

case studies are also included in this presentation.

Now since we first added Assa Abloy and Britvic to the portfolio,

their stocks have returned 117.90% and 134.17% in U.S. currency

respectively, and no longer offered appropriate margins of safety for us to

own them. Both are good companies however, and we keep monitoring

them closely for renewed opportunities to invest in them again.

Despite our continuous struggle to find companies which not only

meet our quality criteria but also whose stocks trade at significant

discounts to intrinsic value, we were able to add three new names to the

portfolio during the period: Accenture, G.U.D. Holdings, and Taiwan

Semiconductor Manufacturing Company. Now for a brief introduction on

Accenture, I’ll pass it over to Jason again and then to Victor Liu to talk

about Taiwan Semiconductor Manufacturing Company.


-12-

Jason: Thanks, Pierre. Based in Ireland, Accenture is a global IT services and

outsourcing company with the majority of its revenues from North

American and Europe, in addition to a presence in Asia and Latin

America. We were provided with an opportunity to make an investment

after quarterly earnings failed to meet market expectations, most notably

at the end of June last year. Having followed the company for several

years, we saw how Accenture generated attractive free cash flow growth

without the needs of high capital reinvestment. Excess capital had been

redistributed to shareholders in the form of both dividends and share

repurchases. With a balance sheet operating consistently at a net cash

position, Accenture has successfully built out of the last decade a global

delivery network, which has allowed it to capture an increasing share of

the growing IT and business process outsourcing market.

In order to understand the normalized earnings power of the

company, we studied over 25 competing firms within the industry. The

evidence collected from our work indicated to us that Accenture’s

competitive position was even stronger than we had thought at the outset

of our research. The company’s cost position appears quite favorable

relative to most competitors, and its ability to reinvest significantly in R&D

and promotional activity also puts it at a distinct advantage.


-13-

Given these positive dynamics, we consider the deceleration in

Accenture’s consulting revenue growth in 2013 to be driven more by

cyclical factors than structural or competitive. Similarly, we do not feel that

the current profitability was under a material threat from a temporary

reduction in its top line growth rate. On the contrary, the longer-term

opportunity for global IT service providers with substantial low cost

production capacity remains promising, and Accenture benefits above all

from a brand name recognized in many countries around the world.

With that, I’ll pass it to Victor to speak about our next new

investment.

Victor: Thank you, Jason. Taiwan Semiconductor Manufacturing Company, or

TSMC, is a company that we have followed for many years. It is one of

the largest semiconductor manufacturers in the world and works with

leading design houses like Qualcomm, NVIDIA, and Broadcom. TSMC

employs a unique business model serving as a pure play foundry that

manufactures for customers, protects their intellectual property, and does

not compete with them.

What piqued our interest in TSMC was its increasing importance in

the semiconductor value chain. As semiconductor manufacturing

increases in complexity, so do the costs, skills, and experience required to


-14-

be a competitive foundry. Over the past few years, TSMC has made large

scale investments in leading edge manufacturing capacity. We believe

this investment will not harm the economics of their business, but should

instead generate healthy returns and widen the lead they already possess

over competitors. TSMC’s combination of strong execution, collaborative

business models, thoughtful capital allocation, and healthy returns made it

an investment for us in the quarter.

Pierre: Thank you, Jason. Thank you, Victor. These two new additions are

outputs of our efforts to go back and review our analytical work on names

that belong to our so-called best-of-breed list, which is something that we

mentioned last quarter. By taking deep dives into companies that we had

long followed but not yet had the opportunity to own, in particular in

situations where they had gone through new developments; we were able

to identify some suitable candidates for the portfolio.

And Accenture and Taiwan Semi are also a credit to that. They’re

also a credit to how we have come together as a team I think. Since

coming on board earlier this year, Jason and Victor have embraced the

process, helped consolidate and expand the research, and contributed

their unique visions and expertise to the process.


-15-

Last quarter we also mentioned our continued extensive traveling,

making every effort to uncover new opportunities in all markets, in

particular in situations that we may have overlooked in the past or where

we identified some agents of change. G.U.D. was the third addition to the

portfolio this quarter and in a large part a product of these efforts.

Based in Australia, G.U.D. is a mix of solid domestic businesses

and restructuring cases as well. While we long knew the management

now in charge at G.U.D., we came across the company itself on a recent

trip to the region. And as it is often the case, we had followed the career

developments of the new management team in place, and we were keen

to hear more about what they’d hope to accomplish in their new roles at a

company faced with some challenges, and that’s what ultimately led us to

the investment in G.U.D.

One last quick comment on portfolio activity, if you look at the

portfolio turnover historically, it’s been very high relative to what we

consider to be our historical standards. On a longer-term basis, we would

expect an average turnover ratio of around 20%, so 3–5 years would be

sort of the typical holding period. That being said, the 3–5 year holding

period is not an investment horizon. We don’t go into a new investment

with the idea that we’re going to be in there for three years; we go into a


-16-

new investment with the idea that we could be invested in in perpetuity.

And we want to be comfortable with that idea; otherwise we should not be

invested in the company in the first place. But we’re also very valuation-

driven.

So essentially what we do is we wait for the discount to intrinsic

value to unwind in capital markets, and that is what dictates ultimately the

holding period. So we sort of guide for an expectation of a long-term

average of 20%, 3–5 year holding period, but ultimately it’s dictated by

market volatility. And that’s what explains the difference between what

we’ve guided as expectation for a typical average holding period versus

what the portfolio has done.

In terms of the portfolio profile, from a top-down perspective, our

portfolio remains driven by our strong value discipline, which translates

into a few opportunities and close to 40% in cash in the current

environment. We only had 23 positions at the end of the quarter versus an

expected 25–35 holdings at any given point in time.

We are a non-diversified strategy, as many of you know, however.

And as such, we can invest in the few ideas that we find actually meet all

of our criteria, and we can concentrate heavily on the best ideas. We had

more than 45% of our assets invested in our top positions at year-end.


-17-

In terms of market cap, as most of you know, we run an all-cap

strategy, and we look at anything with at least $100 million in free float.

We have companies in the portfolio that are anywhere between a market

cap of $400 million and as high as a market cap of $100 billion. But we

are more generally heavily geared towards large cap companies with a

weighted average cap of $25 billion as we stood at the end of the quarter

and a median market cap of $9 billion. For reference, I believe we were at

$18 billion on a weighted average basis at the inception of the first

reporting period of the Fund, and we have consistently been in the teens

and above since then.

In terms of geographic exposure, aside from increased exposure to

Australia and our new Taiwanese holding, the overall profile of the

portfolio did not change dramatically over the course of the quarter. We

remain primarily geared towards companies that are domiciled in Europe,

and that is simply a reflection of where we find compelling value

opportunities, as our approach is agnostic to geographic exposure, as it is

to size for that matter. Many of our holdings are large global companies

and thus generate significant portion of their future free cash flows outside

of their home country, which makes domicile of limited relevance to us.

What matters is where business value is created.


-18-

Similarly we measure our currency exposure based on what

currency the portfolio’s free cash flow are denominated in, and we hedge

defensively any currency that is a significant outlier as long as it is

economical for us to do so. As we stand, we have hedged more than half

our exposure to both the euro and the British pound. The reason for doing

this is that we want returns to be driven by underlying business

performance and the unwinding of discounts to fair value rather than

currency fluctuations. We have no ability whatsoever to assess what the

normalized long-term exchange rates across dozens of currency we come

across should be. If we did and we wish to invest on that basis, we would

not need to take on any business risk. And this is also why we take a

neutral view of currencies when we value individual businesses.

To this point, we continue to have no exposure to firms based in

Japan where valuations have inflated further from levels we already

considered generally unattractive and where we find that management

teams still typically lack the type of financial discipline that we look for. To

be very clear—and I need to reiterate this because we’re constantly

talking about our exposure to Japan, or rather lack thereof—but we do not

have a view on Japan as a whole. We are not opposed to owning any


-19-

companies that happen to be domiciled in Japan. We think that there are

great companies in Japan.

All we are saying is that, based on what we know, as we stand, of

Japan, having spent quite a bit of time in the market meeting with

companies, having looked at many companies there, many businesses,

and based on the type of prices that we see in Japan, in the context of the

quality of the underlying businesses versus our stringent absolute value

approach, we have not been able thus far to find investment opportunities

in Japan that fit our approach.

Similarly we continue to have no exposure to the banks. While they

might make for a successful call on the European recovery, we simply

don’t find them suitable for a bottom-up strategy, as many of these

companies generate what we consider mediocre returns on equity despite

high levels of financial leverage. And the same comment for that sector

goes as for Japan. We are not in principle opposed to investing in the

sector, or any sector for that matter. But we have simply been unable thus

far to find such companies that would meet our investment criteria in that

specific segment of the market.

Beyond that, we continue to be fairly diversified while naturally

gravitating towards businesses that are highly free cash flow generative


-20-

and less capital-intensive. This includes both companies that require very

little capital to operate, like distribution or service type businesses, as well

as companies that are more capital-hungry but generate high returns

thanks to their strong position in the market and in the value chain. We

also find that proven robust industry or companies often offer the type of

long-term sustainability that we seek.

With our longstanding position in SAP and the recent addition of

Taiwan Semiconductor Manufacturing Company, our exposure to

technology is notable, although it is not as meaningful as the GICS

classification would suggest because this includes things like Accenture

and Atea, which is more of a distribution business. But more interestingly

the investment reflects the strengths of the company’s business model

rather than any calls on technological developments or market cycle when

you think of SAP or Taiwan Semi.

In general though, we find that technology-based companies are

extremely difficult to value—that’s new technology in particular—as we

struggle to handicap the risk of disruption and the true long-term

sustainability of their business models.


-21-

Our case study for the quarter is Diageo, and I will now pass it over

to Victor, who covers the company, to take us through a summary of our

investment thesis.

Victor: Thanks, Pierre. Based in the U.K., Diageo is one of the world’s leading

producers and distributors of spirits. It owns about one-third of the world’s

hundred leading spirit and beer brands, including Johnnie Walker,

Smirnoff, Captain Morgan, Guinness, and Baileys. The company has

broad geographic exposure, with more than 35% of its revenues coming

from fast growing regions.

The company has a long track record of robust financial

performance. Organic growth on a compound annual basis has been over

5% for the past decade. Equally interesting, this has been done without a

down year during the same ten-year period. The operating margins of the

business are around 30%, returns on capital employed are in excess of

40%, and the business has very high free cash flow conversion.

Over its history, the company has demonstrated superior execution

throughout its business. The company exhibits strong portfolio

management and takes a long-term view when business decisions are

made. The company does not make decisions based on quarterly

performance, but rather invests in markets and brands over decades. As a


-22-

result, Diageo thoughtfully invests in attractive markets, builds brand

equity, and leads innovation. Despite strong operational performance, the

company does not rest on its laurels. It continues to drive costs out of its

operations and uses these savings to invest in the longer-term growth of

its business.

Diageo’s capital allocation track record has proven to be highly

effective also. The company has a history of making sound acquisitions

and walking away from overpriced auctions. Over the past 15 years,

Diageo has paid £12 billion in dividends and spent £8 billion in buybacks.

This return to shareholders is 40% of Diageo’s current market

capitalization. Even with the consistency and profitability of its business,

Diageo’s balance sheet is conservatively positioned with 2–2.5 times net

debt to EBITDA.

If one simply looks at Diageo’s headline valuation multiple, Diageo

never really appears very cheap. However, Diageo’s a great business that

is a compounding value machine. This is because of the high returns on

capital that it generates and an ability to continue deploying that free cash

flow in new opportunities around the world.

Diageo’s an example of how a high-quality company can be

underappreciated, sometimes consistently, by capital markets over long


-23-

periods of time. We find that some businesses trade at high valuation

multiples but are still attractively priced given their sustainable

fundamentals, business quality, and superior management. Our

investment process and philosophy looks for the right combination of

quality and price—not just price alone. Diageo is a high-quality company

that fits our strategy well. As of the end of the fourth quarter, Diageo

traded at 15.5 times fiscal year June 2016 earnings, a 6% free cash flow

yield, and a 3% dividend yield.

Pierre: Thank you, Victor. And to conclude, we’d simply like to reiterate, as we do

each quarter, the key tenets of our investment philosophy—what our

investment credo really is. We are absolute, not relative, long-term value

investors with a strong bias towards quality. We look for well run,

financially strong, high-quality businesses whose stock we can purchase

at a significant discount to our estimate of their intrinsic value. And we

only invest when presented with such opportunities and will hold cash in

their absence.

And with that, we have no further prepared remarks, and we would

like to open it up for questions.


-24-

Ryan: Thanks, Pierre, and team. For those on the call, please feel free to submit

your questions now. We’re going to pause for a just a moment as we

compile the questions. Please stand by.

Okay, so we received one question before the call on Europe and

one question during the call on Europe, and we’re going to lump those two

together. The question we got before the call was: are you concerned

about a deflationary environment in Europe? And the question we just got

was: How exposed is Europe to the carnage in emerging markets? So,

Pierre, do you want to take that?

Pierre: Right. So these are somewhat different questions actually, so we’ll lump

sort of the exposure to emerging markets with a group of questions that

came through about what’s happening to emerging markets—very

surprisingly so.

So with the first question on sort of… are we concerned about

deflationary environment in Europe. And as you will hear me say it several

times, we are not macro analysts by any stretch of the imagination, and

we select investments and build and manage the portfolio based on

bottom-up analysis, fundamental research, and assessment of intrinsic

value. So a lot of these comments on macro are to be taken with a huge

grain of salt.


-25-

I guess the answer to that question about the deflationary

environment in Europe is, yes, we’re concerned about deflation in Europe,

as we are in other regions. If you look at the U.S. for instance, you see

that growth in prices has exceeded the growth in household income even

on engineered CPI numbers, while the take-home pay is declining. And

unemployment hasn’t come down much adjusted for the fall in the labor

market participation rate. Wealth hasn’t trickled down. Leverage is

increasing again while people are returning to the house and car market.

And capital is not being redeployed at a very healthy rate.

So some of these dynamics are at play in Europe as well. Prices

have run up, while unemployment remains elevated, in particular with

younger people. And income struggles to grow, while tax pressure

intensifies. And we’re not macro economists by any stretch of the

imagination once again, but that seems to us that these are potential

conditions for a deflationary environment.

At the same time, we also recognize that, beyond the economic

low, there is the low of government. And because of that, we are equally

concerned about inflation in many of these markets. We see signs of it in

various economies, and we pointed out to some of these signs both

indirectly in our quarterly commentary—in energy prices, in housing


-26-

prices, in price of good prices, or in asset prices—and more directly.

There have been considerable amounts of liquidities injected into the

system through massive expansion of government balance sheets or

those of their central banks. Rates have been at artificially low levels for a

sustained period of time now, and it seems to us that these actions would

typically be drivers of inflation in the long run.

So we said yes and no. So what will happen eventually and over

what timeframe? We don’t know, and we don’t believe we have the skills

to know. And we’re not sure how anyone would have the skills to know

that. So we read about these macroeconomic developments. We

speculate about them like everyone else because it’s fun, but we don’t try

and articulate a view that would then dictate how we invest and manage

the portfolio. It would be a strategy of the blind. Instead we try and focus

on what Howard Marks called the—and other well known investors and

writer—“the knowable,” so what we can actually understand about the

business and the management team and what gives us confidence in the

value that these businesses create.

We follow an investment philosophy and a process that we think

eliminate the need to speculate on all of these macro developments. We

focus on finding high-quality businesses that we can buy at significant


-27-

discount to what we think they are worth and that we’re comfortable

owning for long term. What we mean by quality is a business that

operates in an industry with high barriers to entry, with low risk of

substitution to the product or the service that it provides in a concentrated

or a rational market where it enjoys sustainable competitive advantage,

and a business that is well positioned in the value chain so that it has

leverage over its customers and over its supplies. And what that means is

that means pricing power, and that means the ability to preserve earnings

generation power in the long run.

In addition to that, we often invest in businesses that are asset-light

with high return on their capital employed. And these are businesses that

we think should fare relatively well in either scenario—whether we have

deflation or whether we have inflation. So the success of our investment

strategy is not dependent on any particular macro outcome so that we

don’t have to focus on that. It’s something that we have no ability to either

research or intimately understand to a point where we’d be comfortable

deploying capital and not work.

Also remember that we build a portfolio based on discounts to

intrinsic value. We buy a company that meets our criteria if we can get the

stock at a discount of over 30%. We weight it in the portfolio based on


-28-

how that discount compares to the other stocks that we own, and we sell

out of the position as the discount unwinds, as I highlighted earlier.

There’s no overlay of strategy allocation or macro consideration in how we

build and manage a portfolio. It’s purely based on bottom-up analysis.

So the only thing of the sort that we have is that we don’t invest in

countries that we consider to be non-investable, but that’s it. And what we

mean by that… we mean countries that have a transparent rule of law and

a fair enforcement system. It’s as simple as that.

So we may indulge in pontificating on things that we read about in

the papers, and we want to try and answer some of the questions that we

get on these calls that are more of a macro nature the best we can. But

ultimately we’re really not the best persons to be asked about these

issues, candidly.

Ryan: Okay, we have question on the emerging markets. How do you minimize

the collateral damage between the companies FPA International Value

invests in and the “chaos in emerging markets”?

Pierre: And that would tie with the other question Ryan mentioned earlier about

how it exposes Europe to the carnage in emerging markets—and that’s

the questioner’s words, not mine. So first, as I mentioned earlier, I think

we pointed out before in some of our previous calls some of the


-29-

challenges and difficulties that we could see in many emerging markets

and how large injections of low-cost capital were distorting not just

valuations, but also capital allocation and management behaviors. We

talked on one of our calls even about the issues that we were seeing in

China coming back from a trip to the region.

You’ve seen us, since the inception of the Strategy, make no

investment in companies that are domiciled in emerging markets. When

we started the Strategy, the sentiment was that Europe was dead, but

emerging markets were developing and would continue to evolve ahead.

What we were finding on the ground at the company level was that

Europe appeared to be an opportunity, and emerging markets looked

expensive.

And that’s why the portfolio ended up looking like it did—not

because we anticipated any of what may be happening in emerging

market, but because we looked at the fundamentals of individual

businesses with discipline and objectivity, we valued them accordingly,

and we found that many of these businesses in Europe were trading at

large discount to fair value, so we bought them, while a lot of the

businesses in emerging market were trading on very high expectation and

high multiples to the normalized operating profit that they can generate.


-30-

That said, to address the other side of the question, we have many

companies in the portfolio that have exposure to emerging markets even

though they are based in Europe. In fact we’ve made that case

repeatedly. Look at where the underlying free cash flow is being

generated—not where the company is domiciled. So that might mean that

some of our companies may get hurt by some of the developments in

emerging markets.

So if you take Diageo for instance, since we used that as a case

study, it has a business in China, as you would imagine. Roughly half of

that is baijiu, which was Mao’s spirit of choice to give his favorite generals

and that is widely used for gift-giving in the country. There’s been a

terrible crackdown on that, and as a result the business is down 66%. So

that means Diageo loses money now in China. Well, that’s maybe a £30-

million loss. That compares to £3.5 billion in EBITA for the group.

So that sort of headlines may cause short-term volatility in the

share price. It may even cause the group to miss out on a portion of the

free cash flow we expected it to generate, but it won’t threaten the

business model, and it will only be a temporary issue. It won’t threaten the

group’s really existence either because they have the balance sheet to

weather much more material storm than that—and longer term in


-31-

perpetuity, which is how we value businesses. There’s still a large

growing, getting wealthier pool of consumers in that market, in the specific

case of Diageo, that may be interested in drinking whiskey, vodka, or

other spirit at some point, and that may have a preference for strong

branded products.

So a temporary hit to cash flow may even be as material and as

prolonged in other situations so as to cut into our discount to intrinsic

value. But we would’ve bought the company at more than a 30% discount

to intrinsic value, so we would have had quite a margin of safety in the

first place. In the meantime short-term volatility means we may get an

opportunity to buy more of the stock at a low price. And generally

speaking on emerging markets, we have long been waiting for a

correction, and I certainly am excited and prepared to take advantage of

that if it’s confirmed.

What’s important to understand, though, is we don’t position or pilot

the portfolio reactively to sudden changes in macro sentiment. We didn’t

react in that way to the fears towards Europe and we didn’t over the

emerging markets love affair two years ago. We didn’t over the Japanese

market bailout. We think that’s a recipe for disaster. What we do is we

look at the underlying business. We understand how it works from one


-32-

end of the value chain to the other by talking to customers, suppliers,

competitors. We meet with management, and we get comfortable that

they can handle difficult situations. We analyze the balance sheet, and we

see that it can withstand shocks. We forecast free cash flow, and we

purchase that perpetuity of free cash flow at a significant discount

because we know that we can’t forecast all of that could happen in

perpetuity and because we’re not going to play allocation strategy with the

portfolio.

Ryan: We have a question about Fund flows, and the question is: have the

inflows into the Fund been manageable?

Pierre: Yeah, the inflows into the Fund have been quite manageable. If you’ve

looked at what we’ve done over the last now 13 or 14 months, we’ve seen

the Strategy grow from around $20 million in asset to well in excess now

of $300 million, and that has had no impact on performance. I think if you

look at the type of company that we own—back to the portfolio overview

that we presented in our prepared remark—the weighted average market

cap of the company we own is $25 billion. The median is $9 billion. So

these are relatively large companies that we could continue to invest in

with the current amount of assets that we have in the current type of

influence that we have. So they’ve been quite manageable thus far.


-33-

Ryan: Question on Asia: why so little representation in Asia in the portfolio?

Pierre: Well, that’s must be a question that came a little earlier, and I suspect we

may not get it as much as we used to now. But it remains a valid question

nonetheless, even as things are coming down on that front. It’s not that

we chose to have little representation in Asia or that we don’t want to. It’s

not that we don’t know what’s over there either, and it’s not that we don’t

track these companies.

In fact as I mentioned earlier, we’ve been spending a significant

amount of time in the region over the last year or year-and-a-half. Last

year we went to China, Hong Kong, Taiwan, Japan, Korea, Indonesia,

Philippines, Singapore, and some of these markets we went multiple

times. This year we plan on returning to some of them, and we want to go

to Thailand, Malaysia, possibly India. I say possibly because this is one

market where we’ve been struggling a bit in terms of whether this is in fact

a region that we would consider to be investable or not, back to my earlier

comment. But I guess making that decision would likely at least in part

come from visiting the market and talking to companies on the ground,

which we have done in the past, but it’d probably be worth going back and

getting an update. We have companies on both the focus list and the

best-of-breed list that are in all of the Asian markets.


-34-

And I guess more broadly speaking to just kind of close the point

on that, we have names from all emerging markets on these two lists. We

follow these companies and, if they come to create enough of a discount

to intrinsic value, we’re more than happy to own them. In fact you can’t

see it yet, but we invested in one such company in our Global Value

Strategy, and it may become a name we would want to own in the

International Value Strategy as well. We even have names in Argentina

on the focus list. So we’re always looking everywhere.

The only reason we have had so little representation in Asia once

again is simply because we have not found the right combination of

quality and price in this market. That’s been true in Japan, as I explained

before. It’s been true in Korea, and it’s true in Southeast Asia on the

emerging market side and more generally in other emerging markets to

this date. Now things might be changing though. We’ll see. And if they do

change, our portfolio is also likely to change along with the opportunity

set.

Ryan: So there’s a follow-up question I think to that question, Pierre. Can you

talk about a few countries or at least your thought process on which

country might be un-investable for the Strategy?


-35-

Pierre: Yeah, it’s always something very dynamic that we do. But I highlighted the

two very simple criteria that we have to determine whether a country is

investable or not. And one is that the country has a clear well established

rule of law. And two is that the rule of law is actually being enforced in a

fair and balanced manner. If we can’t get to that level of comfort with the

framework of doing business, how could we possibly be long-term

investors, or how could we possibly assess the value of businesses?

There are not that many places like that on the list. And like I said,

it’s very dynamic, so places come in and out. But a very obvious example

that we often mention that’s being very much talked about these days is

Russia simply because we can never know what the rule of the game is

going to be to be doing business over there and whether we’re going to be

able to retain ownership of the asset or the free cash flow that a business

generate over the very long run. So in this situation we simply cannot

implement our philosophy and our process, and so we stay away.

Ryan: Thanks, Pierre. Another question that was submitted beforehand… Kyle

Bass, who manages a hedge fund, likes to state that European banks are

3.5 times more levered than U.S. banks. Do you think European banks

present a systematic risk, and how does that risk affect the portfolio?


-36-

Pierre: Okay. Well, I guess whether the European banks are—and I’m not saying

this because I’m French. But whether the European banks are 3.5 time

worse than the… or more levered than the American ones doesn’t really

matter that much to us. We look at those, and we often see mediocre

returns on equity despite significant financial leverage, which is the exact

opposite of what we look for as investors. These companies on top of

that, they’re also very difficult to analyze, and they have many of the

structural flaws that we precisely seek to avoid, such as high exposure to

regulatory and government changes. And because of these issues, we

simply have not been able to find suitable investment ideas in that part of

the market, as I highlighted earlier in the prepared remarks. And as such,

we have no exposure to the banks.

Of course we have indirect exposure to these companies. If you

take an LSL for instance in the U.K., it’s a company that provide portfolio

appraisal services to the banks in a market that is highly driven by

mortgages. So evidently there is an element of exposure there. More

broadly speaking, I think the fact that the banks present a systemic risk

has been established already. I don’t think you need anyone to tell you

that. They are the system, and there’s evidently a risk there. So I don’t


-37-

believe there are many portfolios, if any, that don’t have that kind of

exposure or some kind of exposure to that risk.

Thus the question for us is more how we manage that indirect

exposure from a portfolio perspective. And the way we manage that sort

of risk ultimately is again by investing in businesses that we think the

world needs to have around in all circumstances. We invest in businesses

that we think will survive any cyclical downturn or systemic disruption, and

possibly will come out stronger over crisis. The other thing we look for is a

management team that can run the business well through such temporary

disruptions and a balance sheet that can weather the resulting volatility in

free cash flow or short-term challenges in the credit markets.

Now if on top of this we can buy these businesses at more than

30% discount to intrinsic value, then we think we’ve done as much as we

could to minimize the downside risk, wherever it may come from, and

protect ourselves against the risk of dominant losses. Truth be told, we

actually like that such mechanisms are at play that carry systemic risks

because, when those risks materialize themselves, things get cheaper—

sometimes real cheap—and that’s when we like to buy. So the banks can,

and have to be proven to be, quite helpful in that regard, and we’re happy

that they’re around.


-38-

Ryan: Next question is: can you talk about what changes you’ve made after the

third quarter when you mentioned you missed an opportunity to deploy

capital because you had to wait for an investment committee meeting?

Pierre: Okay. I don’t believe we said that we had to wait for a meeting, or that we

missed the opportunity because of the meeting for that matter. All we said

was that there were only two days, which happened to be right before a

meeting, to review a specific company when the stock of that company

was trading at a discount to intrinsic value—slightly above our required

level to become a portfolio company.

We don’t have to wait for our weekly committee meeting to make

investment decisions. We also have ad hoc meetings. We had one for

Fugro the day before we flew to South America for a two-week research

trip. And in fact that was also right around the time of that other idea that

the question is referring to that we mentioned in our third quarterly

commentary. We had ad hoc meetings for TSMC, for Accenture, and we

had them for a lot of the global names as well. What we will always wait

for, though, is to have done our homework, to have done our research, to

have documented our work, for the team to have had a chance to review

and discuss the idea, and for me as the PM to be able to draw a

consensus view from our discussions.


-39-

In the case of that one stock again that we’re talking about here, it

was no different than for any other stock. We’d been working on it for

some time. So as you’d expect, it was in a compelling enough range of

being a buy. It was what we call a high priority. So typically we grade

companies we look at based on how willing we are to allocate time and

resources between no interest, low priority, medium priority, and high

priority to research and price. And it was a company we had never owned

before, so we were doing the work. We were getting ready.

And we will always do that. We will never jump in first and figure it

out later. We will always do the work. And if we happen to miss out on the

opportunity, so be it. We would rather miss on an opportunity than destroy

capital. And the work is never lost anyway. If it’s a company that we want

to own now, we will mostly likely want to own it in the future at the right

price. So we’ll simply wait for another opportunity to buy the stock.

That goes for this one example. It’s a company I’d like to own. It

was cheap enough. It was not cheap enough, unfortunately, long enough

for us to invest this time, but I’m sure we’ll get another opportunity as it get

cheap again some time. And I think the reason why we are coming across

situations like this frankly now I think is because in the past we were

working on names that potentially had 60%, 70% upside, sometimes


-40-

names that had as much as in excess of 100% upside. Now we may work

on things that have 30% or 40% upside and seem to be heading in the

right direction. We do the work, but we don’t develop a dangerous

affection for the names as we research them and value them. We don’t

give in to the sink in cost bias. Only if the idea meets all of our qualitative

selection criteria and only if it’s cheap enough are we interested in buying

the stocks. Sometimes they don’t quite get there, and they erupt in value

before we can buy them or build a meaningful position. That’s what it is.

That sort of volatility I think where a name can rally double digit

within weeks or even days, having such narrow windows of opportunities,

that’s also characteristic of the environment that we have been dealing

with. It’s madness frankly. If you look at Accenture for instance, that stock

is up 17% from mid-October to year-end and was in close rank when we

bought it. If you look at G.U.D., that one is up by more than 25% I think

since December now. It’s a very, very difficult environment in that regard.

That’s the reality that we have to deal with, and there’s not much we can

do about it. We’re not going to change our philosophy, and we’re not

going to change our process.

We can always do things better though. And since we have a large

team now and since we are finding less actionable ideas, we can go back


-41-

and finalize, update, revisit these companies that we know best, these

companies that are on our best-of-breed list. We can go back to some of

the companies on our focus list even and refine our valuations, discuss

them internally, thereby sharing the knowledge we each have in these

companies or their sectors, and institutionalizing that knowledge. It gives

us an opportunity to challenge some of our conceived ideas on companies

and investigate further more recent developments.

We also look for new angles, for instance, cascade of holdings that

may provide additional discounts or a different type of securities even. In

short, we’re simply consolidating and expanding what we know to deal

with what’s proven to be a challenging environment for value guys over

the past few months. But it will not change the way we invest because of

it.

Ryan: So we have a question on the cash position on the Fund, and specifically

what is cash held in U.S. dollars, short-term U.S. Treasuries, etc.?

Pierre: And that essentially answers the question. I mean, the cash is essentially

in cash and short-term Treasuries. And as we said, it’s about 40% of our

assets now.

Ryan:


-42-

We have a few other questions that we haven’t gotten to, and

unfortunately we are running out of time. And so if it’s important that those

questions be answered, please just email us at [email protected] at

your convenience, and we will get back to you as soon as possible in

regards to those questions. And we apologize that we were not able to get

to all of the questions that were submitted and frankly not even all of the

questions that were pre-submitted for the call.

With that, thank you to our listeners. We would like to thank you for

your participation in the FPA International Value Fund’s fourth quarter

2013 webcast. We invite you, your colleagues, and your clients to listen to

the playback and view the slides from today’s webcast, which will be

available on our website, fpafunds.com within the next week or so. We

urge you to visit the website for additional information on the Fund, such

as complete portfolio holdings, historical returns, and after-tax returns.

Following today’s webcast, you will have the opportunity to provide

your feedback, and we highly encourage you to complete the portion of

the webcast. We do appreciate and review all of your comments.

Please visit fpafunds.com in the future for webcast information,

including replays. We post the date and time of the prospective webcasts

during the latter part of each quarter, and expect the calls will generally be


-43-

held three to four weeks following each quarter’s end. If you did not

receive an invitation via email for today’s webcast and would like to

receive one, please email us at [email protected]. We hope our

shareholder letters, commentaries, and these conference calls will help

keep you, our investors appropriately updated about the Fund.

We do want to make sure that you understand that the views

expressed on this call are as of today, February 3rd, 2014, and are

subject to change based on market and other conditions. These views

may differ from other portfolio managers and analysts of the firm as a

whole, and are not intended to be a forecast of future events, a guarantee

of future results, or investment advice. Any mention of individual securities

or sectors should not be construed as a recommendation to purchase or

sell such securities, and any information provided is not a sufficient basis

upon which to make an investment decision. The information provided

does not constitute and should not be construed as an offer or solicitation

with respect to any such securities, products, or services.

Past performance is not a guarantee of future results. It should not

be assumed that recommendations made in the future will be profitable or

will equal the performance of the security examples discussed. Any


-44-

statistics have been obtained from sources believed to be reliable, but the

accuracy and completeness cannot be guaranteed.

You may request a prospectus directly from the Fund’s distributor,

UMB Distribution Services LLC, or from our website, fpafunds.com.

Please read the prospectus and the Fund’s Policy Statement carefully

before investing. FPA International Value Fund is offered by UMB

Distribution Services LLC. Thank you again for your participation, and this

concludes today’s webcast.

[END FILE]

Documents

FPA International Value Fund Conference Call