FPA U.S. Core Equity Fund Second Quarter 2023 Commentary

Introduction¹

In the second quarter of 2023, the FPA U.S. Core Equity Fund’s (“Fund”) performance was 9.96% (10.31% before fees and expenses), which compares favorably to the 8.74% total return of the S&P 500 Index (SP500, SPX, “Index” or “S&P 500”). Year-to-date the Fund is up 21.54% (22.29% before fees and expenses) compared to the 16.89% total return of the S&P 500 Index.

The Fund’s outperformance in the first half of the year is mostly attributable to its exposure to the Information Technology, Communication Services and Consumer Discretionary Sectors, which saw an increase in eachsector’s performance by 42.06%, 35.58% and 32.33%, respectively.²

The 10-year U.S. Treasury yield increased in the second quarter from approximately 3.5% to 3.8%.^[3] This slight upward move in the 10-year U.S. Treasury yield did not phase the stock market. The strong appetite for equities has been in part fueled by the tech sector thanks to the market’s focus on the growing adoption of artificial intelligence (AI) and electric vehicles (EVs). In fact, two companies (not in the portfolio in 2023) that are prime beneficiaries of these respective trends, Nvidia (NVDA) and Tesla (TSLA), accounted for approximately 21% of the S&P 500’s return in the first half of 2023 despite only making up about 2.3% of the index’s composition at the beginning of the year.^[4]

It is worth reiterating that the yield curve remains inverted with six-month and one-year treasuries both yielding approximately 5.4% at the end of the quarter. I am very thankful that the Fund has outperformed the index in the first half of this year despite holding approximately 10% cash and equivalents, writing covered calls that impacted the Fund’s return by -1.70% and not owning NVDA or TSLA, which have added a combined 3.55% to the index’s first half return.

For more risk-averse investors, one gets paid to sit on the sidelines. Therefore, the Fund has its largest exposure to U.S. Treasuries (approximately 10%, all maturing within 6 months) since I have been managing the Fund over the past seven plus years. I believe this conservative posture including covered calls will contribute positively to the Fund’s performance throughout the remainder of the year.

My hope is that as we patiently wait (and get paid a reasonable return in the meantime) for a possible recession to play out in the future, we will get potentially better valuation entry points into various equities on my wish list. I believe secularly growing mid- to large-capitalization companies trading at compelling valuations will continue to be a favorable place to invest for the long-term-even relative to U.S. Treasuries and other investment alternatives.

Portfolio Commentary⁵

During the second quarter, I continued to make some changes to the portfolio to seek to best position it for future success. To that end I eliminated four positions that made up 4.4% of the March 31 portfolio, increased the weighting of the 50 remaining positions by 1.4% to 86.1%, and added six new positions representing 4.1% of the June 30 portfolio. These new positions are in companies I have been following and that were on my wish list to purchase. They are not at full position sizes yet, and thus I am willing to add to them should the risk/reward make sense to do so.

As of June 30, 2023, the Fund was invested in 56 companies (all of which are disclosed), including 40 investments that are in the S&P 500, which made up 78.2% of the portfolio. Moreover, the 40 disclosed positions in common made up 38.8% of the S&P 500’s weighting as of June 30, 2023. A majority of the 40 positions were overweight in the Fund relative to the Index. The Fund’s remaining 16 investments were mostly large-cap U.S. and foreign companies. Combined, those 16 companies made up 12.0% of the portfolio.

In terms of geography, 84.9% of the portfolio was in U.S. companies, while 3.8% was in foreign equities, as of June 30, 2023. By market capitalization, 89.4% of the portfolio was invested in large-cap companies with market values above $10 billion, with about 57% invested in mega-caps (companies with market values above $200 billion). The Fund’s weighted average market cap was approximately $1.0 trillion, while the Fund’s median market cap was approximately $84 billion.

Regarding portfolio concentration, the Fund’s top five positions made up 43.5% of the Fund compared to approximately 24.9% for the S&P 500. The Fund’s top 10 positions made up 52.4% of the portfolio versus 33.9% for the Index. Over time, my goal is to continue to increase the weighting of some of the Fund’s smaller positions as valuations become more compelling.

From an industry exposure standpoint, the portfolio had disclosed investments in nine of the 11 sectors in the S&P 500. Combined, those nine sectors made up approximately 95% of the S&P 500 and 90% of the Fund’s portfolio. Relative to the S&P 500, the portfolio is overweight communication services, consumer discretionary, and financials while it is underweight information technology, health care, industrials, energy, consumer staples, and real estate. At the end of the quarter, the Fund did not have any investments in utilities and materials, which made up approximately 5% of the S&P 500.

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Compared to the broader market, I believe the Fund’s portfolio is of higher quality and has greater potential for revenue and earnings growth.⁶

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Q2’23 Winners and Losers^[12]

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MAAAM (Microsoft (MSFT), Alphabet (GOOG), Apple (AAPL), Amazon (AMZN), Meta Platforms (META)) continued its outperformance for the year posting another strong quarter. Whereas the momentum for these companies in the first quarter seemed to be largely tied to news of being more efficient in their cost structure, the second quarter was mostly about AI adding another element to their future expected growth.

I first identified AI as a long-term economic growth driver in the beginning of 2020 and discussed it in the Fund’s first half 2020 shareholder presentation.^[13] I chose to play this tailwind predominantly through our investments in GOOG, MSFT and AMZN. I highlighted AI among other secular drivers including the internet of things (such as wearables, digital assistants and digital media devices), autonomous vehicles, smart cities and factories as well as quantum computing that should continue to help fuel enterprise cloud adoption through 2030 and beyond. On top of that the AI powering digital assistants such as MSFT’s Chat GPT and GOOG’s Bard could spur new revenue streams and potentially enhance or complement existing ones.

While it does not show up in the above table, the largest detractor to performance in the quarter was covered calls written against our AAPL position. While AAPL’s net contribution to the Fund in the quarter was 0.96%, AAPL contributed 1.77% while covered calls on AAPL cost the Fund -0.81%.

AAPL began the 2nd Quarter 2023 trading at 25.1x FY2024E EPS. The share price increased nearly 18% in the ensuing three months and finished the quarter trading at 29.6x FY2024E EPS. AAPL is a great company and I expect it to grow its revenue in the mid-to-high single digits over the next few years. However, as valuation expands, there is generally more risk to an investment.

These are exciting times. As an investor the tough part is balancing wanting to be invested in these dynamic companies while their valuations have risen to the point where it warrants some caution. This helps explain the Fund’s posturing holding approximately 10% cash and equivalents along with writing some covered call options on certain positions. I would rather be somewhat conservative, giving up some potential upside to help protect downside-especially in an environment where we can earn over 5% in short duration (one year or less) Treasury bonds.

Closing

I am optimistic that the Fund will generate good absolute and relative returns compared to the S&P 500 going forward.

I look forward to continue delivering value for fellow shareholders. Thank you for your confidence and continued support.

Respectfully submitted,

Gregory R. Nathan

Portfolio Manager

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