While headlines blare about recession anxieties and market turbulence, seasoned investor Steven Romick and his team at FPA Crescent are subtly but strategically adjusting their portfolio. These moves, barely hinted at in their Q1 2023 earnings call, may hold the key to how this firm, renowned for its value-driven, long-term approach, is preparing for the economic uncertainties ahead.

One word echoed throughout the call, a word that often makes even the most seasoned investors shudder: credit.

It's widely known that Crescent has drastically cut its high-yield exposure over the past few years. Romick himself highlighted during the call that their high-yield allocation plummeted to a mere 0.2% in Q4 2021, a stark contrast to their historical averages – 4% over five years and a significant 9% over the long term. The rationale? Historically low yields and narrow credit spreads simply weren't offering the risk-reward balance aligned with Crescent's investment philosophy.

However, the present paints a slightly different picture. While still cautious, Romick and his team see a glimmer of opportunity in the credit markets, particularly in busted convertible bonds.

These often-overlooked instruments, typically issued by companies with promising but unproven business models, have been hit hard by the recent market downturn. As their underlying stock prices have tumbled, many of these convertible bonds are now trading at significant discounts, offering enticing yields to maturity. This presents an alluring prospect for patient investors like Crescent.

Consider this: Romick revealed that the unweighted average yield to maturity for the busted convertibles currently in their portfolio stands at a substantial 11.5%. This is a whopping 310 basis points higher than the 8.4% yield offered by the broader high-yield market. In a yield-hungry environment, this spread is hard to ignore, especially given the potential upside of a turnaround in the underlying businesses.

However, Romick's team emphasizes their characteristically conservative approach to these investments. They meticulously scrutinize each bond, carefully assessing the underlying business's long-term enterprise value and its position in a potential restructuring. This rigorous process underscores their commitment to downside protection, even when exploring the higher-yielding segments of the credit market.

Why This Shift Matters

The move towards credit, particularly these distressed convertibles, is more than just a tactical adjustment. It potentially signals how Crescent interprets the current economic climate. Here's why:

Historically, Crescent has ramped up its credit exposure during periods of market distress. The 2008 Financial Crisis saw their credit allocation soar to around 30% as they capitalized on widespread fear and mispricing. While the current environment doesn't mirror the severity of 2008, the rising credit exposure suggests that Romick might see a similar opportunity emerging. Focusing on busted convertibles aligns with their contrarian value approach. These instruments are often out of favor and disregarded by the broader market, potentially leading to mispricings and attractive risk-reward profiles. This maneuver could indicate that Romick is bracing for a period of slower economic growth. Credit investments, especially those managed with a value-oriented approach, can provide income and stability to a portfolio potentially lacking in a volatile equity market.

Crescent's Portfolio Allocation: Q1 2023 vs. Historical Averages

Source: FPA Crescent Q1 2023 Earnings Call Transcript

Decoding the Signals

While Romick and his team refrain from making explicit market predictions, their actions speak volumes. The quiet accumulation of busted convertible bonds, barely a whisper in a torrent of questions about tech giants and AI, might be the most telling takeaway from the entire earnings call. This subtle shift in Crescent's portfolio could be a canary in the coal mine, indicating a move towards a more defensive stance as the economic outlook remains uncertain.

Only time will tell if Romick's bet on busted convertibles will pay off. However, one thing is certain: when this investing luminary makes a move, it's wise to take notice.

"Fun Fact: Steven Romick has managed the FPA Crescent Fund since its inception in 1993, expertly guiding investors through various market cycles and delivering impressive long-term returns for over 30 years."