May 23, 2014

Steven Romick, Morningstar’s 2013 Allocation Fund Manager of the Year on why he is holding large sums of cash in his FPA Crescent Fund.

Consuelo Mack: This week on WealthTrack, Why is Great Investor Steven Romick hording mounds of cash and other safe, money type securities in his award winning FPA Crescent Fund? Contrarian Romick explains why he isn’t putting his cash to work in the market, next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. Holding cash is considered by most professional investors to be one of the worst investment choices you can make right now. It yields next to nothing, as it has for the last five years largely because of Federal Reserve and other central bank policies that have kept short term interest rates at record lows. And when inflation is taken into account cash is actually a money losing proposition. There is however a small minority of investors who value cash and are not afraid to hold large amounts of it and its equivalents when conditions warrant. Warren Buffett is probably the most famous among them.

This week’s Great Investor guest is also one. He is Steven Romick, lead portfolio manager of the five star rated FPA Crescent Fund which he launched more than 20 years ago. Romick and his team were named Morningstar’s Allocation Fund Manager of the Year in 2013 because of their “capital preservation and strong stewardship which helped the fund achieve its goal of delivering equity like returns with less equity risk over the long haul.” Since its inception this go anywhere, invest in anything fund has delivered better than 11% annualized returns besting the stock market and its balanced portfolio benchmarks by substantial margins. Romick, a proud, self professed contrarian value investor has been a vocal critic of the Federal Reserve’s unprecedented monetary expansion and has become increasingly wary of the rich levels of prices in markets around the world. In quarterly letters to clients he has pointed out several indicators of just how expensive markets have become. One of the most dramatic is this chart sent to clients in his last annual letter showing stock prices as a percent of GDP. As you can see the value of stocks was worth more than 200% of the economy’s total output of goods and services rivaling the market peaks of the dot com bubble. As the markets have appreciated in recent years Romick has been reducing his stock and bond exposure and raising his cash positions to the second highest point in the FPA Crescent fund’s history. I asked him why.

Steven Romick: We’re not that optimistic. It’s not that we’re pessimistic. I don’t want to confuse the two. It’s not a target rich environment, and multiples in the market are higher than average, and there’s real risk out there from central bank action. How it all ends, we don’t know. We don’t know with all the trillions of dollars that have been used in some type of academic arguments, but hopes that it alchemizes into reality has yet to be seen. So we don’t know we’re going to have inflation, if so, how much, when? We don’t know if we’re going to have deflation. If so, you know, when that might occur. And so we have a portfolio today that’s kind of betwixt in between and we’re trying to create it in such a way that it’s robust in more than one scenario, because we have the ability to do more than most. One might say we have more than one way to lose money because of that, but nevertheless, we like to look at it as opportunistically as we can and say we can buy common stocks, preferred stocks, junior debt, senior debt. We can buy containerships, we can invest in different parts of the world, and it gives us a lot of opportunity to lift different kinds of things. When we look across the world today where we have zero interest rate policy in so many of these developed economies, it pretends to convert capital allocation decisions, and as a result asset prices get lifted and we find less opportunity than we have historically found. So at the end of the day, price is going to be our guide. And so you can have a terrible outlook, but as long as the assets you are considering purchasing have that bad outlook priced into them, then it’s fine. So the problem we have today is we have concern about the future for some of the reasons I mentioned, and yet the assets aren’t really taking that into account. So the risk reward for individual investments on a micro basis are not terribly attractive. So cash builds for us as a byproduct of what it is that we do, not as a top-down. “Oh, the world’s expensive so let’s go have a lot of cash.” One thing I’m confident in today is that there will be greater volatility in the future than there has been most recently.

Consuelo Mack: Right. Because we’ve had very low volatility. Why do you think there’s going to be more volatility?

Steven Romick: Well, there’s never been a point in time in history where governments have been able to really get together and say, “Hey! Let’s go and manage the economy by doing all of these things.” We’ve got a four trillion dollar, you know, fed balance sheet that has to contract at some point in time.

Consuelo Mack: So we’re seeing a gradual pullback, at least in this country, and yet volatility has not increased. So is it possible that we could have kind of a soft landing of the withdrawal of central bank easing?

Steven Romick: Sure, everything’s possible. I mean, Kermit the Frog married Ms. Piggy. Nobody thought that would happen. (Laughter) So yeah, anything could happen, although I think it’s unlikely. I think that, you know, we’re challenged by the idea that the government can really manage this in such a way. And you spoke to contraction and quantitative easing, and we haven’t had any great effect yet. However, it’s really a three part process, because we built up the balance sheet, so now what we have to do is A, they’re going to start by reducing asset purchases. Then second, they will stop asset purchases, and then third, they’re going to have to find somebody else to re-fly out the balance sheet as the balance sheet unwinds as those loans that they purchase, or whatever it is they purchase, you know, come due. So there’s a lot that still is yet to come, and we know with quantitative easing is something none of us even heard of a decade ago or ever thought about, and now we’re depending on it. It’s a little bit like we know we’re addicts. I mean, my partner Bob Rodriguez calls it Red Bull Economics. You get all jacked up on the Red Bull and then anything can happen.

Consuelo Mack: How are you managing your cash now versus what you would have done traditionally?

Steven Romick: Well, in the past we were more commercial paper with a little bit of US treasuries, and then as we got into 2008 we started backing away from treasury securities. And we really focused more on US treasuries, just because we weren’t getting paid to play, we weren’t getting paid in the risk, there were too many questions out there, and we questioned the treasury function in some of these companies. It wasn’t an analysis we wanted to make at the end of the day. We wanted to analyze businesses and know that we were buying those businesses or assets at good discounts to what the underlying value was to give us the margin safety, if you will. And we didn’t want to have to make that analysis in the case of commercial paper, so it was a why bother? They’re not getting paid for an equity rate of return so let’s just not worry about it, so we owned US treasuries. So since then we have less of that concern, so commercial paper has come back into the portfolio, and we’ve also gone overseas into certain other …

Consuelo Mack: Some sovereign debt, right?

Steven Romick: Some sovereign debt, and we’ve actually hedged out some of their currency risk, but we still have the sovereign risk, but we’ve actually been able to, in the one case we’ve really done it, in any kind of size been able to actually get higher rates of return than we could even after hedging out the US dollar.

Consuelo Mack: Which is in Australia?

Steven Romick: Singapore. Nearby.

Consuelo Mack: So why are US treasuries no longer the most prudent course?

Steven Romick: Well, for us it was just a question of we think that there’s other places you can do just to protect your capital. I mean, the US treasury market, we didn’t think anything was likely to happen, but you know, in this case diversify is a good thing.

Consuelo Mack: You’re a contrarian investor and you’re very proud of that fact. So are there any contrarian investments out there now that are catching your eye? You know, where else is there to go but cash?

Steven Romick: There have been a few places we’ve been finding to invest in. The problem has been, the reason why cash is built, there hasn’t been enough to create a whole fully invested portfolio. So in the last six, nine months we built a position in the aluminum industry. Aluminum is trading at an historic low, inflation adjusted low, particularly since such a large percentage of the cost of aluminum … aluminum production or energy, and energy costs are a lot higher today than they were a decade ago.

Consuelo Mack: So I know Alcoa, for instance, is one of the …

Steven Romick: And Alcoa is an interesting one because everybody who follows Alcoa, the Wall Street analysts, are metals and mining analysts, and what tended to get lost in looking at Alcoa was that the largest portion of its value was not the stinky, smelly, polluting aluminum business, but was the engineer product solutions business where they are really one of only two people in the world to manufacture these aerospace suppliers, you know, with these highly engineered products that really don’t use much aluminum at all. I mean, more than 90 percent of it are specialty alloys and titanium, so Alcoa, you know, as an aluminum company, it’s most valuable division does very little in aluminum. And people weren’t valuing that correctly, because the wrong people were looking at it. And so that gave us an opportunity to invest in Alcoa back last fall, and we were able to … what we viewed at the time, given the terrific value for the engineering product solutions business whose largest competitor is Precision Castparts … you know, Precision Castparts at the time traded 14 times EBITDA, and we weren’t going to even apply multiples like that to this business, even though we would argue it was as good or is as good as Precision Castparts business. Even at a discounted value, we had a huge option on the turn of aluminum. You know, we didn’t know what aluminum would turn. Will it turn? Will it turn? But we do know that half of the capacity in the world is losing money, so only half of the aluminum in the world actually makes money today, so you either need to see supply, contract, which is happening, Alcoa is closing its melting capacity today as well, or you need to see terrific demand growth, and we are seeing demand growth as well. If you look at the back log for airplanes, for example, it’s an eight year back log, about as high as it’s ever been, and they’re big users of aluminum for skin and other parts of the airplane, as well as you see it really at the margin move in the automotive industry. So you can think of examples in GM or Ford where you see increasing amounts of aluminum use. They’re putting 300 pounds more of aluminum in a Ford F150, which will save 1000 pounds of steel, which makes these cars lighter, easier to handle, and also makes these cars more apt to meet EPA requirements.

Consuelo Mack: How does Alcoa Aluminum get on FPA Crescent’s screen?

Steven Romick: Well, we can thank Brandon Stranzl for Alcoa specifically, who’s on our team.

Consuelo Mack: One of your research analysts?

Steven Romick: One of our research analysts. And, you know, the way he got to it … look, we’re in the business of looking for bad news, in very simple terms. So whenever you see stocks that are making new lows or you see headlines that say, “Well, you know, aluminum is dead. Aluminum pollutes. You know, aluminum capacity closing. Alcoa in trouble. Versall(?) in trouble.” I mean, you see those kinds of headlines, we say, “Hmm, there’s lots of bad news. There’s probably natural sellers, so maybe we can go and take advantage of that.” One of the things that we bring to the table, we believe anyway, is time arbitrage. We’re very patient as investors. We patiently wait for the opportunities that we’ve patiently researched, and we patiently wait for those opportunities to work out. So the bad news today is not unrealistic. It’s fair. I mean, the aluminum business is challenged today. However, we’re comfortable looking out a number of year, and it won’t be as challenged in the future. And so if we’re patient and we can wait for that opportunity or the valuation to reset, you know, down the road, and as long as we can get what we feel is a good IRR between now and then, we’ll look to go in and invest in those kinds of businesses.

Consuelo Mack: So do you tiptoe in? Do you gradually build positions?

Steven Romick: Sometimes.

Consuelo Mack: Or it just depends?

Steven Romick: Sometimes we have to get to know the business better over time. It takes time to get to know these businesses. Sometimes we have a very strong understanding at the get go, or we’ve invested in that business before. At the end of the day it’s a combination of understanding and price. Understanding, conviction and price, I should say.

Consuelo Mack: Looking around the world, where else is everyone running from?

Steven Romick: I don’t know they’re running from a lot of places. I mean, there’s not a whole swath of businesses that are out of favor.

Consuelo Mack: Well, they’re running from the emerging markets, for instance.

Steven Romick: Right, but emerging markets are …

Consuelo Mack: Russia.

Steven Romick: Yeah, emerging markets in general are areas that the multiples have contracted a bit and stock markets have declined in emerging markets. However, more of that decline has really been the result of commodity based companies, more cyclical companies and finance companies. And these are businesses that we aren’t as interested in in many of these markets.

Consuelo Mack: Because they’re just too cyclical?

Steven Romick: We prefer on average doing a higher quality business. And in the case of Alcoa, the aluminum smelting business wouldn’t be as high quality. The EPS business, that engineering product solutions business is very, very high quality. So we want to own these higher quality businesses, and the higher quality businesses in emerging markets aren’t trading at big discounts. You mentioned Russia. We have a small stake in Russia. I mean, Russia’s interesting, because it’s obviously quite combustible over there right now, and it’s unusual because people are running in fear, and when looking at Russia, you can look at a lot of companies that are actually of strategic importance to the state as well as to the globe. So something you couldn’t say about Venezuela, for example. There might be businesses that are important to the state, but not as important to other countries around the world.

Consuelo Mack: Right. I mean, they’ve got these giant energy producers, for instance.

Steven Romick: Exactly. They’re the largest, the largest hydrocarbon producer in the world, and as far as public companies are concerned, they have the largest reserves in oil in Rosneft and the largest reserves, as you mentioned, in Gazprom in gas. And it’s of strategic importance to the state because energy accounts for 25 percent of Russian GDP. It’s 50 percent in Russia of their annual revenues, and representing its strategic importance to the state and how important it is to their neighbors, it counts for 60 percent of their exports. So we understand that there’s risk there. However, these companies are trading at very large discounts to other companies of their ilk. You know, in Exxon, for example. So these large discounts, you know, justify the risk of owning some of these companies in Russia, which has an uncertain future. Not that Russia’s future is so uncertain over the long term, but shorter term those correlate some questions, but that’s what created again these natural sellers which allows us to come in and do some buying. But what’s interesting about looking at Russia is that people there seem to be less concerned. There’s massive insider buying in some of these companies. In the last 12 months in Lukoil, for example, there’s been a billion dollars purchased from insiders. One may question where they got a billion dollars, you know, but we look at these Russian companies, you know, there’s a fair amount of taxation that goes on by the Russian government, and there’s probably another … call it less official means of taxation in the from of, you know, more nefarious activities occurring within the companies. However, the earnings we see are audited by legitimate companies and these earnings that we’re seeing today are already met of both forms of taxation, and they’re cheap on that basis. So as long as things don’t get worse in that regard, we can be pretty comfortable with these companies that we’re buying at these prices today.

Consuelo Mack: So it really is because of the prices? Because I mean, it would make me nervous as an investor to know that you are in basically a thugocracy, as someone told me, with Putin running Russia, and you know, heads of companies get thrown in jail at any given moment if they get too powerful. So for someone who’s most concerned about avoiding the permanent loss of capital, and you always say that your defense is more important than your offense …

Steven Romick: There’s no argument that this is a complex country with an authoritarian regime. There’s no argument there. However, again, we feel that price is the guide, and we argue we do play defense first. We think about it in terms of the whole portfolio, so it’s a defensive portfolio. If you’re not willing to lose a little money along the way in certain investments, you’re not going to make money either. So there’s no chance you’re going to go through life and not lose money. So if you size positions correctly, and we believe that our investments in Russia are sized appropriately. Not to say they won’t increase somewhat, but it’s never going to be the largest part of our portfolio for sure for some of the reasons you’ve mentioned, but we certainly are willing to accept some risk attached to that. And don’t forget, you can’t steal from something that’s insolvent, the country needs these companies to continue to spew off cash. Again, 25 percent of GDP, 50 percent of Russian government revenues, so you need these companies to continue to renew throw off cash flow to fund whatever the regime wants to do.

Consuelo Mack: One of the things that you and I have talked about in the past is that you look for companies that you call compounders, and these are companies that you know you’re definitely going to make money. The question is not if you’re going to make money, but it is how much money you’re going to make, and in five to ten years they’ll be worth a lot more than they were today. So what are your favorite compounders in the FPA Crescent portfolio right now?

Steven Romick: Well, one example of a compounder would be a company called Meggitt PLC. Meggitt is an aerospace supplier, and we actually like the aerospace industry. I mean, you’ll have growth in passenger traffic. You know, 3 to 6 percent over the next 10, 20 years. That’s a nice place to start from. Airline traffic is going to increase around the globe for a number of reasons, not the least of which is growth in emerging markets, growth in population, as well as growth and increase in wealth. More people will fly, more airports are built, you know, and it all feeds upon itself and you’re going to see a lot of that over the next ten, 20 years. So to find a company like a Meggitt, which is dominant in the wheel and brake business, and they have a number of other businesses, but the biggest portion of the profits comes from wheels and brakes. They have more than 50 percent share in the regional jet market as well as the business jet market, where in those two markets they are single source. So a company, an OE, an original equipment manufacturer, will go and contract with a Meggitt or somebody else, and hopefully Meggitt in our case since we own Meggitt, and will contract with a Meggitt, and Meggitt basically gives them the wheels and brakes for free, because they make all their money in the after market, and there’s huge margins on that. And these products get priced as the wheels wear out and parts break, and you know, they get price in this over time, you know, ahead of inflation. So it ends up being a terrific thing, and you’d have terrific confidence that you can get a vision for what the earnings will look like in the future.

Again, to your earlier point as we think about compounders, we can’t know exactly what they are, but this is a company that we felt was going to grow at a very healthy clip that generates a lot of free cash flow. We hope that management makes intelligent acquisitions and uses of that capital, which there’s no guarantee of that, and the risk out there for Meggitt would be how they spend their capital, because they’re an inquisitive company. They’ve done a reasonably good job historically, but the fact is the returns on capital for their core organization, you know, and for the business are very, very, very high, and that’s what we want them to focus on and buy shares back intelligently as prices permit. So as we think of the future as we look at Meggitt, we think that five to ten years from now this is going to be a better business than it is today, and as long as the multiples at least maintain we’ll do very well, and given the fact we bought a company at a discount to the market, there is some option out in the multiple. That’s not something we’re counting on.

Consuelo Mack: We always ask all of our guests at the end of the interview is if there were one investment we should all make in a long term diversified portfolio, and you can never recommend your own fund, what would it be?

Steven Romick: You know, it’s interesting today. I actually see today as being more opportunities in the private sector than there are in public. I mean, where there’s more inefficiency, relatively speaking, is in the private sector, which is why in our fund we also invest in certain illiquids, and we’re able to make certain real estate loans and get low … (Overlapping Voices)

Consuelo Mack: Real estate loans.

Steven Romick: First lien real estate loans. We partner with a AAA real estate investor to make first lien real estate loans. And we’re getting low teens, you know, IRRs … expected IRRs, I should say … on these loans, and we’re very excited about it, given the good loan to values that we have. And I think that for an individual investor, I think at this point in time, one needs to be wary.

Consuelo Mack: One of the things that you and I had talked about the last time you were was you were also investing in farmland, in private partnerships that had invested in farmland. So these are in liquid, they’re long term investments, they’re a very small part of your FPA Crescent portfolio, but that’s the kind of things that you are having to get involved in because there are so few other opportunities out there.

Steven Romick: Yes, but I would also say it’s more than that, because in the case of farmland, which we first invested in a number of years ago, and it’s not as inexpensive as it was.

Consuelo Mack: It’s definitely appreciated.

Steven Romick: So it certainly is work … it’s not just a question of so few opportunities out there, but we like the way that investment would behave in a number of different scenarios, not the least would be inflation, decline in fiat currencies, so we felt it made sense within the portfolio. But it wasn’t just because we couldn’t find investments elsewhere. Same thing with the real estate loans. I wouldn’t say that we wouldn’t own these real estate loans in a different environment where there was more opportunity, because we very well might, depending upon what was there, what was available elsewhere. Because these real estate loans, I mean, our goal is to provide equity rates of return to our clients, and to do so in the void of permanent capital along the way. And if you can go and get low teens IRRs, as we think we’re getting on these real estate loans, then why not? And we’ll take that all day long. And it’s not going to have the same kind of volatility as other investments might, won’t get the same market to market risk, you know, in the portfolio day to day, and we miss clip coupons for a few years.

Consuelo Mack: And last question: What would get you more interested in investing some of your cash?

Steven Romick: Again, it’s bottoms up, and we talked about a couple of themes. Aluminum was one. You know, Russia was an example that you brought up. And so it could be thematically driven, where we see areas of the world or asset classes or industry groups that fall out of favor or individual companies having a little stumble along the way.

Consuelo Mack: So Steven Romick, it’s always a pleasure to have you here on WealthTrack, so thanks very much for joining us.

Steven Romick: Thank you.

Consuelo Mack: At the close of every WealthTrack we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s action point: keep a stash of cash in your portfolio. Cash has become a dirty word in most investment circles because it yields close to nothing right now, but it has other redeeming virtues that make it a must have asset. Cash adds ballast to a portfolio in choppy markets. While other investments rise and fall, it provides stability and protection. It adds liquidity and opportunity. Cash can be put to use in a moments notice, especially to buy when others are selling. And it provides a psychological advantage: Fairholme Fund’s Bruce Berkowitz calls cash “financial valium.” It keeps him calm when others are panicking. Next week is the start of one of public television’s fund raising drives so WealthTrack might be pre-empted in some markets. We are therefore revisiting an interview with another Great Investor and Morningstar fund manager of the year, the Royce Funds’ Charlie Dreifus will explain why a small-cap manager is also investing in large cap stocks. Please go to our website to hear our extra interview with Steven Romick. Also visit our new WealthTrack women section. We will have updated financial advice specifically for women from our panel of award winning women financial advisors. In the meantime as you enjoy your Memorial Day holiday take a moment to remember all of the soldiers who sacrificed throughout our country’s history to make our precious freedoms possible. We owe them our undying gratitude. Have a lovely weekend and make the week ahead a profitable and a productive one.

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