Transcript: Steve Romick 10-19-12 #917

October 19, 2012


#917- 10/19/12


CONSUELO MACK: This week on WEALTHTRACK, Great Investor Steven Romick describes the balancing act necessary to keep his five star FPA Crescent Fund on its top performing route, as he juggles the forces of inflation and deflation, Fed easing, and the fiscal cliff. A rare interview with Steven Romick is next on Consuelo Mack WEALTHTRACK.


Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack. This week we marked the 25th anniversary of the 1987 market crash. On October 19, 1987, Black Monday as it is known, Wall Street felt as if the sky was falling. The Dow dropped by 508 points that day, a stunning 23% plunge which still remains the largest percentage drop in history.


But as one looks back it doesn’t seem nearly as scary. The Dow actually closed about two percent higher on the year and since then the market has had an incredible ascent from that Black Monday close, experiencing more than a seven fold increase to today’s levels. From this perspective, the 1987 experience looks relatively benign, especially considering the prolonged bear markets of the early 2000’s and more recently, the financial crisis induced 54%  peak to trough decline in the Dow from which we are just now recovering.


One of the hallmarks of Great Investors is their ability to adapt to changing circumstances and not lose their focus while doing so. The famous Rudyard Kipling poem “If” says it best:


“If you can keep your head when all about you

Are losing theirs…

If you can trust yourself when all men doubt you…”


This week’s guest has proven his mettle in many different market conditions over the years. He is Steven Romick, portfolio manager of the FPA Crescent Fund which he launched in 1993. Over the last ten years, it has delivered about 10% annualized returns, placing it in the top 2% of its fund category. The go anywhere, invest in anything fund is rated five star by Morningstar and Romick was also a finalist for its Fund Manager of the Decade Award. I began the interview by asking Romick what’s really changed for investors since the ’87 market crash a quarter of a century ago.


STEVEN ROMICK:  25 years ago it was a very relatively narrow world. I mean, I think that it was confined. Investors kind of invested slightly inside of a walled garden. So in the 1980s index funds were the rage and you had large cap stocks. And managers would invest in large cap stocks or small cap stocks. It was growth. Stock managers weren’t buying bonds, bond managers weren’t buying stocks. You were either international or you were domestic. People weren’t doing all those different kinds of things. And there weren’t a lot of different types of markets and asset classes available to people back then, as there are today.


So this walled garden; the walls have kind of come down. And I guess metaphorically you kind of look at the Berlin Wall was up at the time as well. So that fell; this walled garden’s kind of walls have fallen as well. And you can now go outside the garden and see other types of asset classes and areas in which to invest which didn’t exist before. So the expertises that had to be developed over time in order to do that, and this is how we’ve developed in our team, to attack each of these things.


But back in the ’80s, junk bonds really were still a nascent industry. They were bonds issued below investment grade or at just barely investment grade, and they hadn’t gone through a cycle yet. And now you’ve seen a few different cycles. You can what can happen and you can see what it’s like to work through a restructuring process. And so we had to develop an expertise to kind of go and do that. You couldn’t go and invest in public funds. There weren’t many people investing in less liquid investments, as we have come to do, by investing.


CONSUELO MACK: Like private equity, or?


STEVEN ROMICK:  Well, like farm lands. We’ve invested in farm land in the fund. And through the funding and getting the backing, providing the backing to a private REIT and helping them get off the ground.  And this is a scenario that we believed in. Or purchasing subprime whole loans directly from the lending institutions, who, I would argue, are for sellers. So this whole world of expertise and breadth of investing that didn’t exist back then that we have the availability to invest in today. Most people don’t take advantage of it. That’s one of the things that’s a little bit distinct about what we do at the FPA Crescent Fund


And not to mention the world’s obviously become a whole lot smaller. I mean, at that point in time, in the ’80s, the U.S. was by far and away the world’s biggest economy. It’s still the largest, but you obviously have a rapidly increasing economy in China that’s approaching the U.S., and in addition to that, that’s where some of the biggest companies in the world are. The biggest beer company in the world’s now based in Brazil, Anheuser-Busch. You sell more cars in China than anywhere else in the world. And the largest casinos, as measured by kind of cash flow per location, are now in Asia. So the world’s smaller. By not considering how to move offshore and look at other types of investments, I think that as a value investor, I think we’d be kind of shooting ourselves in the foot.


CONSUELO MACK: One of the big changes that you told me about when I pre-interviewed you was how much macro matters, and policy matters now. And so what difference has that made in how you invest, as well?


STEVEN ROMICK:  Well, I’ve come to realize over the years that by being unaware of the macro backdrop, you really are setting yourself up for potentially some pretty large mistakes. So if you, for example, weren’t aware what was going on with the easy lending cycle, in the mid-part of the last decade, that led to the whole subprime crisis, you really end up losing a lot more money than you had to, at least on a mark-to-market basis in 2008.


CONSUELO MACK: And so, because one of the things, and I’m going to quote one of your reports to shareholders, is that you call it the ‘grand experiment of printing money and government debt proliferation, which could lead to a disastrous ending.’ So how much closer are we to a disastrous ending, and what is the disastrous ending that you could envision happening?


STEVEN ROMICK:  Well, for every dollar that we keep printing and dumping, it gets us closer to, that it actually ends up– a lot of people use this metaphor, of kicking the can down the road and making problems to be something you have to deal with later. I think that’s really probably a fairly inaccurate metaphor, because I feel it’s really a snowball, gaining forces. It rolls and gets bigger because it goes downhill. And I think that’s the problem, is that the more money you throw at this problem– think about all the money we’ve thrown at the problem so far. And think about how little we actually have to show for it in terms of employment, in terms of economic growth. And yet the Fed’s goal is just to lift asset prices, with this idea that we’re going to have it all trickle down. People have these assets are going to feel wealthier and they’re going to spend more in the stores, and the stores are going to hire more employees and the stores are going to order more from the manufacturers to replenish inventory. And this is going to work all the way down and it’s all going to be a beautiful thing.


Well, I just don’t see that happening. And meanwhile, I think it just erodes the confidence in fiat currencies. And I don’t honestly know how it ends. I really truly don’t. There’s going to be unintended consequences. But I think a lot of people such as myself are very comfortable that we’re, sadly, on the wrong path, and what makes us feel less comforted and more secure in that statement is that just like at what Mr. Bernanke says about what I call the grand experiment, and as a quote recently of Mr. Bernanke’s where he says, “learning by doing.”


CONSUELO MACK: Learning by doing. We had Jim Grant on a couple of weeks ago talking about that. I mean, what is this learning by doing business?


STEVEN ROMICK:  It scared me. Look, we don’t know. Again, we could end up with inflation, because of all the expansion of the monetary base could lead to a lot of inflation at some point in time. It’s entirely possible. On the other hand, it could end up freezing the economy, as we take away levers that we’ve historically been able to pull, if the economy tilts back into recession, we have less room to work with. And if China rolls over at the same time, then we could end up with deflation.


CONSUELO MACK: So let’s talk about how you navigate that at FPA Crescent, because I think you’ve called this period like a purgatory for investing.


STEVEN ROMICK:  Yes, it feels like hell.


CONSUELO MACK: Oh, even more, it’s even worse than that. So how do you navigate these conflicting forces of deflation and inflation?


STEVEN ROMICK:  Positioning the portfolio is vastly different for an inflationary book versus a deflationary book. In an inflationary book, if you think that there’s going to be a lot of inflation, you don’t want to have any cash. Right? Because inflation’s just going to erode cash. And so the cash would be pretty bad in that environment. But if you’re going to bet on deflationing, that that’s going to occur, then cash actually will do pretty darn good. And stocks won’t do particularly well, and bonds won’t necessarily do well, either, since you’re already dealing with pretty low rates. But long bonds will clearly be worse in a more inflationary environment. So it’s difficult.


So what we’re trying to do is we’re trying to make our portfolio not robust to any one scenario. We’re trying to buy, at this point in time, the highest quality businesses with the best balance sheets with more of the businesses than not with global franchises. And we’re looking to kind of navigate this turbulent time, what we think will be a more turbulent time in the future, by owning these very stable businesses, that we think that in a downturn, we’re very comfortable buying down.


But most important for us is understanding our businesses. And understanding what the right valuation is. What the right price to pay for those businesses are. And that’s what we do best. But at the same time we look at how policy actions can affect that, and God knows what policy’s going to be. And it’s impossible to bet on policy. And I feel today that policy has a bigger weight in terms of what it does to what it can do to your portfolio, over time, than it has at any other point in time in my 27-year investment career. But that doesn’t mean I’m going to go sit there and try and bet on some derivative. Because it’s not in our ability. So in those points in time where we’re really concerned about it, we just pull ourselves back and just try and find the best investments with the largest margin of safety.


CONSUELO MACK: So what’s so interesting is you’re a value investor, and I mean, one of the things that you’ve said at FPA Crescent is you look for misunderstood and hated companies, and that you’re a contrarian. Now, these big cap and multinational companies that are paying dividends aren’t misunderstood. So isn’t this really different for you, as far as a strategy?


STEVEN ROMICK:  We put a lot of capital to work in the summer of 201, when many of them were less loved. Whether it be WPP Group, the international publicity…


CONSUELO MACK: Advertising, right.


STEVEN ROMICK:  Advertising and P.R. firm. Or Wal-Mart, even. Wal-Mart, here we have the largest retailer in the country, and Wal-Mart, a year ago, was trading barely above ten times earnings, which we thought- we looked at it as an infinite duration bond with a rising coupon. And we felt there’s a lot of opportunity to make a very good rate of return. And we’d rather on that than almost any bond at that point in time. And here we are a year later and the stock’s up almost 50%, so it’s hard to believe for a company that’s the largest retailer in the world and it’s still at 50%  a year. So at a point in time, valuations get to the wrong place. They get to be too high, they get to be too low. And it’s not that we think that they’re necessarily too high today. It’s not that we think the stock market’s terrible expensive today. It’s just there’s points in time when certain industry groups get really cheap and certain asset classes get really cheap, and that just doesn’t happen to be at that time today.


CONSUELO MACK: So you call them ‘compounders,’ is that right? Kind of this investment theme. So explain what the compounders theory is.


STEVEN ROMICK:  A compounder is a business that we feel over the next five to ten years, it’s not a question if you’ll make money, it’s a question of how much money will you make over that time frame. These are businesses who’ve got big moats, they’re generally larger, and they’re going to grow. They might be tied to GDP growth, but they’re going to grow. Ten years from now, they’ll be larger than they are today. And these businesses have fairly protected margins. There could be some movement in margin, but you go back to the Wal-Mart example- Wal-Mart, over the last 12 years or so, the difference between the high margin and the low margin is all of 0.5 percent. It’s probably the narrowest, I mean that’s an extreme example, it’s the narrowest spread of any company I’ve ever seen, to my recollection. But these are the businesses we think that over time are high quality, and it’s going to be very hard to lose money.


CONSUELO MACK: So are there any misunderstood and hated companies out there that you’re investing in, that deep value typical FPA Crescent company?


STEVEN ROMICK:  There’s not a lot of industries, companies, or asset classes that are really deeply out of favor.


CONSUELO MACK: So, Steve, let me ask you about some interesting, to me, investments that you’ve made recently. And here you are in a period where you’re lacking conviction, that there aren’t these screaming buys out there. But you always do interesting things. So one of them is AIG, for instance. You’re buying is it AIG debt you’re buying? What’s the story with AIG?


STEVEN ROMICK:  Well, AIG has got a book value that’s around $60 or so, and the stock’s trading down in the $34 range. And it’s got– really call it three businesses. One is the life business, which is a good business; not a great business. But it’s not a terribly high ROE business. And you’ve got the property and casualty business, which I kind of break into two parts: the domestic piece as well as the international piece. The domestic piece is more problematic, although they’re doing good things in jettisoning certain types of underwriting that they were doing. They just aren’t as aggressive as they were. And so that business, ROE should be increasing. Meanwhile, the international PNC business is pretty darn good. So with ROEs in the mid-single digits, they should be higher. They’re never going to be a high ROE business. But as an ROE comes up and people realize—


CONSUELO MACK: Return on equity.


STEVEN ROMICK:  Return on equity comes up, people are going to accord a higher value to this company, allow it to trade closer to its book value. And as they also take a bunch of non-earning assets, or lowering assets to their books and they get rid of them, as they sell them off over time.


CONSUELO MACK: You’re long Renault, the French auto company, and you’re short Volvo and Nissan? So explain that trade.


STEVEN ROMICK:  Well, Renault, I mean, there’s a lot of distress in Europe, and so wherever there’s bad news, we go and look and say, is there something we can do? And try and figure out how we can potentially take advantage of what we feel are poor sellers. We don’t want to buy other sellers, we don’t want to buy an IPO from the smart private equity guy who’s selling the stakeout. We want to buy from people who are poor sellers, who need the money for something else, or just because they need the money to have the cash, because they’re too scared to own it. Well, in the case of Renault, I mean, look, the European auto industry is not doing well, nor is the U.S. And although the U.S. has come up a little bit off of its bottom, Europe has not come up to the same degree. So Western Europe’s clearly in a difficult place with respect to auto sales. So why would we buy a French automotive manufacturer? Well, because they own 44% of Nissan and seven percent of Volvo, and they own a little less of two percent of Daimler, they have this huge store of value in these assets. Because if you look at the public market value of these investments that they have, these equity investments they’ve made, it actually exceeds the value of the common stock price.


So there’s more value in these companies than where the common stock trades. So effectively, if you short Volvo, just Volvo and Nissan, you can create a company at negative three-and-a-half billion euros. And so they’re actually paying us to own Renault.


CONSUELO MACK:  Omnicare in another one, again, just to show how eclectic your portfolio is. So what’s the story with Omnicare?


STEVEN ROMICK:  Well, Omnicare is a very interesting business. They sell drugs, they’re an institutional pharmacy. They sell drugs to nursing homes. And they have more than 40% market-share, they’re three times the size of the next nearest competitor. And I think they have a very defensible moat, as they invest more and more in technology and people. And that’s very important, because this company was incredibly mismanaged for years. It was a rollup, it started actually as a hospital, you know, pharmacy business, and morphed into a nursing pharmacy business. They’re reinvesting in the sales force, which they’d underinvested in. They had not invested in technology.


And now with the investments they’re making in technology, there is a lot of cost savings that it’s going to benefit them in two ways: it’s going to lower their costs, something some of their competitors can’t do, throughout their entire supply chain. But also through these technology investments, without going into too much detail, will also drive unit volume. Because they’re actually going to be able to, for example, put kiosks in the nursing homes, which can have the top 2,000 drugs. So one of the things that makes a nursing home operate and do business with an institutional pharmacy is location. We need those drugs now. We have a patient who just got came over to us at 11 o’clock at night. Well, Omnicare, if their location is 60 miles away, may not get them ’til the next morning. And there might be a guy next door. So now, when they actually have the drugs onsite, where the nurses go in and put their thumbprints and can get the drugs out after the prescription’s been written, it’s right there, they don’t have to go anywhere.


CONSUELO MACK:  That’s a great idea.


STEVEN ROMICK:  Yes, it’s great, and nobody else is going to be able to do this, I don’t think.


CONSUELO MACK:  So one of the things that you’re following at FPA Crescent Fund as well is the trajectory of the U.S. economy, which has been slowing over the decades. So how are you changing your investment strategy to reflect the fact that the U.S. economy has been slowing?


STEVEN ROMICK:  We’re looking to have more of our capital invested overseas, and to be able to invest in other asset classes. So let’s take the overseas investment first. In our portfolio, we have about 21% of the portfolio is domiciled overseas. But more important than that, as I don’t really think that’s as relevant as how much the revenues are being foreign sourced. And that’s about half the revenues of our long equity book. And so our portfolio has a lot of international exposure. And it’s split between emerging markets and developed economies. And we don’t get the choice to say, well, we wish J&J could have more in emerging markets; it doesn’t work that way. But we’d like to get as much emerging market exposure as we could, through these companies.


CONSUELO MACK:  So the issue of government spending and government debt is a big issue in this year’s presidential election. So what impact, if any, do you think that the election is going to have on the economy and the investment environment that you’re going to find yourself investing in after November 6th?


STEVEN ROMICK:  Well, candidly, I’m sure there’s going to be some impact. It’s too hard for us to try and figure out.  Because we’re not trying to figure out what’s going to happen for the short-term, in a bit of time. We’re trying to figure out, you know, buy good businesses at really great prices, and own those over time. And since our motto, more or less, is prepare for the worst and hope for the best, some part of that worst is and includes government possibly making bad decisions, or decisions that are not optimal. And in fact, those companies that will be most impacted by a Democrat winning or a Republican winning, whatever the case may be, are those companies, if it’s really dependent upon which party is in office? Those are probably companies we shouldn’t be buying in the first place.


CONSUELO MACK:  Cash has always been an important part of the FPA Crescent Fund. And you use it for all sorts of reasons. So what’s your current cash position?


STEVEN ROMICK:  It’s in the mid-20s.  But the cash is a residual of our investment process. It’s not a top-down decision, oh well, God, things look so cheap, let’s go draw cash down to 12.4%. Oh, things are expensive; let’s take it up to 40.2%. It doesn’t work that way. If we find things we like, cash goes down. If we’re not finding enough that we like, then cash goes up. It’s really, really that simple.


CONSUELO MACK:  So mid-20s, is that telling me that there is 20%of your portfolio or so that you don’t want to put to work in anything else?


STEVEN ROMICK:  Most of that cash today, actually, interestingly, I mean, since our equities are actually near a high.


CONSUELO MACK:  Sixty-some-odd percent of the portfolio?


STEVEN ROMICK:  Yes, right. It’s actually pretty close to a high for the equity portion of our book. But our corporate bonds are near low. Because high-yielding corporate bonds are so unattractive, and there really isn’t much distressed debt that exists out there at all. Although spreads aren’t terribly narrow today, they’re pretty close to average. However, the starting yield is so darn low. I mean, to simply go out and have the sub-two percent on a ten-year and go and tack on a 500, 600 basis point spread to that is still giving you a really great rate of return  Are you really willing to assume the risk, the credit risk for that? And the answer for us is largely no. Particularly when the amount of new corporate issuance that is triple C and not rated is at an all-time high.


CONSUELO MACK: So what’s interesting about what you just told me, as far as your stock position in the FPA Crescent portfolio being near an all-time high is that, for a guy who lacks conviction, I mean, you’re certainly investing in equities. And also in a time when a lot of other investors are fleeing equities. They just want out of stocks. But doesn’t that tell us something, or am I reading too much into it? I mean, are equities the place to be?


STEVEN ROMICK:  No, it’s a fair question. However, I said we had more equities, and close to their high we’ve had, versus the past. But where I didn’t make the distinction was, however, that the quality of our equities, the companies we own, those businesses is higher than it’s ever been; which admittedly gives us somewhat less torque, but more safety. I mean, less upside, possibly more safety, whereas in the past, we had a lot of companies and a lot more operational leverage. Not financial leverage- we’ve never tended to really invest in equities with a lot of financial leverage. But we had a lot more financial leverage in the past in what we owned, and smaller cap companies. So those businesses could be more easily upturned than some of these larger cap companies than we own today. So we think on average that the risk profile of our equity book is as low as it’s ever been.


CONSUELO MACK:  What’s your One Investment for long-term diversified portfolio? What would you have all of us own some of?


STEVEN ROMICK:  Well, I actually think that, if one could, I think it makes a lot of sense to own farmland. And the reason I say that is, and there’s actually certain ways to do it. It’s very difficult in the public markets. But the reason why I like farmland is I’m very concerned about, as I’ve told you, what the government’s doing. A lot of people buy gold, and I think gold’s a terrific investment, and I’m not suggesting for a moment that it won’t be a good investment. But I will opine that gold is something I don’t know how to value. I know what it costs to pull up out of the ground; I don’t know whether it should be traded at $800 an ounce, or 1,500 or 3,000. I don’t know if it really goes to 3,000, if it’s not going to 4,000, then will the government take it away from you like they did in the ’30s? Make it illegal to own gold for investment purposes. So I don’t know.


So what can I own that can benefit in the same way that gold could, in the event there is that huge amount of inflation that comes down the road? Or there’s an erosion in fiat currencies, particularly the U.S. dollar? Well, farmland would benefit in that. Benefit from inflation, it would benefit from should the U.S. dollar weaken. But if you do buy a farmland, you’ve got to make sure you’re paying the right price for it, you’ve got to understand the dirt you’re getting. You’ve got to make sure that the hydrology’s right, that it’s really got the water. That there’s an aquifer, there’s irrigation in some form. And you also have to make sure you know how to find the right kind of farmers. So it’s not an easy thing for somebody to do by themselves. And we’ve actually partnered with people to try and invest to go and take advantage of this.


CONSUELO MACK: Steven Romick from FPA Crescent Fund, thank you so much for joining us on WEALTHTRACK.


STEVEN ROMICK:  Thank you.


CONSUELO MACK: At the conclusion of every WEALTHTRACK, we give you one suggestion to help you build and protect your wealth over the long term. This week’s Action Point is a current investment theme of Steven Romick’s. It is: consider investing in what he calls “compounders.”

What are compounders? According to Romick, those are companies whose businesses will be even better off in ten years than they are today. As he said it’s not a question of will you make money in these companies- he says you will. It’s a question of how much money you will make.

The dominant global businesses they run and their skill at reinvesting their capital gives them the margin of safety Romick is looking for in this uncertain world.


Among Romick’s favorite compounders in the FPA Crescent fund are insurer AON, a leading global provider of risk management, insurance, and re-insurance; the WPP Group, the holding  company for a portfolio of leading marketing and advertising firms such as Young & Rubicam and Ogilvy & Mather; and Unilever, the Netherlands-based packaged food and consumer product giant.


I hope you can join us next week. We are going to talk to two investors whose sights are trained overseas. Small cap oriented Royce Funds portfolio manager, David Nadel and Andrew Foster, founding portfolio manager of the recently launched Seafarer Overseas Growth and Income fund will discuss their best international opportunities.


This weekend on, we will have a WEALTHTRACK Extra podcast interview with financial historian Richard Sylla, on how the investment world has changed since ’87 crash and why he is optimistic about the markets longer term. And that concludes this edition of WEALTHTRACK. Thank you for watching and make the week ahead a profitable and a productive one.

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