Oxstones Investment Club™By Steve Forbes, Forbes.com,
Steve Romick is a managing partner at FPA Funds and was previously chairman of Crescent Management. I recently sat down with Steve to talk about “deep value investing,” his diverse portfolio and what a $9.5 million rock at the Los Angeles County Museum of Art has to do with markets.
Steve Forbes: Steve, thank you for joining us. You’re in the investment business. But it didn’t start out that way. You majored in education.
Steve Romick: I did. Bachelor of Science Education. I made a left turn some place when I probably should have gone right.
Forbes: So how did you go from education to management?
Romick: Well, it’s funny, actually. I actually met a gentleman who was a friend of my father’s, who asked me to coffee at a hotel in Chicago. He was coming to visit. I went to Northwestern. And he told me that he was tired, and I quote, “of unlearning MBAs.” He goes, “I would like to hire somebody else, who I could train from the ground up. And would you be interested in that?”
I said, “I don’t know anything about finance.” He says, “Neither do the guys with the MBAs.” So I said, “Okay, I’m game.” He’s a very successful gentleman, by the name of Jeff Nathan, who ran an investment partnership. I said, “I’d love the opportunity.” So he sat me in his office with a desk abutting his. Every time he picked up the phone to call a company, I’d be on the phone with him.
Within the first couple months of being and working with him, it was really funny. I ended up in a hotel down in Laguna Beach with a guy in his pajamas, pajama bottoms anyway. I had no idea who this was. But as a young kid with no experience whatsoever, I didn’t realize I was taking tea with John Templeton.
Forbes: Eventually Sir John.
Romick: Yes. I think he was Sir John then.
Forbes: So how do you describe your investment approach? You used the word “deep value investor.”
Romick: Yes, we are deep value investors. Let me start with our goal. Our goal is to generate equity rates of return and to do so without assuming the same risk the stock market does. So we want to avoid permanent impairments of capital. So our strategy is to really invest A) across a company’s capital structure — so common stocks, preferred stocks, junior debt, senior debt, bank debt — but as well as in different asset classes.
Forbes: Going short.
Romick: Going short to some degree, as well as farmland we own in our portfolio. We purchased a lot of the subprime whole loans back in 2009 and ’10. And we looked for other types of vehicles like that in different asset classes.
Forbes: Hedge fund it sounds like.
Romick: Public version. Hedge fund light, lower fees.
Forbes: So you range everywhere. Now some would say, “How can you do that? How can you get real value added if you’re spread all over the place?”
Romick: We’re spread all over the place in terms of different asset classes and different market caps and across the capital structure. But at the end of the day, we focus on one thing. We focus on where the bad news is, where there are poor sellers. Wherever the poor sellers are, that’s where we’re spending our time.
And if you think about looking at a bond versus a stock, what’s the difference, really? If it’s a building. If you’re looking at this building that we’re in right now, we want to value it. We’re gonna try and figure out what the replacement cost is, how good is it tended, is it an A credit or a C credit, what the vacancy in the building is, what the turnover in the leases are, the terms. Then you take that analysis and look at it from an equity perspective, but think of it as a debt, as a bond, as well, the mortgage on that building. The analysis is not so substantively different. So I would argue that we are in the business of buying assets at discounts, whether they be businesses or some other kind of asset.
Forbes: 2009, for example, after the market turned, for awhile after the sharp rise, you were skeptical. You went into bonds. And you’ve reversed that since then.
Romick: Well, no, with the bonds we went into, it’s very, very important to know, we invest in stocks and bonds. We’re not buying conservative bonds. We’re buying high-yielding bonds. And we do buy debt. It’s corporate debt. Higher-yielding corporate debt, distressed debt, restructurings, et cetera. So the bonds we went into in 2009, it may say corporate bonds in our portfolio, but in fact what we were doing, we were heavily invested in higher-yielding bonds and distressed debt.
So actually, I and our team look at high-yield bonds as equities. We use equity-like risk to that asset class. So in 2008 and 2009, we believe that corporate bonds had priced in a depression. Common stocks had not priced in a depression. So we were able to go out there and buy these businesses with huge asset coverage, whether it be airplanes in the case of international lease finance or a combination of trains and airplanes and lots of other kind of things in the case of C.I.T.
So we actually were taking a very aggressive posture in 2009 in investing. What’s happened since then is many of those bonds, we were on the precipice of a depression. That depression was avoided. Many of the bonds we own have matured or went above par and we’ve ended up selling those bonds. And we’ve repositioned the portfolio and other higher-quality global franchises.
Forbes: Talking about bonds, you’ve written about how we seem to be in something of a bubble today. Anyone who can issue a bond is insuring a bond at record levels. I think you used the number $780 billion on the corporate side. What do you see unfolding there, this kind of promiscuous issuance of debt?
Romick: Well, what you were talking about really was, what I was speaking to was the fact that high-yield bonds in the last few years over $300 billion worth of bonds have been issued. And not only have they been issued, these companies are appropriately taking advantage of an unusually low interest rate environment. I would argue too low of an interest rate environment.
Zero interest rate policy perverts the capital allocation decision. An elderly person’s who’s all of a sudden not getting much return on their portfolio all of a sudden feels obligated, pushed into out of need into investing in something with greater risk. And many corporations do the same thing. So of these $800-plus billion in bonds that have been issued, higher-yielding and corporate bonds in the last three years, there’s been the largest dollar amount in history of triple-C and non-rated debt have been issued.
And in the levered loan environment, 25% of the issuance of bank loans are covenant light. So we’re actually looking at more risk in that system than we actually have had in many years. How it unfolds is you tell me what’s going to happen to the economy. And it’s scary to me, but we look at that as fodder for future opportunity.
Forbes: Let’s hit the Fed. And then we’ll get to investments.
Romick: Let’s hit them?
Forbes: I’ve hit them. One of your letters, you have this wonderful quote from Malcolm Gladwell, “Incompetence is the disease of idiots. Overconfidence is the mistake of experts. Incompetence irritates me. Overconfidence terrifies me.”
Romick: I wish I had said that.
Forbes: Explain the thing.
Romick: It’s a wonderful turn of phrase. We look at the Fed and we look at the actions they’ve taken and we look at statements that have been made by Ben Bernanke, who in 2006 didn’t think there was a housing crisis, quoted as saying such. In 2007, didn’t see the subprime issues being much of an issue. In 2008, argued that there wasn’t a recession coming, the we weren’t on the precipice of a recession. And also said at that point in time that Fannie and Freddie were solid. In 2009, they told us that the Fed would not monetize the debt. Then in 2012, he wraps it all up with the statement that us along with other central banks of developed economies are in the process of learning by doing. Doesn’t give you a great deal of comfort. So this academic argument that many economists have is just that. And how it actually will manifest itself as it’s put in place is anybody’s guess. So they’re hoping that this academic argument will alchemize into reality.
Forbes: You use that word “alchemize” deliberately?
Romick: Deliberately. And without any evidence that they actually have the skill set to do that or that their past prognostications have been anything close to accurate. And we’re giving them trillions of dollars of our money to bet with. To me (and I’m not an economist) that’s scary.
Forbes: The fact that you’re not an economist is probably a good thing. You wouldn’t believe this stuff out of thin air. Yes, it always works. Getting on the investing side, in the past, you’ve closed funds. Explain why you did that and what decision goes into opening and closing.
Romick: I used to basically run my fund myself. You’re referring specifically to the FPA Crescent Fund.
Forbes: 2005, yes.
Romick: And I closed the fund in 2005. I was more or less running the fund by myself. And I wasn’t seeing much opportunity. So as I wrote at that time I said that, “Until we see more opportunity and have built up a team, I’m not going to reopen the fund.” So 2008 rolls around and there was a lot of opportunity. I spent the last few years building a team. And that allowed us to reopen, because we had the ability to deploy the capital. I think that as long as one has a stated goal, as one believes they can continue to deliver on that goal, one can remain open. I felt in 2005 that I wasn’t going to be able to.
Forbes: In terms of building a team, you mentioned a disdain for MBAs. Do you share that?
Romick: I mentioned my former employer’s disdain for MBAs. I don’t have anything against MBAs. We’ve hired a number of different MBAs. But not everybody on our team has an MBA and nor is it a necessity to be able to be a part of our team. We have people, some who have MBAs, some who don’t, but the most important thing is have they been inoculated with the value vaccine.
If they have that sense of value in understanding businesses and they do good work to report on such, then we embrace them. We have people on our team who have very little business experience. I mentioned to you before, we started talking just now that we have a journalist on our team, a Pulitzer-Prize-nominated journalist, who helps us dig a little deeper in companies, to learn that which may not be as readily apparent just by reading the trade magazines or speaking to the company or reading Wall Street research.
Forbes: Reminds me of our former editor here. He was editor from the ’60s to the late ’90s. He made it a point not to hire people from journalism school or from newspapers, because he said, “Then I have to reteach them to what journalism is.”
Romick: This journalist did come from journalism school, one of the better ones in the country.
Forbes: Talking about the Fed, why hasn’t this promiscuous, huge increase in the balance sheet of the Fed led to traditional inflation? Some would argue, and I believe it, it led to the housing bubble. You could never have had that, if you had a stable monetary policy. But we haven’t repeated the ’70s yet.
Romick: Well, capacity utilization still isn’t quite at that level, I think, to push you over the edge. And there’s different kinds of inflation. You can get inflation in different ways. You can import that inflation by having a weak dollar, for example. It seems at this point in time anyway that if you go into the dirty clothes hamper and you pull out the dollar shirt, it’s the cleanest of your dirty clothes.
Forbes: It reminds me of the way you describe investment prospects. You say, “We wish there was more to be excited about in the portfolio today.” You think things are fairly priced, overpriced?
Romick: I think they’re at least fairly priced. We look through our portfolio. Of I look at our win column, that which we’re making money in, it’s fairly universal. And we’re not that smart. If you’re making money on everything, it means that things are going a little too well, at least as far as we’re concerned.
It’s okay to be down for a period of time. We don’t mind stocks going down or bonds falling. It gives us a chance to buy more of them. But things are priced very, very well. There isn’t a lot of fear out there. The fear is of not getting enough of an income, which is pushing people into risk assets. So if you were to think of the stock market in the context of what’s happened with quantitative easing, so quantitative easing, market’s going down, quantitative easing comes in, market goes up. Then there is an easing, the market’s going down and it goes back in, then market goes back up. And that’s what’s been happening. So if you look at the expansion of the Fed balance sheet along with risk assets, the correlation’s right there.
Forbes: So that’s why you had this photograph in your end report, you describe this “rock in earthquake prone Los Angeles”?
Romick: Yes, that rock in earthquake prone Los Angeles is a $9.5 million boulder that was purchased by the Los Angeles County Museum of Art and placed over, spanning a walkway. You walk underneath this thing and you look up and you’re admiring the fact that this seems to be levitating. It’s called Levitated Mass and it’s very reminiscent to us of what this market is.
There’s a lot of false underpinnings to what’s driving asset value is higher. For me, I look at this and the idea — you showed me a picture of people looking up at this big boulder — and if there’s an earthquake, I’m not going to be walking there. I’m going to walk around it. We take that same approach to the stock market, to investing, whether it’s stocks or something else. We want to make sure that we have a margin of safety. We want to, as we like to say, prepare for the worst and hope for the best.
Forbes: Farmland. You call it “Gold I can eat.” Farmland has really gone up very sharply in the last 10 years.
Romick: It has.
Forbes: Do you feel this is like the replay of the ’70s, where once the inflationary bubble is popped, this thing will crash? Why farmland now?
Romick: Interestingly, we haven’t had the inflationary bubble yet, as you just pointed out. So I think you’re going to have that first before you’re likely to see that pop. When we first started about farmland and investing in farmland, it was a few years ago. So yes, it has increased since then.
But I think that, look at gold for example, why people own gold. I don’t know, gold is a one-decision investment. It’s a bet against fiat currencies. It may be a good bet. It’s not one I feel competent in making. I don’t know how to value gold. I don’t know if it should be a thousand dollars an ounce, the rough cost to pull it out of the ground, or $1,600 an ounce, where it is today, or whether it should be $2,000 or God forbid it’s $4,000 because government may take it away from you.
So I don’t really feel comfortable making that decision nor charging people a fee to make that decision for them when I feel that they have the same ability to make the decision as myself. I look at farmland. Farmland has increased in price. But farmland, interestingly, will benefit from the same things that gold will benefit from.
If there’s inflation, farmland will benefit. If there’s a decline in fiat currencies, particularly the U.S. dollar, farmland will benefit. Ag prices are denominated in dollars. So if the dollar drops by 50% versus the won, for example, in Korea they can buy twice as much or their economy can benefit by not having to spend as much for the same amount of food.
But it’s also a play on emerging economies. There’s more protein in ones diet in emerging economies. So as one comes out of poverty, they eat better. So in the U.S., where we eat more, they’re eating better in developing, emerging economies. So if you consider that it takes a pound to grain to get a pound of grain, in a grain-based diet, it’s two pounds of grain to get a pound of chicken, four pounds of grain to get a pound of pork, and seven pounds of grain to get a steak, and more if you want foie.
So as you have these improving diets, you’re going to have to work these fields much, much more. We need much greater productivity. We’re only growing herbal acreage globally at 0.3% a year, versus population growth is 0.9%. So you better get that productivity improvement.
So I don’t think you can just generalize and say, “Farmland, why don’t you just buy?” We’ve actually partnered with some people who we believe have the ability to find better farms, at a discount to the market, and are able to really improve the productivity on those farms. So those numbers have been shown where farmland is traded with a cap rate of around 3.5% or so. We purchased a portfolio of farms at a 5.1% cap rate and finished buying a couple years ago, year and a half ago or so. In fact, we’re actually generating cash flow on those, before fees, of a little over 7%, with the fluctuants that we get. So we’re actually buying these farms at very handsome discounts to what we see out there.
Forbes: So it’s an ag REIT?
Romick: Yes, it’s a private REIT. And someday, hopefully, it’ll be a public REIT.
Forbes: Picking equities, describe Orkla, which most people aren’t familiar with, it’s Norwegian.
Romick: Orkla is a Norwegian holding company that is controlled by a Norwegian billionaire named Erik Stein Hagen who created his wealth in grocery. And he had a Norwegian grocer, merged it with another Scandinavian grocer estate, which they sold as a package together to Ahold, became a billionaire in the process, reinvested that capital in a number of things. But his largest, single investment is in Orkla.
Orkla is the number one food brand in Norway. They’re number one or number two in most of their brands that they have under their umbrella. But they also have all these other silly assets that are unrelated to the food business, whether it be a paint business, a chemical business, which they’ve spun, or an aluminum smelting business and so on and so forth. Businesses that are non-food-related.
What we did was we looked at the business, applied a conservative evaluation to what they established as being more non-core assets. And what was leftover was this stub of a food business that was trading at about 10 times earnings. And so that stub is now traded, since we bought it, at mid-teens. So it’s worked out.
Forbes: So how did you discover a Norwegian company? And what kind of screens do you use since you cover everything?
Romick: We have a pretty good team, and I’m supported by a great team. And in particular, Mark Landecker and Brian Selmo, my two key people on my team that I couldn’t do this without them. And Mark Landecker is the gentleman who pointed Orkla to us. I’d have to call him up and ask him where he got the idea. But Mark knows all the better businesses in the world. So he focuses on that. This was something that came up on his screen.
Forbes: Microsoft. Microsoft huge cash flow, does well, very profitable, but as somebody once described it, Microsoft stock, not the company but the stock, is like Brazil. It was once described as having a great future and always will. Why do you think it’s finally going to have its day in the sun?
Romick: I don’t know that it will, candidly. I just think it’s priced as if it won’t. If it happens, the stock’s going to go up a lot. You’ve got a tremendous cash flow. You’ve got the Windows business. You don’t need the Windows business to do great. Windows 8 is not doing great right now.
You’ve got the entertainment business with the Xbox, which doesn’t make that much money, but is valuable nonetheless. They’re one of the top spenders in the cloud. That cloud business could be worth a lot. But leaving those things out, just like at their Office business and servers and tools. And the cash they’ve got on the books, including discounting the cash that’s held overseas, which is most of the cash. You’re getting the stock, everything else for free. That covers the stock price, where you are. So we like to say good things happen in cheap stocks.
Forbes: Google, when did you get into Google? And that’s had a big run.
Romick: We invested in Google along with other companies, at the time, when there was a pull back in 2011. Market was weak. And there was a chance to pick up some very good branded businesses at nine to 11 times earnings. And in that space of advertising, which will include the more technologically-oriented Google along with our public group and a W.P.P., that’s an advertising company, we purchased all three of those companies.
Forbes: Financials, A.I.G., C.I.T., what’s in them?
Romick: Well, C.I.T., we actually accumulated our position in C.I.T. through the debt and the restructuring. So that was one of those debt investments that you talked about, where the debt position came down and stocks went up. Well, they gave us the stock. We bought it when it was deeply out of favor. I bought the bonds as low as the 40s. And we ended up getting equity as a result, expecting to get equity in the restructuring, and happily got it and held it. What happens next is anybody’s guess.
A.I.G. not dissimilar. A.I.G. we owned a lot of the debt of subsidiary companies of A.I.G. We own debt of American General Finance. We own debt of International Lease Finance. We knew the business quite well. A.I.G. is in two businesses. They’re in the property casualty business both here and abroad in Chartis. And they’re in the life insurance business.
Well, the Chartis P.N.C. business here in the U.S. had not been terrifically well run. It seemed like they had to get every last policy underwritten, regardless of whether or not it was gonna be profitable for them. Whereas in Europe, they actually were much more circumspect and allocated capital more wisely in budgeting in their underwriting.
The life insurance is an okay business. When you add it all together and look at turning the U.S. business around, allocating the capital more wisely, valuing the other assets, including mainline assets et cetera conservatively. We bought this at less than 50% of its book value. And again, good things can happen to cheap stocks. And they were buying their stock back from the U.S. government at significant discounts to that book value. So every one of those transactions was quite accretive.
Forbes: Forgive my lack of French or Flemish — Groupe Bruxelles Lambert.
Romick: Right, Groupe Bruxelles Lambert. As we look for ways to have allocations to various companies into that exposure and environment, it could be prove to be inflationary before you know it, but it may take longer. In a world where things aren’t terrifically cheap, you look through to the assets of some various holding companies, trying to figure out if the underlying companies are good businesses, is this on a sum of parts basis, priced to discount? And it’s not a large position for us, but that’s a company that makes that cut.
Forbes: You seem to like pieces of health care.
Romick: Pieces. Health care is something we’re not —
Forbes: CVS Caremark.
Romick: Yes, CVS Caremark’s interesting, because we actually purchased CVS Caremark at a point in time when people are very fearful. Stock has done very well, but CVS as the pharmacy also owns Caremark. And the revenues are pretty close to 50-50 give or take. And Caremark business, the pharmacy benefit management business is a more complicated business. One that I truly don’t understand as well, do not know how they will be impacted by government reimbursements and how they could get impacted upstream.
But I felt that they were better positioned with a new management team in that division vis-à-vis their competition. So I felt at least versus Express Scripts or Medco, they actually could succeed relatively speaking. So what we did was we went long CVS Caremark and we shorted Express Scripts and Medco to kind of neutralize a good chunk of that P.B.M. exposure. And those are the kinds of things that we do periodically. Recently, able to put on a couple of other positions like that, where we were able to create a stub.
Forbes: Renault-Nissan.
Romick: Yes, Renault. Renault, the largest French car manufacturer, owns 44% of Nissan, used to own 7% of Volvo truck, as well as owning a couple percent of Daimler, as well as another percent or two in a Russian automotive company. And if you add up the value of these other things that they own, it exceeded the value of where the stock was trading.
And we looked and said, “Wow, they’re gonna pay us five billion euros, pay us five billion euros to own Renault? Okay.” For a business that’s cash flow positive marginally, but where European SARs, auto sales are at relatively low ebb because of the weak economy in the E.U. And a business in the finance side that’s been very strong, better than our auto finance companies. We’ll take that.
Well, now since then, that stub has narrowed up from $5 billion to more or less flat. We also did it recently with Vodafone Verizon. Vodafone owns 45% of Verizon Wireless. Verizon owns 55%. So we were able to just a couple of weeks ago, we were able to buy Vodafone while selling Verizon Wireless short and create a stub of just the Vodafone assets at 2.9 times EBITDA. So sometimes the market hands you these things. And we’ll take advantage of that.
Forbes: What other things have you drooling now in this otherwise unappetizing environment?
Romick: Not a lot have us drooling. We see where opportunity could come. I don’t want to go and mention a couple things we were spending a lot of time focusing on, because we’ve invested a lot of time in one particular industry, where we’re just beginning to allocate some capital. We’ve done so in the debt side. And we would hope to create some opportunity there for ourselves on the equity side.
Then we also kind of hope that sequestration hits hard and allows us to investment in a number of different defense companies that we have done work and we’ve put it into our library. And we hope to pull it off and take it off the shelf and dust it off and put those companies in our portfolio.
Forbes: Most investors wouldn’t they be better off in index funds?
Romick: Probably. Particularly if you’re looking at large cap companies. They’re very tax efficient. They’re lower fee. But for us, we actually don’t expect that everybody should have their money with us, in our fund, the FPA Crescent Fund. We manage the portfolios if they do. It’s a portfolio that invests in lots of different things. It’s not just stocks. It’s not just large cap stocks. It’s a lot of mid-cap stocks. It’s got, as we talked about, high-yield bonds at points in time. And subprime whole loans and farmlands and other types of things and other types of special situation trades which we can put in there, like the Renault a mentioned, Vodafone, Verizon, et cetera. So we look at things a little but differently. But I don’t think there’s anything wrong with index funds.
Forbes: ETFs, are they going to continue to grow explosively? And why would somebody go with a fund versus an ETF version?
Romick: I don’t know. It is a lot of argument to be made for ETFs. I think that if you want to get exposure to a certain sector of the market or a certain region in the world, it may make sense for somebody to do that. But most people I think want to find somebody they can trust to manage their capital. We aspire to be those type of people that those investors can trust. We’re not the only ones. There are a lot of very good portfolio managers out there. But in fact, it’s not incorrect for you to talk about the importance of index funds and ETF in the context of most managers don’t do as well as the index over time.
Forbes: And you can continue to best it?
Romick: We have bested it for the last couple decades. Whether or not we will in the future is anybody’s guess. We’re certainly gonna try to do so. But our goal is not even to best it, although we have. We’ve actually bested it with only half of our portfolio and stocks and averaging 25% in cash. But our goal, actually, is just to do as well, do as well with less risk. Because if you can have less risk, we think that your clients, your shareholders can actually end up sticking with you a little bit longer.
Forbes: It sounds like a good way to go. Your benchmark, you went from the Russell 2500 to the S&P 500.
Romick: Well, we did that a while ago. The best benchmark really I think for most investors, for us what think of as understanding what the rate of inflation’s going to be and adding some equity risk premium, and is the manager with whom you’re investing, are they justifying the risk they’re taking with the returns they’re generating for you. Benchmarking stuff. We certainly don’t look at what we’re doing any given day, quarter, even year. It just becomes a lot of noise. What’s this investment going to do over the next five years? And we just don’t worry about the stuff in between.
Forbes: Steve, thank you very much.
Romick: Thank you very much.
http://www.forbes.com/sites/steveforbes/2013/04/23/steve-romick-trade-into-the-gold-you-can-eat-farmland/
Tags: Crescent Management, deep value investing, deep value stock picks, farmland, finding investment opportunities where the poor sellers have to sell, focus on where the bad news is, FPA Funds, investing across a company's capital structure, investing lessons, investment wisdom, private REITs, Steve Romick