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Romick: What I've Been Buying

FPA Crescent's Steve Romick found some value among large financials and high-yield bonds earlier this year, but a blend of low rates and high valuations gives him pause today.


Daniel Culloton: Hi, I'm Dan Culloton, director of equity manager research at Morningstar, and I'm here with Steve Romick, manager of the FPA Crescent Fund, which receives a Gold Morningstar Analyst Rating.

Steve, thanks for being here today.

Steven Romick: Thank you for having me.

Culloton: Steve, we got off to a very tumultuous start to the year here, and I'm wondering if you thought that valuations across corporate bonds and stocks got low enough and attractive enough for you to deploy capital.

Romick: We actually were able to participate because certain sectors were more attractive. But let's start with a point at the end of last year, in 2015, on a trailing basis P/E, price/book, and price/sales of the market were at levels not seen since the peaks of '07 as well as the peak in 2000. And nevertheless, in February, there were a number of different securities and asset classes that were trading down, not the least of which were financials, lenders in specific, and so we were able to increase our exposure to that sector and so we were buyers, wholesale, of a number of different names in our portfolio and added a couple of other names in our portfolio as well into the depth of that weakness.

Culloton: So, you added to large banks like Citigroup, Bank of America, American Express, not a bank but a lender.

Romick: But a lender, yes.

Culloton: So, these are companies that perhaps due to the memory of the financial crisis which lingers and maybe some of the increased regulation people are very afraid of. What got you comfortable enough to invest or add to these positions?

Romick: Yeah, people always seem to be fighting the last war. I mean, we're going to have different wars in our future. Thankfully, we are not having another civil war in the United States and the war of--and we're having that fear of the systemic risk as a result of what the financials are doing--the big companies--I think is somewhat misguided because it's not taking into account the lending portfolios. The loan portfolios, I believe are somewhat stronger, but more importantly, they have got massive amounts of more capital that exist on the books.

Citigroup, for example, in 2007 had 3.5% tangible equity to assets and it's in excess of 10% today. So, you have three times the capital in the bank supporting the assets of the bank. So, it gives you a much larger margin of safety for that bank. And then you can say the same thing about many, many other banks that exist in the United States as well.

So, I think that the financial system as far as the banks are concerned is in good shape. 

Culloton: So, it's not necessarily a matter of nothing can go wrong. It's just that they were priced as if things far, far are worse are lurking.

Romick: Sure. Yeah. I mean, banks can lose money. They can have charge-offs. I mean there are NGO loans out there, people are going to get--the banks are going to get hurt by. There's loans to China and other parts of the--now the basic material businesses are going get hurt and there will be charge-offs. But if you stress-test these banks and assume some very high level of default with some very low level of recovery, these banks on average are going to be--the ones that we own--are going to be in very good shape coming through that.

Now, if that were to occur, then we believe that a lot of other companies are going to be hurt as well--particularly, if they are to get hurt by more of other sectors that started underperforming, which caused charges to increase further still, to go into something beyond energy, for example, and going into industrial America. Well, if that were to occur, industrial America is not likely to earn what people think they are going to earn, what analysts have them earning...estimate that they are going to earn in 2016. So, both can't be true. You can't have--Citigroup in February was trading at 60% of tangible book. At the same time in the world, the market is trading at 18 to 19 times trailing earnings.

Culloton: On the fixed-income side, you still have a lot of cash; the bulk of the portfolio is still cash. But you were able to buy--add to additional high-yield positions, particularly in energy and basic materials. What attracted you there?

Romick: Well, the portfolio has expanded from 1% to 5% in the last six months. So, we have--as you stated, have been able to find some things to do, and we hope to find more. Now, most of the opportunity set has really been in these--it hasn't been broad-based. Most of the weakness in the high-yield market--and there has been weakness and the spreads are now wider than average, although way, way below their peak spreads. Yields, however, are still not even at average in the high-yield market. That's largely a result of--or maybe you can say entirely a result of--the fact that interest rates are as low as they've ever been in history.

So, the sectors that have been weak have been basic materials, energy, and transportation. That's where the real pain has been and it has not been broad-based. So, we've been able to find some opportunities in companies that are exposed to these industries as well as a few others. But they have been one-offs outside of those three sectors, so it has allowed us to go and get some exposure in the portfolio to various high-yield bonds such that our yield in this portfolio at the end of the year was around over 13%, which is 4 points higher than what the high-yield market is, which was about 9% at the end of last year.

Culloton: And what particularly about these companies gives you the confidence that they are going to survive whatever downturn they are in, or had been in?

Romick: Well, in not every case do we think they will survive in their current form. There could be some restructuring. But in the restructuring we're comfortable with where we are in the capital structure such that even if we end up with equity, we'll be happy to own those assets coming out the other side. In some cases, a restructuring can work in your advantage because if you buy a bond at $80, all you can get is $100 if it goes to maturity. If you buy a bond at $80 and then it restructures, and you get put into equity, well, then all of a sudden when the world comes back then you can end up with something well in excess of $100.

Culloton: Last year I believe it was you who lifted the cap on international investments for the fund. I'm wondering if you since then, in the last or so, you've taken advantage of overseas.

Romick: We have. Well, today we've certainly been finding opportunities outside the U.S. Our portfolio today has roughly just about a third or less than a third of our equity long book is--our investments in companies that are domiciled outside of the United States. And that's going to be part of our future as well. We have a broad team that can look around the world as we look for various kinds of businesses.

Now, what's important is, as we look for these companies, whatever it is, whether it's a U.S. or overseas, we're looking for certain quality of business. We're looking for certain kind of company that offers an investment--that offers a particular risk/reward where we feel it's going to be hard to lose money. And so we can go and collect a basket of companies in our portfolio that are good businesses at good prices. As long as we can deliver on our stated goals of equity rates of return with less risk than the market, we'll continue to invest wherever that opportunity sends us.

Culloton: Steve, you've, and FPA in general, has never been shy about expressing their ideas about macro trends.

Romick: We never have been shy about much of anything I don't think, right?

Culloton: So, I'm wondering if you could share with us what you think of the current--what are the current biggest macro headwinds that you are scared about in the markets today.

Romick: Well, first, I think others in our firm have been historically more willing to go out on a limb and say what the world will look like in the future. We are--myself and Brian Selmo, Mark Landecker, my co-portfolio managers--are less apt to do that. But just--I mean, more about just expressing a concern about where things are.

So, we'll start with valuation. We have less for margin of safety when valuations are high versus low. Valuations are higher than lower. It's partly justified by low rates. Well, how long will rates remain this low? What can happen? It's a big headwind we've got with these declining rates. We're living in a world where there is a certain complacency that exists because people are driven into other types of investments because rates continue to decline.

You have three choices if you live off of a fixed income. You can--you are living and you're spending all that money each year. You can either--if rates drop, you can either spend less, reduce your lifestyle, you could assume greater risk, or you could spend principal. Most people begin by assuming some greater amount of risk and that pushes them in the direction of MLPs as was the case over the last few years, can push them in the direction of high yield, can push them in the direction of high-quality, dividend-paying stocks. So, low rates pervert capital allocation decisions across the board, for not just individuals but corporations and as well as institutional investors as well. So, we just want to be mindful of that and knowing that rates have dropped as they have--I don't know what happens next--but it's hard to bet on rates continuing to decline for us--it's not what we do anyway--and recognize that rates could increase at a point in time.

So, when you look at our businesses, we try and normalize for a higher level of interest expense if it's a more levered business than what the company might be borrowing at today. That's how we think about it as we look at this. But it scares us that things can flip around and we're so dependent upon rates, we're so dependent upon this quasi-coordinated effort of central banks to have such easy money and lower rates, quantitative easing, et cetera, around the world. It gives us great pause because we do wonder how long can that go on. And sometimes the medicine creates the future illness.

Culloton: So, what should investors expect from the markets in general, from FPA Crescent in particular, and specifically, over the next several years?

Romick: Well, I can never--I actually honestly don't know what one can expect specifically other than to say that we will continue to--we expect to continue to deliver on our goals, which is to drive equity rates of return with less risk than the market. But if the market offers lower rates of return then we're going to be tied to that; if the market offers higher rates of return, we're tied to that still as well. But we always--we think very much about managing our portfolio over full market cycles, not any short time frame. And sometimes it's easy to get lost in what's happening at the moment and the moment might be three months, six months, one or two years. But market cycles are years and so we think and we manage our portfolio with our capital alongside our shareholders' with that mindset that we're in this for the long term.

Culloton: Well, thank you very much, Steve.

Romick: Thank you very much.

Dan Culloton does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.