Steve Romick: 'We Think Defensively'
The longtime manager of FPA Crescent Fund talks balancing risk and reward in the COVID-era, why he's not holding even more cash, the case for Wells Fargo, and more.
|Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.|
Our guest this week is Steve Romick. Steve is a portfolio manager at First Pacific Advisors, or, as it's probably better known, FPA. Steve comanages several FPA strategies, including the FPA Crescent Fund as well as the Source Capital closed-end fund. Steve joined FPA in 1996. Before that, he was chairman of Crescent Management and an analyst for Kaplan, Nathan & Co. For his work managing FPA Crescent, Steve was the recipient of the Morningstar U.S. Allocation Fund of the Year Award in 2013 and was previously a nominee for the Morningstar Fund Manager of the Decade Award. Steve earned his bachelor's in Education from Northwestern University and is a CFA charterholder.
Bio and Background
Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, global director of manager research for Morningstar Research Services.
Christine Benz: And I'm Christine Benz, director of personal finance for Morningstar.
Ptak: Our guest this week is Steve Romick. Steve is a portfolio manager at First Pacific Advisors, or, as it's probably better known, FPA. Steve comanages several FPA strategies, including the FPA Crescent Fund as well as the Source Capital closed-end fund. Steve joined FPA in 1996. Before that, he was chairman of Crescent Management and an analyst for Kaplan, Nathan & Co. For his work managing FPA Crescent, Steve was the recipient of the Morningstar U.S. Allocation Fund of the Year Award in 2013 and was previously a nominee for the Morningstar Fund Manager of the Decade Award. Steve earned his bachelor's in Education from Northwestern University and is a CFA charterholder.
Steve, welcome to The Long View.
Steve Romick: Thank you very much. Thank you for having me.
Ptak: I want to start with your most recent shareholder letter in which you wrote the following: "We would have thought that a global pandemic, social disturbances, extreme political polarity, and all that has accompanied those trends would have created more fear, or at least caution, in global markets. Yet stock markets and debt markets are up around the world, and in many cases, way up."
Despite this, the portfolio recently had about three quarters of assets in equities and corporate bonds, which is around the fund's biggest stake, at least that I could find on record. So, my question for you is, How do you reconcile that with the cautious note you seem to strike in some of your recent comments?
Romick: Yeah, I can see why on the surface that observation in my letter and our portfolio would raise the question. However, our current exposure is actually not close to its highest. If you go back pre- some of your records, I guess, in the late ‘90s, we were more than 90% invested, which, interestingly was at a point in time when the stock market was the most expensive we'd ever seen. So, while many stocks have performed exceptionally well, there is, you know, the large cohort that have not, particularly those that are more cyclical with the greatest enmity reserved for those companies most impacted by COVID, including restaurants, retail, airlines, energy, lodging, aerospace companies, by extension their lenders who could have their capital impaired, certainly in a worst-case scenario. So, while some stocks are expensive, others are pretty inexpensive. We own a good number of cyclical businesses that offer solid longer-term prospects.
The Crescent's equity portfolio trades less expensively in the stock market both on a price/book and price/earnings basis. A knee-jerk reaction knowing that we are value investors might be that these companies have less growth. However, that's not the case. And we talked about this in our recent shareholder letter. The trailing three-year historical earnings growth for the Crescent portfolio as of this past June has been substantially higher than the market. That was also true in June of 2019. In addition, the expected three-year earnings growth of our portfolio, based on not our estimates but consensus expectations, is better than the market, as was also the case a year ago.
A discounted valuation and a higher historical and expected earnings growth in the market gives us the comfort to manage a slightly more than average exposure. It's also a bit hard to compare different periods because while our exposure on a risk basis is greater today on average, we believe it is comprised of higher-quality businesses than in the past.
Benz: One of FPA Crescent fund’s signatures has been its resiliency in periods of market trouble. It suffered smaller drawdowns than the equity market, and it's been less volatile. But that's at least partly a function of the larger cash balances that you've tended to carry. So, what's an investor to make of the fact that you have less cash in the portfolio today than you've had at other junctures in the past?
Romick: We're talking about 10 points more in exposure versus our historic average. So, not a huge number, but – and this can partially be explained by buying into weakness and having those names rise, as well as the fact that our portfolio, as I mentioned, trades at a discount to the market, yet has exhibited better historic earnings growth and is expected to have better prospective earnings growth. The 1998 to 2000 tech bubble created a huge valuation gap between the cheapest part of the market and the average stock, and we were happily invested able to subsequently post positive returns in 2001, 2002 and 2003 despite the S&P declining.
The great financial crisis--2008-2009--was different. The market wasn't particularly cheap coming into 2008. Expectations for earnings of many of the companies were too optimistic and valuations for the cheapest companies were closer to the average. In addition, we saw some element of systemic risk at the time. So, we were more cautious about allocating capital.
A bottom-up portfolio, such as ours, is not necessarily one where you will see crazy valuation differences. This COVID event was a health event with economic consequences that affected many different industries disproportionately and created opportunities to own some companies that had previously been trading at levels that didn't offer us much of a margin of safety. Importantly, we're not market-timers. Bottom-up investors, if the market sells off from a high index price level but we are able to find attractively priced businesses to own, then we'll own them. Risk exposure for us is never a constant and is dictated entirely what we see at the company level--how they're doing and how they're priced. If we find attractive risk/rewards, we will be more invested. If not, we'll be less invested. And the cash position is entirely the residual of that. With cash still at a meaningful 20%, we have the ability still to take advantage of opportunities should they unfold. And we haven't changed, importantly, what we've been doing since our 1993 inception. Our mandate has always been to deliver equitylike rates of return over the long term, while avoiding permanent impairments of capital along the way. And this has resulted in fund's varied exposure over time that is translated into less risk than the market.
Benz: Steve, you referenced that early 2000s period where growth stocks kind of handed it off to value and there have been a lot of comparisons to this period with the late ‘90s, early '00s. Can you compare and contrast how things look different or the same to you as that period?
Romick: They're similar in the fact that there's a lot of businesses that the world has become very narrow certainly in its valuation. In terms of the market's expectation, for many of these companies, has become very, very concentrated in the market, many of these businesses. However, unlike back in the '00 period, in the Internet bubble, there's many better businesses today than there were then. And in every good period, when the market begins to go up a lot because of something good that's happening, there's truth in all of it. I mean, even in the Internet bubble back in '98 to 2000 period, there was great truth in all of that. It just took longer for it to materialize into reality and then to be monetized. So, the similarities are that the world has gotten a little bit narrower today, but the difference is there are a lot better businesses today.
Ptak: Do you feel like this environment is forcing you to revisit and even modify your margin of safety requirements? In a climate that's marked by such low yields, is the hurdle rate lower and does that mean you wouldn't demand the same discount to intrinsic value as you might have before?
Romick: We expect lower returns in the future given from where we're starting today, which in turn lowers our hurdle rate. We had the ability to upgrade the portfolio in Q1 and own better businesses. And although we believe the portfolio is more robust today, we still anticipate that future returns are likely to be lower than what the average investors might expect. It's always a challenge. And you never know what the world sets you up differently at different points in time. We can't will into reality what we want to be true. So, we appreciate the world for what it is, and therefore look more fluidly at our hurdle rates. A ton of opportunity raises it but less causes it to decline. Of course, there are times when the pitches just aren't there. So, cash builds as a result, as I said earlier.
I appreciate what is within my control and what's outside of it. I mean, I wish I knew that if rates would stay low forever. I wish I knew that interest rates have gone from 9% to zero percent over my investment career. I certainly would have made some different decisions along the way. High yield is a good example of how we modify our views though. The 10-year Treasury was trading at a 5% yield in 2007 in the fourth quarter. At that time, we required a double-digit return for high yield. Today, with the 10-year now at less than 60 basis points and admittedly no idea how long that might be the case, but we appreciate that the government imperative is to keep rates low. Our hurdle rate has come down along with that. Ideally, we'd still prefer 10% as a yield to maturity in high yield, but we're now considering the very high single-digit range as well. I mean, it's almost as if like 10% has become the new 15%. And we were able to in second quarter--beginning the second quarter--able to buy some senior secured term loans of Carnival Cruises or Royal Caribbean at 12% yields. But we were sadly not able to deploy as much capital as we would have liked. Prices were down, but only for a minute before rebounding.
Benz: You wrote in your recent letter that you saw fewer possibilities for extreme negative outcomes, the so-called left tail of the distribution, than you did before. Can you walk through how you came to that conclusion and how that might have informed the way that you run the fund?
Romick: I think you're referencing our comment that the COVID tail risk has been flattened, and we may not have written it as well as we could have. But what I was trying to say was we now know more about the disease than we did then. And as a result, there should be less fear--that most of us will survive this and will do so with the global economy that will not be sunk permanently into the abyss. So, it's really more a statement I was making about the disease than about the markets.
Ptak: Maybe widening out again, I think that you had mentioned recently that you like the optionality of cash, but given the increase of global money supply and an express commitment by central bankers to hold rates near zero, you're reluctant to hold too much dry powder. So, maybe sort of jumping ahead, supposing you're right and it is more beneficial to own risk assets like stocks because fiscal and monetary authorities won't allow interest rates to rise, how will you know when it's time to get defensive again? We know you're not a market-timer, but also there's fundamentals that you would look at. And so, what are those things that you would be looking for to understand that the regime had changed again?
Romick: We think defensively. Everything comes back down to price. And again, bottom-up. And the important point is that price dictates action. If we see the opportunity set in the market on a bottom-up basis, then we end up building our positions. And at a point in time, when it's no longer there, then we end up selling. It's not a top-down view. We look at it as there's the stock market, and there's all the individual companies that trade within it, so it allowed us to be invested aggressively, relatively speaking, in the late 1990s and then less invested as we approached the great financial crisis. It's not any one thing that drives a decision. It's a whole host of variables that have to be considered as we look into these different environments.
Ptak: Maybe jumping to allocation, the portfolio was recently split about 70%-30% between stocks and bonds/cash equivalents. Within the equity sleeve, it's about 70% U.S. stocks, 30% international stocks, if I'm not mistaken, by domicile, and the bond sleeve is mainly in corporates and cash equivalents. So, what's the risk/reward balance you think this allocation achieves versus, say, the U.S. 60%-40% allocation, which is probably most familiar to our listeners?
Romick: Just as a point of information, we're almost 40% in companies based outside the United States now. With respect to the risk/reward of Crescent Fund relative to a 60% stock/40% investment-grade bond portfolio, I can't offer up an easy answer. The biggest variables we encounter with interest rates in the economy if rates were to rise and remain sustainably higher, then the tailwind that the 40% investment-grade portfolio has been enjoying for now going on its fourth decade will evaporate. In that scenario, we think we should look pretty good by comparison. In the second scenario, if rates were to remain lower, go lower, but the economy recovers moderately and allows for the earnings recovery for those companies that have been challenged of late, then we should fare pretty well as well, given how we've reset the portfolio.
Now, on the other hand, in a third scenario, if the economy falls out of bed from here, and we don't have the economic recovery from COVID that we hope, then our fund's larger equity exposure could be a headwind. I say “could” because, as I mentioned earlier, equities are of a higher quality than has been the case historically. Over time, though, we expect the portfolio allocation to move around, unlike a 60%-40% static allocation. The fund's more dynamic exposure will be dictated by what our view is of the companies we own bottom-up. It should be noted, though, if you look back over time, we have done very well when we pulled from our cash reserves and gotten more invested.
Benz: If I'm an investor and I want to try to beat the 60%-40% portfolio over the next decade, and Jeff noted that 60%-40% classic sort of U.S. equity-Treasury portfolio has done really well, what's the single biggest tilt that I could make in my portfolio to influence my possibility of outperformance? Would it be to emphasize foreign stocks, shorten up duration on the bond side? What would be the single best thing that I could do for myself?
Romick: Remember, you're talking to the guy that missed the single best thing over the last 35 years of his investment career, which is that rates have gone from 9% to zero. So, I wish I had a strong answer for you in that. We obviously--as I said, we aren't a 60%-40% fund with a static allocation. And we're comfortable with our portfolio by comparison, but it isn't any one thing that's the driver. We own more of some sectors and asset classes but less of others. We've tilted more to foreign stocks, as Jeff alluded to earlier, because overseas analog of the U.S. businesses are cheaper. We don't ever take duration risk, which has hurt us given the level to which rates have declined. But for that same benefit to accrue prospectively to the typical 60%-40% fund, rates would have to go to zero and then keep going negative another 1, 3 points to offer the same benefit in the coming decade as it did the last.
We continue to not own much high yield. We hope to before too long, but that will have to be when the higher yields are being offered to account for the restructuring risks that so many of these overlevered businesses face. Our strategy has faced a number of headwinds in the last decade--value has underperformed growth, low volatility, or perceived quality has outperformed the more cyclical companies; interest rates, of course, have continued their inexorable trek lower and internationals have underperformed the U.S. So, the next decade offer up any combination of changes rather than just any one driver of these variables and then the Crescent Fund should set up very well by comparison prospectively.
Ptak: I should have asked this to begin with, but just to further orient our listeners to the way you run money--and many of them are familiar with you but a subset are not.I If you had to tear down the portfolio and started it anew, what are the fundamental tenants of that process of building the portfolio, your points of orientation when you think about what it is you're trying to deliver to your shareholders through a market cycle? Is there a particular sort of return target? Is there some sort of information ratio? How does it all come together?
Romick: Well, it's a great question, particularly because we have all these tools in our tool chest, I mean, more than most other managers. But we use these tools as a way to manage a portfolio of securities if someone has given us all their money for at least five years, right alongside ours, our family and friends. In order to deliver on this mandate of equity rates of return, we invest across the capital structure. We're buying common stocks, preferred stocks, junior debt, senior debt, bank debt. We've made private loans over the last decade as part of the portfolio and had been able to generate midteens rates of returns in that as well to help deliver on this mandate.
So, at our core, we're just trying to deliver this equity rate of return by using lots of tools available to us. Then just because we have all these tools to deliver on that mandate doesn't mean that at any given point in time those tools should be used or can be used because it's a function of what opportunities are being presented by the market.
Benz: Out of curiosity, what role would a strategy like FPA Crescent fill in an investor's allocation? Is it designed to be kind of a core holding or something that would be used alongside other holdings? How do you envision it being used in a real-world portfolio?
Romick: Well, we use it as a real-world portfolio for ourselves--my partners and corporate fund managers, Brian Selmo, Mark Landecker, myself--and as I mentioned in a previous question, our money is invested alongside our families’ and friends’. And so, assuming the appropriate time horizon, we look at it as a core. Now, I don't want to be so presumptuous as to suggest that it being a core is appropriate for someone else. But that's certainly how we use it.
Ptak: If I may, I had admittedly a very dumb question, but I think that FPA Crescent--I think that you referred to it as a contrarian value strategy, if I'm not mistaken. I could have the terminology wrong. There's a part of me that looks at the portfolio and wonders why it isn’t even more contrarian than it is. And that's not a question to challenge the way you put the portfolio together. It's really more sort of wrestling with this notion that an oversimplistic approach to contrarian investing would dictate that you'd be heavier in things that have been really out of favor like value, small, foreign, emerging, shorter duration, hard assets as opposed to intangibles. For you as a portfolio manager in assembling the portfolio, given your contrarian impulses, why don't we see even more of those elements in the portfolio? Or would you argue that we do, they're just obscured by some other things?
Romick: It's a good question. Being a contrarian investor or a value investor doesn't mean that you can't ever buy a growth stock. It does mean that if you do buy a growth stock, that the price you pay must still afford you a margin of safety. Warren Buffett and Charlie Munger taught us a long time ago that the margin of safety was historically as practiced in the Graham and Doddian kind of way was you were protected by the balance sheet. And what we've learned over time, in part because of technological innovation disrupting so many different businesses over the last couple of decades, where it's become increasingly apparent to all of us, that a lot of businesses just won't be the same in the future as they were in the past. I mean, rivers do run dry. And so, what we try and do is we try and buy those businesses that at a point in time that offer us that margin of safety and that could end up allowing us that owning a business like as we own today in Alphabet and Facebook. I mean, they aren't necessarily value socks. And we actually think that there's genuine value in companies of different sorts at different times.
And so, when we bought, for example, Alphabet, it was at a point in time, back in 2011, when the economy was showing signs of strain and investors were questioning its growth. So, it was contrarian, at least at that brief moment in time. And we purchased Facebook in 2018 amidst the Cambridge Analytica scandal. And both of our initial purchases, for each of them, these two companies were both trading at low teens P/Es after backing out their cash holdings and their nonearning assets and reducing their earnings by their share issuance.
I think that one can be a contrarian investor by buying good businesses when other people don't want to own them for some period of time. And some of these things were what people would think of as the more traditional value names, and we have some of those in the portfolio as well, but there are certain sectors that we just are staying further away from, where they don't offer the same opportunity set that they have in the past. Prospectively, retail is not going to be as good a business in the future, brick-and-mortar retail, as it's been in the past and that in turn spills over to mall REITs as well. Owning a traditional media company, a broadcaster, is a different business in the next 20 years than in the 50 years preceding it as a result of streaming, etc. And even businesses that--like the cable companies that we own in the portfolio, Comcast and Charter, an element of their business that has been disintermediated on the video side of the equation, yet they've been fortunate to have the broadband side as well. So, it's very important to us that we are willing to buy businesses that are more challenged at a point in time, that are cyclically challenged, if you will. But what we're not willing to do is knowingly buy those businesses that are secularly challenged, where the industry is facing great headwinds. And we avoid the companies like, say, you go back to the 1990s, you saw video-on-demand coming down the road. You didn't know that there would be a Netflix delivering a CD to you. But Blockbuster as a business had a future that was unclear.
So, we stay away from businesses like that back in the ‘90s and we stay away from brick-and-mortar retail starting a decade ago, where we used to have a large brick-and-mortar retail exposure for a long period of time, as we did in energy at a point in time as well. Again, disintermediation in the part of energy as well. This is an industry we used to own in size back more than a decade ago. And we bought it at a point in time coming out of the 1990s when oil had been hitting lows, and two things we thought were true at the time. We thought that these managements had learned good capital allocation. And we were a believer in peak oil. Well, we subsequently learned during the course of the period called 2002 to 2008 that these companies were not good capital allocators; they did not learn their lessons from the past. And then, the second issue was that we were no longer believers of peak oil thanks to the development of oil in tight formation, shale. So, you had millions of barrels of production a day coming on that we hadn't expected earlier that decade. So, when the facts change, we have to change. And we did change along with it and sold out of those positions, again, focusing on those companies at the cyclical risk and avoiding those when we think that are more secularly challenged.
Ptak: Do you think it would be fair to say--and perhaps it's not so correct me if I'm wrong-- that, your team is warier of buying into some of these secularly challenged stories that were very, very inexpensive? Maybe you're being more than paid commensurately for whatever risk that you're courting because they have gotten so cheap. Are you just leery of those types of situations because maybe the world is just that much more dynamic than it used to be and the game has changed for value investors like yourselves?
Romick: Well, we've made purchases in some hard-hit industries that are cyclically challenged. But we're avoiding, as I said, those businesses that are more secularly challenged. So, businesses like travel, leisure, and hospitality, we own, and we bought in the depths of the downturn, the stock market downturn, because we believed those businesses are going to grow over time. And after COVID, we're even more convinced that people want and need to get out. We're living through what we believe will be a temporary disruption for many great businesses. Whereas some businesses or industries like energy just fundamentally are crappier business with a bleaker future as the world becomes more electrified, in addition to the additional supply that we've seen come into the market.
Ptak: In a situation like energy, where--I don't think we would quarrel with that characterization that that business is secularly challenged--you could still own them really, really cheap. And so, in a situation where you're being presented that kind of opportunity, you hate the business longer term, but they're so inexpensive that you feel confident that you're going to be paid with a suitable margin of safety. I mean, under those circumstances, are you still going to be leery about wading into energy the way maybe you did before?
Romick: Well, I would answer the question in two parts. One, we're not likely to say never. Price does matter, and price, as you're pointing out, can solve a lot of problems and create such a great margin of safety where it's hard to lose. So, in certain circumstances, we could actually see owning an energy service company or two. It's unlikely we'll be able to assemble a portfolio with the kinds of management teams that we want and the businesses that are good enough, that would be as large a position as it was, say, 15 years ago in the portfolio. But I certainly can't say no, that we wouldn't own them at a point in time in the future at least to some degree in the portfolio, because, as you pointed out, price matters. And if you have that margin of safety, then we certainly could justify.
But what we would want to do in that circumstance is to kind of neutralize price where we don't have to make such a large bet that the price of oil has to be at a certain level in order for us to make money. And we would want to own those companies at a point in time where the price of oil could be at a relatively low level and this company can still do what we want to depend on oil being $60 or $70 a barrel in order for us to get a good rate of return on that asset.
Benz: Would you say, when you think about the portfolio, do you make a conscious decision to balance some of the better secular growth companies alongside the traditional, maybe more cyclical, value names?
Romick: That puts more emphasis on a top-down view and trying to create that balance consciously, where in fact, it really does come from the bottom-up when we see these different businesses show up in the portfolio. COVID hits, it creates an opportunity set within the travel and leisure sector that wouldn't otherwise have been there. We couldn't have predicted that. And so, the portfolio migrates to where the value is. So, our portfolio always migrates to where we think the opportunity set is. That, I think, is probably the most important point, not that we say, “Well, we want to have this balance between growth and value.” The truth is, we own both in the portfolio, of varying sizes at various points in time. We'll end up more overseas not because overseas looks statistically cheap, but because certain companies based outside the U.S. are, in fact, attractive opportunities on their own. So, we ended up with more cyclical names in the portfolio that look more like the traditional value names. And we can end up owning a HeidelbergCement, for example, or an Otis elevator or Wabtec. And despite being value investors, which to us simply means investing with a margin of safety, but in a growth-driven market, we've actually been able to perform marginally better than the S&P 500 since the great financial crisis and more than 3 points better annualized versus the MSCI at least since 2011, when our international portfolio started becoming a larger part of what we do.
We've been successful in the past, not just by focusing on the upside for these different businesses, whether they might be ascribed a value moniker or growth moniker, but because we focus not just on the upside, but on downside protection. Our returns, in other words, have been generated not just what we own but what we don't own. And this focus that I discussed earlier, we focus on these growing businesses, whether the growth be secular or cyclical, is where we end up allocating capital in the portfolio and sometimes it ends up being a bit more of one than the other. But what it does do is it keeps us away from those more secularly challenged businesses that I mentioned here, whether it'd be the brick-and-mortar retail, as I said, throw broadcasting or throw restaurants into that bucket as well. And some of these companies that are really just good quality businesses, even though they are cyclical with good incremental returns on capital, that should grow well over time. And if they are growing well over time and they're offered at an attractive valuation, then that's something that you could very well see in our portfolio if they're good businesses.
Ptak: You mentioned earlier, to paraphrase, sort of this notion of flowing to the opportunity. One area where it seems you're not finding plentiful opportunity is among defensive stocks. And it's interesting because it's an area that seemingly boasts some high-quality businesses. We're talking about healthcare, consumer durables, certain utilities. Do you feel investors are overpaying for the consistency that these businesses can boast?
Romick: I think we're effectively saying that by the lack of those positions in our portfolio, certainly. We think that investors on average are paying too high a price for what is viewed as defensive today. It's giving people a lot of psychic comfort to know they're getting their staples delivered to them as they quarantine at home and those businesses aren't being as impacted in the portfolio as some hotel company. As Warren Buffett opined to Carol Loomis in a now well-known 2001 Fortune magazine interview, he said, “I'd rather have a lumpy 15% return on capital than a smooth 12%.” And right now, we're clearly at the lumpy part of that path. We don't have anything against defensive stocks to be clear. We owned a number of global consumer staple franchises earlier in the decade when there were much cheaper, companies like AB InBev and JNJ, Unilever and Orkla were positions that we once held. We just don't see that same margin of safety in owning them today that we did in the past. And we know these companies can offer a smoother ride, but we don't think they'll get us to where we want to go at the current prices. So, for us, it makes more sense to own what's inexpensive and good, rather than just what the market suggests one might want to own.
This has led to Crescent's traditionally large active share. The portfolio doesn’t move around quickly, but it does move around. Healthcare was our largest exposure after the great financial crisis. That was then followed by tech. We will always migrate to the asset that is best priced that can offer us future upside while protecting our downside.
Benz: You own Wells Fargo, which can't seem to get out of its own way. What's the market missing about this company, which has been under a cloud for so long?
Romick: I don't think the market is missing anything right about now. But, I mean, at least for the moment in time, our job is to think about what the future might look like, not just what it looks like at the moment. We bought Wells Fargo after that bad news was hit in a contrarian fashion. We knew when we got in it wasn't going to be a quick turn. And it's certainly proven true, if not longer than we probably would have thought at the outset. But we should begin with by saying that Wells Fargo's balance sheet is solid. I mean, the company is better capitalized today than it was in the great financial crisis and that's after putting up some big reserves in the recent quarter. Management is good. And we think that Charlie Scharf is the right guy to ride this listing ship. And the company trades at a substantial discount to its tangible book.
Years ago, we used to tell our shareholders that there was a Wells Fargo inside of Bank of America. Now, we didn't think a decade later we'd be saying that there's a Bank of America inside of Wells, but we think there is. When they do fix, we believe they can, fix their commercial banking business, based on returns that are similar to Bank of America or Chase’s commercial bank business. And just like it wasn't a quick turn for Bank of America, it's not going to be a quick turn for Wells Fargo. So, the jury's out, but the indications as to what is likely to happen is an analog that we've seen before. How exactly will it play out? It remains to be seen, but priced where it is, with as much of a negative view circulating the stock as there is, we think it sets up for an attractive risk/reward.
Ptak: You're courting some regulatory risk, it could be argued, in the portfolio. You mentioned some of the names that you own, which have grown into very dominant positions in their verticals, Facebook, as an example, Alphabet, another example. Maybe a lesser cited example would be Comcast, which is a top holding in the fund. To what extent does your thesis for Comcast assume the firm will be able to continue to raise Internet access pricing to offset maybe any weakness in the television and phone parts of the business? And do you think increased regulation could undo those plans?
Romick: It's a great question. It's something we certainly have pondered and discussed with industry experts as well as the companies we own. I want to take a step back and think about regulation more broadly, first, and then dive more specifically into the cable companies. The specter of regulation raises a lot of fear in investors, and understandably. You don't know what's going to happen. But if you look at the most significant cases over time with regulation, it hasn't been a bad thing. John D. Rockefeller became richer after Standard Oil was broken up. All the investors in the Baby Bells after Ma Bell broke up did very, very well.
So, regulatory fears are just fear. We don't know what the reality will be. We know what it could be. You can create the worst-case scenario certainly. But it is a question that we do ask ourselves, and we think about how that might impact this utility. So, we should frame this question to include both Charter and Comcast, companies in our portfolio and they offer this utility that, as you pointed out, provides video and broadband as well as telephony to its customers. Now, telephony should hardly be mentioned, as it means so little to the economics of these businesses. And as you appropriately point out, video is weak and won't likely rebound. As we dug into understanding the industry, we realized that, given the high variable cost and capital-intensive nature of the video business, the profitability for at least Charter and Comcast were somewhere in the order of $10 to $20 of EBITDA per customer per month for those two companies. Then you rent trucks for service. They need to front the money for the receivers. They need to pay their content providers for each subscriber that receives a service. Unfortunately, that's variable. Given video's low profitability and that profitability wouldn't go away overnight, we felt there was enough time running them and a large enough pricing umbrella to not run afoul of the regulators. Nevertheless, it is something we watch closely.
Benz: I wanted to ask about inflation. Inflation has been a nonissue for investors for quite a while now. But we've begun seeing breakeven rates nudge a little bit higher very recently. How much does that worry you, and how does that inform how you put together the portfolio, if at all?
Romick: When we try and create a portfolio, that’s robust to multiple outcomes, whether it'd be inflation, a recession. We obviously, as I stated, we don't know what we're likely to have happen in the future. The fears of inflation don't specifically impact how we create the portfolio because we don't have a view. If inflation is low, we know certainly’, but it may not always be. So, we prefer to focus where we can develop the view with conviction. If there is inflation, we think that owning businesses that offer good unit growth over time and pricing power will be an excellent way to protect against that. And that's what you see throughout most of our equity book in our portfolio.
Ptak: You've written a few times recently about how the Fed in essence took the bat out of high-yield-bond investors’ hands. In effect, they scooped up the value there when they stepped in. My question is, What is the new supply dynamic in bonds with the Fed now an even more determined buyer, and I use the term “Fed” somewhat liberally. I think I'm speaking more generally of monetary authorities.
Romick: Yeah. I mean, look, it's--and as you speak more generally, I mean, you see this problem in different parts of the world. I'll start with the ECB. They actually lent money, well, at least, we understand it--it hasn't been published yet. But they're buying high-yield bonds in Europe if they meet certain parameters. And those parameters were met by Louis Vuitton's issue of debt that was used to purchase Tiffany. So, here you have a country that has socialist tendencies with a wealthiest guy and brands who's able to borrow money with the paper that goes out as far as 11 years at an average yield of less than 50 basis points, and some part of that was actually negative, and apparently some--and he said, he was buying some of that. And so, people, including central bank, were actually lending money to the richest guy in France and paying him to buy a U.S. luxury goods retailer and manufacturer, it's crazy.
And so, we haven't seen that same element of craziness in the United States. But clearly, in the Fed's willingness to exercise their will in such a ways to backstop the market, it took high-yield prices up. So, the opportunity set that exists in high yield and I mentioned that we bought some bonds earlier, including, the senior secured debt of Carnival Cruises and Royal Caribbean. But there wasn't the huge opportunity with the market staying down for an extended period of time that we would have hoped for. We were able to in 2008 into 2009 increase our high-yield book to more than 30% of the fund at that point in time, where this opportunity existed for a period of days. So, we didn't act as quickly to be able to take advantage of that. That's not our nature. We need things to sit down a little bit and understand what it is we're buying. So, high-yield bonds today are trading closer to their highs, so far from bargain prices. And although ever hopeful what the future might bring, given the Fed's entrance as a high-yield-bond buyer, we aren't sanguine over the near term. But that doesn't change there's still a lot of restructurings that are taking place. And we think there's going to be opportunities for us to get more engaged as we work through this. And that story is not entirely written yet.
Ptak: You used the word “crazy” before, and I don't think that any of us would dispute that characterization, given what you described. I guess it leads to another question, which is, When you see some of these situations where there's clearly an imbalance and things have gotten out of hand--I mean, another choice that you can make as a portfolio manager is to push it a little bit further and not just be underweight, but to actively short in size, for instance, bonds and duration even more aggressively than you are. You're underweight, but have you considered taking it even further, and if not, why so?
Romick: Shorting is part of what we do, but it's not a large part of what we do. And we have three kinds of short strategies we will run in the portfolio. And I'm going to circle back to that in just a moment, because you addressed the idea that we're short some bonds, and I want to make sure it's understood the kind of shorts that we obviously do have in the portfolio, because we aren't actually naked short bonds. But I think you're looking at are some of the shorts of some corporate bonds that is offset by a corresponding term loan that we're long in the same company's capital structure. So, we've never taken a view on rates. It is not our history. We just don't have that expertise. But we do take a view on credit quality, both absolutely and relatively.
A number of these different issuers have both term loans that are secured and senior loans in the same capital structure. So, when we put this trade on, the pricing of the senior secured loans of some of these cyclical and secularly challenged businesses are trading at higher yields than the lower rated and slightly lower-yielding unsecured bonds of the same company. This is true of Avis, Penn National Gaming, amongst others, and is a good example of some of the different kinds of investments that we will make in the portfolio. The kinds of strategies we generally employ are threefold--there's naked shorts, paired trades, and arbitrages. We don't have many naked shorts. But the ones we have made over time have underperformed the market. Some shorts that we hold on the paired side are in companies that allow us to own a position in a long that is otherwise larger than it might have been. So, for example, we shorted a public PBM company while being long CVS, which effectively serve to neutralize CVS', the pharmacy companies', pharmacy benefit management exposure, albeit with some basis risk, because the PBM that we were short wasn't the same PBM that they owned inside of their portfolio. The third short strategy are the arbitrage positions, where there's less basis risk between the long and the short. And for a more recent example, I'd say, you can look in the first half where we went long SoftBank and shorted out its public telecom exposure.
One of the things we try to be careful of when we're shorting is the recognition that shorting has a couple of inherent challenges to it. One is that it's tax-inefficient. Your gains, assuming you're fortunate to get them, are taxed as ordinary income. And second, that the setup on a risk/reward basis has the asymmetry going in the wrong direction, as opposed to a long where you've got this theoretical upside, which could be infinite, and the downside that you max out at 100%. Well, the opposite is true in shorting.
Benz: I wanted to ask about retirement. And so, say, we have listeners who are embarking on retirement, and they're trying to balance income, production, alongside total return and safety. How would you counsel them, and I realize you're not running a retirement deaccumulation vehicle, but we're in this era where yields are really, really low. How would you suggest that retirees approach that?
Romick: We wrestle with that every day. And for us, Crescent has been our answer. When we think about our equity portfolio, there's more growth in the market on average and expected more growth in the future, the fund’s 2.2% dividend yield or so is both higher and more tax-advantaged when compared to a 10-year Treasury. Retirees are scared today to retire because there's this great need for income replacement because the 5% Treasury yields you were getting back in 2007 doesn't exist today. And so, the average retiree is looking at that and saying, “Well, what do I do?” So, unfortunately, it does speak to a need for the acceptance of some greater volatility to achieve a rate of return that's even close to what you would hope to. But if you look at our equity portfolios we laid out in our second-quarter commentary, the stocks we hold trended up over a 5% earnings yield on depressed COVID numbers.
Assuming the consensus earnings growth over the next few years, and then just a relatively meek 4% earnings growth for the balance of the decade, our equity portfolio, should it remained unchanged in price, would have an 11.5% earnings yield in you year 10. Not so bad. And on the unlikely event that there'd be no dividend growth, you'd receive 22% of your capital back in dividends. Now, compare that to just a 6% pretax yield you would get back by owning a 10-year Treasury with the ability to reinvest whatever opportunity set might exist at the point you received your dividend payment. So, framed over the longer term, the Crescent equity portfolios' earnings and dividend yields appear superior to the bond and cash markets.
We've chosen to accept a bit more volatility in exchange for the opportunity for a better longer-term return on capital. I talked to my father, for example, who's a retiree, we have this same conversation as to how he has to be comfortable with some degree of volatility. We believe that when global economies recover, investors will appreciate the merits of many of these unloved companies with deeply discounted valuations compared to the market. And investors will end up being better off with their portfolio like that as you look down the road. Now, again, this assumes that investors' time horizon is more than just a year or two.
Ptak: For our last question, I wanted to widen out a bit and ask you about markets as discounting mechanisms. In your experience, has the market gotten better at this? And when is that mechanism likely to break down yielding opportunities? We talked about one of the newer dynamics, which is the entry of central banks, let's say, into the price discovery process. There was perhaps an opportunity in high-yield bonds. And that quickly closed as we had these other participants who maybe weren't a part of the process formerly now entering into it. And so, maybe you can reflect on your many years of experience on how effective the market is as a discounting mechanism.
Romick: I don't know if the market has gotten better, or if it's really as simple as with rates as low as they are investors find little alternative. I mean, time will tell. There was a point in time where--I mean, markets have always been driven by greed and fear. And today, there's a little bit of greed and need driving this, or need and fear—some combination--but need is certainly into the equation. And Christine asked the question about what is a retiree to do?
The idea that helped really drive the tech bubble in '98 to 2000 was really one of FOMO--that “fear of missing out”--and now there's a new acronym today. That's TINA, that “there is no alternative”. And so, if you don't get the yield that you're getting in a conservative fashion, what does one do? And it pushes people into other instruments that are out there. And whether these people who are making that shift have the ability and comfort level to stay with a trade like that when it becomes more volatile--particularly when it stays volatile for an extended period as opposed to just rapidly rebounding. So, what appears to be a better discounting mechanism might just be that there's been so little alternative that capital has flooded into as people have sought to find a place to get some returns in their portfolio.
I'd observe that markets can still be volatile. Now, March was volatile for a relatively short period of time. But for that period of time, valuation spreads around the world blew out to levels not seen since 2008--I mean, 3 plus standard deviations. Price movement was way in excess of changes in business value, and one should generally expect us to find opportunities in those periods. If the markets are really such a great discounting mechanisms, you wouldn't see companies like AIG, that was trading in the 50s earlier in the year, trade down as low as $16 a share with book value that's still in the 50s. Now, maybe book value drops to the 40s. We own AIG, by a way of disclosure, but we don't think the business value of AIG has changed as much as the stock price. And the stock went down 65% and now it's up 80%, 90% from its low. Its business value isn't moving around that much, but the perception in the marketplace that is clearly something that's quite different.
So, it's hard to tell. And the other variable that we kind of touched on earlier that's been a driver that makes it appear as if the market has a better discounting mechanism today, or is a better discounting mechanism today, is the fact that some of these larger global businesses that really encompass such a large percentage of the market as a whole have really been big drivers, or these few companies and the top five companies now have 22% of the S&P 500. That's all-time high. That's a driver as well.
Ptak: Well, Steve, this has been great. Thanks so much for your time and insights. We really enjoyed chatting with you today. Thanks again.
Romick: Thanks, Jeff. Thanks, Christine.
Benz: Thank you.
Ptak: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts.
Benz: You can follow us on Twitter @Christine_Benz.
Ptak: And at @Syouth1, which is, S-Y-O-U-T-H and the number 1.
Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.
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