Steven Romick’s Top-Down Bottom-Up Value Investing
Romick normally wants average businesses at good prices. He has reconsidered, however, now that high-quality, large-cap companies are available at average prices. A basket of large tech stocks is 5.6% of Crescent’s portfolio as of June 30.
Although Microsoft had the greatest negative impact on his portfolio in the first quarter, he added in the second quarter 1,805,000 shares at $25.06 a share, bringing his total stake to 7,055,000 shares. “Large-cap tech stocks are as cheap as we’ve ever seen them,” he said in his second quarter letter.
Bad press and a general feeling that the demand for Microsoft’s core products is waning (supported by some evidence) have dragged on the stock price. From Romick’s perspective, those issues don’t matter nearly as much as its prime valuation and earning potential. Currently, the stock trades for even less than it did during the financial crisis, with a P/E ratio of 9.7 compared to 10.4, indicating low earnings expectations. It also boasts 50% higher earnings in fiscal 2011 than five years ago.
To demonstrate Microsoft’s competitiveness, Romick compared it to cloud leader Salesforce.com (NYSE:CRM) in his second-quarter letter. Salesforce.com had $1.7 billion in earnings last year and is valued at greater than 100x forward earnings, astronomic in Romick’s view. By contrast, he said:
“Microsoft is already a leading cloud player, as measured by number of users and revenue, and yet the market seems blind to this fact, awarding it just one-tenth the P/E. To secure Microsoft’s place in the cloud, Jean-Philippe Courtois, president of Microsoft International, said earlier this year that the company would spend 90% of the company’s annual $9.6 billion R&D budget on cloud strategy (more than 4x Salesforce.com revenues). With Microsoft’s R&D staff of 40,000 and a portfolio of product offerings that touches almost every organization in one way or another, we give ‘Mr. Softee’ at least a fighting chance at remaining relevant in the world of corporate cloud computing.”
Likewise, he established a position in Cisco (CSCO) of 5,450,000 shares at $16.48 in the second quarter. Cisco’s stock price has dipped 19% year to date despite record revenue of $40 billion in fiscal 2010 and a revenue increase from the first to second quarter of 2011. At its current valuation, Romick sees a reassuring margin of safety, considering questions still remain about how large tech companies flush with cash will allocate their capital, and how their businesses might get disrupted by new developments in the sector.
Romick also added 85,000 shares to his position in HewlettPackard Co. (HPQ), an out-of-favor tech stalwart, at $38.06 a share. He initiated his position with 1,915,000 shares purchased at $44.63 a share. HewlettPackard trades for just six times forward earnings and after growing steadily through most of the last decade, it has had declining annual free cash flows since 2008.
In the second quarter, HP announced drastic changes aimed toward honing its focus and driving shareholder value. Most notably, it nixed its TouchPad and webOS phones, will acquire British software company Autonomy Corporation, and could sell its PC business as consumers increasingly prefer newfangled tablet devices.
“We enjoy the flexibility to invest in various asset classes; yet having the ability to go anywhere loses its advantage if there’s nowhere to go. That’s the position we find ourselves moving closer to today, given that many stocks aren’t particularly cheap,” Romick said in his last investor letter. Retailers are another sector where he has found value, aside from large tech. He has been particularly greedy with Walmart (NYSE:WMT) and CVS (NYSE:CVS) recently.
Romick added 33,000 shares of CVS to his holding at $37.07 a share in the second quarter. He now owns 6,325,000 shares in a position he initiated in the third quarter of 2010 at $29.57 a share. It is 6.1% of his portfolio.
CVS will soon benefit from the spate of prescription drugs coming off patent in the near future, as the elimination of the distributor drives up margins. Again, his macro view comes into play – an aging population will need more drugs, and healthcare reform should bring in 32 million new people, he estimates. More customers will then purchase more goods at the front of the store.
CVS’s cash flow reached $2.7 billion in 2010 compared to $1.5 billion in 2009, and it has raised its dividend every year since 2003. Romick gives his in-depth thesis on CVS here.
Financials: Contrarian to Contrarians
Romick wishes he could buy more financial stocks. As of mid-2011, they are just 1.3% of his portfolio. His awareness of the macro environment helped him to avoid huge losses during the financial catastrophe of 2008 – he had moved most of his fund to cash at that point.
Today, his firm is still leery of financials as “a result of the intersection of our bottom-up approach with our consideration of the macroeconomic environment,” he said in his investor letter. He went on to say, “…functional insolvency of Western governments, the potential real estate bubble in China, unnaturally fixed currency exchange rates, untrustworthy official data, and highly manipulated interest rates, create the fear that the oasis of bottom-up bargains we see could prove a mirage.”
However, his fund has established a position in three banks according to his second quarter letter. He had a long checklist for the banks he chose: strong operating franchise, significant market share, exposure to the global financial system, much stronger capital position than during 2006-07, robust reported capital strength (based on traditional measures), unusually low price to current tangible book value, low valuation to prospective normalized earnings power. The three banks that made the cut are Bank of America (NYSE:BAC), Citigroup (NYSE:C) and Bank of New York Melon (NYSE:BK).
Romick’s fund is bullish on energy. Oil and gas stocks are 9.6% of his portfolio, and his fourth largest holding is Ensco (NYSE:ESV), a provider of offshore drilling services with the world’s second largest offshore drilling fleet. Romick named Ensco a “loser” for the second quarter, as the stock fell 8%. The stock then tumbled 24% in early August on its second-quarter earnings results that missed analysts’ expectations.
Ensco, however, has 100 years of contracted backlog, or more than 1.4 years per rig. As for long-term growth expectations, the company is having continued success in exploration and appraisal, increased demand for energy, strong commodity prices, emerging deepwater basins and more client spending. Their recent acquisition of Pride International should boost third-quarter revenues to $930 million from $563 million in the second quarter.
Romick increased his exposure to drillers following the BP Gulf of Mexico oil spill, which lowered prices and put many oil-related companies at a discount. Romick saw things from a macro perspective as well. At the time, the government banned all drilling in the Gulf. His firm felt conviction that drilling in the Gulf of Mexico would resume because ceasing critical production of oil from the region would cause a supply/demand imbalance and subsequent spike in prices.
In the fourth quarter of 2009, the company moved from Dallas to London to appear more internationally-oriented, become more accessible to customers, and save on taxes. Romick believes that that decision increased Ensco’s intrinsic value by at least 15%, subject to estimates of dollar repatriation.
Overview of Romick’s Thoughts on the Economy
Romick does value investing through the lens of approaching national default and resulting austerity, until he gains confidence in elected officials. He believes printing money won’t solve the problem of national debt that overshadows the economy, the stock market and consumers. Rather, he believes Congress must look at both discretional and mandatory cuts, including social programs, to make a real difference.
If stimulus spending proves unsustainable or ineffective, Romick says that interests rates could spike due to higher inflation expectations and because foreign buyers of U.S. debt won’t have confidence that the country won’t default. His firm expects the dollar to weaken versus a basket of global currencies over time.
Romick finds the current investment environment difficult, risky and frustrating for investors. Central banks’ efforts to drive asset prices higher have effectively created wealth, but made the opportunities sparse and margins of safety insufficient. Few assets classes are cheap or out of favor. Markets are enjoying, he says, a period of relative calm between two crises.
“We have, in effect, borrowed from our future returns,” he says, “and we therefore continue to find less to get excited about in the equity markets.”