GuruFocus.com Interview with Steve Romick, Portfolio Manager of FPA Crescent
Here are Steve Romick's answers to readers' questions:
GuruFocus: Most value investors, as we know, are bottom-up value investors. Even Warren Buffett said he doesn’t care about the economy – he just looks at the individual companies. But at your company, FPA, you seem to look a lot at the macro economy, macro market. Why do you think it’s important?
Romick: Well, we are primarily bottoms-up analysts. If a business is cheap or an asset trades at a discount we’re interested. But we always have an eye to protecting capital. That’s where our macro considerations come in. For example, our financial system is more leveraged than most realize, and this was particularly apparent in 2008. It was just too easy to get a loan to buy a home. People were living beyond their means. There was too much leverage in financial companies both on balance sheet and off. And too many of those companies weren’t reserving correctly either and their earnings were therefore overstated. So we wondered, okay, what happens when all of this gets unwound, and there’s a negative outcome? So we postured ourselves conservatively in order to protect capital.
But then on the other hand, as bad as things looked in 2009, some parts of the securities market had priced that in. When things looked really bad, like in early 2009, when we were on the precipice of a depression, we were excited about all the opportunities, particularly distressed debt and high-yield bonds at the time. So we were investing a lot of capital. The macro was bad, but our bottoms-up work suggested that we weren’t going to lose money in the worst of all scenarios – a depression.
GuruFocus: So that worked very well because you avoided financials during I think 2004 starting maybe, until 2007, 2008. But if valuation is good enough, you’re still going to invest there, right?
Romick: That’s right.
GuruFocus: Okay, so the reason in 2004 until 2008, you avoided financials was maybe because the valuation was just not reasonable?
Romick: The question is "how do we see valuation". Valuation alone I think is too simplistic of a view because what are you evaluating? What earnings stream are you evaluating? We thought the earnings stream wasn’t real.
GuruFocus: Okay. So it’s not just a surface report in earnings, it’s deeper, whether these earnings will be sustainable, whether it’s real. Is that right?
GuruFocus: Okay. So talk about the macro picture. What is the macro risk now?
Romick: I think today, the biggest thing is that the central banks think the only way out of this is just to print money, and so we’re in uncharted territory. We’ve taken what was an academic discussion and decided to experiment in the real world. There’s a whole range of outcomes, some that we can identify and others that I’m certain that we can’t identify, and it’s scary. Will we have inflation or deflation? If it is inflation, will it be a deflationary path to inflation? And then, how do we position a portfolio if we don’t have a strong conviction that it’s one or the other, inflation or deflation? What benefits a portfolio in an inflationary world is very different than what benefits a portfolio in a deflationary world. It’s very, very complicated.
GuruFocus: So you still haven’t decided which way it will go, whether deflation or inflation?
Romick: In this environment, it’s more important that we’re bottoms up, and we need a larger margin of safety in the companies we buy.
GuruFocus: What do you think about the QE3 just announced yesterday? What does that do to your portfolio management?
Romick: Well, it’s just more of the same. It's academics experimenting in the real world. And how it plays out is anybody’s guess. All the chips are on the table.
GuruFocus: Some people think that the effect from the QEs will gradually diminish, will gradually decline. Do you agree with that? The effect on the market, on the economy, on psychology?
Romick: Let’s break it down: the effect on the market and the effect on the economy. The effect on the market – since when is it the Fed’s responsibility to be driving the market higher? That’s the role they’re playing today, it's "let’s get the stock market up." And why do they want to get the stock market up? Because they argue that people will feel wealthier and therefore spend more as a result. And then hopefully those people who spend more will actually allow people they bought from to get more of an income, and put more people to work in those places where they’re buying more, and it will help the economy. That’s just a very weak set of assumptions. The reality of it is that driving rates lower has helped a certain group of people. It’s helped the wealthy. It’s protected their capital and protected financial assets better than it has actually provided or created any real jobs for people. So all it does is further create a unfortunate gulf between the haves and have-nots, which is not their true intention, but the one of many unintended policy consequences that we’ll read about in the years to come. QE has not created much in the way of new jobs. And, from these already low levels, dropping rates further won’t drive the housing market higher. The Fed is not, at least at this point in time, using their magic to conjure up a down payment for people so they can actually buy a home. And, look what low rates have done to the elderly. It’s completely decimated their ability to have an income on their savings. So QE benefits some, is neutral to some, and hurts some.
GuruFocus: So overall it does not help the economy at all. Maybe hurt the economy even over the long term?
Romick: In the longer term I think it will.
GuruFocus: Do you think it is also the reason why we have very high profit margins now? The corporate margins are very high – you wrote about it.
Romick: Lower interest rates benefit pretax margins, but corporate America really isn’t that leveraged, so I don’t think it has that much of an effect. We have better after-tax profit margins, in part, because taxes have gone down around the world. Many companies have more earnings from faster growing foreign markets that have lower tax rates, while others have redomiciled to more tax advantaged locales. That’s one example that's helped margins. Another benefit has been lower labor costs, as a result of jobs moving offshore and, in many cases, companies have rationalized their businesses, such that fewer employees are needed. These changes have already occurred and I think it would be overly confident to think that they can improve much from here. We believe that margins may not be so sustainable from these high levels.
Ultimately people buy companies today as if they’re going to be able to keep these margins up. I think that’s problematic.
GuruFocus: Now back to some more value-related questions. What does “absolute value investors” mean?
Romick: We want to understand our businesses well enough such that we can avoid permanent impairment of capital. Temporary impairments of capital we can live with.
We seek to buy businesses or assets at a discount – enough of a discount that we have a margin of safety. We try to get some kind of expected range of return, but in talking about absolute value investing the idea is that you’re buying businesses or assets at enough of a discount where you think it will be pretty hard to lose money. We consider the downside at least as much if not more than we consider the upside.
GuruFocus: That’s back to my question because you talked about the margin of safety. The margin of safety relative to what?
Romick: A margin of safety is just that you’re buying at a discount. Period.
GuruFocus: Discount relative to what?
Romick: Well it’s what you think the value of the enterprise or asset is.
GuruFocus: Can we use an example?
Romick: In 2008 and 2009 we were buying the debt of Ford Credit of Europe at 60 cents or so on the dollar. We felt that the price we were paying would make it very difficult to lose money under most any scenario. We believed that the worst-case scenario would still allow us to break-even on a principal basis, while still allowing us to collect our coupon interest along the way. And that was an unrealistic worst-case scenario.
GuruFocus: Yes, it’s more obvious if you apply to debt. What about stocks?
Romick: Okay, Walmart (WMT) as an example. Walmart as of last fall was trading at $50. The biggest retailer in the world has since seen its stock rise almost 50% since then. The company was trading at a multiple of 10 and a half times earnings-ish. And at that price, we said, let's look backwards, what should revenue growth be? We established a range. What should earnings growth be, relative to revenue growth? The margins of Walmart don’t move very much over time. In fact, of any company I’ve ever seen, the rate between the high margin and low operating margin is only 50 basis points. We’re talking about an earnings growth that should be pretty close to revenue growth. So we establish that range, a low and a high. Then we said, in addition to that we’re getting the benefit of share repurchases. In the last decade they bought back more than 20% of the shares outstanding. It’s like a creeping buyout for the largest retailer in the world. And we believed that they would continue to use their free cash flow to repurchase their shares at a rate of 2.5% or so per year. That added to our growth in earnings. And then we said they have a dividend on top of that. We added that to what we thought we could earn. By the time we were all done, we had an expected outcome, assuming no change in the P/E – which at the time was a lot lower than it is today – the expected outcome was going to be in a range of returns of anywhere from, call it 7% to 13%. We felt that we’d rather own this than bonds or cash. And we believed that it would be quite likely that we couldn’t lose money, over time.
GuruFocus: Okay, I understand. When we talk about margin of safety in the case of bonds, it’s very obvious. Relatively, you can see the discount there. You have the face value, you have the current market value. But in the case of stocks –
Romick : I don't think the margin of safety in a bond actually is obvious. You have to analyze the asset value of the enterprise to understand what that margin of safety is. Don’t be fooled by the fact that it’s a contractual obligation, because companies do go bankrupt, and then you have to go through restructuring and maybe the debt ends up becoming the equity.
We simply believed that we couldn’t lose money in Walmart. The fact that we feel that we cannot lose money over a period of time is a margin of safety. You can’t just look at margin of safety as being a discount to an asset value.
GuruFocus: Because in our case, we usually do a certain model. In this way, we will think, how much is Walmart worth? Then how much is it traded for in the market currently?
Romick: We don’t just think in terms of establishing an intrinsic value and then buying it at a certain discount. We consider risk/reward in different ways.
GuruFocus: Okay. How do you get your ideas?
Romick: From bad news. We generally look for that which is out of favor. What’s challenging different industries? Or what companies? We look for negative headlines. Wherever there’s dislocation, that’s where we shop. We shop at stores that are having sales, stores where the windows are blacked out with paper and we can’t see what's in there, so we have to walk in the store and take a peek. For example, with natural gas prices having dropped from $14 to $2, we look to see if there’s opportunity in that space? If headlines read (as they did) that Johnson & Johnson (JNJ) needs a bandaid, we’ll do some work on the name. Microsoft (MSFT) had their share of negative articles written about them as well. We ask ourselves: Are they real? Are they justified? There’s truth in them, certainly. But is that company’s stock price trading at a level that reflects that bad news? That’s how we look for ideas.
We look for IPOs. I’ve got a list of IPOs right in front of me, companies that came public in the last couple years, and they’re down a lot. A member of our team runs a screen and they put it in front of me.
GuruFocus: Maybe a high-quality company has current just temporary problems.
Romick: Well, with any company we want to make sure the problems are just temporary. And by the way it’s not just a company, it could be the industry as well. It could be the industry is out of favor.
GuruFocus: Okay. Let’s go back to Walmart. I’m seeing that you’re selling Walmart. So do you think the margin of safety is not that much anymore, or do you have other opportunities?
Romick: We have sold some.Walmart. It’s just not as cheap as it used to be. The margin of safety is not as good as it was.
GuruFocus: Okay. How about CVS (CVS)? You wrote about CVS before very favorably, and it went up a lot too.
Romick: We like what the business has been doing, how it has been executing. They’ve been doing a good job. It’s also not as cheap as it was when we bought it. Its stock is also up, in this case more than 50%. We continue to be attracted to the business, but it’s not as cheap as it was.
GuruFocus: How about Walgreens (WAG), which is a competitor of CVS. Do you like Walgreens at these prices?
Romick: Well, we’ve made money in Walgreens. It’s a much smaller position for us than CVS is. We like the industry, we like the way the industry was priced. We do not like the acquisition they made of Alliance Boots.
GuruFocus: Why don’t you like the acquisition?
Romick: Because they paid too much money. There’s no synergies.
GuruFocus: How about Microsoft now? It went up a lot too.
Romick: Again, not as cheap as it was. When you look at the headlines over recent years you just see lots of bad news on Microsoft. And that’s why we were attracted to it, and the stock is up a fair amount since our purchase. We liked the fact that there was a lot of bad news in the stock. We thought that there was a margin of safety in there because of that. If you were to take Microsoft’s stock price and deduct their cash, after adjusting for taxes on the overseas portion, the stock looked inexpensive. We also believe that they continue to have a great franchise and are doing a better job allocating their capital, but could be better still on that front. Because their capital allocation hasn’t been as good as you would hope, then you have to discount their cash flow generation to some extent, and even then when we bought it, at ten times, maybe a little bit less, we thought it was a pretty attractive risk-reward. As one of my associates, Mark Landecker, likes to say, "good things happen to cheap stocks."
GuruFocus: So you wrote before that actually those large-cap quality stocks, they were cheap, but it seems that lots of them went up a lot, like Walmart, Microsoft. Do you think as a result, do you agree that they’re not as cheap as they were?
Romick: That’s for sure.
GuruFocus: But you bought more Cisco (CSCO). Because the price didn’t go up that much?
Romick: Yes. The stock went down, we bought more.
GuruFocus: Okay. You think the valuation is good there? You’re not worried about the outlook of the industry, of the company?
Romick: Again, there’s bad news. There’s both economic and competitive headwinds. Margins are a little bit lower, but it’s more due to product mix shift than anything else. They continue to have a high return on capital. And, based on market data and competitive reports, they’ve also seemed to gain some good share in their core markets in this rougher time. And we also think their competitive position at least at this point in time remains strong. They have a large installed base. There’s tremendous customer stickiness. And customer satisfaction is high, and relatively sticky. It’s also a challenge for Cisco customers to go to another vendor. It’s not like shifting from Dole pineapples to Del Monte. They also continue to invest a huge amount in R&D – $5.5 billion. In addition, their huge sales and marketing department will be working hard to further insure that their business won’t be going away anytime soon. Our investment thesis would change if we observed some kind of meaningful degradation in Cisco’s returns.
GuruFocus: Is it a similar story with Hewlett Packard (HPQ)?
Romick: You know how I said earlier good things happen to cheap stocks? Sometimes not such good things happen to cheap stocks. Hewlett Packard was a mistake. Pure and simple it was a mistake. We bought a stock we probably should not have bought, and we certainly paid too much for it. HPQ is certainly the worst stock I’ve had at least on a market-to-market basis in terms of total dollars lost. It's not ideal, and we’ll learn a lot more next month. The first week of October, there’s an investor day, and our hope is that they’re able to successfully articulate a clear strategy, which is something that they’ve failed to do thus far. It’s under new management at this point in time, and they’ve got the benefit of the doubt. But this is not going to be any kind of quick turn. Fortunately, the only saving grace I can tell you is it was never a big position. It was a smaller position, thank God.
GuruFocus: But you still added to the position during the second quarter. You think it’s a mistake, but you still added to it?
Romick: We didn’t believe it to be a mistake at the price where we added a small amount. My prior statement referenced our initial purchase that was at a much higher price. That was a mistake.
GuruFocus: But now when you added to it, it’s okay? It’s not a mistake anymore?
Romick: It’s to be determined.
GuruFocus: That’s actually a question that lots of value investors have. How do you distinguish whether it’s a good value investment or a value trap?
Romick: That’s a great question, but I think one of the variables that really drive that is whether the company has a growing business or shrinking business? Most value traps are businesses that are shrinking. So our job is to try and find out if the business is growing or shrinking. We do deep work on industries and companies to determine what the economics of those businesses are.
We ask ourselves, is the business going to be bigger or smaller in five years? If you believe the business will be bigger, and you’re correct, then it’s not going to be a value trap. In the case of Research In Motion (RIMM), just because they were growing for a period of time, it’s doesn’t mean they’re going to continue to grow. Where are they going to be in five years? That’s the question. You had some growth along the way and some false starts and some turnarounds for Blockbuster video along the way. And it was a value trap.
GuruFocus: But how do you predict a company will grow in five years or not? Sometimes it’s very hard to predict.
Romick: Well, if it was easy…
Romick: It is hard, but our job is to just analyze the variables that impact a business.
GuruFocus: Sometimes we look at the profit margin. Actually, for RIM and Nokia (NOK), their profit margin had been shrinking long before their business shrank. Do you think that makes sense?
Romick: No, because profit margins do not dictate the success of the business. What dictates the success of the business is the ability to get a reasonable return on capital over time. So you have businesses with high margins, like at Tiffany’s (TIF). They get a good return on capital. Then you have businesses with low margins also getting a good return on capital, like Whole Foods (WF). So it doesn’t really make a difference whether it is high margin or low margin, the question is, what is the return on capital that you’re getting? Now, if margins are going down in a company, you have to ask yourself, has something changed in the business? Are they selling a different kind of product? Is there a mix shift in what they’re selling? It doesn’t mean that profit margins going down aren’t bad because it very well could be bad. But just because a margin goes down, my point is, doesn’t mean it is bad.
GuruFocus: Yes, but lots of times when we margins begin to shrink, we saw that with the newspaper business, with Nokia, RIM, their margins were really shrinking.
Romick: Okay, but you cannot draw a linear conclusion predicated on the fact that margins go down therefore the business is bad. Margins going down can be reflective of the fact that the business is having challenges and is getting worse. That can be true. It doesn’t mean it is true.
GuruFocus: Okay. I think I agree with you on that. We just look at that as a warning sign.
Somebody wanted to know about Covidien (COV)? They said that there seem to be more attractive medical device companies out there? What do you see in it that other investors don’t?
Romick: I can’t speak to what other investors perceive. We bought Covidien when there was certainly more than one good medical device company out there. We bought Covidien over others at the time because we felt that at the time that it was undermanaged by its former parent, Tyco (TYC). They were short on sales people, they weren’t investing in product development and there were also tax benefits once they became a separate stand-alone company that weren’t available to them when they were part of Tyco. So we felt that sales were going to go up, that margins were going to go up, and we felt that it was a good growing business that wasn’t really well understood by the street at the time. But that was then. It’s not as inexpensive as it was. We’ve owned it for a number of years. It’s been a good stock.
GuruFocus: Okay. Given the latest developments on Aon, with them falling short on some of their goals in the Hewitt acquisition, how has that changed your evaluation or expectations?
Romick: It doesn’t. Aon (AON) remains a good business. The Hewitt acquisition is not going to set the world on fire, but we don’t view it as terrible either. By the way, when they bought Hewitt, at first we were somewhat nonplussed by it, because we really wanted just a pure play on the insurance brokerage side. So we didn’t love the idea, but at the same time we felt that there were enough reasonable arguments to be made that we said "we’ll wait and see." I think the jury still is out on the acquisition. So while we’re not suggesting it’s a great acquisition I also would argue it’s not a terrible acquisition. It’s not the worst thing to do with one’s capital; although, we would preferred them to have bought their stock back at the time. But Aon still remains a good business that has not really had all the benefits that we would like to see happen to it. They’re going to come from a firmer insurance market, that has better insurance pricing, so as pricing continues to firm, that’s going to benefit Aon’s earnings. And earnings are also a little bit better than they appear, because this company doesn’t reinvest as much in their business as their depreciation and amortization might suggest. So their actual cash earnings could be almost a dollar higher.
GuruFocus: How would you analyze a company like Sears (SHLD) that owns what might be considered real estate at the malls…
Romick: I don’t know Sears, but if I was looking at it, how would I analyze it? First I’d ask how good is the retail business? Then I would separate out the real estate and say, how good is the real estate? I’d value the real estate separate and distinct from the operating business, recognizing, though, that you can’t divorce the two. If they sell the land, they’ll bring in some cash but then will have to start paying rent on those properties. So you have to figure it out. You value a business differently if you’re going to liquidate it versus operate it. It’s two different types of analysis.
GuruFocus: How do you determine if a company’s profit margins are protected from compression or not?
Romick: By understanding the competitive moat that surrounds the business. The more players there are, the more susceptible it might be. If there’s only one coffee store in your town, odds are that place will make a decent return. Open one across the street, and the return on the first establishment drops. So you have to understand the competitive environment in order to understand what margins are.
Oh, I have a question for you. Do you know which of your readers asked “I heard there’s a connection between you and Route 66. Care to share?"
GuruFocus: Do you know what they’re talking about?
Romick: My late wife’s father wrote the song. That’s the answer. It’s funny. How would somebody know that?
GuruFocus: That’s from one of your shareholders.
Romick: Maybe one of my family members is messing with me.
GuruFocus: You might have touched on this. What is the worst individual stock mistake you made with the portfolio in the last 5 or 10 years? What was your thought process?
Romick: Tthe worst one in terms of dollars lost so far on an unrealized basis has been Hewlett Packard. We’re pretty good stock pickers. Our security selection has been very good. We don’t have a lot of big misses. When we generally swing at a ball, the ball is usually coming over the plate. We’re not swinging at the pitches that are high and outside. We’re looking to swing at strikes. So our batting average is pretty good as a result. I think the biggest mistakes we make aren’t ones of security selection but really ones more of omission or execution. Like in 2009, when we should have bought even more high yield bonds than we did. If all the orders on our trading desk were executed, we would have used up most of our cash. It wasn’t that we were being cute on price. It was more a function of arbitrarily capping our position size. When we weren’t getting execution, we should have increased our exposure in the bonds we were able to buy. By not being more invested, we left good money on the table unnecessarily. We made good money coming off the bottom in 2009, but we could have done better still.
GuruFocus: So why do you think you didn’t buy more? What caused that?
Romick: Because at the time, the world was a very scary place, and I felt this whole universe of high-yield bonds and distressed debt was just dirt cheap, so cheap in fact, that I didn’t feel that we had to be overexposed to any one company. It was a mistake. Historically, I’ve bought up to 3% or 4% position in bonds, and here I said, I’m going to go in and buy, call it 2% positions instead of 3% positions because I need more positions. The problem is one bond would get to say a 2% position, and another bond only got to 50 basis points, and we weren’t able to get any more. When I wasn’t getting the position sizes, I should have taken up the ones where we were able to get the volume.
GuruFocus: Why do you think about bonds, even in 2009, March of 2009, stocks were much cheaper. You could have bought more stocks.
Romick: Were stocks cheaper or were they lower in price?
GuruFocus: I think they were cheaper once, a lot cheaper once than now.
Romick: Why were they cheaper?
GuruFocus: One area we were looking at was like Ben Graham net-nets. Lots of companies were sold below the net cash, lots of them.
Romick: If they’re going to lose money, cash goes down. One of the biggest losers I ever had was a net-net.
GuruFocus: We actually tracked a basket of those stocks. They did very well afterwards.
Romick: But don’t think for a moment that because you tracked something that did well, therefore it’s a validation. You have to ask the question what risk were you assuming to get that? Look, it’s easy because the survivors and the winners are the ones that get to write history. Right? Do you agree that we were on the precipice of a depression in 2008 and 2009?
GuruFocus: I think I agree with that. It was definitely very scary.
Romick: So if we had a depression, do you think those stocks would have done well?
GuruFocus: I think like the way Ben Graham was doing it, he bought a basket of net-nets. That’s how he did it. And we have stocks that were generating positive cash flow, but they were selling like 50% below the net cash. And actually later on, lots of those companies were acquired, but of course they are all small companies, and for you they were probably too small.
Romick: I’m saying something different. I’m saying, if we had a depression, most companies wouldn’t have performed as well and many would have gone bankrupt – wiping out the equity but not necessarily the debt. The corporate bond market had priced in a depression. Stocks had not. We were buying bonds at 30 to 80 cents on the dollar and we believed we weren’t going to lose money across the portfolio even in a depression scenario. And that’s the point I’m making, that corporate bonds were much, much cheaper than stocks at that time because they had priced in the depression. And so you have to have considered the macro backrop to ask, if X happens, will I still make money? How much money will I make, or could I make?
GuruFocus: Definitely. Thank you very much.
Romick: Thank you.