Episode #444: Steve Romick, FPA Funds – Live at Future Proof!
Guest: Steve Romick joined FPA in 1996 and serves as a Portfolio Manager for the FPA Crescent Fund.
Date Recorded: 9/12/2022 | Run-Time: 45:47
Summary: In today’s episode, Steve shares his view of the world and where he sees value today. He explains why he owns Google, Comcast, CarMax, and even some SPACs and convertible bonds. Then he updates us on investments we discussed on his first appearance on the podcast in 2019, including farmland and container ships.
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Links from the Episode:
0:39 – Sponsor: Composer
2:16 – Intro
2:56 – Welcome back to our guest, Steve Romick
3:42 – An update from Steve from his 2019 episode appearance
5:40 – Steve’s take on what being a value investor is and his approach to it
9:12 – Steve’s take on rising rates
12:19 – Episode #136: Steve Romick, FPA Funds; Opportunities and themes in the US market
19:18 – Possible landmines in the US market
22:34 – Countries, regions, sectors and names he finds interesting
23:41 – Steve’s take on the Chinese stock market and farmland
26:32 – Why Steve purchased container ships
29:15 – Educating advisors about his fund and position sizing
33:11 – General thoughts on ESG investing and its growing popularity
35:26 – Audience Q&A
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Meb: What is up my friends? We got a special episode for you today from last week’s Future Proof Festival. I recorded live with Steve Romick, portfolio manager for the FPA Crescent Fund. Steve is also one of my favorite portfolio managers to read and talk to and he’s also just a all-around good dude.
In today’s episode, Steve shares the view of the world where he sees value today. He explains why he owns Google and Comcast and CarMax even some SPACs in convertible bonds. Then he updates us on investments we discussed on his first appearance on the podcast way back in 2019, including one of my favorites farmland and even container ships. Please enjoy this episode with FPA Funds, Steve Romick.
What’s new man? Last time you were around things hadn’t got weird yet so no COVID, no war in Europe. You’ve been at this for a while, 1996?
Steve: No, I started in ’85 working for a hedge fund and then started my own firm about five years later. I started the mutual fund the FPA Crescent Fund in ’93. And then the ’96 date is when I merged those assets for the first specific advisors. So I’ve been doing it a long time.
Meb: I mean, you got to be one of the longest, consistent mutual fund managers out there. Have you run that stat?
Steve: I think we are pretty close. Ryan Legere’s out there and he could answer that question. We’re pretty close to it.
Meb: All right. So you’ve seen a few things. What was the last couple years like? Starting after we chatted, let’s call it starting in 2019 what’s the world been like? What’s going on?
Steve: I have four daughters and so COVID, everybody at home it’s been horrible. Oh, you mean investing?
Meb: Yeah, yeah.
Steve: I mean, as value investors, we’re looking to really generate returns with a certain margin of safety. And look, going into COVID your portfolio looks one way and if you’re in a hotel company you didn’t underwrite for 7% occupancy. So things were a little painful for a little bit, but we ended up, you know, being ultimately correct. So it created some opportunities along the way.
But what’s interesting is even predating COVID is since the great financial crisis, we’ve been living in this period of unusually low rates. I mean, Edward Chancellor has a new book out now and you can look at interest rates going back, you know, 5000 years. I wouldn’t really hang your hat on those statistics going back more than a millennia.
But be that as it may, we’ve never had rates this low. And rates being this low pervert any capital allocation decision for companies who are deciding to make an acquisition or invest in a new factory, or buy a piece of equipment. For investors who are looking to buy stocks or used to buying conservative bonds and all of a sudden you can’t anymore because they can’t get the yield, particularly because they can’t keep up, you know, with inflation.
And we’re dealing with negative rates. And even with this rise in rates that we’ve seen recently, we’re still dealing with negative rates. All capital allocation decisions have been perverted. So we’re living in this period of government-managed capitalism, where the people who are in charge are kind of hoping that kind of their theoretical arguments will alchemize into reality so it’s hard. I mean, it’s hard to know what to do. And for us, what we really try and do is to always take a page out of the conservatism book and make sure that we’ve underwritten whatever it is we’re writing, whatever it is we’re looking to invest in conservatively. So we are…hopefully we’ll be right under a range of outcomes.
Meb: So you describe yourself as a value investor, but you guys do a lot of different stuff. And we’re going to talk about a handful of them today, eventually. But give us like when you kind of describe yourself to an advisor may not know about y’all, like, what’s the framework? When you say value investor yes, I get the umbrella, but like what does that really mean for you guys?
Steve: It means avoiding permanent impairment to capital. It doesn’t mean we’re trying to seek some kind of market-to-market protection. By and large, it’s given us more downside protection the way we invest, but that’s a byproduct of our process. Most importantly, we want to make sure we avoid permanent impairments of capital, and we’re willing to accept some volatility along the way in order to get those equity rates of return that we seek, you know, in our portfolios.
But to do that, you just have to invest with a margin of safety. Make sure the asset you’re buying whether it be a stock or a bond, it has to be something that gives you some protection, you can’t buy it at your net asset value, you have no protection that way.
Meb: So I was talking to a friend earlier, we’ll call him Bill because that’s his name. But you know, we were talking about…he’s also a line value investor. And we were saying, you know, when you think about something and you have a position, and you think you have this margin of safety, and that sucker goes down, you know, painful, let’s call it like, 20%, 40%, 50%. And, you know, you’re like I have my thesis but you’re down 50%.
Something, particularly like COVID, hits where, like, the rules changed a little bit, not only the rules, but the environment macro just shifts and you’re like, unclear what’s going to happen. How do you think about that as a portfolio manager?
Steve: Every day, I start with the fact that how could I be wrong? And then it gets magnified in periods…
Meb: I say that to my wife. I am like “How could I possibly be wrong?” My wife and I’m like, what I mean, what is an impossibility. But let’s hear it. So you’re…
Steve: Look, we’re guaranteed to be wrong at times nobody has a batting average of 1000. And so it’s not even a question. So we’re always constantly underwriting and re-underwriting everything we own even outside of the events like COVID. And so we just want to make sure we’ve done our work right.
So if something is going down 20% that could just be noise. I mean, stocks can move around 20%, you know, over the course of a month and come back the next month. And 50% is obviously significant and you have to, you know, test your assumptions again and again.
And you have to ask yourself the question, what’s permanently changed because of COVID? You know, is there something that, you know, we didn’t underwrite correctly because of COVID, that could create a permanent impairment of capital.
But if you’re Marriott, you know, Marriott’s still going to be Marriott 10 years now, we believed and so we started buying Marriott in COVID when people were hating it. Stock was down from 140-something goes down to 80 or change. And, you know, we looked really stupid at first because it broke 60, you know, before too long. But we did our work and we kept buying and we look correct, today, we looked correct not that long thereafter, but you have to make sure you do that work.
And so to do that work, you have to understand not only the business well and the competition landscape in that industry. You have to understand some of the macro variables that could impact you, you know, certainly. But most importantly, understand that company, that management team, that industry, in order to do that, is spend a lot of time reading and reading some more.
And we even have an analyst in our team who’s a journalist whose job is to really understand more of the qualitative variables and help us find experts in the field and ex-employees talk about this management team, or employees of other corporations that are in the industry to help us understand what that business is, and how good these people are at the company we’re trying to buy.
Meb: You know, I think a lot about being in environments where the vast majority of people that are managing money had not experienced something like that. So the environment where we hit almost negative rates in the U.S. like pretty weird, negative sovereigns around the world.
Steve: We are negative rates real, we’re still negative rates.
Meb: Yeah, real. So coming out of COVID, coming out into the last year how are you thinking about the world? By the way, one of the cool things that Steve and his company does is they publish for the fund percent of assets across for like 14 categories. And not only percent of assets, percent of assets going back to like inception so, for better or worse. But it’s really cool because you guys aren’t just letting these suckers float. So talk to us about 2022. Rates are coming up, what’s the world look like to you because you’ve been a little active.
Steve: Yeah, I mean, look, inflation’s real where it normalizes we don’t know. But you have to ask yourself the question as an investor…you know, our money is alongside our clients. You have to ask yourself the question, would you rather be in cash? And every day is a decision, do you want to be in cash or not in cash? If you’re not in cash what asset class do you want to be in?
And for us, is we try and think about, you know, make that decision right now we look and see. There’s a lot of inflation, we’ve been talking about inflation for more than…you know, since the great financial crisis in ’08-’09. So clearly, it took a long time to rear its head, and cash is worth less every year.
But if you own stocks, you also could see markdowns in your portfolio, you know, periodically, that are maybe not inconsequential across your portfolios, if you’re investing with different managers. And that can be very disconcerting to people. But for us, we look at it and say it’s, you know, part of life, we’d rather be invested more than not because inflation is real. We don’t want to have that cash burning a hole in our pocket and be worth less every single year.
And so if you own these good businesses, that we’re confident are going to be earning more money will be more valuable, you know, 5, 10 years from now, and we’re paying a, you know, good price for those better yet a great price, then we’ll allocate capital to those kinds of equities. And the same can hold true of debt.
One of the things you talk about these different categories we’ve been big distressed debt and high yield investors over a lot of years, going back to the ’80s. You know, back in the days when Drexel still had junk bond conferences. And we used to own a lot of double-digits in high yield. And in the financial crisis, we went from, you know, low single digits, mid-single digits, and high yield and distress to more than 30% over three, four months.
So it really will move the portfolio around a lot when we see the opportunities, but with rates coming down like this, and with government stepping in and backstopping companies with different stimulus packages, we just haven’t seen the opportunity. And for us, it’s been more like return-free risk. So that is an asset class that has not been very attractive.
And we’ve begun to see some more opportunities in bonds and public bonds, you know, in the recent months. So that’s been, you know, how we’re looking to position the portfolio is more in equities than not, some in-depth, we’ve been seeing opportunities. And we still have a lot of cash because the world’s not dirt-cheap.
Meb: Last time you were on we talked a bit about the Googleplex and I see that still holding. What are some other themes, names, just general opportunities on the U.S. stock front, sectors?
Steve: On the stock front, you know, when we bought Google…and you know we’re value investors, how do you argue that Google is a value stock? Well, we bought it originally, back in 2011, at a point in time where the company was trading, you know, 11-ish times earnings net of its cash. And today, it’s still not an expensive stock, if you back out the cash you make adjustments for their non-earning assets, their moonshot portfolios, etc, portfolio singular I mean.
And we’ve seen a number of different businesses that are, you know, busted tech stocks, you know, thematically that we’ve been able to…I know your question was about equities. But with this market downturn, we’ve been buying busted convertible bonds of various companies businesses that, you know, had a lot of headlines in stocks. Stocks are down 50%, 70%, 90%.
And some of these bonds were trading with this great, you know, very, very low yield with a great expectation that the option value with a conversion, you know, prices coming to the stock, you could get maybe one day was going to pay off. I mean, you’re getting the yields of these bonds ratio with a quarter point, half a point, three-quarters of a point yields, and we didn’t buy any of them. Now we’re getting yields of 9% to 11% and we think that’s a pretty attractive, you know, rate of return for these businesses that we think are good businesses. Other themes in there some people…
Meb: Is that mostly tech or is that things …
Steve: Those are tech-related. You know, I say tech-related I mean creators of tech but users of tech. You know, new COVID-disruptor business models. You know, we’ve got a good-sized position. Our number two position, if you look at them together, would be our cable companies, Comcast and Charter and there’s a lot of fear that surrounds these companies there’s fear of competition.
And using Charter as an example. Charter is market cap today, it’s give or take $65, $68 billion. And the fear for Charter Cable…the second largest cable company in the country Comcast being slightly larger. The big fear, you know, for these companies is just a lot of competition.
The side of their business was the video side the cord cutting created a lot of fear in people, but these companies don’t really make any money on the video side. It’s a variable cost business and every time that somebody disconnects, they don’t have to pay Disney as much for ESPN. They don’t have to go and, you know, roll out of truck to go repair the boxes or send new boxes, which are huge capital investment
5G is not a real risk because if you have a conference call, you know, and it’s important call you’re not going to do it on a cell phone if you don’t have to, you’re going to do with your broadband. And they’re in the broadband business and they are very successful in the broadband business. And nobody, you know, else out there has a business as good as the cable business in terms of delivering a consistent signal.
Now, the fiber to the home is a real competitor, 5G is not, you know, in our view, but fiber to the home is. But even with that, we think that these businesses are still going to do quite well even with overbuilds in certain markets. And so we expecting something like a Charter, that more than half of the market cap will come back to you in one form or the other in free cash flow over the next five years. And there’s not a lot of companies you can say that about where more than half the market cap should come back to you in free cash flow over the next five years, that’s pretty darned attractive.
Meb: Sounds like a good screen.
Steve: You don’t see a lot of it, a very small screen.
Meb: Yeah, give us a couple more ideas you’re thinking about in the U.S., and then we’ll start to hop over.
Steve: So because of so many of these tech stocks getting killed if you invested in those businesses it has been very, very problematic. But if you haven’t been…and we’ve managed to avoid most of that carnage, thankfully. But there are a lot of businesses that have been beneficiaries of the slowdown and the disruption.
And the business that have been following since they first existed as part of Circuit City, you know, back in the ’90s, is CarMax. And CarMax is a business that sells used cars retail, and they also make car loans. It’s economically sensitive, particularly on the used car loan side with almost $17 billion loan book. So in a recession, they’re going to get hurt, we don’t have a full position because in a recession, we would expect that the company would go down.
So we talk about, you know what we’d like to own and how long we’re willing to own. We think about permitted impairments of payments of capital, we think about entry points, and we think there’s going to be better entry points along the way but there’s no guarantee of that. And it’s attractive enough at the price that we bought it, which is very close to where the current mark is when we first started buying it in late spring.
But this is a business at CarMax that sells used retail, used wholesale, and they got their auto loans. They’re overearning on their auto loan side. Their used car side they’ve got…I probably say they’re underearning a little bit. On that side, they got massive investment because everybody’s aware that used car prices have gone through the roof.
So for them to sell a used car, they’ve got to have a lot more in inventory. In the future, that will be less, that could be three plus dollars a share. And they got a wholesale side that I think is a growth engine. And because the likes of peddle, Lyft, and most significantly Carvana are doing well that gives them another lease on life to really perfect their omnichannel experience.
Meb: How much of the time when you’re looking at some of these companies where it’s CarMax, or Comcast, etc. where it looks so great. And how much of it is like you’re like, I’m just waiting for the market to realize this value? Or is there often like a…you’re like, look, what the market sees is wrong in this capacity, we have a value-added insight that the market doesn’t understand. Like, if you put it into the Venn diagram buckets, like, is there a more traditional place most of these names end up in?
Steve: It’s a great question, but I think it’s specific to a company or industry in a moment in time. So I think it’s true and it’s not true. Sometimes things are undiscovered it’s rare, you know, more often than not, they’re misunderstood. And when they’re misunderstood it’s because there’s a lot of fear and fear creates price action. It creates a lot of fear, you know, selling as a result of people fearful that these businesses are going to, you know, erode like in the case of the cable companies.
And so it remains to be seen if we’re right. I can’t promise anybody we’re right, you know, but we believe we’re right over the long-term we’ve done pretty well with them so far. But even though they’ve come back a lot, they’re still well above our cost. And we think they’re good opportunities, but there’s no guarantee as I said that we are right.
But there’s also another fear which is a fear of missing out, that fear that FOMO that people get. And when they have that a lot of these companies end up going up in price because people just are buying something because oh, it’s like the Peter Lynch principle, which is, you know, buy what you know, and buy where you shop. And you can buy these businesses that are going up even though the business models are unproven.
I mean, Carvana might be fine over 5 to 10 years very well could be. But, you know, in this environment today with the stocks down almost 90%-ish% a little less after today being up 10%. We don’t own Carvana. But the debt on Carvana trades with double-digit yields. So it’s almost in conflict when we think you know compared to the equity this environment.
Meb: As we look around the market, do you see any landmines any areas in the U.S. where you’re like look, some of these things are down 80%, 90% but it’s still dumpster fire? Are there other areas where you’re worried about or is it more opportunity than not at this point?
Steve: There’s always landmines. You know, you just…
Meb: You can name them I don’t see you have any shorts right now what’s going on?
Steve: You don’t have them, we don’t do a lot…
Meb: At times…
Steve: We used to short more than we do now. Now with inflation you can be nominally right and real wrong just because even stock might go up. If you have massive inflation, stocks can rip and the shorts might not go up as much, but they could still be going up. So we’re very, very cautious about that.
And the problem also with shorting is the asymmetry isn’t there so you really have to be more precise
about it. Because, you know, by asymmetry, I mean it’s like, all you can make is 100% and that’s if you’re perfect, right? Your stock will go bankrupt but if you really held it all the way to the very end, and how often do you get that right? And it’s also tax inefficient because you don’t get the benefit of capital gain. So, you know, we try to think about tax efficiency as well.
So yeah, there’s landmines out there. There’s a lot of these businesses, you know, that are still unproven business models and, you know, again, they might be okay but I think one has to be very, very careful of that. There’s a lot of stories oh, you should go buy mall REITs because they can be redeveloped into something else. And we’re like, yeah, but they could be but it’s going to require billions and billions of dollars to turn them into something else. So that’s not a play that, you know, we would participate in.
Meb: Yeah, shorting stuff. One of the areas you’ve been creeping up lately is beyond our borders, foreign stocks, is that kind of a macro situation, is it because the dollar has been ripping up, is just opportunity what’s going on?
Steve: We try and understand the best businesses around the globe and not all of them are in the U.S. The rest of the world is on average cheaper than the United States. Now part of that is for good reason because in Europe, for example, you don’t have the big tech franchises that you have here in the U.S. you don’t have, you know, the Googles, you know, of the world. And a lot of these companies like Netflix is here even though Netflix has had their share of headlines, you know, of late.
But if you look across the Atlantic, you have businesses that they don’t have a lot of those kind of business. You have Spotify, but Spotify doesn’t own their customer in the same way that some of these other businesses do because they’re so dependent upon, you know, the tune of we’re almost three-quarters of their business. They’re dependent upon the big publishers, you know, the Universal Music Groups and Sony/ATVs, Warner’s, etc.
But they’re still are good cheap businesses for these foreign analogs. If you can find a U.S. company, and you can find a similar kind of business outside of the U.S. on average it’s trading less expensively, outside the U.S. And in part that’s fears about what might happen next in the wars in Europe, what might happen regulatory with government intervention, involvement in the Pacific Rim. Will China go on vacation in Taiwan like Putin has been on vacation in the Ukraine. I mean, there are all these fears. And so we don’t know what’s going to happen.
But our job, you know, is to take advantage of dislocation, you know…But many of these companies, although they’re based outside the United States, I mean, it doesn’t mean they’re actually foreign companies per se. Many of them have just as much sales in the U.S. as many U.S. companies have. So we really think more of revenue domicile than we do of, you know, country where they’re based.
Meb: You know, Morningstar actually has a pretty good modules that talk about this. In your recent webinar, you guys kind of went into this where, you know, the geography seemingly is becoming less and less important on the domicile. I mean, you have stocks in the UK that are of the index that have no UK sales, right? And on and on and on examples.
Are there any particular countries, regions, sectors, names, you think are pretty interesting? I mean, you know, the emerging markets is a lower percent, but it’s been an up and down for you guys. Anything particularly interesting?
Steve: There are some companies are particularly interesting, but they’re smaller cap names. And they’re names that are harder I think for people to want to own because of the illiquidity of them. And we’re limited to the position sizing, so I don’t really want to talk about them in a public forum. But I think the better opportunities…
Meb: This is private. Yeah, everyone here…
Steve: My closest friends.
Meb: …agreed to put their phones in a box.
Steve: I think that some of these companies that are based outside of the U.S. and are illiquid are really attractive, smaller, mid-sized companies in Europe, where there’s a lot of recession fears, there’s a lot of attractive opportunities I think.
Meb: Do you guys do anything in China at all? There’s a big China panel tomorrow big debate, you guys…
Steve: We own some businesses that are…you know, some Chinese-based businesses, but it’s not a very large, you know, part of our portfolio.
Meb: Before we get this opened up to the questions, of the weird stuff. Last time you and I were wrapping farmland investing wasn’t cool and now it’s kind of cool. People are starting to come around. You guys still own a little bit? I mean, it’s tough with the big public vehicle.
Steve: We own a little bit. We have a public fund for those less…we have a public fund. We do some privates in the fund. We’ve had an investment in farmland going back a decade. We have done historically a fair amount in private credit, which I think is particularly interesting today, particularly asset-based private credit to the degree and to the extent that you can access vehicles like that.
But farmland, you know, the portfolio manager of our funds, you know, the one who had responsibility for farmland, you know, didn’t do a very good job of underwriting the manager and that would be me. The manager’s, you know, has not been great. He made one strategic error in swaps in Great Missouri farmland they paid a 5.3% or so cap rate, sold it at 3.7% cap rate, and swapped it into some Florida, you know, farmland that was permanent crops as opposed to row crops and it was not a good trade.
So we’re going to make money but it hasn’t been as good as we would like. I think the best way to access farmland…and I’m a big believer in farmland as part of a diversified portfolio robust to multiple outcomes, but it’s easier to own just farms directly to the extent that people can own good farms. I wouldn’t own anything in California because you need farm…you know, agriculture is water, and we just don’t have the water. I felt that over the decades, I’ve avoided California, but there’s a lot of really good farmland. I’d rather own that than gold.
So you get the current yield you get inflation. You know, inflation bumps along the way and the appreciation has gone up a lot, since, you know, the war in the Ukraine because, you know, Russia and Ukraine are bread baskets in the world. Then the supply has been curtailed because of that, and prices along with input costs going up, have really jacked farmland prices up. So it’s probably a little bit more invoked today than I would like, but it’s kind of interesting.
And this is something we don’t have in our portfolio, but it’s something we talk about is we try and think longer term. We try and think about what can change, what can happen, what does the world look like in 10 years, as we try and look around corners. And you can buy farmland in Northwest Minnesota, and pay $2,000 an acre one-third the price if you can of farmland in eastern Nebraska.
Now Northwest Minnesota, you know, has maybe 80, 85 grow-day corn. And Nebraska has got 120 plus grow-day corn. So if global warming continues to be a thing, which I suspect that it will, you’re going to end up with more grow days, 50% more grow days potentially in corn over the next, you know, 15 years, potentially that could make it a very interesting arbitrage.
Now, again, trying to find ways to express that, you know, are challenging. So again, I want to emphasize it’s not something we have in the portfolio, but I’m just trying to give it as an example lay it down as an example of the way we think.
Meb: Didn’t you guys own a container ship or something at one point?
Steve: We own lots of ships. We bought…when people hated shipping we…sometimes there’s better ways to express a trade, an investment, a thesis and if you can do it in the private sector. So we own a bunch of boats, we bought them when people hated them. I’m not so terrible high above scrap value and now they’ve gone up a lot.
Meb: What’s the process for those coming across your desk, by the way, you know? Like I feel like most of us don’t have boats coming across our desk on the regular. Is it something is it traditionally through the banks or the credit just through…
Steve: It’s through different relationships. We look to create relationships that will help guide us to be able to execute on a theme. So for the farmland example, we look for ways to go and try and take advantage. For shipping, we look for ways to take advantage. We have lots of conversations, we’ll use our journalist, for example, try and uncover relationships and we say, look, we’ve got capital, do you have need for some partners in this, or can you show us opportunities?
Meb: I saw a big line item that I think is newer maybe wasn’t from last time we talked, which was SPACs what’s going on?
Steve: Well, SPACs had…I think, you know, when they peaked, they peaked at more than 25% above their trust value. So you’re buying these assets, these blank checks and paying, you know, $12.50 on average, you know, per share for something that, you know, you’re guaranteed 10.
So is a 25% premium that people were paying insanely for this optionality for all kinds of people who aren’t investors, because they played hockey real well, or baseball real well, or they were a really good singer or whatever it might be that maybe they’ll find a business. It was crazy, the way they raise money.
That’s not to say that all SPACs were bad. That’s not to say that all companies, you know, that were going public via the SPAC market as a back door, you know, were terrible opportunities, but 25% was crazy.
So what we did was when the world collapsed, you know, in SPACs, I think it peaked in February of ’21. And we created a basket, it’s now, you know, they have 3% and 4% of the funds fall below their trust value. So on average across the board, but below $10.
So if something good does happen with one of these ex-athletes happen to stumble across a company, every…as the saying goes, right, you know, “a blind chipmunk finds an acorn every now and again,” right? So it could can happen and you could get that service-free option. And if it doesn’t happen, we’re guaranteed to get $10 back. It was a lot more interesting when cash was yielding you almost nothing less interesting today when you get 3% on cash.
Meb: Are those opportunities drying up to a degree now that cash is becoming competitive or still not as much?
Steve: Yeah, they’re drying up.
Meb: Your fund is kind of a unique animal, right it can shift and move to different opportunities. How do you tell people how to position it because it doesn’t…a lot of today, advisors always want to talk about where something fits like StyleBox where does this go? So where do you guys fit in?
Steve: That’s a fair question. For those of you who know our fund less well, you know, I started the first Go-Anywhere Fund, the FPA Crescent Fund, back in 1993. So we can do lots of different things. And you know, for better or worse, but lots of different things equities mostly but distressed debt, high yield bonds, convertible bonds, preferred stocks, struck on occasion, you know, shorting. We’ve done one currency trade in our life having bought yen puts a decade ago and so…
Meb: That was a little early.
Steve: …credit. No, we’ve invested a whopping eight basis points or so and we made 10x. So it had 80 plus basis points over the next year 2011 and ’12. So it worked out very well.
Meb: Because the yen right now it’s been fallen out of bed.
Steve: You know, for us, when we think about what we do is we look very ordinary at times too because if there’s not the opportunity, we just don’t get invested. We weren’t going to go on buying high-yield bonds with 6%, 7% yields just in interest. When you see these high yield index yields, they report a gross yield, not the net. There’s still going to be defaults guaranteed. And there’s going to be some level recoveries. So the net yield is always lower, you always get a net lower and a cash yield. And so we’re very, very sensitive to that as we put the capital to work.
And so now we’re beginning to see some more opportunities in these different asset classes again, which makes it interesting to us. And we’ve done private credit, you know, asset-based private credit we’ve put out across our different strategies, you know, almost $900 million over the last decade in private credit. And got about a 14.5% yield or so, you know, for that capital we put to work. Not tax efficient admittedly but 14.5%’s pretty darn good.
And we’ve only lost money when one loan along the way only lost 8% net of the yield we received. So we still like that as an asset class to the extent that you’re finding good underwriters. You know, there’s a lot of people who aren’t very good at it there’s too much capital that’s floating in space.
Meb: Someone wants to buy your fund today.
Steve: Oh, sorry. Your question though was how do you position it. So with all these different things we do, we think about it as a…the way we think about is kind of a hub and hub-and-spoke strategy. Because we operate in up … delivering historically an equity rate of return global equity rate of return. And for people who want something more specific, they want to go do busted converts over here, they want to do distress debt over there, they’ll go and circle around it.
Now, some people, you know, also will use this as the spoke not as the hub, because we are doing so many different things. So look I’m not saying one should do this because this is a lightweight, you know, alt fund. But now we look at ourselves the way we allocate our capital internally, you know, for ourselves, we think about it as a hub.
Meb: You get a better marketing, I’d say it’s the only fund you need changes your entire portfolio, get a little bit of everything. We’re going to be a little weird at times, but you guys got all the ingredients. Well, I’ll ask some of the questions I see on here. Other value investors, who do you particularly take a shining to? Who’s doing it right? Who do you like? Any mentors, friends?
Steve: There’s not a lot in the public fund space I have a lot of friends in the private, you know, fund space, we’ll watch to see what a lot of these people are doing. And Baupost group in Boston, Seth Klarman would be an example of that. There’s other people like that across the landscape. But more of my relationships are really in the private fund space.
Meb: So why do you think they all gravitate there? Here’s this lone public manager? I mean, Seth’s great, because I love looking at the managers where you look at the 13Fs, for me, at least and I’m like, I don’t know what any of these stocks are. You know, I was like they’re not traditionally like the hotel names where everybody owns them, they tend to be a little weird and different, they do a ton of private stuff too.
Steve: They do, which we can’t do given a public fund. So why do they gravitate there because they’re very good. Look they’re investment partners, so they get higher fees. I mean, it’s economics.
Meb: Yeah. Somebody wants to ask you about ESG.
Steve: Where do you see particular value in ESG? Look, ESG, as a construct is I think, is an important…I’m going to shift over here to this sliver of shade that I see right here. He’s smart to bring a hat he’s done this before.
If you look at ESG, and think about, you know, the three components of it, you know, environmental, you know, in governance, and social. A company over time that doesn’t treat its employees well, that’s polluting the environment, that’s not allocating capital well, is probably not going to be a good investment over time. So it stands to reason that ESG makes sense as a strategy.
However, that said, there’s been this like tipping point some people have tilted so much towards this idea of ESG that they’re really ignoring some of the other facts, you know, that’s in front of them. They’re buying businesses that are scored. I can’t remember there’s a number of companies that score give you these ESG rankings. But some of these companies, you look at some of these large ESG funds, they own a lot of these oil companies and that’s like, are they really that good to the environment? And how do they end up in there? I’m not really sure.
So I think as long as you’re…we are mindful of it. And we do want to own good management teams that are kind and sensitive to the environment and good capital. Because I use the example of Charter Cable as an example. John Malone is the largest shareholder there and he cares how his money gets allocated. So the 30 plus billion of cash flow that we expect to be generated over the next five years, we think is going to be spent well in the form of either debt repayment or share repurchases. You know, Excel they’ve already bought back a ton of shares, same with the CarMax which has bought back, you know, 30% or so over the last decade.
So we’re very mindful of that but we know we don’t actually look at the specific scores, and we don’t rank companies based upon some external scorekeeper. For us, we just look at the different businesses and make sure that, you know, they pass muster.
Meb: While we’re on buybacks the new legislation is going to have…from the CEOs you talk to is it going to have much of an impact with taxing the fee?
Steve: Yeah, I mean, if you tax anything it’s going to have an impact, but we’ll see what happens.
Meb: Yeah. Questions, anyone while we’re going?
Man 1: Hi, do you think for people that are interested in investing solely or mostly in ESG would it be better for them to direct index and build that portfolio as opposed to investing in like, ESG or any of the ESG ETFs?
Steve: Well, I think that…I mean, it’s a pregnant question, right because it presupposes a certain capability….somebody else up here in the front too has a question. But it presupposes a certain capability to analyze these companies individually.
So how likely are you or whoever’s making that decision to go and source the investment, get the idea, do the work, and feel comfortable with the decision such that…and going back to Meb’s earlier point. Stocks are going to go down at points, where you’re going to have the conviction to own it, or buy more better yet, and ride it through to the other side, as opposed to panicking out and selling.
So I think one really has to start with what’s your capability to buy individually? And if not, I think there’s lots of good managers out there who aren’t just ESG ETFs that are mindful investors who have an ESG policy statement in their firms. And you can find them usually, I think on their websites. And that’s probably the direction I would go if you wanted to do something like that.
Meb: The hardest part for me has always been on ESG is the ES and the G often mean different things to different people. You know, you’re seeing this to me with a lot of the narrative around nuclear energy right now. You know, I mean, that was considered a really unpopular source of energy that seemed to 180 pretty quick. For me, it’s a very personal decision, I think more than anything, but…
Steve: I agree with that.
Meb: Few up here.
Man 2: Hello, thank you for doing this. I’m going to ask a follow-up to Bill’s question that Meb asked because I’m Bill. So with Charter, for instance, right on a per share basis we’re pretty much below or at the COVID lows. So the market is like telling you probably like T-Mobile or whatever is a real risk. So I guess, as a discretionary portfolio manager at what point do you…and the answer may be never. But like, at what point do you look at something and say, okay, this is at COVID lows, like, what’s the market telling me and what am I maybe missing here?
Steve: Well, I think that goes back to Meb’s question about constantly re-underwriting everything you own, you know, constantly. First, it’s 2x COVID lows, you know, so it’s still well above COVID lows. You know, stock was in the low 200s or there about and now it’s 400 or thereabout so give or take. But it’s still well above COVID lows but still I think you could make the same point. Hey Steve, the stock is down from 800 to 400 maybe you’re wrong. So what these guys have is something that nobody else has, that doesn’t mean…again, no guarantee it’s going to work I just think nobody else…
One hundred percent and that’s Comcast back in 2014, they cut a deal with Verizon, and Verizon, you know, gave them, you know, the ability to use their network for backhaul and to go and sell wireless. You could go to…if you’re a Spectrum customer today, you can go get a package deal, get your broadband, you know, get your cable if you wanted it you know, for the video side, and you can get your wireline and your wireless. And these other companies can’t reverse engineer that they can’t do that.
And Verizon, you know, cut a great deal you know for the benefit of Charter and Comcast. Now, it’s not on the one hand, so great for Verizon, you know, in a vacuum, but they don’t operate in a vacuum, it’s better for them to do it at the expense of say T-Mobile or Sprint or somebody else. We’re constantly looking to see what’s happened to market share, what’s happened to connects disconnects, we’re evaluating that stuff, you know, constantly to see if there’s some problem with them.
So every business you buy, we lay out what the KPIs are the key performance indicators. And we are just religious about trying to understand if they’re still consistent, you know, they’re hitting the metrics that we’ve laid out for them. So it’s important to constantly, you know, go back and readdress those points.
Meb: All right. Anybody got some follow-up? So we got a question here it says basically, value traps anything that looks kind of like value-y that most people are cheap on traditional measures?
Steve: Let’s take a step back and think about, you know, for those of you familiar with the book “Security Analysis,” you know, the Graham and Dodd book, that’s, now, you know, coming out with their seventh edition. Value investing has morphed originally…you know, value investing was about just buying an asset at a discount.
And so often that asset value was predicated on some hidden asset that might have been there. You know, might have been real estate. Steinway piano 20 years ago at real estate, you know, all over New York City or a number of great locations in New York City, and you could buy Steinway, you know, for very a inexpensive price as a business and get all this real estate for free. That if they ever really did something rational that shareholder-friendly would have been a good investment.
So many of those businesses now that have these traditional value investments as we knew them, you know, or businesses that were more likely to be disrupted. So let’s just take Amazon, you know, for example. Amazon comes into being they’re originally, you know, a reseller of books, they ended up being becoming the everything store as we all know and probably everybody here uses, you know.
And as we look at that, what Amazon was doing I mean, as we looked at it, we realized that this is really bad for retail in general. I’ve owned retail…you know, I started out as a bank of thrift analysts, you know, but I did a lot of retail back in the ’80s, working with this investment partnership, and we sold all our retail, you know. We said to ourselves, this is not good for these retail businesses we know they are the disrupted companies. So we ended up, you know, selling all of our retail, and the mistake we made back in the great financial crisis, candidly, was not buying Amazon.
So our goal today is make…whereas that margin of safety as a value investor in the past was predicated on the asset value of the business that sits within, you know, maybe it’s a hidden asset, maybe it’s right on the balance sheet, you know, is it more obvious. But, you know, could be hidden real estate, or an overfunded pension plan. Maybe it’s a contingent asset because of a lawsuit, they might potentially win lots of different ways you could do it. But so many of those businesses were the disrupted businesses.
So we morphed a number of years ago didn’t change as value investors because we’ve always invested with a margin of safety. But we became much more anchored to the idea of the quality of the business, not just the quality of what’s on the balance sheet. And that candidly is a harder analysis, and it’s more likely a more volatile stream of income that comes from buying those kinds of businesses. Because the perception of what they might enter into the future changes so much more than the actual value of the real estate that more traditional value investor might have owned.
Meb: And when you think of quality like what does that mean to you? Like a lot of…if you talk to the quants, it means something but if you talk about like a business in general, is there a particular metrics or things you look at?
Steve: We look at normalized free cash flow is what we look at. And we look at the most that business has. When we bought Microsoft, I had never owned Microsoft, you know, going back to when it went public. And I certainly didn’t own it, you know, when it peaked in the first quarter of 2000. And Microsoft, over that next decade generated earnings in the high teens, earnings growth in high teens. And its stock, you know, a decade later after generating earnings growth high teens, was still down a little bit from where it was, you know, at the end of ’99 beginning of 2000.
So we got involved because well, people really hated it, this company was trading net of the cash, you know, at a relatively low multiple, low teens multiple net of the cash, and there was a lot of fears. You know, you asked a question, you know, Phil about, you know, when you might be wrong. We didn’t know Microsoft would be as good as it was, we had no idea sometimes, you know, you get lucky. And things ended up being a lot better than even we anticipated.
But we set ourselves up for that optionality, we had a free option of those things working out really, really well. And, you know, we were there at a point in time where the people are so fearful about changing form factors, when people aren’t going to use Windows, and they weren’t going to use desktops, you know, they’re all about the iPad. And so they don’t have a place in the digital future they felt at that point in time.
Since then and obviously, that hasn’t been the case their cloud business has exploded, you know, Windows is even stronger today than it was it’s now a subscription model, which it wasn’t at the time. They’ve found ways to wring, you know, more dollars out of that talent that was already there and they found new opportunities.
So we’re always looking for these kinds of businesses where there’s again, that misunderstood but we go back to this trying to understand the businesses themselves. And again, we did not know it was going to be as good as it was. I don’t want to tell you that we…there is no crystal ball, we’re going to be wrong. Fortunately, we’re right more than we’re wrong, but we’ve been wrong and we’re going to be wrong again.
Meb: Just look for businesses that are oozing cash flow, simple.
Steve: Or likely to lose cash flow.
Steve: I mean, Microsoft was oozing cash flow at the time. Other companies, we expect will be if you normalize them for excess investments or making and other things, which was the mistake we made candidly with Amazon. You know, the cash flow was being generated by one side of their business was being lost in the retail side of their business they weren’t losing the cash flow that we would have thought. But if we just normalized it, you know we would have owned it. So shame on us.
Meb: Well, this is close to my heart because I’ve been renovating a house for the last six months in the worst time in I don’t know 30 years to renovate a house. So I’ve been oozing cash flow the wrong direction though. So, you guys on that note, everyone give a big round of applause for Steve.
Steve: Thank you.
Meb: Appreciate you for joining us today.
Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us feedback at [email protected] We love to read the reviews, please review us on iTunes and subscribe to the show anywhere good podcasts are found. Thanks for listening, friends, and good investing.