Thu, 17 Oct 2013
The FPA Crescent manager takes a pass on long-dated bonds and high yield, but found value in old-school tech firms.
Jason Stipp: I'm Jason Stipp for Morningstar.
Minding the downside and focusing on the long term are two important factors for successful investing, and few managers do it better than those at FPA Crescent, a Gold-rated, 5-star fund. Joining us today is lead manager Steve Romick to talk a bit about how the portfolio is positioned today.
Thanks for being here, Steve.
Steve Romick: Thank you.
Stipp: Let's start by talking about what you're not investing in, which seems to be a lot of things these days. In your last letter you wrote, "We avoid those investments that appear overly exposed to obvious macro excess."
A notable attribute of your fund recently has been its cash stake, which has been upwards or higher than 30%. What is it that you're not finding attractive when you look at the marketplace?
Romick: Long-dated bonds; we don't think you're getting paid to play. We don't really know what direction rates will go; we expect over time that they will increase, and they could just have a stair-step function up, and we just don't think, given where the 10-year is, you're getting paid to play.
High-yield bonds, which aren't so high-yielding--there's not a lot of distress in those--and spreads to Treasuries are relatively low, and the starting yield given the already-low level of interest rates makes it even lower still.
So, you just can't look at spread. A lot of people look at spread--well, spread to kind of a risk-free rate of return is normal, but we find that it doesn't really take into account the lower level of rates.
Then there are other areas that we just … put up there as too complicated. Health care is some place that … with all the changes that are taking place, it's hard to see what the outcome is going to be for various companies. So where we do invest in health care, which is in a very small way, we tend to tread very, very cautiously.
Stipp: What about equities as a whole? They look perhaps relatively more attractive than bonds, but does that make them attractive?
Romick: I think you answered the question with your question. They are relatively more attractive than bonds, and I think that if you are going to have to look out 10 years and where you'd like to be, I think being 100% in cash is too big a bet for people to make.
Stipp: One of the areas that you had mentioned in your manager letter, where you did see some opportunity in recent times, was in technology, but not the names that a lot of people are talking about in the news, the Twitters and the Facebooks, but sort of old-school technology: Microsoft, Cisco, Oracle. What was it about these companies that you found attractive?
Romick: For one, we know they weren't in the news, and any company that's in the news is less likely to have a lot of selling attached to it, or at least if it's in the news in a positive light.
These three companies were actually all in the news in a negative light. If you looked at the headlines across a host of periodicals, you could just see bad news, bad news, bad news, and everybody's lunch was being eaten someplace.
Cisco is being competed away over here and somebody is being competed away over there in the cloud, and … tablet sales are eating the PC sales of Microsoft, etc.
But … let's just talk about Microsoft for a second, as kind of a proxy for the three. Microsoft is a business that clearly has some bad news impacting it, and issues surrounding it. You have a management team that hasn't made the greatest capital-allocation decisions. You have a part of the business that's devoted to the consumer that is more challenged. You look at PC sales declining, and it begs a number of questions.
But what they do have is, … a very good core franchise that benefits from business, whether it be Servers and Tools or Office. When you have 750 million people around the world using Office, it's not going away overnight. That's three-quarters of their business, and that's not going away anytime soon, at least as far as we can see.
The consumer business is being impacted, but you can go and look and really take a pretty good hit to that, and still find that the company was still trading relatively inexpensively in what we viewed as conservative normalized earnings.
When we think about conservative earnings, we look at all three of the these companies. We gave them a little M&A hit, or we looked at it as R&D. In order for Microsoft to be Microsoft or Cisco to be Cisco or Oracle to be Oracle, they need to make acquisitions. So we actually budget that M&A and reduce our earnings, almost as a second R&D expense. So our earnings tend to be lower than the consensus estimates. Even on that basis, in the case of Microsoft, you had a company that, if you back out the cash adjusted for … if you were ever able to repatriate it and tax-effect it … it was trading at single digit P/Es at our cost, and it made it attractive. And as Mark Landecker, my co-portfolio manager likes to say, good things happen at cheap stocks.
Stipp: I want to talk to you about the strategy of the fund and the fund operations itself. Your fund has seen pretty tremendous growth [in assets] over the last five years. Has that changed at all the way that you execute your strategy or the strategy itself?
Romick: There's no question that managing more money doesn't allow you to invest in small-cap stocks the way you may have once done, or even once did. But that train left the station a long time ago. Whether you're $7 billion, $10 billion, $15 billion, it doesn't make that much of a difference. You're not $1 billion anymore.
But at the same time, mid-cap stocks tend to correlate quite closely with small-cap stocks, and so that opportunity still exists, and we still are able to take advantage of that. Then there's also the opportunity to do things we weren't able to do before--certain types of loans that we're able to make that are less liquid, and other illiquid types of investments that we have made. It can't be a large part of the portfolio, but it's enough to move the needle.
In addition to that, we have the ability, given our additional growth, to get a seat at the table that we wouldn't otherwise get with certain investments, and that might include being invited to have discussions with boards of directors because we carry more weight than we used to.
Stipp: So some doors close, some other doors open for you.
Romick: We were instrumental earlier this year in having a chairman removed from a Fortune 500 company.
Stipp: Last question for you has to do with a lot of the noise that's coming out of Washington right now, and I think long-term investors want to look beyond the noise so that they don't get caught up in trying to make these short-term moves.
But I think a question that long-term investors have is, is there a possibility that I would see fundamental impairment because of the short-term wrangling that's going on in Washington, and that's where I think the real fear lives.
When you look at your portfolio and you look at the companies that you own, is the possibility of a long-term impairment from this short-term wrangling in Washington something that concerns you?
Romick: Well, I would characterize it not so much noise, but as just abject stupidity. I think there is a lot of short-term wrangling, but it always goes on, and I think that there's not going to be a lot of near-term consequence to that. I think all these short-term issues and short-term decisions that Congress is making--they're made in Washington--are things that are going to impact us down the road, and they are going to be quite negative. You look at our national debt, and how we have to finance that in the future. How are we going to finance it? What will the cost of that debt be, as we continue to make these spending decisions that we can't really afford. So I'm more concerned about that. At some point, there will be hell to pay, but we don't know at what point in time or from what level, and we can't really look to make decisions from that to guide our portfolio.
What we do consider, as you look at these companies, you try to establish what you think … the macro environment could deliver in terms of GDP growth, if it's a GDP-type company, and then back into that and use it as part of your top-down analysis, as you consider a given company.
But we don't try to make bottoms-up decisions as a result of what the government is going to do short term. Somebody called me the other day and said, what are you doing with all your cash? If your cash is sitting in Treasuries, if there's a government default, you are going to be screwed. I said to this gentleman, well, the rest of your portfolio is sitting in equities. I will take my government bonds against your equities at that point in time. Not that government bonds will do well, and by the way short-term government bonds--we're talking about Treasury bills.
Stipp: Steve Romick, lead Manager of FPA Crescent, thanks so much for joining us today and giving us your insights.
Romick: Thank you.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.