Romick: Waiting for Another Bite at the Apple

Jeff Ptak: Hi, I'm Jeff Ptak, global director of manager research at Morningstar, coming to you from the 27th annual Morningstar Investment Conference, held here in Chicago, Illinois. I am very pleased to be joined today by Steve Romick, portfolio manager of Gold-rated FPA Crescent (FPACX).

Steve, thanks very much for joining us today.

Steven Romick: Thank you for having me.

Ptak: So, I wanted to touch on a few different topics with you, one of which is [the market]. We know that you are a bottom-up security selector, but we very much value your perspective on markets, given the fact that you look at all the different parts of the capital structure--equities, fixed income, and other types of assets. What are you seeing right now? Is it a target-rich environment? And if not, what sorts of adjustments have you had to make in the way you manage the portfolio?

Romick: For us, it's not target-rich. It's not target-rich because we're not able to invest with the same margin of safety that we've historically been able to invest with. So, I don't want to go so far to say that the market is expensive. If interest rates remain at these levels, one can argue reasonably that it's not. But that's the question: Is this the right level of interest rates? And I think that central banks around the world have come together--and separately, independently--and have engaged in practices that are potentially perilous.

Now, that said, I said potentially because I don't know actually what's going to happen. But if rates don't remain at these levels and they go higher, then things aren't as cheap as they were because these low interest rates will have perverted capital-allocation decisions. Companies were able to make acquisitions of other companies or purchase their own stock, and so on. And it's spilled over to other kinds of risk assets; that includes bonds as well--high yield, distressed debt, or even just high-grade bonds and Treasuries.

So, since a portion of our portfolio has, historically, on average, invested in high-yield bonds, we're not seeing the same opportunity there. So, that portfolio has just been decimated. We have a ton of cash sitting there, waiting for the next go-round--the next bite at the apple.

Looking at the equity side of the book, we just don't see the same juice in our portfolio that we have at other points in time. It's not the best marketing move to talk about your book in such a fashion--to say, "We manage a lot of money of your money. Thank you for being our client and oh, by the way, we're not terribly excited about our book."

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Ptak: Let's talk about repurchases for a minute. You mentioned it earlier. We had Jeremy Grantham of GMO; he was in here giving a keynote yesterday at the conference, and he bemoaned what he views as an excess of repurchasing that's going on. What your perspective on it? I would imagine that you're comfortable with the repurchasing that your equity holdings are engaged in; but more broadly, across the market, do you think that we're looking at a situation where companies are overdoing it?

Romick: Well, I think it's a company-specific question. Some companies are certainly overdoing it. It's ironic that companies were so aggressively buying their stock back in 2007. You made the statement that you imagine we're comfortable with the companies that we own that are buying their shares back. Not in every case--candidly. But we don't get to control the cash flow, unfortunately, in our portfolios--unlike owning the company free and clear yourself or private equity being involved in it.

So, we have to depend on management teams to make the right decisions. Today, many companies aren't. And you can't go and approach this in such a fashion as to say, "Look, we're going to go and have a payout ratio of 30%--free cash flow after the capital for growth [capital expenditures]; then after that, we're going to go and give a dividend of X, and whatever is left over we're going to go and return it you in the form of share repurchase." And companies are making these statements without respect to price.

If their stock price is 30% greater, it's not going to be as attractive as if it's 30% lower. So, we find a lot of these share repurchases to be suspect that are happening today. But I don't want to make a blanket statement about them.

Ptak: Let's talk about credit, which you alluded to earlier. It's conspicuous by its absence in the portfolio, given the traditional exposure that you've had to high yield in some pockets of distressed. So, is the primary issue there price? Is it issuer condition and behavior? It seems that companies are quite profitable; they are able to raise money very readily--in certain cases, to go out and fund repurchasing that they want to do of their shares. What's the fly in the ointment for you and your team?

Romick: I think it's definitional: "high yield," "high." It's not high. It's low. The starting yield is low. If you've got a spread to Treasuries that doesn't seem so crazy at 5%, but you are working off of a 2% or 1.5% Treasury in that maturity in that part of the curve, and all of a sudden you are at 6.5% or 7% yield, that's incredibly uninterested. You are not getting paid to play, in my opinion, in so many of those investments that are being made out there in the high-yield space because it is, without question in our mind, a seller's market, and we're more interested in a buyer's market.

Ptak: I wanted to talk briefly about the shift and the complexion of your equity portfolio. I think your term for some of the names that populate it now is "compounder." These are sort of steady-Eddie, highly cash-generative, often competitively advantaged businesses. They seem to be assuming an even more prominent place in your equity portfolio versus the three-to-one situations that you focused on in the past. Can you talk a little bit about what's hastened that evolution in the portfolio? I'm sure valuation is one factor.

Romick: Valuation is one factor. When things become more extended--we're in year seven of a bull market--the three-to-ones, the more commercial opportunities, those companies that have more upside than downside, are less prominent. There is not a plethora of opportunity. So, by default, we end up shifting to something else. That could be cash, by default, if we don't see other opportunities. The second reason is we've built up an expertise, in no small part thanks to Mark Landecker's influence in our team as a [co-portfolio manager], in these higher-quality global businesses. So, our research capabilities have evolved over time. We're able to look at more things, different parts of the world, different asset classes. And as our skill set has expanded, we have been able to own more of these larger-cap quality businesses, and we've taken advantage of that.

So, we look at them more as infinite-duration bonds with rising coupons--think of them as an earnings yield, a free cash yield to add to the equity that you have. Think about them on an unleveraged basis. And when we can find business that offer a good yield, thinking about them like a bond, we want to buy them. And we will sell them when the yield is too low. Buy them when the yield is high; sell them when the yield is low.

Ptak: So, does the higher-quality character of the equity portfolio--if I can use that term--does that have any sort of influence on how you would think about the remainder of the portfolio? The thinking being that maybe this is a stable or more cash-generative set of businesses; therefore, I might do things a little bit differently in the fixed-income sleeve than I would otherwise--or not really?

Romick: It has nothing to do with the fixed-income sleeve; but what it does do--and this is very important--is that by having this large component of higher-quality businesses, we believe that over time we will be able to run, on average, more investments than we have in the past. Our average cash over the last 22 years of managing this fund has been in the mid- to high 20s. We didn't use these high-quality businesses in the past as a sleeve in the portfolio. Now that we have that opportunity, we will be able, over the next decade, to be more invested--again, on average. It's certainly not the case today, given the smaller number of opportunities we see out there.

Ptak: Last question: I wanted to ask you about a specific stock--that being Naspers (NAPRF), a South African media company, which would probably be relatively obscure here in the U.S. Most people haven't heard of it. But it's notable in a number of ways--one of which is that it has a significant stake in Tencent (TCEHY). Can you talk about how you've managed that name, which is somewhat unusual and unique?

Romick: Sure. It's emblematic of other investments we've had like it. We create stub trades when we can. We were long in the past on two different occasions more than five years apart--long Renault (RNLSY) and short Nissan (NSAN). Renault owns 44% of Nissan. It used to own Volvo Trucks as well. We were able to short the other public-equity components of these businesses that they owned and create a stub at a low value or negative value. In the case of Renault, it was a negative value. We had opportunities in the past. We had long RJR Nabisco and short Nabisco.

We had opportunities in the past to be long limited and short different brands. Today, we have an opportunity to be long Naspers--the South African holding company--and short Tencent. The shares that they own in Tencent, which they purchased in the early part of the last decade for $30 million in change is worth $63 billion. Compare that $63 billion to the market cap of Naspers, which is only $61 billion. So, you are being paid $2 billion--I'm not tax affecting the Tencent investment for the sake of this discussion--you are being paid $2 billion to make this trade. You are being paid $2 billion to own Naspers effectively--everything that they have. And they've got some other good businesses. Old print-media assets that are OK. Some really good pay-TV assets in Africa and Sub-Saharan Africa. They've got a whole other e-commerce portfolio with exposure to online classifieds. It's a terrific asset.

I don't know what all of these assets are worth, but I do know that they are worth more than minus $2 billion. So, by being long Naspers and shorting their exposure to Tencent, we're able to create a stub of just the Naspers ex-Tencent--basically cleaving it off, if you will. And that opportunity to make good money with a negative capital investment is terrific for us.

Ptak: Steve, thanks so much for your insights and for joining us today.

Romick: Thank you for having me. Really, it's an honor.

Ptak: From the 27th annual Morningstar Investment Conference, I'm Jeff Ptak. Thanks very much for joining us.