The Eclectic Strategy of a Winning Fund Manager
Steve Romick, manager of FPA Crescent Fund (symbol FPACX), calls himself an "absolute value" investor. He aims to deliver positive returns over a typical investment cycle, which he says lasts five to seven years. And he tries to do this by investing in securities that are inexpensive on an absolute basis, not cheap relative to similar securities.
The use of the word securities in describing Romick’s holdings is deliberate. Crescent, a member of the Kiplinger 25, looks a lot like a balanced fund. But unlike a typical balanced fund, which may have two-thirds of its money in stocks and the rest in bonds, Crescent holds a smorgasbord of assets, including junk bonds, convertible securities, even direct investments in mortgages. Romick, 48, is willing to hold large amounts of cash and to bet against stocks by selling them short.
His eclectic yet conservative approach has served shareholders well over the long haul. Over the past ten years through September 7, Crescent returned an annualized 8.9%, topping Standard & Poor’s 500-stock index by an average of six percentage points per year.
We recently visited Romick at FPA headquarters in Los Angeles to learn more about his strategy and his views on the economy and the markets. Below are edited excerpts of our conversation.
KIPLINGER: What is your take on the economy?
ROMICK: The big picture -- in a nutshell -- is scarier than heck. We had a deep recession precipitated by a financial crisis that was largely due to an over-leveraged banking system with too many bad loans. The government responded by throwing lots of money at the problem. But were its actions effective? I think it’s really easy to say no. We got a short-term bump in GDP [gross domestic product], but we failed to make the investments necessary to perpetuate longer-term growth.
Does the downgrade of the U.S. debt rating trouble you? At the end of the day, do you feel any less confident as a U.S. citizen that your money will be paid back? Of course not. The U.S. will never default.
But we could pay back our creditors with cheaper dollars. That’s exactly right. We won’t have a literal default. We will default through higher inflation. If the foreigners who lend us money -- and they represent about half of our outstanding debt today -- think that the dollars they put in will be worth less at some point due to inflation, they are going to charge us a higher rate of interest. So interest rates will rise at some point. But figuring out the timing is impossible.
Are we in a recession now? I don’t know. But I believe the economy will be weaker than people suspect.
What’s been your approach during the recent period of stock-market weakness? We went into the decline about 60% invested in stocks. Our first decision was to maintain our exposure. We then decided to take up our stock exposure. So we are now about 64% in stocks. We’ve been running hard to stay in place and go a little beyond.
You recently expressed frustration at the difficulty in finding attractively priced securities in virtually every asset category. How do things stand today? Let’s start with bonds. The ten-year Treasury is at 2.0%, and the 30-year is at 3.3%. Those are stunningly low yields. I don’t understand who the hell lends money to this country for 30 years at 3.3%. Buying longer-dated Treasuries is nuts. Our basic bond strategy is to buy corporate credits when they’re out of favor. We’re not getting paid to play now, so we have just 7% of the portfolio in corporates, and their average maturity is just 1.5 years. Basically, they represent a cash substitute.
How do you describe a perfect Steve Romick stock? We look at three things when we analyze a stock. We want to understand the business, the management and the valuation. When we look at the business, we break it into two parts: the company and the industry. For me, a perfect stock starts with a good business in a growing industry. The company has a good management team with proper incentives and knows how to allocate capital, whether to reinvest in the business, pay dividends to shareholders or use intelligently for share repurchases. Plus, the stock trades at a valuation that does not anticipate the good things that may be coming down the road. Our favorite investments are those that are so cheap that we feel we really can’t lose much money.
Do you own anything that fits the bill? Nothing today. We hold businesses that we like and management teams that we like. But none of the stocks have valuations that would cause us to back up the truck.
Anything come close? CVS Caremark [CVS] is a good example. CVS is the drug-store chain and Caremark is a pharmacy benefits management business. The stock trades at about 12 times estimated earnings.
And a company like that should be able to hold its own in a struggling economy. Right. And CVS has built-in profit growth in 2012 because of the large number of drugs that are losing patent protection. The company makes more on generic drugs.
Where are the best opportunities now? Our portfolio is tilted heavily toward larger, higher-quality companies, more so than it has ever been. Look at Wal-Mart [WMT]. Over the next ten years, I’m willing to bet that other parts of the world, especially Asia and Latin America, will grow faster than the U.S. So why not buy companies that have exposure in those foreign markets? Wal-Mart gets 27% of its sales overseas. I also like Tesco [TSCDY.PK], a British company that is one of the world’s biggest food retailers and gets one-third of its sales from emerging markets. Other examples are Johnson & Johnson [JNJ], Kraft Foods [KFT] and Unilever [UN].
You own Cisco Systems, Hewlett-Packard and Microsoft. Have you been adding to your technology holdings? Not Hewlett-Packard. I just don’t understand what its management is doing. I’m unhappy with management, but we still hold the stock because even in Hewlett’s distressed state, it generates a significant amount of cash flow.
What are your thoughts about gold? It’s a shiny metal that has proved over a couple thousand years to be a great thing to own in difficult times. But what is the right price for gold? I have no idea. Gold is a clear bet against the success of fiat currencies. And it may be the correct bet for a period of time. But at the end of the day, I’d rather buy what I think are great businesses that can generate cash flow and do wise things with that cash.
What’s your approach to short selling? Most of our shorts today are hedges for stocks we own. In the case of CVS, for example, we’re short two of its competitors on the pharmacy benefits management side. We own shares of Vodafone [VOD], which owns 45% of Verizon Wireless, and are short shares of Verizon Communications [VZ], which owns the rest, to effectively give us a short position in Verizon’s wireline phone business.
Your fund also has some unusual mortgage investments. We’ve invested in a couple of things that are less correlated to the stock and bond markets. For example, we’ve gone to certain banks and have bought pools of mortgages that originated in the 2005-07 period and that the banks have budgeted for sale at a loss. We bought these loans at 50, 51 cents on the dollar. With the help of a special servicer, we can go to borrowers and offer them mutually beneficial terms for restructuring their mortgages. Those loans represent about 2.5% of the fund.
FPA also provided $40 million to a group that has loaned $130 million to a developer to complete a 650,000-square-foot office building in the Southeast. We estimate that the investment will produce an internal rate of return of 11.8% over the next three years. We don’t really feel it’s possible to lose money on this investment.
Your efforts have paid off. Yes, but our contrarian strategy dictates that we be willing to underperform for periods of time. Over the past eight years, we’ve beaten the stock market in only four years. But our total return over that period is better than the market’s because we have done a fair amount better when the market is down.