#91 - Steven Romick: Value, Quality, and Adaptability

0:06Welcome to the Insightful Investor Podcast, a weekly series that seeks to share industry, investment, investment, and market insights. Learn more about our show at insightfulinvestor.org. I'm excited to have Stephen Romek join us on the podcast today. Stephen is the co-managing partner of First Pacific Advisors, or FPA, and the longtime steward of the FPA Crescent Fund, recognized for his go-anywhere philosophy and 32-year track record. FPA manages about$20 billion as of June of this year. Stephen, welcome, and thank you for joining us. Thanks, Alex. Happy to be here. Let's start, I guess, at the beginning.

0:49How did your passion for investing develop? And where do you feel like your core investment beliefs originated? You know, passion's interesting because I think passion really didn't come right away. I think that I had an interest and I think I had a natural proclivity for attaching myself to the mathematics of investing, and looking at tearing apart the balance sheets and all the financial statements. And I think it was fun, but I was terrible at it at the beginning. I came out of undergrad and was offered a job by a gentleman named Jeff Nathan, who said to me, I'm tired of unlearning MBAs, and so let me train you.

1:32But here I am with a Bachelor of Science in Education and took a couple of finance courses, thrown into the wolves of the first day in the office and given a stack of prospectuses that, I kid you not, was two feet high to take home and read. And I didn't know what the heck I was doing. So it developed relatively slowly. I went and got my CFA to try and teach myself along the way to try and self-educate along with his help. But it really began back when I was in junior high school and I began to invest with my grandfather. And then some friends said, you know, buy this, buy that. I started buying some stocks and it was really no more than gambling at the time.

2:18But, you know, because of that, I learned early on that, you know, and I only made money at the very beginning. It was like, you know, clocks right twice a day and I got that clock right. And, but I learned, you know, I just didn't like losing money. And as I got better at it, the core beliefs, as you asked about, really, you know, this foundation is just my distaste for losing money. Do you feel like you were born with that focus on protection against permanent impairment of capital? Or do you feel like you learned it and it stuck through experience and study? I don't know if I was born with it, but I certainly received an inoculation at a young age.

2:58and so don't tell RFK about that. Be that as it may, I think that not losing money vaccine that I had at an early age was really a very big part of it. But I also think a depression era mentality, just like, well, it can all go away tomorrow, kind of lives with me a little bit. I'm not really sure why. There are scientific studies that suggest that it takes a number of generations for your DNA to actually get back to what was before some kind of traumatic event that your forebears might have had. But I do think that my success over time was driven by something a little bit different than maybe most.

3:43I mean, success is often driven by this blind ambition. And there's me, which is really somebody who was so fearful of failing that I worked my butt off to ensure that I wouldn't. I probably employed a similar work ethic as those who have that inherent need to win. So I thankfully ended up in the same place. And I guess that could also feed into this notion of minimizing losses and permanent impairment of capital. Because if you're so focused on not losing, it's just a very different orientation. Yeah. But if you set yourself up not to lose, but create the optionality to win, some of those options are going to hit.

4:26So, you know, your returns are driven over time, not just by what you own, but what you don't own. And so avoiding, you know, these mistakes can be a big driver of your return. I think that, I mean, minimize the mistakes in terms of the absolute number of mistakes, because where is the loss per mistake? And I think that's really key. You talked about your investment philosophy DNA. Would you describe that and maybe how your core beliefs have or haven't changed over the past 30 years? At my core, I haven't changed. As I said, and you brought up, I hate to lose money. One important way is to protect capital.

5:11And one way to do that is to make sure that you pay an appropriate price for an asset. And the only thing that's really changed since I've been in business is that I'm less willing to own lower quality businesses. But at my core, I'm really the same person. I've evolved as an investor over the years, but my core hasn't changed. Some would describe you as a value investor. How do you define value, especially regarding this notion of a margin of safety? I think you actually answered the question and your question is to us, to me, value is just investing with a margin of safety, period. It doesn't mean buying companies at deep discounts to book value.

5:54It means that an asset you think is worth 100, you can buy it at a discount to that where you're able to absorb the risk of potentially being wrong and retain the optionality of being right. I think is a terrific way to make money over time. In the past, as I said, it was more accepting of lower quality businesses. I had the protection of the balance sheet. Solid book value is support adjusted for hidden real estate value and such. But with so much disruption from technological innovation today, many cheap companies are are seeing or have seen their businesses disintermediated. And this has increased our focus on higher quality businesses.

6:43Balance sheet protection is good, but all else equal, give me a better quality business at a great price. That makes sense. So obviously there's times when your investment decisions diverge from consensus. Do you view that as being deliberately contrarian or does it just stem from a more intuitive conviction about what is value? I don't know that it's intuitive and we certainly aren't deliberately contrarian. You know, the crowd isn't always wrong. We are able sometimes to develop a variant view that other investors might be less accepting of or would prefer to wait to see how things develop and try and time it a little bit better.

7:24We know we're not good at timing. And so we're willing to look across, you know, the cask of when things are bad. you know, it's sometimes hard to envision, you know, getting up and climbing that hill to get to the other side. And sometimes with just that conviction that we will get there, we're not exactly clear on the timeframe, but as long as we can get there and we believe that our IRR even, well, it takes, you know, seven years instead of four years, for example, and we can still have a good IRR in that circumstance, you know, that works out, can work out quite well. Sometimes all we offer is just patience to look longer term.

8:01It is interesting how long term, it seems to me the definition has changed over time. It feels like it's shorter, long term is shorter term now than it was maybe five years ago or 10 years ago. Is that your sense? Oh, for sure. I mean, I think it's true across society. I mean, I have four daughters and my two youngest daughters are, you know, in the midst of this, you know, came up in the social media generation. My older two didn't. And that short-termism is really significant. If it didn't happen, if I've not recorded for posterity, it didn't happen, it seems. And everything has to happen. If it's going to be good, it has to happen by tomorrow.

8:44There's no willingness, it seems, generationally. It's not just speaking to my daughters, generationally, to do the work and what it takes to really invest that intellectual capital, your human capital, your energies to to succeed over, over 10 years and focus longer term, you know, on that. And we, you know, never want to, um, be those people who just demand success tomorrow. We know it doesn't happen immediately. Yeah. And I guess in some ways being patient could actually be an advantage because maybe other investors are less patient and it creates an opportunity. Yeah. And I think that's actually, I think that really is a significant statement today, because I think that with so many people like me who've been put out to pasture because they've become less relevant as investors, maybe some of them might've been a bit more dogmatic.

9:41Sometimes it's just, I mean, I'm not going to underestimate good fortune that over the years that we've been in the right place more than we've been in the wrong place. but that has made it a little bit less competitive for us in the one hand but also interesting with all of these pod shops and you know momentum players and and etfs and so much money shifting from from active to passive when there is selling it can happen really quickly when there's that loss of conviction it really can create tremendous opportunities i think that And that might be more of our future than it has been in our past, which is actually, you know, makes me feel a bit more optimistic about where I sit and, you know, here at First Pacific Advisors.

10:27I know you've emphasized the importance of continuous learning. How do you decide when to be dogmatic, as you said, versus adaptable? And where's the line between maintaining core beliefs and evolving as markets change? I don't think I ever said I want to be dogmatic. I mean, we never want to be dogmatic. We don't operate with perfect knowledge, and we know that. So we don't have that perfect knowledge of industries and businesses that all continually evolve. There's always a regular flow of information that we must consider, some of it confirming, some of it disconfirming. So we therefore must always be adaptable.

11:08And so when you talk about our core beliefs, I mean, that hasn't changed. We have never been so dogmatic as to say, we're right and the world's wrong. I guess the line is core beliefs in terms of margin of safety, minimize the risk of permanent and permanent capital, and then adaptable in terms of just about everything else. Is that accurate? Yeah, that's accurate. You also asked, as part of the question, I didn't answer to it. You talked about evolving with that line between maintaining core beliefs and evolving with the markets. I mean, both can be true. I just don't think they're mutually exclusive circumstances.

11:46You can have a core belief, and yet you still need to evolve with the market. So markets can throw out different things to you at different points in time. We were able to buy interest rate caps when rates were at all-time lows. And that's something we had never done previously. We were able to – we bought – we've only ever made one currency investment, and we bought puts in the yen more than a decade ago. We were willing to, you know, it was very binary. It was a very, very small amount of capital that was invested that if it paid off would offer us a very asymmetric rate of return to the risk that we assumed and the capital we invested.

12:25And that actually, we were lucky and it did pay off in the time. But it was anytime you start, you know, using derivatives, I've got a, there's a, there's an expiration date attached to it. So you got to not only be right, but you got to be right in that timeframe. So sometimes you could, you could be dead right. It could happen the day after your options expired. Right. Yeah. And also in terms of the evolution, in the beginning of our conversation, you talked about how just even the notion of margin of safety has evolved from maybe just pure financials to the quality of that business. Yeah. I mean, I always hoped for business quality, but I was able to buy 30 years ago businesses is that I had the great protection of the balance sheet by companies at or below book value.

13:16And it was great. I just wasn't worried about that disintermediation that has really been happening in the last 20 years because of technological innovation. And I guess that disintermediation and competition goes to protecting capital, right? Because you're thinking about permanent impairment of capital. How do you relate that to just regular market volatility and the price going up and down? Great question because stocks can trade any price on any given day based on whatever animal spirits may have taken over the market or an industry or a specific company. However, that doesn't suggest anything as to how a company and its stock price might perform over time.

13:59We really try and shut out that daily noise. volatility today doesn't say anything about a price tomorrow it's like using a thermometer to predict the future i'm looking out my window and look at santa monica beach and it's 75 degrees and sunny but tomorrow it might be 65 degrees and rainy so we really just volatility doesn't really tell you much of anything and and volatility often you know i think people use it as a measure of risk. And we think that's not appropriate, at least for us. But I see how it is a measure of risk for a lot of people because a lot of people will just use volatility.

14:41And volatility will affect them in a way that causes them to get in or out of the market or individual stocks. It scares investors in and out of stocks. The market going up, we got to buy. We're the market going down. We got to sell. And then you talk about a permanent, permanent capital, which is really something very different because no matter, the stocks are going up and down on any given day over a period of time, but you don't have to, nobody's telling you have to sell it, you don't have any leverage and the banks aren't going to have a margin call. But so I really think that you're not forced to realize a loss.

15:17Sometimes it is appropriate to realize loss, going back to that question of being dogmatic and we don't want to be dogmatic. Sometimes you just have to realize, you know what, we were wrong. And so while a law should have nothing to do, permanent impairment should be because you either made a mistake or your thesis has changed. Some of that information, as I talk about that flow of information, has come through and you did your initial work and your initial work guided you to buying something or guided us to buying something. And yet new work suggests that the information flow has changed and there's new competition that's out there, for example.

16:00And that company might not offer the unit volume that it wants growth that it once had. It might not have the margins that it once had. It might require a lot more CapEx to even maintain their place amongst their peers. So all that has to be taken into account. And when it stacks up against us, we exit. So when we build our models, we look at a low base and high case. And our low cases is when we think we could potentially lose money, hopefully not that much. And when the company doesn't quite execute on their plan as much as we would hope they would. The base case, the company excludes in the plan, the economy is relatively good, and the market ends up reflecting the stock price in the market, and we end up making decent money.

16:51Then there's the upside case where things are even better than we might otherwise. Well, they're as good as we hoped for, but they're not as good as we were willing to underwrite to. And so that's just optionality. And sometimes the high cases, sometimes the low cases, but more often than not, we have been more successful than not over the last three decades focusing with these very, very simple rubrics. And these are not other models that appear to offer great precision when it has earnings down to the penny. It's just the result as a byproduct of the model. That's it. I guess a simple way to think about it is you have a company out there that you think is worth$100 and it's trading at$80.

17:39And so you've got a decent margin of safety relative to what you feel it's worth. And then you buy it at$80 and you think it's worth$100. If new information comes out and you now realize, you know, it's not worth$100, it's actually worth$90, that could be viewed as a permanent impairment of capital, regardless of what the market price is. That 80 could move up or down because that's just a reflection of what the consensus view is of that company. Is that a simple way to think about it? The one pushback I have is the permanent pyramid in capital locks only happens when you sell something, but it is a permanent pyramid of value in that case, or maybe not even.

18:17Maybe it's went from 190 today and maybe it ends up being 110 in the future because they write the ship. new information, you know, suggests the ship is listing. And then the new management comes in as the current management team wasn't able to execute. And they end up, you know, riding the ship and creating greater opportunity in the future. And things end up going swimmingly. I mean, a good example of that would be take Microsoft, right? I mean, Microsoft grew its earnings someplace around 18 % from 2000 to 2009 for the first decade of this century. And the stock went down because it was priced so inappropriately going into it in the internet bubble.

19:00And at the time, there was a lot of fear that people were going to be using different form factors. You know, in 2009, 10, people were going to be not using iOS and not DOS. People were not going to be using Word. They'll be using Google Docs. And, I mean, all of that, you know, didn't end up being true, as we now know. And they moved into the cloud and started doing other things. And that's a good example of a different management team coming along the way and helping push that stuff over the finish line. You founded a, quote unquote, go anywhere fund 32 years ago when the concept was relatively unique.

19:39Why was this path so intuitive? I guess I wanted more places to potentially lose money than others. You know, I always thought it was silly to pigeonhole oneself. Why only buy large cap stocks when you can buy small? sometimes one market gap presents more of an opportunity than another. Why only buy U.S. when we can buy overseas? You've got Nike here, Adidas in Europe. You had Oracle here, you had SAP in Europe. You've got, you know, similar businesses in different parts of the world. And maybe they're being managed better in other parts of the world than the U.S. Or maybe not. But not to look at the whole landscape didn't make sense.

20:17Then why only buy equity when I can buy corporate debt that might offer an equity rate of return? So it just seemed really silly to not consider opportunities right in front of you. A good example would be, let's just take real estate. If you were to look at an office building that's a four-story office building, the relatively small footprint, and compare it to a 20-story office building, compare that to a 50-story office building, and call them small, medium, and large cap stocks. The analysis is going to be the same. What is the occupancy? What are the credit quality of those occupants? How good is the location of that building in the city that it's in?

21:01How good is that city in that state? Is there a lot of deferred capex to bring that building along? There's a lot of TI that tenant improvements expenses can be required to bring new tenants to the building as these leases expire, et cetera, et cetera. The analysis is the same. So why not look at small versus large? Or what if you're looking at that larger, bigger building when you can buy the debt of that building and get a 12%, 11%, 12 % rate of return? A good example of that would be Rockefeller Center, Rockefeller Properties. When the keys returned back in, back in the late night or mid, I guess it was 90, I'm losing track of my time, but call it 96, 97 timeframe.

21:42frame. I guess that comes down to this balance between specialization and the benefits of that. And what you described, it's essentially the same type of analysis. So the specialization isn't as significant when the analysis is comparable. Yeah, exactly. I mean, we do, we look at where some industries, we just don't, short product lifecycle companies, we kind of stay away from those industries. Businesses that offer more of a binary opportunity, You know, biotech would be example. It doesn't mean one shouldn't invest in them. We just don't have a, we don't bring great skill to the table in that regard.

22:19But if we can go it, bring skill across different asset classes and geographies and why not? Is there a reason you typically hold more cash than many managers? And how does that fit within your bottom up process? Yeah, cash is merely a byproduct of our investment process. As we see opportunity, we pull cash down. When there's not opportunity, we end up selling some of the more expensive companies in our portfolio and cash bills. So cash is truly a byproduct of our investment process. And there's been points in time when it's been drawn down into the mid-single days. It's been quite some time since that's been the case, but we hope for it to be the case at some point in the future.

23:07What does it say when you have more cash? What should investors take away from that? Well, it means that we aren't seeing the risk reward in the markets broadly when we have more cash. We might see it narrowly. We might be in certain asset classes, to certain industries, companies, regions, but to put together a whole diversified portfolio is harder for us at certain points in time when markets are generally more expensive. So I think that the only takeaway one can have is that we aren't seeing the opportunity. That doesn't mean there isn't opportunity. It doesn't mean that we are right. That's fair.

23:47Today, and maybe for some time, we live in a world of great uncertainty in the macroeconomic landscape. I guess you could say it's always uncertain. and it just seems like it's more than normal. How do you reconcile your macro views with your bottom-up investment analysis? So as I mentioned, when we do our analysis, we build these models that have, as I said, this false precision, this low case, base case, and high case. And so our macroeconomic views end up being a backdrop that we use in those models, Like in the bad economy, if we end up with a lot more inflation, we end up with higher interest rates, how does that affect a business you're looking at?

24:30And that will get built in off and still locates. Look, we try and handicap outcomes as to what is more likely. But at the end of the day, we're really trying to ensure is that company XYZ that we're buying today will still be company XYZ with its position in the marketplace and with more earnings than it has today, five and 10 years from now. Now, macroeconomic, again, you have to get, you know, with long term versus short term, too, right? I mean, Mark, the economy is going to go up and it's going to go down. And while I think the economy is going to be better in 10 years than it is today, more GDP globally, I think the economy better in 20 years than it is today than it is in 10 years, I think over time we will continue to grow.

25:13And along the way, there's going to be episodes of weaker economic environment. You're going to have recessions and that will hopefully create opportunities to put capital to work. So when you're buying companies, you're hopeful of the things that can go right, but you're also thinking about what can go wrong. How do you weigh macro risks like an economic downturn versus more specific factors like competition, business model weakness, and the company's level of innovation in your analysis? That's really a great question, but not one that's possible to answer globally because different companies require different ways.

25:55Some are more subject to what the competition is doing. Some operate more in a duopoly or algopoly where it's less of an issue. Today, some are more impacted by the economy than others. So I really think it's company-centric. We try and anticipate what can go wrong. And as we realize that more things can go wrong than will go wrong, but we're always trying to figure, okay, let's dream the dream on the one hand, and then let's live in fear on the other hand. So we kind of operate on a quotidian basis with that kind of duality. Your fund has over a 30-year track record, and few funds share that characteristic.

26:34What do you feel has allowed you to survive and adapt through so many cycles over the last three decades? I think it begins with intellectual honesty, requires continuous learning, and a love of learning. Every day is different. New companies, new industries crop up that can disrupt old industries. And having the portfolio that offers the flexibility to move around to take advantage of that in different environments is also key. And lastly, I would say that none of that could be done for me without my great partners, Brian Seltko and Mark Landecker. Well, in the last 30 plus years, you've lived through many major market cycles.

27:21What do you see as the potential drivers for the next big cycle? There's been points in time where it's been more obvious to me was me the driver. I mean, it was pretty obvious to me how much leverage there was in the system back, you know, preceding the great financial crisis and how that really was going to be a great unwinded result. And speaking to that specifically, you know, as I said before, returns are driven not just by what you own, but what you don't own. And we had sold out of all of our financials. You're talking to a guy who started out for the focus on bank and thrifts, working for the first investment partnership when I left college in 1985.

28:02But I think that low rates have preferred capital allocation. So a lot of capital has been put into manufacturing facilities and into R &D and other CapEx needs with an expectation of some future return. Well, an expectation of a future return can be lower if rates are lower. And high rates are going to cause us to change and magnify that with any company that's got higher debt levels. And that in turn can get magnified by the sovereign risks that exist, you know, with high debt levels. And so, you know, higher interest rates, you know, could be a serious problem along with the weak economy. We could end up with stiflation.