Episode #136: Steve Romick, FPA Funds, “Value Investing Is, To Us, Simply Investing With A Margin Of Safety, Believing That You’ve Made An Investment Where It’s Hard To Lose Money Over Time”

Episode #136: Steve Romick, FPA Funds, “Value Investing Is, To Us, Simply Investing With A Margin Of Safety, Believing That You’ve Made An Investment Where It’s Hard To Lose Money Over Time”

 

 

Guest: Steve Romick serves as Portfolio Manager for the FPA Crescent Fund, Source Capital, Inc. and the FPA Multi-Advisor Strategy. He was named Morningstar’s 2013 U.S. Allocation Fund Manager of the Year and was also nominated for the Domestic Manager of the Decade Award for 2009. Prior to joining FPA, Steven was Chairman of Crescent Management and a consulting security analyst for Kaplan, Nathan & Co.

Date Recorded: 12/5/18     |     Run-Time: 1:01:44

Summary: The conversation begins with Steve explaining that he hated losing more than he enjoyed winning, and while there wasn’t one event that led him to value investing, he considers his aversion to loss a contributor to being drawn to the value-oriented investment approach.

Meb then transitions the conversation by asking Steve to characterize the investment strategy of FPA’s Crescent Fund. Steve talks about the value investing framework as investing with a margin of safety and how it has morphed over the years from being about the balance sheet to now, through technological innovation, the corporate lifecycle has been as short of it has ever been with the most of the density of innovation happening in the past 50 years.

Next, the discussion turns to investment framework. Steve describes this team of 11, and how the job of his team is to understand the business and industry first on both a quantitative and qualitative basis. He describes the go-anywhere mandate as a potential recipe for disaster as there are more places to lose money. Steve then discusses looking at equities and debt for the portfolio. In the equity space, they’re looking at two categories, the high quality growing businesses considered “compounders,” and more traditional value investments, where there’s potential for 3 times upside to downside. Meb then asks Steve about Naspers, and Steve follow’s up with commentary about one of the biggest losers the portfolio’s ever had, but reiterates that his biggest concern is permanent loss of capital, and as the holding is still in the portfolio, he’d be surprised if they didn’t make money on it long-term.

Meb asks Steve about credit. Steve talks about high yield and distressed debt as an asset class being periodically attractive and one doesn’t need to be there all the time. He explains that the gross yield of roughly 6.5% looks interesting on the surface, but once you consider the history of defaults and recovery, the yield drops significantly to 4.4%, right above the investment grade yield, and it isn’t so attractive. Steve talks about how the fund allows the freedom to seek asset classes that offer value, and that for the first time, they now own a municipal bond. Steve then discusses the small allocation they have to farmland.

Meb follows with a question about holding cash. Steve expands by talking about going through the research process, and when there aren’t enough opportunities that meet their parameters, cash results as a byproduct. The discussion then gets into Steve’s background at FPA, and what it was like going through the late 1990s. Steve talks about trailing the market going into the late 90s as valuations appeared unsupportable, but fast forward a few years and he and the team were validated. They allocated to high yield, small cap, and value, and made money in 2000, 2001 and 2002 when the market was down.

Meb then asks how Steve views the rest of the world. Steve responds that while it is more expensive generally here in the U.S., it is important to remember that international exposure can be had by owning U.S. stocks with revenue exposure overseas, and that like-for-like companies are trading at similar valuations outside of the U.S. Next, Meb and Steve discuss the importance of managers investing alongside their clients. Steve feels it is important that investor’s energy should be aligned with the client’s interests and holdings.

Comments or suggestions? Email us Feedback@TheMebFaberShow.com or call us to leave a voicemail at 323 834 9159

Interested in sponsoring an episode? Email Justin at jb@cambriainvestments.com

Links from the Episode:

  • 00:50  –  Welcome and background of the firm
  • 1:39 – When Steve’s interest in value investing started
  • 4:14 – How Steve and his team pick value investments
  • 8:11 – Why companies don’t last as long these days
  • 12:07 – The process for making value picks
  • 15:23 – Naspers
  • 19:11 – Steve’s view on debt and high yield bonds
  • 22:41 – Thesis on municipal bonds, specifically the fund’s Puerto Rico investment
  • 23:25 – Opportunity Zone Podcast
  • 24:54 – Investing in farmland
  • 28:46 – The strategic decision to hold cash
  • 32:14 – Taking a long-term view on investing and performance in the 90’s
  • 35:21 – How the current market compares to the 90’s
  • 37:36 – Steve’s view on global markets
  • 45:25 – Importance of managers investing in their own funds
  • 47:02 – Educating investors and advice Steve wants to provide
  • 53:02 – Steve’s take on the current sentiment on the markets today
  • 54:57 – Household investment chart
  • 56:30 – Catalyst to derail the current bull market
  • 59:08 – Most memorable investment
  • 1:00:37 – Best way to connect: fpafunds.com

Transcript of Episode 136:

Welcome Message: Welcome to the “Meb Faber Show,” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.

Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.

Meb: Welcome, podcast listeners. We have an awesome show for you today. This man needs no introduction. He serves as the portfolio manager for the FPA Crescent Fund. Welcome to the show, Steve Romick.

Steve: Thank you, Meb.

Meb: Steve, a little congrats is in order. You guys just passed a big milestone, 25 years.

Steve: Yeah, I’m old.

Meb: You don’t look that old.

Steve: I’m old.

Meb: You don’t look that old. That’s amazing. We’ve said many times on this podcast that the biggest compliment you can give anyone in our business is just surviving, being able to exist through market cycles. So we’d love to talk about it today. So listeners, if you’re not familiar with FPA, this is a firm that dates back to the 1950s, the origins, I think. You joined mid-90s and have been running this fund, which now sits over $15 billion and firm-wide, over $30-ish billion. But you started out as a journalist?

Steve: No.

Meb: What did you study undergrad?

Steve: I studied as education.

Meb: Education? Okay. Well, I’m an engineer, so neither of us are really doing exactly what we started out as. But a lot of value guys, I’ve heard you reference this, I know Uncle Warren Buffett has also referenced this. But talk about when you really got struck by the value lightning bolt. People talk about it as this inoculation. Was there a period where you really kind of developed your investment approach?

Steve: You know, I can’t point to any one event and there certainly wasn’t a bolt. For me, value was just this idea of, I hate losing money. And even as a kid. And I’d go and my friends would…when I was in college, would go to…we’d go and gamble someplace. And I was the guy that didn’t gamble. I mean, you have to think about this idea of, if you gamble…and as I told my friends at the time, they can’t afford to build billion-dollar hotels because they lose money in Vegas. So the idea of gambling didn’t appeal to me, because I felt I was more likely to lose than win. And then, dovetail that with the idea that my feeling of winning, say I won $1000. I’d feel like I dodged a bullet because I’d go like, “Ooh, I didn’t lose.” But if I lose $1000, it would just wrack my gut.

Meb: That’s miserable.

Steve: So the feeling of losing money hurts more than it feels good to win. And that’s just always…I’ve always been that way.

Meb: And so, that’s actually kind of expressed itself with the way that you guys have designed your crescent fund, which is…feel free to correct me, but a kind of a go-anywhere fund that is meant to…kind of, you get equity-like returns, but with lowered volatility and risk. Is that right? Is that how I say it?

Steve: Well, less risk, but defining risk as a permanent impairment of capital. We don’t consider volatility to be risk for us, but it’s a worthwhile conversation and a rabbit hole we could go down, to talk about risk and what it means to different people and why I think for most people, it actually is risk. But for us, risk is a permanent impairment of capital. We want to generate equity rates of return and avoid permanent impairments of capital.

Meb: Okay. Well, it’s funny you mention that, because…by the way, it does express itself. You guys end up having lower volatility. I mean, the long-term numbers are really impressive and you guys have done a good job of it. It’s funny you mentioned that about gambling because I have the opposite gene, where I’ll take as much risk and gamble if you give me anything to possibly bet on. But that’s why I’m a quant. I learned that lesson early. I had lost and lost and lost and said, “Okay, I need rules for what I have to do.” But that’s a good lesson for me to learn.

Steve: But if you frame it that way, I feel the same way, because you said, “If you give me the money.” Well, if you give me the money, I’ll gamble your money.

Meb: All right. So let’s talk a little bit about it. And so, you guys…I think you had characterized yourself as a value investor. But I have a quote from you from a shareholder letter that I think we’ll let you kind of use as a jump-off point where you said, “Buying growing business with an adequate margin safety is as much a value investment as buying, say, a financial firm at a discount, a tangible book, or a holding company at a discount to readily ascertainable net asset value. We’ve held all three types of investments in our portfolio over the last decade.” I think when people hear “value,” often, people think it’s something like, it just has a low PE ratio. But talk a little bit about your kind of prism, your framework for how you think about picking value investments.

Steve: Value investing is, to us, simply investing with a margin of safety, believing that you’ve made an investment where it’s hard to lose money over time. I mean, over any short periods of time, anything can happen. So that’s really what it stands for, for us, and it can wear a lot of different cloaks. And as you just mentioned in that quote from that shareholder letter that I had written in a while back, value investing, though, when you think about it, has morphed over the years. There used to be a point in time where it was really all about the balance sheet. I mean, going back to Graham and Dodd and thinking about the margin of safety and buying net-nets, you know, the companies that are trading below net working capital.

Meb: The old cigar butts?

Steve: The old cigar butts. And that was a not-unreasonable way to invest, certainly. Today, the world’s changed and it’s changed because of technological innovation. The world changes so quickly, the life cycle of a company is, it existed in an index. And the S&P 500, for example, is shorter or as short as it’s ever been and it’s continuing to decrease. So businesses are being put out to pasture. I mean, just a very obvious conversation would centre around retail and the disruptive influences from the likes of Amazon and other online companies. So of late, we had Toys R Us’ bankruptcy this year. And we have Sears’ restructuring that’s currently…well, it remains to be seen whether it’s going to be a liquidation or it’s going to be a restructuring. And that’s because these businesses aren’t what they used to be, because of a competitor that’s come in.

So I did something just for fun and education a year ago. It’s in our year-end shareholder letter. And I measured technological innovation over the last 6,000 years. Why 6,000 years? Because it was 4,000 B.C. where you had the invention of the wheel. And all I did was just take public data for what others have defined as being new inventions and technological innovation. And I just created a scatter plot over the last 6,000 years and you can see the increasing density as you move through time. So you’d go from the Stone Age to the Iron Age to the Bronze Age. And there’s things like…I’m mostly making a value judgement as to what those inventions were. I mean, indigo was in there, for example, along with the steam engine, clearly very different kinds of things.

But in the last 50 years, we have seen more new inventions, more technological than innovation, more ways to use the technology in a disruptive way than we’ve ever seen in history. And businesses, just by buying something on book value, book value can erode pretty quickly if you can’t get a return on that capital investment. And let’s take Warren Buffett’s company, Berkshire Hathaway, a defunct textile mill. I mean, he made money on it because he bought it at such a good discounted margin of safety, but it got disrupted by manufacturing offshore.

And so, he was able to sell the land and the building for…I don’t really know, he had a profit to alternate what he had paid for it. And so, it ended up being not his worst investment or he certainly didn’t lose money. But it certainly wasn’t his best investment, either. So when we think about making money, we think about value investing, we want to make sure that we have some kind of telling where the business is going to be better, at least, in 10 years than it is today, ideally.

Meb: I’m trying to think of unpacking that, just, 10,000-foot view in the life cycle of companies. Is the main reasoning just that knowledge compounds over time and the impact to technology? What do you think? Is it just the creative destruction, is it globalization? What is the reason that companies just don’t last as long over the years? Do you have any good thoughts?

Steve: Probably not? I have some bad thoughts.

Meb: Let’s hear them.

Steve: Simply that…I mean, we’re at a place where certain things get accelerated. If you think about life sciences and how that started with just a cancer and cancer drugs and sort of just chemical compounds that were very simple compounds, where you came out of mustard gas in World War I. And they found that it was killing cancers along with everything, all the other…the replicating cells. And that morphs through time and it becomes…and you get a much denser molecule and you end up with biosimilars. And now, we’ve mapped the human genome and now, there’s tremendous advances that are going to take place in the life sciences, such that cancer, I believe, in the next couple of decades…and many forms of cancer, because it’s really a number of hundreds of diseases will be treated as a chronic illness, just to arrest that development.

So we’re at this cusp of things, where so many new things have happened. And so, we’ve been able to take advantage of it. I mean, just because DARPA created the Internet, think about how others came along and built a platform on top of that with the likes of AOL and then…and Google, etc., and how technology that goes back to the 70s and 80s just became so much more and became disruptive in somebody else’s hands. And so, I think that’s it’s very important to know what can disrupt you as much as it is to understand, how can one benefit from that technology as a user of that technology?

You’re sitting with an iPhone. I think that’s an iPhone that’s upside down in front of you. And that didn’t exist, what, 12 years ago. And now, you have more computing power sitting here on the desk in that one little device than you had on your desktop 12 years ago. And there’s fears, and sometimes, these fears get overblown and that means form factors change and they disrupt other things. So iPads became a very big thing and you’ll say, “Oh, well. PCs are dead, laptops are dead. And so, Microsoft is dead.” And sometimes, you throw out the good with the bad and you assume the worst. So every good idea, I find over time, gets taken to an extreme and people become too optimistic.

And similarly…conversely, I should say, the ideas get taken down the other direction, where people have great fear that something is not going to ever be good again. So you look back in the early part of this decade and Microsoft did nothing in 10 years, yet their earnings are growing in the high teens. And here is…there was a point of time where the new form factors of iPads are going to eat their lunch, they’re going to move away from a Windows-based ecosystem. You’ve got a problem with…you know, the cloud’s going to eat other parts of their lunch, even though they were number two in the cloud. And you had a CEO who was lighting money on fire and making investments in companies like Nokia, etc.

And now, a lot of things have changed. You end up with an Office which is a huge breadwinner for them. It was going to be viewed as going away, because Google Docs was going to take over that, too. Well, we now have Office 365, we pay a subscription fee for it, it’s better now for them than it’s ever been. Clearly cloud, they’d been successful, a new CEO is there in place, and the Windows ecosystem is not entirely dead. And I actually now own a Microsoft service which I love using.

Meb: I’m a subscriber. What’s interesting…because I think… Didn’t Microsoft just retake the “Top Market Cap Company” title, I think, recently? They might have, they go back and forth on occasion. When you said technologically developments, I thought you were pointing at my coffee cup. I have…I don’t know if you guys remember the old coffee cups you used to have like, plug into the wall. This is a wireless Ember, if you’re listening, anybody. It keeps your coffee or tea warm, good Christmas gift. But anyway, I digress.

So talk to me a little bit about y’all’s process. So you’ve been doing this for a while. When you talk to investors and value folk, everybody’s got a little bit different process. Some, like me, are a lot more quant-based. Some people, it’s chatting with management, etc. You and I were talking about, you used to follow hundreds and hundreds of banking companies around the world. What’s the general framework? You’ve got a team now, how’ does the day-to-day look for you guys?

Steve: There’s a team of 11. There’s 10 research analysts on the team. The three portfolio managers, myself, Mark Landecker and Brian Selmo are analysts, as well. We do work on companies, we visit companies, we build our own models, we’re visiting with companies and talking to them constantly, as well as people around the companies. Our job is to understand the business first before we can really start to think about investing in any business, understanding what it looks like, the business and its industry. And that’s what the 10 of us are doing, plus the help of a journalist who we’ve had on the team in some form or another for more than a decade, would help us gather information that is more qualitative around the company and its industry and help do due diligence operational checks for us in different companies that we’re looking at.

But if I were to oversimplify it, let’s take it into two parts, because you said we can go anywhere. So “go anywhere” can be a recipe for disaster, because there could be lots of places for you to lose…a lot more places for you to lose money: domestically, abroad, in small cap, mid cap, large cap, in different industry groups, in different asset classes, whether it be equities, preferred stock, junior debt, senior debt, bank debt, DIP loans, etc. We’ve bought co-loans in 2010 and 2011 from banks that were selling them, thousands of mortgages.

These were not mortgage-backed securities but the loans themselves, I mean, even as part of a big basket, a $4,500 loan in Detroit that we’d made many multiples on. It was just part of a basket. So we look for equities and we look for debt. And over such an interactive portfolio, they wedge it between it. And equities, we’d largely consider two categories: the high-quality growing business that we consider compounders, businesses that we were confident that the earnings will be higher a decade from now.

Meb: Is that…? Did Microsoft fall into that one, or no?

Steve: Let me…Microsoft bridged the gap between the two. And the second are companies that we felt are more traditional value investments that are just really inexpensive. And then, we call them our more commercial opportunities and another name for them we have internally is “three-to-ones,” where there’s three times the upside to the downside. Microsoft, we felt the earnings would be higher over the next 10 years. The fears that were surrounding it were real, but we felt at their core, what they had was growing and was going to be better in 10 years. Let’s not talk about what their rate of growth is going to be, just the fact it was going to be bigger was important for us to understand.

But we also felt that the price that we were paying for it, at 10, 11 times earnings instead of the cash, it was very hard to lose money for a business that was growing. And then, we felt that the downside to the upside was at least three to one…growth side to the downside, I should have said. So that fell into both categories. It’s not always a bright line that divides these, what is in value investment or in growth investment. And show me a growth manager that doesn’t think what they bought was a value, because if you give a… But if you pay 35 times earnings for a company growing 50% a year for the next five years, that’s a good value.

Meb: Right. That’s the whole two sides of the coin for value and growth that investors talk about. Well, there’s also a third category because I’ve been reading your letters for years. So you guys also even do some shorting, but usually, it often is somewhat pair trades as well as some other things I’d love to hear about. But the one that I loved following and talked about maybe a couple years ago, Naspers, was that….? Is that still a part of the portfolio?

Steve: Yes. He hesitates to say. I’m glad you brought that up, really happy to talk about one of our largest losers we’ve ever had.

Meb: Is that right?

Steve: Yeah.

Meb: All right. Well, good. Let’s hear it.

Steve: Thus far, anyway. So Naspers is something that should not exist. Naspers is a South African-based holding company, media company, that was originally the government media business. Now, you have television stations, you have newspapers, etc., that became a public company many, many years ago. And the management team did something very smart back in 2004 or so. They put $35 million into a Chinese tech company that was called Tencent. And Tencent is, again, it flip-flops, as you mentioned, with certain other companies to be the most valuable company in the Chinese market. And their investment of $35 million, at its peak, reach over $160 billion, just for themselves. I mean, a [inaudible 00:16:33] of almost 80%.

So that was a huge, huge return and then, worth the value of everything else that they had. And what they had was a reasonable media business, a cable business included, other sub-Saharan cable as well, outside of South Africa and an e-commerce portfolio. But if you assume zero value for both of those…there are other e-commerce investments, as well as the media investments. The market was paying you tens of billions of dollars to own Naspers. So what we did was, we went along in Naspers and shorted out their Tencent exposure. And the spread was in the billions of dollars and it went to the tens of billions. And so, we lost some money along the way.

What’s interesting about it is that we’re… And again, I’m just describing no value to the e-commerce business and to the $400 million of [inaudible 00:17:19] that was being thrown off on the old-line media business. So it’s something that shouldn’t exist, but it exists. Why does this exist? Why does this opportunity exist? It exists because a) the management team in South Africa is less willing to take the necessary action to close the gap. They just don’t care. At least, they don’t care today, but it remains to be seen if they’ll care in the future. Ultimately, the discount will narrow. Ultimately, it will work out, but there can be something called being dead right, right?

It can be right in 10 years, but your clients may not stick around with you long enough and they go on to something else. But what’s interesting about it is that another reason why the gap widened out was, so much interest was taking place in China that capital flows were going over there. And there was plenty of room in the Chinese market to absorb those capital flows and the South African market could not absorb the capital flows. And in fact, the company, Naspers, became so big, represented over 30% or, it does say over 30% of the entire index, that they started re-categorizing the index. And as a result, flows actually went the other direction.

So what we have done is, now that the Chinese market is weakened, we’ve actually adapted our exposure somewhat, because now, you can actually own by owning Naspers, which is a discounted Tencent. And Tencent owns so many different businesses that are non-earning assets or under-earning assets today, including assets like Tencent Music, which is soon to go public. And that you’re actually owning this whole basket of assets, assuming no value for the other e-commerce and old-line media assets, that’s a low-teens multiple on a look-through basis. That’s a good value. So we’d be surprised if we don’t make money, longer-term, on it. And that’s why again, our focus is always to avoid permanent impairments to capital. Short term, this is a perfect example. Companies can trade anywhere, too high and too low.

Meb: Well said. The other big part of the portfolio is often on the credit side. And you have another quote where you said, “High-yield bonds are like vacation homes. You go to them when the weather is nice.” And in this case, we mean…by “nice,” we mean stormy. And you want to invest, but…and I actually don’t know the day to this, you can tell me if this is still correct. But, “Yields today are crappy,” I think was the technical term. “They should take the word “high” out of “high-yield.” Talk to us a little bit about…

Steve: Except in Colorado, your home state.

Meb: Yeah, totally. And here. More and more here, as well. So talk to us a little bit about how you view that side of the portfolio.

Steve: So high-yield as an asset class is…and distressed debt is periodically attractive. One doesn’t need to be there, as I’ve said before, all the time. You need to get attractive in anything. Whether it’s stocks or bonds, you need an attractive rate of return. So today, the high-yield market is roughly a 6.5% yield in the U.S., gross yield. That sounds pretty good on the surface in the context of a treasury. A three-year treasury’s, like, 280%. So that sounds pretty interesting, although a sequel, but that’s a gross yield. That’s before any defaults, before any recoveries of those defaults.

If you take history as a guide and assume this is a placeholder, that historic defaults will be the future defaults and the recoveries, historically, will be the same in the future, you get to a net yield. That net yield is 2.1% lower than the gross yield. So now, your yield drops from 6.5% to 4.4%. That’s not interesting, decidedly. Nor is a 6.5% gross interesting to us either, because it’s not, in our view, an equity rate of return over time. Or it shouldn’t be. We hope it won’t be. But if you look at the 4.4% yield, that’s actually right on top of the investment-grade yield. So why are people buying these bonds? And there’s just too much money to chase these things down, these high-yield bonds and people are reaching for yield. And that’s always a risk, reaching for return.

And so, as a result…and this is true of not just high-yield bonds, but different asset classes and industry groups. We go in and out of sectors and regions based upon where there is value, which is obviously, in our view, opportunity. So it’s largely, it’s frequently going to where there’s bad news or where there’s something misunderstood. It means spending time in China today, because the stock market’s down 30% over there. It means spending time, in 2009, on high-yield, because our market was getting destroyed. And in 2009, we didn’t know what the Fed was going to do, and the Treasury and we were very concerned that we were on the precipice of a depression.

I mean, it could have happened. More things always could happen than will happen. But at the time, stocks had not priced in a depression in 2009. But they certainly had priced in a depression, in our view, in the debt markets. So we’re able to buy debt with huge yields…I mean, in excess of 30% yields with terrific asset-backed loans with huge margins of safety. And that’s where we allocated a lot of resources. So our portfolio went from 5% distressed and high-yield to below 30s in about five, six months, as we aggressively allocated our resources to that asset class.

And that same thing’s true of large-cap tech when we had nothing in it for years, then we went a lot into it. We didn’t own any mortgage-backed securities forever and then, we started buying mortgage-backed co-loans, in the example I gave earlier. And we had never, until December of 2017, just a year ago had never owned a municipal bond in the portfolio. And yet, we now own Puerto Rico.

Meb: You want to expand on that a little bit? I would love to hear the thesis there, because, for a long time, they were in the news, less so today.

Steve: Puerto Rico, you mean?

Meb: Yeah.

Steve: Well, we were able to buy general [inaudible 00:22:53] buses, certain other parts of the capital structure, at a very large discount. We’re going down into the 20s. We didn’t know for sure it would be par. We felt that there was probably more bad news or the bad news…it was real bad news. The company’s been devastated by a poor economy compounded by a major hurricane, a complete devastation. And yet, we felt that there was too large of a discount, wasn’t as bad as far as these bonds were concerned. And they’re worth more than 25 cents on the dollar.

Meb: We did an opportunity zone-focused podcast and noticed that recently, on the tax incentives, that the entire…

Steve: The whole country’s an opportunity zone.

Meb: …the entire island is an opportunity zone.

Steve: [crosstalk 00:23:31]

Meb: So hopefully, that’s where some economic growth. It remains to be seen how those play out. I’m hopeful.

Steve: But it’s an interesting point that you’re making, though, is, you talk about the opportunity zone and the whole territory’s an opportunity zone. But decisions that are made at a point in time have long-range ramifications. We’re very mindful of that and we try and think about what’s coming down the road, what is disruptive. I mean, you could have bought Blockbuster Video in the mid-90s and still have it in business in 5 years and in 10 years. And it’s just…it’s a company we wouldn’t touch, because…and we actually were short a movie gallery. And there was another company we were short as well. As I’ve gotten old, I’ve forgotten the other company. But we were short two companies in this space, but we weren’t short Blockbuster.

But we knew that the [inaudible 00:24:13] was getting fatter, we knew that pay-per-view was ultimately going to happen and we knew that that was ultimately going to be disruptive to Blockbuster’s business. So why were we going to sit there and try and be smarter than what was actually coming down technologically? Now, we didn’t know Netflix was coming. We didn’t see that and we didn’t know the red envelopes were going to be delivered to your door with CDs. It was disruptive even before the pay-per-view ended up taking hold.

So we’re very, very cautious and we try to be careful about these long-term decisions impact different businesses. And it impacted Puerto Rico because they took away the tax haven that it was and it takes a long time for it to cycle through. And we just try and be aware of these things and think about what it looks like in 10 years.

Meb: You guys mentioned, kind of in some of your materials on the FPA Day and other presentations, there’s three categories that you guys look at in credits: performing, stressed and reorg. Are all three areas that you guys pretty lightly invest at this point in the cycle, or are there areas where you’re still…?

Steve: Back out Puerto Rico and we’re just above…just a few percent.

Meb: Before we get to the third main point, which is cash, there’s also a farmland element I saw. Do you guys still have any of…?

Steve: Part of…we do, but it’s at…we shouldn’t dwell on it, because it’s such a small investment. But we have the ability to do…”go anywhere” means do lots of different kinds of things. And so, we own farmland and we own a container ship in the portfolio. We have some interesting things in the portfolio, we have to be careful. We’re a public fund and we can never let these kinds of investments get to be too large, because we want to make sure that if somebody wants or chooses to redeem, that they’re able to get their money back.

Meb: Yeah. I mean, farmland’s particularly interesting to us. We come from, on my father’s side, a family of farmers in Kansas, Nebraska. And for a long time, for a lot of the 2000s, a wonderful asset class, but then, it got kind of distressed for some years. But there’s not a lot of opportunities for public investors to invest in farmland. There’s only a couple REITs, sadly, and most of the funds are still private. But a really cool asset class, I’d love to see more development at some point.

Steve: No, I agree with you. I think it’s a great asset class. I think people ought to understand what it is and have a long-term view, because you’re not going to get a… If you think of, like, a REIT, you’re not going to get the big cash flow yield that an apartment REIT will give you. But you get the appreciation over time that should be at an inflation or higher. And what you, at the end of the day, have is water. You’re exporting water. And then, if you have water shortages, then the value of that farmland goes up over time, because the value of the crops are going up over time.

So we partner with a group in North Carolina that is one of the larger…they were a sizeable operator themselves, but they were up and down the vertical in the farmland supply chain, owning cotton ginning facilities as well as trucking facilities and John Deere dealerships, etc. And we partner with them to go buy farmland, because as we came and we looked at what the Fed was doing, had this massive quantitative [inaudible 00:27:00] experiment which I liken to an academic argument that they hope will alchemize into reality. I mean, who knows what’s ultimately going to happen? We’re still in this period of unknowns. There’ll be longer-term impacts from this.

I felt that inflation was a likely…it’s a likely outcome and it still might be, ultimately. We could be on a deflationary path to inflation. But I felt that for myself…and we believe in investing alongside of our clients. For myself, I wanted to own some farmland. I like it better than gold, intellectually, because it actually has a yield where gold, you actually have to pay a cost to carry. And it’s a bet on inflation at a point in time, it’s protection in certain environments and has created non-correlation to the stock market, and it can deliver an equity rate of return over time.

Meb: I’m smiling, because I have a couple of thoughts. I remember my old man used to say…this is years ago when farming was really out of favour. He’d say, “One day, farming will be important again.” It used to be the farmers that drove around the Cadillacs. But I laugh now, because we just sold some of our wheat and I said our farm basically does all the benefits of a Treasury bill yield with none of the certainty. Right now, we have mainly row crops. But I would love to diversify across blueberries and almond and everything else around the world. But…

Steve: Well, you’ll be able to. This fund that we’ve…

Meb: …maybe [inaudible 00:28:20] soon.

Steve: Well, this fund that we’ve invested in is actually going to end up being a fund that individuals can invest in. It’s going to be a core fund that the private partnerships that we’ve invested in are going to be…the first series is going to be converted into a new fund, where the others can invest in it.

Meb: Yeah. If you look at kind of the global market portfolio of what’s publicly investible and what’s not, a lot of the private that’s missing from most investor portfolios tends to be farmland and a lot of private real estate like housing, etc. But maybe one day. All right, so back to the third pillar of cash. You are pretty well-known for not being shy about holding a big slug of cash at times, and I think right now, have a pretty decent allocation as well. Maybe talk about how you view that as either a strategic and/or opportunistic sort of part of the portfolio.

Steve: It’s important for our investors to understand that we are bottoms of investors. We have a macro backdrop that we consider, but certainly, we build our models and companies. By the way, when we build models, I don’t want to sound like we’re so clinical that we’re looking to every quarter and every year. We just keep things very simple and think in terms of low base and high cases, in a range of outcomes.

Meb: But using Microsoft Office, not Google Sheets?

Steve: But using Excel. Using Excel.

Meb: Although you guys also own Alphabet, don’t you?

Steve: We do. And we can talk about that, too. As I said, we should talk about that in a minute. So we think about interest rates, interest rates going up. Interest rates could be higher in the future and they’ll be, for borrowing costs. So that’s a function of two variables. One, base rates could be higher. Two, the spread to treasuries, could be narrower. And…I’m sorry, be wider, because they’re so narrow today. So bringing the two together, a higher base rate and a wider spread total higher progress. Even when the base rate is lower, you can end up with a wider spread and still have higher borrowing costs. When we build our models, we consider a normal cost of funds.

We have some companies…one company I’m looking at recently that’ll remain nameless that’s in the United Kingdom has a current borrowing cost of 3.5%. That’s not in our model. We don’t expect that to be the case. So we try and take a more conservative view and budget at four percent, five percent and six percent. And maybe that’s not conservative enough, but it’s certainly more conservative than just extrapolating the recent past and moving into the future. So when we think about the macro backdrop, it’s just to go and build a model that [inaudible 00:30:37] accomplish from the bottom up and direct us to certain areas of certain asset classes or certain regions.

Cash ends up in the portfolio because after going through that process, we don’t find companies that meet our risk/reward parameters. The upside isn’t there to support the downside risk. There’s not enough juice for the squeeze, if you will. And so, cash is entirely a by-product. It is not meant to be a pessimistic statement. It’s not meant to say that the market’s expensive. It’s not meant to say that we’ve gone on vacation, aren’t doing our homework, either. It’s just meant to say that, “Look, we are working our butts off with our capital alongside of yours. And we aren’t finding companies that meet our risk/reward and we’re not just going to go and invest to invest. We’re not just going to go and appease those who want us to be fully invested at all times.”

There will be a point where there’ll be future opportunity. We’re in the longest bull market…not the biggest bull market in percent returns, but the longest-tenured bull market in history, second longest economic expansion in history. And we always tend to underperform in the later stages of these cycles. And we’d look at this and to us, cash looks like a good asset class. Not as a top-down decision, but if we don’t see it, it’s there and it’s actually optimistic. It’s optimistic that we expect that there will be future opportunities for us to pull from that cash and invest, because at this point in time when you need to make those investments, good luck trying to find the liquidity to sell the other things you want to go and swap into when everything is attractive at that moment in time.

Meb: We have a pretty broad range of ages of people who listen to this podcast, many of which are on the younger side that maybe had invested through 2008, 2009, but probably not the late 90s’ bear market as well, in the U.S. But maybe talk a little bit about as we go through cycles and think about long-term. I mean, it’s so hard in our world, where investors want to talk about month or quarters, even years. And you’ve famously came onto FPA in the mid-90s in a pretty difficult environment for value investing in general. But when it came to the late 90s, maybe talk a little bit about that experience and how you even survived it.

Steve: This is terrific. We just talked about Naspers, we just talked about me hardly surviving the late 90s.

Meb: Well, you can decide to stay on for a second hour and we’d get all the good stuff.

Steve: The late 90s were tough. The late 90s, we underperformed in the market massively in 1998, 1999. I was on the cover of “Money” magazine in 1998 and it was literally like the “Sports Illustrated” curse. My performance, the performance of the fund relative to the market, from that point forward, I looked like an idiot. But I was never as stupid as I appeared. There was a lot of…what was actually happening at the time, a lot of ridiculous investing and building up of companies in the Internet and tech space to levels that were untoured, unheard of and ultimately, unsupportable, as we came to find out.

Companies were trading at levels that were more expensive even than in 1929. Companies [inaudible 00:33:42] RCA in 1929 and 1930 was trading, like, 86 times earnings and you had companies trading at 500 times revenues. I mean, it was complete insanity and it was happening after, “Oh, here’s a $2-million revenue company. Let’s go value it at $1 billion.” I mean, it was nuts. So we…in those two years, we were down slightly and the market was up, we were in the high 50s behind the market over two years. In two years. I think the only reason that we had any money left in our fund was that people forgot…they either a) forgot they had money with us, or b) felt badly and didn’t want to be the…didn’t want to redeem.

Meb: Or may have passed away.

Steve: Yeah. Well, there’s that.

Meb: That’s the third bucket.

Steve: But then, 2001 and 2002 came around and we ended up being validated. So I mean, in 1999, the stock market was up 21% and change. And yet, more than half…that’s the S&P 300. And yet, more than half the stocks in the S&P declined in value that year. So it was not a broad-base market. Value was out of favour, high-yield was out of favour and small cap was out of favour. So we allocated our resources, too: high-yield, small cap and value and were aggressive about it. And we made money in ’01 and ’02 and yet, each of those three years, the stock market was down. So when you look at 2002 and look back over the five years, including 1998 and 1999, which was a terrible start for that five-year cycle, we ended up 42 points ahead of the market.

So there’s something to be said for having a philosophy and sticking to it and not always trying to worry about what’s happening this month or next month. Always think about where you’re going to be in five to seven years. That’s how we think about that, in terms of rolling periods.

Meb: You had mentioned something that I think is important, where we talk a lot about…with valuations, which so many people want to focus on what’s the good buys and what might be cheap. But the challenge with a lot of investing approaches is, it’s avoiding the big, really expensive, nasty stocks, too. And so, do you see any echoes? You know, that was obviously a painful period and this period has been a graveyard for…a lot of really famous managers have really struggled. You guys seemed to just keep chugging along and, I think, only had two or three down years since inception. Do you see any kind of rhyming right now, with today’s market with the late 90s, or nothing comparable?

Steve: No, because…I’ll show you a chart when we’re done. I think I have it in my bag. But we focus on skew and the standard deviation between the cheapest stocks in the market and the average stocks in the market. And in 1999 to the beginning of 2000, you had a massive skew. There were…the cheapest companies in the market were trading at a big discount to the average-price company in the market and that gives a huge opportunity. Today, there’s very little skew. The difference between the cheapest stock and the average stock is pretty narrow. So there isn’t that opportunity for us to go in and spread our wings and show what we can do, because the markets were moving, more or less, up or down together.

The last time we had a little bit of skew in the market was at the end of ’15, beginning of ’16. And if you recall that moment in time, we ended up with banks and energy companies, and certain telecom-related businesses were out of favour. So there was a dual pop, a little fragmentation and vulcanization in the market that created some opportunity. And we were able to put a lot of capital into banks in particular at that point in time, but ever since then, it went right back to this level of very, very little skew. And so, we don’t see that same…that rhyming. And I wish we did, because I’d love to be able to say that our portfolio is dirt cheap like it was in 2000. It’s not.

It’s not expensive and we can look ourselves in the mirror today with greater honesty and satisfaction that our portfolio is a more reasonable portfolio for us to make money on over the next five to seven years than our portfolio was even a year ago.

Meb: So your positioned a fair amount, I believe, in kind of what people would consider tech or large tech, IT maybe, a smattering of financials. And feel free to talk…we are going to talk about Alphabet a little bit. But also, the extension to this question is, how does the rest of the world look to you, too? Does it look better beyond our shores, or do you spend most of the time finding opportunity here?

Steve: On the other hand, here is more expensive than elsewhere. But on the other hand, you can invest here, but looking at large-cap companies and get tremendous exposure offshore. I think it’s the mid-50s of the S&P 500 companies have revenues coming from outside the United States. So less than half their revenues are coming domestically. So you can get a lot of good international exposure if you’re buying U.S. companies, but they’re priced quite well. There is opportunity offshore, but like-for-like companies in different parts of the world were trading at similar values [inaudible 00:38:31] the Chinese [inaudible 00:38:32] that’s less true in the last few months than it had been.

But if you could go and buy an Oracle here or an SAP in Germany, Unilever in Netherlands versus Proctor & Gamble here, Google here versus Google and a Facebook, compared to an Alibaba and a Tencent over in China, these companies are trading at similar valuations. When you look at a lot of these different markets, the level of valuation looks cheaper on the surface, but there’s not the same governance that exists there than you have here. In fact, in China, you have to accept the fact that you don’t actually own the company. You own a WOFE that owns part of a VIE that the government may decide you don’t have a right to in the future. So there’s certainly that risk that exists.

But I like the fact that you’ve got the SAC looking over our companies’ shoulders and we think that the U.S. will continue to be an interactive market for many years to come. That does not mean there aren’t opportunities outside the U.S. We have been finding more, of late. I don’t want to talk about most of them on the podcast, because we’re still in the midst of buying them. But if you look at a company like Alphabet…some of these companies exist overseas, companies like Tencent and I mentioned Naspers already…there’s lots of hidden value in these companies, when you think about what value is.

And value, when we think about a margin of safety, as we just talked about earlier, as being a definition of value, at least our definition of value. And you look back over time and the value used to be…as we started talking about the Graham and Doddian type of fashion, the value of the balance sheet…and it’s morphed to being the business. But you have to understand the business. And that’s not as easy to understand the business as it is to understand the balance sheet. It’d be easier to understand a piece of real estate rather than what a business might be worth [inaudible 00:40:14] for the next 5 or 10 years.

And so, there’s more chances to be wrong, I would argue. But there’s also a lot more chances to have growth. And let’s take Alphabet as an example, Google, as most know it. Google’s market cap is $700 million…$700 billion. I wish it was only $700 million. $700 billion. And the company’s got $100 billion in cash, so take that out. Now, it’s $600 billion. The company’s estimate for next year…these are just consensus estimates, they’re not ours…is $41 billion of income. You’re trading at 15 times earnings, next year’s earnings, if you take out the cash. But there’s more adjustments that one could really make.

They’re burning throughout their taxes. A few billion dollars a year is on moon shots. They’ve got companies like WeMo that they own in there, I haven’t taken that value out. It’s not worth zero. WeMo is…you know, last year’s… You know, I don’t know the numbers for 2017, but in 2016, there was…it drove 635,000-ish miles autonomously with only 100 and, I think, it’s 24 disengagements. And if you go look at the next nearest one, which was WeMo…I’m sorry, which was Cruise, which is owned by General Motors…they drove less than 10,000 miles and had 140-some-odd disengagements with a fraction of the miles driven.

SoftBank made an investment in Cruise, GM’s Cruise, and capitalized at the equivalent of $11.75 billion-ish. I don’t know what WeMo’s worth. And I’m not saying the number that SoftBank…I mean, [inaudible 00:41:43] unpaid for Cruise is the right number, but let’s just use it as a starting point. If $11.75 billion is right for Cruise, WeMo’s worth a lot more. We are using in our model $25 billion, but we’ve seen other analysts come up with numbers as high as $175 billion. I’m not saying that’s right, I’m not saying $25 billion is tight. It’s not zero. You’ve got all the other non-earning assets, assets like Lyft that they own a piece of, Airbnb, they own a piece of, the non-earning assets.

They have YouTube. Now, YouTube, we don’t know exactly what it’s earning. It’s not zero, but I would argue it’s probably still under-earning what it could be earning five years from now. So you should take off something out of that $600 billion we had left, the $700 billion market cap less the $100 million in cash less something for these non-earning assets. And the $40 million in earnings that you’re going to have next year, if that number’s a right number, you can add something back to that for the moon shot investments they’ve got. So the multiple ends up being lower still. For a company that grew 20% last quarter, I mean, that’s not an expensive stock.

Meb: I have a soft spot in my heart for Google, because you mentioned as a Tahoe guy, I used to live in Tahoe. And Google used to throw their, pre-IPO, yearly parties in Tahoe, so they’d rent out all of Squaw. And for someone who was essentially a glorified ski bum at the time, I was friends with all the industry folks that were local. And so, all my Google friends from San Francisco…you would only get, like, one invite and two drink tickets. But my friends helped set up the tents and they had, like, nine tents with flamethrowers and ice sculptures. Again, this is pre-IPO, so they would just spend all the money in the world.

My friend came home with an entire roll of probably 300 drink tickets. He’s like the guy that helped me set it up. He’d just, “Here, you guys can have it.” Anyway, so we used to go to the annual Google party, but I got ejected because a girl came up and looked at me and I didn’t look like Google material. Had a big beard, was wearing a puffy jacket. And she says, “Which Google office do you work in?” And I said, with utmost confidence…as portfolio management, we know that that’s…you display confidence and you could fool anyone. I said, “Singapore,” or something, somewhere in Asia. And she knew I was probably lying, but couldn’t tell why.

She goes, “What’s the address?” And I just named some address. And she was befuddled and just stormed off, but eventually, I got kicked out of the party. But that was pre-IPO. Things were much more fun when they were a private company.

Steve: I’m trying to think about what part of that story gives you the soft spot.

Meb: A soft spot? They hate it. I’ve been short for years. Just kidding. I’m a quant, I don’t even know…we probably own it. I have no idea. We may own it, we may not. But that’s interesting. So you touched on something prior to the Google thesis, which I think is interesting that not a lot of people will… People will talk about it as far as the U.S. exposure, but what they don’t talk about, everyone thinks about country and equity investing or sectors when you could easily have companies domiciled in Spain or U.K. or anywhere that would have all of their revenue in another country.

So it’s really somewhat of an arbitrary. And I’ve been waiting for an enterprising ETF company…it’s not what we do, but for someone to build revenue-based indices rather than location-based, but…and if you’re listening, Blackstone, feel free to steal that idea. It’s not something we do. But it’s always something that I have thought about, but rarely, people talk about.

Steve: That’s a good example, because we bought a number of years ago, Aeon. Aeon was based in Chicago at the time and then, it…for tax reasons, it moved to the U.K. I mean, less than 10% of its revenues or so come from the United Kingdom and yet, that’s where it’s based.

Meb: Yeah, it’s kind of like artificial doors that people put up. All right, so we only have you for so much longer, I want to talk about a few more things. You guys list on your website…I mean, it’s required information, anyway…but portfolio managers investing in their own funds and you mentioned investing in your own funds. Is that something you find important, I mean, having skin in the game? Or is that something you think is kind of an afterthought and it doesn’t really matter as much, because you already have exposure? What do you guys think, in that terms?

Steve: I think it has to be true, right? It has to be. I mean, I believe that if you don’t do that, you are working…and presumably, you’re working, but you either a) don’t believe in what you’re doing and you’re putting your money someplace else and then, why should everybody else put their money someplace else? Or you’re spending money on companies…spending time on companies that you’re considering investing for yourself, that’s the resource that should otherwise be applied to the portfolio that you’re managing. So we feel very strongly that your energy should be aligned with your pocketbook, or it just should be aligned with your clients.

Meb: We agree. I mean, we are consistently frustrated. I put 100% of my net worth in our funds and strategies. But there’s a stat that Morningstar does that’s, like, 50% to 80%. But mutual fund managers have zero, not even less than $100,000. It depends on the category, of course, but zero invest in the fund. And we’ve always thought that was a little odd, to say the least.

Steve: But I do want to make a distinction, though. I think it’s a…we’re talking about equity funds now, because if a bond manager…I can understand why they would have less. You can be a successful manager and focus on that and then, put money with an equity manager. It’s a different risk profile.

Meb: Right, totally agree. So as a former education guy and for someone that works in a world and sector that is notorious for having a massive education gap with investors, where…and I’m not just talking about individuals in retail, but pros alike, where I think it’s really hard to bridge that gap. How do you guys approach chatting with investors? I mean, there’s a lot of famous research out there on people and fund managers that the time-weighted returns are so much worse than the dollar-weighted returns and people chasing performance and everything else. Is it…?

I oscillate. So half the time, I spend thinking it’s a very worthwhile cause to try to educate people. The other time, I say people are going to be human and do stupid shit over and over and over again, just throw up my hands. What are your thoughts on education in general and approach to y’all’s shareholder base?

Steve: I think both your statements you make are true. I think some people don’t want to learn and you can’t teach somebody who doesn’t want to learn. And so, it does make sense, on the one hand, just to let the performance speak for itself. And cash will go in and out based on visceral reactions tied to recent performance. On the other hand, many investors do want to learn. I can’t imagine there’s anybody listening to your podcast who’s not here, right now, listening to this who doesn’t want to be educated.

So when we write and when we speak, we speak to them. I don’t know what percentage of our client base it is, but even if it’s one percent, we owe it to them to educate them, because it should be helpful to them over the longer term for their own portfolio, whether they’re only investing with us or they’re investing with lots of other people.

Meb: When you guys do your annual FPA Day…don’t you guys have an annual day that…?

Steve: We do have bi-annual FPA Day.

Meb: Bi-annual now?

Steve: Well, it’s always been. We’ve never done…the world doesn’t change enough to warrant annual. And we’re value investors and so, it’s an expensive day to put on.

Meb: Well, it’s too slow. Are you guys wholly in Santa Monica? Where is it?

Steve: In Santa Monica.

Meb: Santa Monica? Beautiful. Yeah, it’s interesting, because we’ve thought a lot about this over the years. And we, at one point, had reached out to all of our followers and…thinking about… Someone has asked me, “Meb, if I can tell my college student or someone that’s really interested in investing where to go to learn about investing.” And other than just saying something dumb like, “My podcast,” or something, it’s a hard answer. And so, we had actually asked our audience. And I said, “What’s the one book you would give someone,” and we got 300 answers.

And the top 10, some of them, despite the fact that they’re great books, are not really a wonderful book. Like, a first investor book is not going to be “Security Analysis.” I mean, it could be, but God bless you if you can get through it. I don’t think I’ve ever gotten through it. But it’s a…we struggle with it and we continue to do it, but…

Steve: Well, you’re also speaking to many different kinds of people and investing is so idiosyncratic. People have…we all have different risk tolerances, we all have different return needs, we all have different net worths, we all have different time horizons and we all have different psychological wherewithal to withstand market volatility. And so, it isn’t one message we try and deliver to our clients, in terms…well, there is. In terms of how we invest, there’s one. We try and make it one clear message. But we recognize with the types of examples we use and types of books that we recommend that our investors are different. So we try and find different ways and connect with different people and yet, still say the same thing.

Meb: So for someone who speaks a lot to, I imagine, institutions, RIAs, advisors, individuals, all of your various shareholders, what sort of advice or thoughts would you want to convey about them, thinking not just about your fund but investing in general? Is there anything that you’re like, “Oh, my God. I always want to say this?” Is there a mind-set or something you want to pass along at all?

Steve: Well, I think to be successful in this business and to have a reasonable quality of life as well, one has to be okay with being fired. I don’t care if you’re a portfolio manager in a mutual fund or [inaudible 00:51:17] managed accounts or an RIA, a stockbroker, an institutional manager working for a foundation or endowment, pension, etc., you have to be okay that you’re not going to please everybody all the time. And if the expectation is somebody looking for that pleasure, that you can…want that yearly outperformance, then I think that you’re asking for a disaster.

I think you…we’re more comfortable with just thinking longer-term and making sure our clients think longer-term to the best of our ability. And there’s points in time where we have…we go through cycles where we’ve got a redemption cycle, we have a contribution cycle and it’s [inaudible 00:51:52]. And far be it from me to ever complain about that, because I’m very fortunate to be in the position I am, to have the kinds of clients we do have and to have the business that we do have and have the partners I have at First Pacific Advisors and…starting with Mark and Brian as my co-PMs. I’m very, very fortunate in that regard.

But we can’t expect that if the world is not…if the world is entirely rational, there’s no place for active management. So if the world, then, I would argue, is not entirely rational, then there will be opportunities to take advantage of emotion, to sell into favourable emotion and buy into moments when people are fearful. I can’t then expect, with our asset base, with as much money as we manage, that our clients are not going to be, to a great extent, the market. So you can’t have it both ways.

Meb: Well, see, this is sort of the agony, actually, of being a public fund manager. It’s trying not to get too despondent when assets go down a bunch…we’ve experienced it many times…and also, trying not to get too excited and think you’re the most brilliant person in the world when they go up. What do you think about the sentiment right now? Do you feel that it’s euphoric like at other times, or do you think it’s just pockets, or do you think euphoria is even required for this bull to end?

Steve: I don’t think it’s euphoric. I think a lot of what was happening in the market today, it’s need-based. And I think that…and Bridgewater had this study that they did that I saw that said, “The market, over the last couple of decades, is driven 40% by the decline in interest rates.” And interest rates have been going down for 35 years, for the most part, except for the last year or so. And I don’t know if 40% is the right number or not, I have not done the work myself, but it’s certainly a very big number. And I can certainly easily get to 20%, I mean, not to spend the time on the call on how the math works. But I think that with rates going down, people have not been able to have a safe…conservative alternative in conservative fixed income, as it had in the past.

And if you had reasonable savings…let’s just say that you’re fortunate enough to have $2.5 million in savings, which most people in this country don’t have. But let’s use that for the math. A decade ago, you could have had $90,000-odd of your taxes from that, just buying a five-year treasury. Today, that number is…I don’t know…$60,000, something like that. You’re down by a third. And if you were living off that money, if that’s the…in this hypothetical, if you were living off that money, what do you do with that $30,000 gap? You only have a few choices.

You can reduce your lifestyle, hard to do. You can spend principal, hard to do. You can take out more risk. Well, that seems easy, because my advisor’s telling me that I can’t lose over on this. But I think that’s problematic. I do think that the…and as a result, what we’ve seen is, there has been an increase in household investment in stocks. And what I did was… And I’m going to show you a chart that you can use in one of your…

Meb: Yeah, we’ll post it in the show notes.

Steve: …that I think is interesting. It’s, household equity investments isn’t an indicator of market returns. So what we did was…is, we took the household investment in financial assets and then pulled it forward 10 years and inverted the curve. This is what we… The reason why we pulled it forward 10 years and the reason why we inverted it is so that it could align better with the other line item on the chart, which is trailing 10-year returns. And it’s as if to say, does the household investment in financial assets suggest what the next 10-years’ returns will be like? And you can see what this chart looks like. It moves up and down together.

Well, you can see the peak here, which reverses to be a trough in this chart. That was back in 2000. And the returns in the next 10 years were solidly…and that was almost 50% in exposure at the time, give or take. And the returns were solidly negative and that is the next 10-year period. So today, where we are when looking forward, household exposure to financial assets is the second highest level it’s been since the early 1960s. It’s approaching 45%. And if the past predicts the future…which it doesn’t, there’ll be movement around this…it suggests that the future rates of return over the next 10 years will be in the very low single digits. And it won’t be. Might be, it’s slightly negative. Maybe it’s six percent, seven percent. It’s not going to be historic averages.

Meb: Do you see any catalysts…I don’t know that there has to be one and they’re often obvious in retrospect…but that would cause the most pain, as far as this bull market to end? Whether it’s just valuation, is it debt, is it Fed policy, any catalyst that you think could derail.

Steve: There’s so many variables and then, as I said earlier, more things could happen than will happen. The catalyst is a continuous rise in interest rates that freezes out the consumer in the U.S. and in other countries. I mean, it’s harder to buy a home today than it was before, because your borrowing costs are higher than it was a year or so ago. And it’s also true for companies that have to refinance their debt. There are more zombie companies today that exist around the world, because they can afford to pay their interest, they’re just going to have a problem refinancing their principal. So there’s more of those companies. And so, rates going up are going to go push those companies over the…many of those companies over the edge, we’ll have more bankruptcies.

And so, a recession…the rates going up, a recession could be the driver. I don’t know what it will be. I know there’s a lot of things that will magnify it and potentially catalyse it, including the rise of corporate bonds. Corporate bonds, a decade ago, were $4.5 trillion. And it broke down roughly, call it, $1.5 trillion in high-yield bonds and leverage loans and $3 trillion in investment grade. Today, we’re talking over $9 trillion in corporate bonds, so we did a doubling. So the rate of corporate bond growth has been at double over the rate of the economic growth. And you can’t say that if a company borrows money that it has, in some form, found…[inaudible 00:58:03] found their way into the economy.

Currently, it’s been similar to some degree, we can argue about to what degree. But of the $9 trillion, you now have…you have $3 trillion of high-yield bonds and leverage loans, so that’s a doubling as well. And you’ve got $6 trillion of corporate bonds, a doubling of investment-grade corporate bonds, a doubling. If you look inside…if you’re going to unpack this a little bit…of the investment-grade universe, which was $3 trillion a decade ago and $6 trillion today, a decade ago, you had 30%…or it’s a little less than 30%…that were triple “B.” So, call it $800 billion, $900 billion or somewhere in that range.

Today, with the $6 trillion in investment-grade, more than half are triple “B,” one notch above junk. So you’ve had a quadrupling of triple “B” credits in the U.S. and that’s going to pose a problem in the next downturn.

Meb: Maybe we’ll start the tail-risk equivalent of the corporate bond bears fund. People would probably love that as an ETF and buy a bunch of puts on the corporate indices. We’ve got to start winding down. I promised I would only keep you for a certain amount of time and then, we’ve already passed it. But I have probably five more pages of questions, so we might have to have you back in six months or a year. But there’s a couple of questions we always ask people at the end. One in particular has been, as you look back over your career, what’s been the most memorable investment or trade?” It could be good, it’s bad. We’ve covered a lot of your tough ones today, man, so you can give a good one, too. Or you can give both. You can give both of the…it’s usually the first one that comes to mind.

Steve: Well, the most memorable, for sure, for me, was really taking a portfolio and shifting it to distressed and high-yield in 2009. It was really, really fun and we just found it so hard to lose money.

Meb: It’s always funny to me, because was that a really difficult decision, or was it actually kind of like a Christmas morning feeling? I mean, I feel like the world was collapsing so much around us. I remember being at a value investing conference and watching a famous hedge fund manager speak. And he said, “I like this stock at 10%, I think you can go to 30%.” And while he was speaking, the stock went down to five percent. It’s that sort of environment where things and every day…it was just going crazy.

Steve: I’ll close with this. I don’t think it’s like Christmas morning, because that means the present are there. I think it’s like Christmas Eve, where the tree is dressed and we really do expect that Santa Claus is coming, because he’s come every year.

Meb: That’s a good analogy. Well, we’re going to wind up. Where can people find more? If they want to follow what y’all are doing, your writings, your portfolio management information, what are the resources? Where do they follow you guys?

Steve: Www.fpafunds.com is our website and our fund that I…and my co-managing partner at the firm. And the fund that I manage is the FPA Crescent Fund that we’re talking about here today.

Meb: Awesome. I was going to end this…I was going to end this, but maybe we can just end this with the acronym “WTF,” which is what your mom asked you what it famously meant. And you said, “Wow, that’s fantastic.”

Steve: And now, she uses it all the time.

Meb: So that’s actually my brother’s initials who’s visiting right now. So I have a lot of “WT” mugs and hats at our house. So every time I see it from now on, I’ll say, “Wow, that’s fantastic, Wayne.” That’s his name. Steve, thanks so much for joining us today.

Steve: Thank you. Thanks for having me.

Meb: Listeners, we’ll post show notes, some of these charts, all the links to FPA and all other goodies for the holidays on mebfaber.com/podcast. Send us your thoughts, feedback at themebfabershow.com, any questions, comments, complaints, etc. You can listen to the show. Subscribe on iTunes, Overcast, Stitcher or my favourite, Breaker. Thanks for listening, friends, and good investing.

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