Every few years, Steve Romick pens a long letter to clients about looming risks for the stock market. His timing is usually too early—credit-default swaps in 2002, subprime mortgages in 2005, excess leverage in banks and investment banks in 2006—but eventually the dangers came to pass. Recently, Romick wrote his latest jeremiad, this time about the risks lurking in sovereign and corporate bonds.
We checked in last week with Romick, who, with Mark Landecker and Brian Selmo, steers the $17 billion FPA Crescent fund (FPACX). The three are consummate stockpickers, but the fund also holds cash and bonds, reflecting their broader views. Over the past three, five, 10, and 15 years, FPA Crescent (FPACX) has beaten the average moderate asset-allocation fund in Morningstar's database—funds that typically hold 50% to 70% of assets in stocks and the remainder in fixed income and cash.
The trio were picking up stocks in last year's carnage, but are still holding a quarter of assets in cash, as Romick sees more opportunities ahead. For more, keep reading.
Q: What's keeping you awake?
A: The markets tend to fight the last war, which was about the overlevered consumer, the overlevered financial system. Consumers are in a much better place today, with more equity than a decade ago. Mortgage debt is lower, and home prices in most parts of the country are higher today than a decade ago.
I'm well aware that there's a divide between the haves and have-nots. There's a cohort with increased auto loans and credit-card debt. But this time, the consumers are better, and banks are better. Banks have more equity capital on their books than in the past and hold better assets on average. A lot of lending demand has been filled through the corporate debt market. People don't understand that this time, consumers and banks aren't the problem.
The problem is the corporate debt sector, as well as sovereign debt. Sovereign debt levels are as high as they've ever been relative to gross domestic product around the globe. That's true of the U.S. Treasury and of the state and local levels in the U.S. This rapid debt expansion can't continue forever. At some point, there will be a price to pay in the form of slower economic growth or recession. Buyers of sovereign debt could demand a higher yield. Corporate defaults could result from higher borrowing costs. The weak economy could cause lower cash flow. Figuring out the timing on sovereigns, in particular, is impossible.
Q: What accidents are waiting to happen?
A: The sovereigns, and state and local governments. When you've got governments that can print money, or state and local authorities that can change tax programs, they can keep the game going a lot longer. A lot of local municipalities will have trouble. Detroit was a recent one. There will be more Puerto Ricos in the U.S. I don't want to take as strong a stance on the sovereigns; it's easier to see the fissures in the corporate debt market.
We have the largest amount of U.S. corporate debt in history, with about the highest leverage ratios outside a recession, and some of the weakest covenants we've ever seen. The total corporate debt market is in excess of $9 trillion today. There is the high-yield, levered-loan piece, and the investment-grade piece. Both have expanded.
The problems surrounding high-yield bonds or levered loans are more understood. There is a lack of understanding with respect to investment-grade. High-yield bonds and levered loans grew from $1.3 trillion in 2008 to $2.4 trillion today, not quite a doubling. The investment-grade market increased from $2.5 trillion to $6.4 trillion.
Debt to Ebitda [earnings before interest, taxes, depreciation, and amortization] is higher than it has been outside of recessions, and you have some of the weakest covenants—Moody's covenant-quality index is near its low. I'm trying to discuss this outside a recession because in a recession, Ebitda declines and your leverage ratios go up. So you don't have a big margin of safety in this universe of corporate debt. We're 10 years into a good economy, and, at some point, there's going to be a recession and a price to pay when Ebitda declines.
Q: Where precisely are the risks in investment-grade?
A: In 2008, 32.5% of investment-grade bonds were BBB-rated, a slim notch above junk. Today, about half are rated BBB. Investment-grade debt has more than doubled in the past decade, but the BBB tranche has quadrupled. It has never been this large, either on a percentage basis or in dollar terms. Credit metrics are already worse than typically observed in a recession, and we're not in a recession yet.
Zombie firms that are surviving longer than they otherwise should because of low interest rates and an accommodating lending market. Much of the corporate-debt funding is coming through a lot of private funds and mutual funds, both active and passive. It has also invited a lot on the mergers-and-acquisitions side, which has levered up corporations to the point that the equity is a smaller sliver.
Q: What would touch off a decline?
A: I don't know anybody who invests today who has really lived through a period of rising interest rates. The bet for lower rates is a very difficult one to make. Higher rates could occur for reasons you don't necessarily anticipate, including a buyers' strike on sovereigns. Whatever happens with sovereigns in the future could create duress and a higher-rate environment. With yields as low as they are, people don't recognize the risk.
Q: How should someone invest, especially since you don't have a timetable for the problem turning into a crisis?
A: It's not going to end well, and the stock market isn't going to be immune. Equities will be weak because there will be more corporate bankruptcies. This next go-round will have a below-average recovery rate because you're going into it with more leverage, weaker covenants, and a much larger absolute level of corporate bonds. But it will create future opportunity for us to put even more capital to work. We invest with a five- to seven-year mind-set, and I think we're going to have some very attractive IRRs [internal rates of returns]. We'd rather have our money out there and accept some volatility, rather than just keep it in cash.
Q: What's an investor to do?
A: Passive investing is a terrific tool, but if you're a hammer, everything can be a nail. You have to recognize the limitations. Now, more than 40% of the equity markets are invested in passive vehicles. I don't know the percentage of debt, but it's not inconsequential. Purchases of equities and debt in any passive vehicle are indiscriminate. If there's any kind of redemption cycle, the indiscriminate purchasing will turn into indiscriminate selling. It will create big opportunities in less-liquid investments like smaller-cap equities and certain mid-cap equities, as well as a lot of corporate bonds. I'm not going to suggest for a moment that our portfolio will offer stellar returns into a weak environment. But we're comfortable with what we own, and we'll be able to capitalize on future opportunities.
Q: Let's talk about some names that you like.
A: We first bought American International Group (AIG) after the last recession. The problems of a decade ago are mostly behind them, and they're focused on improving property and casualty underwriting. The company brought in new management in 2017, with the new CEO Brian Duperreault, who had a successful track record in the insurance industry. He brought in Peter Zaffino as chief operating officer, who has a successful track record across many companies in the insurance industry and had been a top executive at Marsh & McLennan.
AIG's underwriting problems [it had to boost reserves to meet larger-than-expected claims] won't be fixed overnight. Even with the big catastrophe losses last year—hurricanes, fires, and such—AIG still earned money. They're improving and will eventually show better profitability and a higher return on capital. The stock market doesn't believe in this turnaround, but we're favorably disposed to the company because of a belief in its people, who've done this before.
The risk-reward ratio is attractive. The stock is $44 today. The company has tangible book value, ex-deferred tax assets—of about $56 a share. It should earn a 10% to 12% ROE [return on equity] on a growing equity base. If correct, that would translate into $6 or $7 of earnings per share. A conservative price/earnings ratio of 10 to 12 times would put the stock at $60 to $80. And as a sniff check, that would have it trading at 1.3 times tangible book value. And deferred tax assets of $11 a share will gradually convert to cash.
Q: You're a fan of Jefferies Financial Group (JEF), the former Leucadia. Why?
A: Jefferies operates a strong broker-dealer and a successful merchant bank. A common variable of a lot of what we own is the good quality of a business—even if it's a turnaround—combined with good operators. All the better if they're owner-operators who have their money invested alongside ours. Jefferies had success creating value through timely investments in the merchant bank and opportunistically repurchasing their shares at a sizable discount to net asset value. This company met earnings expectations last year. They enhanced net asset value by reducing their majority stake in National Beef. Jefferies aggressively repurchased 13% of its shares in 2018, and, despite that, the stock price declined 35%. It now trades at less than 80% of its tangible book value, and at about a 30% to 35% discount to our conservative low-$30s assessment of net asset value.
Q: Is CEO Rich Handler taking it private?
A: He has a long way to go, but he recently wrote about the stock price being out of sync, and said "it was as if we were getting the call from our own company about a compelling new investment opportunity." In 2018, Jefferies was their single largest investment. He said the investment story "is becoming more focused and straightforward," meaning he's cleaning up some of the merchant banking stakes, including the National Beef stake.
Q: What else do you like?
A: We own both Charter Communications (CHTR) and Comcast (CMCSA), two geographically diversified cable companies controlled by owner-operators, although we're admittedly suspect of Comcast's purchase of Sky.
We built the positions thanks to the fears of cord-cutting that would displace the video business, and the development of 5G that would allow wireless to make inroads into broadband. I don't place great stock in either view now. I don't believe that video is as profitable as industry segment reporting suggests. Its per-subscriber free cash flow will likely slowly erode. But we believe in the latent pricing power of broadband, which is necessary for the consumer to cut the cord in the first place. The average typical broadband customer is going to be perfectly happy paying, say, only $10 to $20 more per month—our estimate for video profitability. Otherwise, you don't get your Netflix or your new Disney streaming or Hulu, or your videogames. And with 5G, only Verizon has made any substantive investment in cable infrastructure for the back haul, and it's many years away.
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