A Conversation with Steven Romick, First Pacific Advisors, and David Herro, Harris Associates.
Steven Romick & David Herro: Bottom-Up Investing In A Macro World by Litman Gregory Analytics
We recently hosted an investment panel with FPA's Steven Romick and Harris Associates' David Herro. Romick serves as portfolio manager of FPA Crescent Fund and the FPA Contrarian Value product. Herro has managed the Oakmark International, Oakmark International Small Cap, and Oakmark Global Select funds since inception. The conversation, moderated by Litman Gregory chief investment officer Jeremy DeGroot, centered on how these fundamental stock pickers are navigating today's investment environment.
Many well-known hedge fund managers are also philanthropists, and many of them have their own foundations. Seth Klarman of Baupost is one of those with his own foundation, and he invested in a handful of hedge funds through his foundation. This list of Klarman's favorite hedge funds is based on the Klarman Family Foundation's 990 Read More
You are both bottom-up investors, but we're operating in a world where macroeconomic events can impact and overwhelm industries and individual companies. And these are certainly interesting macro times, particularly when we have examples such as Greece in the headlines. How do you balance or incorporate specific macro risks given your very bottom-up focus?
David Herro: Well, if you back up, a company operates in an environment in which it either has a very fertile environment where you have strong demand growth and you have euphoria—people are buying your goods or if you're a business-to-business, the capital spending boom is on—[or it may be operating in not a fertile environment].
A lot of this environment depends on what's happening in the macroeconomy and with macroeconomic policy.
I think all too often, we ignore what's happening in microeconomics. If you look at Europe, the whole European crisis—in my view—is more micro-driven than macro.
Europe cannot compete—same with Japan, by the way—because of structural inefficiencies. Not because of some macro. What you have is structural inefficiencies leading to macro disturbances, in a way. Having said all of that, remember we're pricing a business based on its cash flow stream. So if there's a macroeconomic slowdown, it will impact the company's earnings stream for maybe a quarter or two. Or even a year or two.
But wait a minute. The value of the business is just not a function of the next couple quarters' or the next couple years' free cash flow. The value of the business is all those cash flow streams discounted into perpetuity.
I think the big mistake people make is trying to play these macro cycles. Yes, you have to be aware how the businesses you're invested in are impacted by changes in the levels of aggregate demand, etc.
And you also have to be aware of how they're impacted by the local rules of which they're operating in around the world. So, macro certainly is the biggest event or influence that people like to think about, and I think it's completely wrong. People should be looking at the company's ability to grow profit streams. They should be looking at the risk factors to those profit streams of which macroeconomics is a very small factor, generally speaking.
Again, it's a small factor because it affects it over the short term. And if a company has a strong enough balance sheet, we can analyze their ability to withstand macro shocks.
If this is the case, then we could use macroeconomic volatility as our friend. And I think one of the best examples for us is, if you remember in late 2008, when we all knew the world was in a recession, and a very stiff one, but we kind of piled into consumer discretionary stocks. Not because we thought, well, the world's going to bounce back in a couple months. But because the price of those businesses dropped like 60% and 70% and 80%—far more than what were the “safe” consumer staples stocks.
So, what was the barometer? Price. We knew that the companies were going to be impacted by the business cycle. And a very strong business cycle.
But then you go through it and look for companies that have the balance sheets, the brands, the capital position, the unique selling propositions that could withstand the weakness. Enabling us [to determine] that when the storm leaves, the stocks aren't [going to be] up 20% or 30%; but up 70% or 80%.
So, we like to look through the cycle and use the volatility of the macro economy to position the portfolio to the degree at which we could populate that portfolio with companies with the most economic upside.
Steven Romick: You imposed the question by saying, “macro.” David had interpreted it to be macroeconomics. I'll just give it a little bit of a different spin. So I'll just call it macro-big-picture.
So I'll just put the question to all of you. Right?
We've never seen rates this low in our lifetimes. The perversion in asset prices that we've seen out there as a result of low interest rates is affecting many different parts of the world. And it's lifted all asset prices.
So a very, very smart friend of mine said very simplistically, “Look. So goes the 10-year, so goes the market.” Now obviously, again, it's a fairly trite view. But, it does beg the question, what happens to rates?
And I, by the way, don't have a view. I'm not going to call it on the rates or direction or the timing or the magnitude. Anything like that.
I tend not to engage in that. I do come back down to whether or not the business we buy is a good business and if it can operate successfully through whatever is coming our way.
I do feel that [investors feel] a need to be invested because there is a lack of opportunity elsewhere. This has tended to lift prices to a level where we don't see the risk-rewards for our portfolio.
We have cash in our portfolio as a result. A lot of it. It's a byproduct, though, of the underlying [bottom-up] analysis of these businesses we're investing in or looking to invest in.
So, if we see something that meets our risk-reward, we'll buy it. I don't care about the environment.
We had 40% of the portfolio going into cash going into 2008. Then we just were buying distressed debt hand-over-fist in 2008 and 2009. I mean we were on the precipice of a depression. Now, I didn't know what was going to happen. Obviously, a depression didn't hit. But I didn't know how it was going to come out.
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