Replay: Across the Capital Markets with Steven Romick

Interviewee: Steven Romick
Interviewer: Jeremy DeGroot, Jason Steuerwalt
Date: May 5, 2021

Mike Pacitto: Hi, everyone. I’m Mike Pacitto with Litman Gregory. Thanks for joining us, today.

We have a great call in store for you today. First, we’re going to be doing a quick 10-minute update on the Alternative Strategies Fund for clients and prospective clients, with coPM Jason Steuerwalt. Then we’re going to shift over to an interview discussion between Litman Gregory’s CIO Jeremy DeGroot and FPA Managing Partner and Portfolio Manager, Steven Romick. Going across the markets, that should make a really interesting conversation.

We’ve received some questions already through registration. Thanks, everyone, that send those questions in. We’ll try to address those during the call. If you also have questions that you’d like us to address during the call, just submit them through the interface on the bottom of the Zoom screen, and we’ll try to address them probably in the back-end of the discussion.

Starting off with our all-weather Alternative Strategies Fund, where Steve Romick is actually one of the five portfolio managers, some quick takeaways in terms of performance. Then I’ll hand it over to Jason, to go over a quick update, in terms of the managers of the underlying strategies.

Q1 was solid. You’ll see that the three-month return was 2.44%. 12-month return was 20.14%. That beat all of our major benchmarks. For clients that use the fund to diversify their fixed-income allocations, the fund beat the Agg substantially. For the quarter, it beat the Agg by almost 500 bps. With a trailing 5-month yield of almost 3%, the fund has a yield in the portfolio of almost twice the Agg itself.

In terms of the compounded line chart on the next slide, you’ll see that we did some increased volatility at the onset of the Covid crisis. Beta on the fund went up for a short time, but still was substantially less than equities. The fund quickly returned to its more typical behavior when those dislocations relocated.

Next slide you’ll see is a bar chart for the fund. It’s in orange. It gives us a year-by-year look at the fund against the Agg — the HFRX and the Morningstar Multi-Alt category.

The fund continues to have the highest Sharpe Ratio in the category, and it’s coming up on its 10-year anniversary at the end of September. Over the lifespan of the fund, it’s had consistent, reliable, low-volatility returns and delivered nice alpha for clients. We’re really happy with the fund and we hope that our clients are, as well. We hope that prospective clients will continue to give the fund a good look.

With that, Jason, I’m going to hand it over to you. There’s one more slide that has a little bit of performance-data on it, if you’d like to touch on anything there. Otherwise, a short update on the manager’s sleeves and their positions.

Jason: Yes. Nothing too much to say on this sleeve. There are a lot of numbers, here — obviously. I think the nice one, which you alluded to earlier, was the Sharpe Ratio is still very strong at 0.9, compared to the other alternatives on the page. Except for the Russell 1000 — which is kind of a mind-blowingly large number for a 10-year period.

Jumping to the managers, I guess to start, we got nice contributions in Q1. The fund was up 2.4%. We got nice contributions from the Value/Reopening themes, I’d say. But we still feel like we have good return potential in the fund, remaining. It’s not overly exposed to those themes. It’s got balance and some dry powder.

DCI — starting on a manager that did not benefit from that theme — was down, slightly — net of fees — in Q1. Down by less than 10 bps.

Going back to last year, DCI held up really well during the pandemic. It started making some nice gains during the middle of the year. Then it got hurt post-vaccine announcements at the end of the year, as things that had been beaten down rallied. The value trades started.

That really continued into Q1, as they were really hurt by the magnitude of the value-reopening rally. They definitely have positions that benefit from that on the long side, but not enough to be able to keep up with the short side of their long-short sleeve.

I won’t go through all the exposures, here. You can read those. I would note that in the bond portfolio, the yield is about 3%, net of credit hedges. Some nice tailwind there.

We started seeing some performance traction toward the end of March, with fundamentals driving performance rather than the risk-off/risk-on behavior that we’d seen a lot of.

That’s a positive, somewhat offset by a lower-spread environment, which isn’t great for them, overall. It’s kind of a mixed environment, but trending in the right direction, in terms of fundamentals moving prices.

If we go to DoubleLine, they were up about 1.7% in Q1. Not surprisingly, outperforming the Agg by quite a bit, given the composition of the portfolio and a much-lower duration.

ABS was a strong contributor where aviation-backed securities performed very strongly, reopening the economic-growth theme, as well as CMBS — particularly in the Hospitality Sector.

Agency MBS was the only sector that was a detractor from performance, which isn’t surprising, given its longer duration and the rise in treasury yields during the quarter.

One thing to note here is that non-agency RBMS is now down to about a third of the portfolio. That’s historically been the biggest part of DoubleLine’s sleeve. The other credit sectors — CMBS, CLOs, ABS, et cetera — are now over 40% of the portfolio. That’s something to note.

Given that the structured credit areas were the slowest to recover coming out of the pandemic, they still have quite a bit of value left, as you can see by the yield of almost 6% at the end of the quarter. And a duration of only 3.3.

Going to FPA, I won’t spend too much time here, since Steven is on the call with us, obviously. But their sleeve was up about 8.8% in Q1 — benefiting from the value recovery. Although, I’ll note and I’m sure Steven will, as well, it’s not purely a value portfolio — by any means. They have a number of strong, high-quality, compounding and dominant businesses. As well as some of the value sectors like financials and industrials.

Financials were the biggest contributor in Q1. They did trim some of those. Not a big change in terms of sector-exposure, with still about 75% or 76% net-long equity. A little bit of credit. And a good bit of dry powder — about 20% cash.

If we go to Loomis, they were up about 80 bps in Q1. Structured credit and high-yield were the biggest positive contributors here, while emerging market was challenged by the USD strength. They still have a decent amount of net-long risk-exposure. The high-yield is about 35%, and structured credit is about 30%. Although it’s significantly lower than it was a year ago.

Loomis took the opportunity and were probably the most aggressive in terms of rotating their portfolio during the pandemic. Going from about zero-percent in high-yield exposure up to around 50%, which was a mx of cash-bonds as well as CDX. They’ve obviously pared that back quite a bit, but still have some exposure there, given the supportive environment and low-default regime that we’re in.

Still a nice yield on this portfolio — about 4%. And a relatively-low duration of 3.

Finally, Water Island. They were up 3.2% in the quarter, continuing a nice trend of performance from them. Held up relatively well during the pandemic, and benefited really strongly the rest of the year. Their contributions in Q1 were, from both the hard and soft catalysts, tilted about 70/30 toward the hard-catalyst side. In terms of their net exposure, the vast majority of it is in the hard-catalyst merger positions.

They’re still very positive on the environment, given the sharp pick-up in deal volume from obviously the big slowdown in Q1 and Q2 of last year. A lot of private-equity dry-powder on the sidelines is waiting to be invested. A good spread environment and a good deal environment.

Just quickly to note on the SPACs, which were a strong contributor for them last year — even though they are less than 10% of Water Island’s portfolio —

Water Island last year became increasingly invested in SPACs over the second-half of the year. They were not a huge part of the book, but were really strong contributors to returns. They had a basket of SPACs, and they were very selective in terms of the sponsor-teams they invested with. Very sensitive to the valuations, they were quick to cut when they felt things were getting too far ahead.

They also did a handful of pipe transactions and generated really nice returns, there. SPACs were profitable in Q1, but during February, their timing was actually really good, here. They cut back exposure quite significantly during Q1, as the market was just getting ridiculously overheated.

I’m going to welcome Steven Romick. It’s pretty interesting, actually, Steven. It was really exactly one year ago that you joined us on our Alternative Strategies webinar, in literally the first week of May. Obviously, a lot has transpired since then, but it’s good to see you. Welcome back.

I did shave, in your honor, as you noted in our pregame conference. Good to see you! Thanks for your time, today.

SR: For those of you who weren’t on that call — which is most of you — it was a very tough year for Jeremy DeGroot. He cleaned himself up.

Let’s see. Just to set the stage, first let me mention that listeners — we welcome your questions in the q-and-a box on Zoom. We’re probably all familiar with the routine here, but you can type in questions and I will be able to monitor those and work them into our discussion where appropriate. We’ll shoot for ending at the top of the hour.

It’s great always talking with Steven, because he’s a global investor. He and his team look across capital structures and market-caps — equities — fixed-income and so forth. Basically, the world is their investment oyster.

To set the stage, we’ll start off with a bigger-picture take, setting the stage of the financial markets. To the extent it’s relevant, the macro-economic backdrop. Then we’ll dig into where the rubber meets the road in terms of what you’ve been doing in the portfolio. The areas of investment opportunity throughout this really incredible market rebound over the past 13 months. And where you have concerns and risks.

You did prepare some slides, which I think are useful for the backdrop. The first couple touch on valuations for the US equity markets. I’ll just say —

Jeremy: Challenging. And challenged absolute-value investors — really the five —

Basically, I’ll let you jump in. You provided a couple of slides here on US — valuations — different ways of looking at that for the market.

SR: I think there’s a lot to unpack here on this one relatively simple slide. It shows both the S&P 500 growth index versus the S&P 500 value index.

I think the gap between the two is almost as wide as it’s ever been. Not quite as wide as it was back at the peak of the internet bubble.

However, I think it belies somewhat alternative considerations that you must take into account.

If you actually look at the value index, and I don’t know exactly what the numbers are, but the growth in earnings for the value index has been terrible in this timeframe. It’s no wonder that the growth index has been so much better.

I think that for us, the difference between growth and value is a fuzzy line. Everything we buy or trim are growing businesses. Some are growing better than others. I think the greatest difference for what we do — as compared to just looking at the growth stock indices on their own — is that to us, price matters.

When you think about being a value-investor, for us, it’s merely about investing with a margin of safety. Buying an asset that is at a sizable-enough discount to its fair-market value that you’re comfortable being able to own that asset and know that you’re relatively protected. Assuming you’ve underwritten that asset correctly.

What’s happened in the past — in the Graham & Doddian kind of value-investing construct — is really about the protection of the balance sheet. Today, the protection falls more — I would argue — for the business. So many of the companies that comprised the blue line were the disruptors. And so many of this yellowish-green line are the value index, or the disruptees.

Owning a business that is the Amazon of yesteryear — Sears — buying that 20 years ago because you had all this protection of its real estate — didn’t end up working out so well for you.

In fact, you had that protection. I think it did give you a margin-of-safety at a point. But it lulled you into a false sense of security, because they started selling that real estate and mortgaging that real estate and using the cash to just sustain the operations as they were, without making the necessary investment to compete in an online digital world, in a fashion that Target and Wal-Mart did, to more successfully compete against the likes of Amazon.

One has to be very, very thoughtful about what the future holds for any business one owns. The point I want to leave you with is, there are a lot of crappy companies in that yellow line. And we own companies in that yellow line. We own some companies in that blue line. But two things matter for us. As I said already — price matters. But the quality of the enterprise matters.

If you get a good-quality enterprise at a good price, those are the businesses we seek to own. Yellow and blue colors.

One other observation from this — these are price-to-sales ratios. On an absolute basis, over 5-times for the growth line. But it obscures what’s going on with profit-margins, which would come through in a P/E. Which we know are also quite high. But it’s related to the quality of the businesses. As we all know, profit-margins in many of the global tech/growth leaders have also been reaching all-time highs. There’s the question of sustainability, et cetera.

But on the other hand, you can’t muck around with sales. There are no accounting gimmicks here.

SR: Well, there are accounting gimmicks. There are a lot of companies that have been busted for reporting false sales. There are also ways to muck around with billing at the end of quarters, et cetera.

But I don’t think — to your larger point — that that’s affecting this graph.

Jeremy: True. There are always endlessly-creative people out there trying to beat the system.

I’ll let you describe it in more detail, but valuation-spreads — looking within the cheapest quintile and the most-expensive within the S&P 500. A different way of not defining value/growth indices.

What would you like to highlight? What’s your takeaway and what’s the relevance from this chart?

SR: We tend to get more invested — and you spoke to our cash position — well, you didn’t — but I think Jason spoke to our cash position going into the end of the quarter. It actually increased somewhat since then, because there’ve been continued asset sales within the portfolio since quarter-end; we have a few more points in cash since quarter-end.

What you can expect here is that these peak-year periods where the line spikes up — what that shows you is that there is a large cohort of companies that are trading at a discount to the market average.

As the line goes down and gets to this dotted-line, which is about average of where we are today, it shows the difference between the cheapest companies and the market-average are wider. We like to take advantage of points in time where something is really being — when they’re throwing the proverbial baby out with the bath water — where companies end up trading all-too inexpensively.

That’s what we try to do. To make those investments in those better-quality businesses at those better prices, at that point in time.

It’s no great surprise that our portfolio was getting much more invested in the first quarter and second quarter of last year. You can see that spikiness. No difference than when we got more invested back in the ’08/’09 period. And no difference than when we got more invested when we were getting at that point in time [in a low].

That’s something you should expect. It’s always been the case for us in our portfolios. But actually, predating our public fund and predating our sleeve that we manage for Litman Gregory — which goes along the way back to 1990 — we’ve always invested that way.

We look for those areas of the market that offer greater opportunity. Where there’s some kind of natural selling. Where people don’t understand something.

Or it could be that the whole market has sold off. Not that we buy the market, but we buy those industries and those companies that we feel offer more attractive risk-reward.

Our portfolio is a lot of what people call “Active Share.” Our portfolio is not like the market. We will be invested in certain regions or not. Certain industries or not.

I think another observation that jumps out is how these valuation-spreads spike, maybe not surprisingly, during recessions. We should draw a shaded point there in 2020 — March — “Market Dislocation, ” is the common industry term.

Jeremy: A lot of babies get thrown out with the bath water, but that’s also reflective of market-volatility and opportunities.

Having the dry-powder — having the cash — to put to work. But it’s ultimately that cash, for your strategy, that’s the residual. It’s not a market-bet. It’s based on the bottom-up opportunity set and it’s not surprising that it tends to coincide when everything is generally expensive and you’re finding fewer things to buy.

That really ties into the next question and the next slide. This is getting at the point of valuations.

I’ll speak from the Litman Gregory perspective. We run broad client portfolios. We’re longer-term valuation-driven fundamental investors from an asset class perspective. We’ve wrestled with the absolute-valuation point. Look at Cape-Shiller. Look at P/Es. Look at normalized fundamental absolute-valuation metrics relative to history. Even post-’80s history — it’s pretty high.

But then you move to the relative valuation world — the equity risk premium. What do stock-valuations look like compared to the alternative? You have to put your money somewhere.

Bonds — broadly-speaking — are the alternatives to stocks. We all know bond yields are zero for cash and 1-point-something for core bonds. I’m sure you’ve seen the charts, as well. The risk-premium — the additional equity yield or expected return — above expected returns from bonds — is historically still above-average. Because yields are so low.

I wanted to just dig into this question with you a bit more to understand how you’ve been thinking about the impact of interest rates on your absolute —

I think of you guys as absolute-value investors. You’re not saying, “Well, if I could get 6% from this stock and the S&P is 3%, I’ll take a 6% return.” You’ve always had an absolute-return hurdle for taking on equity risk. Typically, of low-double-digit expected return.

Long question to ask, “How are you, if at all, incorporating what may be an extended period of low interest rates?” Sustainably low interest rates. Into your valuation approach and your business-valuation approach.

SR: What happens with interest rates, to a great degree, will be a big driver of the market.

I think interest rates have been the single-biggest driver of market-returns over the last 20 years. One has to go back 40 years before you actually saw rates rising for any measurable amount — for some extended period of time.

If rates remain lower for longer, one can justify higher-sustained values in the prices of the market. But there’s no guarantee they will. We don’t actually have a view as to what will happen.

The world — it just makes me nervous to think that nobody or largely nobody — very few people — have lived through rising rates. We’re all expecting there to be lower rates and lower-for-longer. I don’t think that’s a lend in. Certainly the sovereign incentives — right — because they’ve got to keep rates lower for their own balance sheets.

Let’s just keep the constants. The growth rate of the company — is it constant? Let’s keep the dividend a constant.

For a company that’s growing at the same rate today as it was growing back in 2007 — this is 2020, rather than 2021. It’s a chart from last year that we’re sharing with you.

The discount rate is 4 points lower, because your risk-free rate was significantly higher back in 2007. You could get 5 points for a 10-year treasury.

What’s happened since then is it’s not only that rates have gone down, but the risk-premium — the spread — has narrowed, as well. People become increasingly comfortable taking on more risk in their portfolio, so you’ve seen that discount rate come down.

It’s not any kind of stretch to say the discount rate has gone from 10% to 6%. Well, if the discount rate drops from 10% to 6%, you can see here in this example, all else equal, that asset is worth 5-times more. It’s no great shock that when rates are down, asset-values are higher.

Those companies — particularly those that are cash-growing — today, are worth more. Companies that are cash-flowing out into the future are worth even more, still. Compared to a typical value investment that has more cashflow in the here and now — versus the proverbial growth company that’s investing for the future. It’s not making any money today, but it’s worth a lot and trust me, it will make a lot of money 10 years from now.

If you make money 10 years from now and you discount that back to today, your future values are being discounted at a lower rate. They’ll become worth a lot more. And your terminal value is worth a lot more. Growth companies are disproportionately benefited by low interest rates compared to value companies.

We don’t know what’s going to happen. We’re very sensitive to the fact that rates are low. We wouldn’t be surprised to see them remain low for extended periods. But we also know they can go higher. The question is, “Why do they go higher?” Are they going higher because of inflationary reasons? You’re getting companies that are getting pricing? Or are they not getting pricing and your uniform is kind of sloppy and you have more of a stagflationary period — you get rates that are higher, which would lead to a different conclusion.

What’s interesting about low rates today is not just that it’s affecting values in and of themselves, because you discount their future stream of cashflows in the examples I just gave — but — cashflows are also —

Your investors — our investors — the population as a whole is hurt by lower rates, to the extent that they have or want anything in some kind of fixed-income security.

If your alternative is something that’s lower-risk, and frequently that lower-risk shows up in the high-grade bond market or treasury or other sovereign-debt —

But today rates are so low, and you don’t get a yield in your deposit in your local bank, what do you do? If you want to return enough to keep your value of a dollar from eroding, because what you’ve been getting at the banks is less than the rate of inflation — you’re pulled into something else. For most people, that means stocks. It offers the liquidity to them when they’re investing in smaller-size, on average. Not everybody can go out there and buy an apartment building.

Between the increasing value because of low rates in and of themselves, you also have this driver of demand for securities — demand for shares. That’s what’s helped drive the lower-risk-premium out there. Because of the lack of alternatives.

But what happens in the future is anybody’s guess. We have a view that — look — inflation is a percolator. But will it be inflation with low rates or inflation [high rates]? We don’t know.

But I think that one of the best ways to protect capital over the next 10 years is to own really good-quality, growing businesses. That doesn’t mean they’re going to be marked to market. There’ll be negative markets at points in time along the way.

We looked awfully stupid a year ago, because our portfolio was getting killed. Now it’s since rebounded. But if you buy Marriott at 80 on its way to 60, in the midst of Covid, you’re not looking very good as it drops 25% — after it’s already down 40% from its high. You don’t look that great.

But — given where Marriott is today, we don’t look as dumb today as we might have looked a year ago with Marriott trading at north of 140.

That’s just one example, but I think it speaks to the need of investing with a certain amount of patience. Being willing to lean into opportunities when the market’s giving them, with managers you trust.

Jeremy: Okay — yes — thanks for all of that analysis. It’s useful. The simple example says that a stock that was worth 20-times P/E is now 100-times P/E.

SR: That’s not P/E — that was dividend. That assumes that’s the payout; [not your earnings].

I guess I’ll take this — your point on quality of companies. Jason also highlighted this in the quick update. It’s also from comments you’ve made, before. You just talked about and we heard about the quality of the portfolio. It’s in better-quality businesses — higher than — I think you wrote, “Any point you can recall,” in your 50-60-70 years in the business.

That relates to your cash position, which is something we’ve also talked about. You talked about it publicly, regarding some of your other strategies. That is again related to a zero-percent cash environment. All these points.

Can you just elaborate a bit more on this point about owning better-quality businesses? Maybe you’ve hit it a lot, but —

Maybe just a couple of quick examples of what you have in mind when you’re talking about quality businesses you own now that you might not have owned 10 years ago?

We are more willing today to make a bet on our capabilities. To understand the business models. We look into the future, to own those businesses that we think are more likely to be successful than not. There are more businesses today that are winner-take-all or winner-take-most types of businesses. Businesses that didn’t exist that way in that fashion in the past.

SR: There weren’t Google and Facebook and Amazon living in the world of 50 years ago.

Today there are many businesses — you touched on this earlier — that are better businesses with higher margins. But there are also businesses that are higher-margin in part because they deliver something to the customer that others aren’t capable of.

It’s like there’s not room for lots of Grub-Hubs or Uber-Eats. There are only so many that you can actually bring to market that can operate in the market and sustain, in a sustainable fashion with good returns on capital.

Today we’re early-on in the streaming wars. Who are the winners going to be in the streaming wars? There are many players out there today that will not be players out there in the future. I’m confident that Disney-Plus and Netflix are going to be winners. But I don’t know who else will be in that business.

It’s our job to try to understand who’s likely to be the winner, and make a bet on those winners, if it’s at a point in time when prices are trading at reasonable levels. We’ll own more of those businesses.

We own Google today. We own Facebook. We bought Google in 2011 and Facebook a few years back, during the Cambridge Analytical scandal. Those are and have been incredible stocks. They’re incredible businesses.

Twenty years ago, we were less willing to buy something that was going to come. That kept us from owning a company like Amazon. Shame on us! We did the work to understand the business just well enough to understand that, “Well, this is a lot of danger to our retail investments. Let’s go sell our retail!” We sold all of our retail and we did a very good job by avoiding the downside that’s affected so many retail bricks-and-mortar businesses today — as well as [Hall]’s — which was at a point in time — small REITs, in the past.

We did a very good job of avoiding those mistakes, but shame on us for not owning Amazon!

When you spend a little bit of time and study your mistakes, you realize — especially after reading, “The Everything Store,” a number of years ago —

You realize that we truncated our work. We just didn’t go all the way where we needed to go.

We’ve done that work since then, and we deliberate carefully on owning these different businesses. We’re very careful about trying to own these businesses that are growing. I don’t think you can point to a company in our portfolio that is not likely to grow. We can argue about the level of growth, but they shouldn’t be shrinking. If they’re shrinking, then we look to get out.

Those businesses we would have owned in the past that are more problematic businesses — that just were cheap on a book-value basis, but were never intentionally businesses that weren’t growing, by and large.

There’s one company I can think of off the top of my head, that we owned many years ago, that was a net-present-value calculation. It was a business that was in liquidation. But other than that, we own businesses that are growing.

I think there are more companies being disrupted today than at any other point in time in history. We do want to be careful about [necessarily] what the future might bring.

When we looked last year at the cruise industry and when we looked at it the year before that — pre-Covid — we don’t love the cruise industry. We don’t think it offers the growth that we like. We don’t think it’s very capital-intensive. Obviously, it’s economically-sensitive.

We weren’t willing to get engaged with the equities. If the world goes to hell in a handbasket because of the pandemic —

We ended up buying Carnival Cruises and Royal Caribbean Cruises. We bought the debt of both of those companies. We bought the senior-secured loans. They were offering low-teens’ rates of return.

The only decision we had to make in making those senior-secured loans for those two companies that had not in their past ever had to offer senior-secured loans — there was always unsecured and subordinated debt they were offering —

But the only conclusion we had to come to was that the cruise industry would be in business. Not that Carnival wouldn’t be restructured or Royal Caribbean wouldn’t be restructured. But that the industry would still exist for these two companies — whether or not they restructured. The boats they were using — we had the first liens on them. They were going to be in operation.

They were relatively young boats and we had such large discounts to their depreciated values. Even if half the fleet went away, we still would have had our assets covered.

Those are the kinds of things we love. We can get teens’ rates of return where it’s very, very hard to lose money. Not the highest-quality businesses of the world; not terrible businesses. Not as good as we’d like to own equities of.

Other companies that are in the portfolio are more traditional value investments. We have a company called First Energy in the portfolio. It’s an Ohio-based utility that ran afoul of the law. It broke the law in terms of getting involved in some [graft] in trying to — with the desire that — certain bills would get passed in the Ohio Assembly.

That’s a business we bought as a utility. The stock was down by 40%, and we had a pretty clear understanding as to what we felt the downside was. It’s fairly cookbook, as you look at the fines that get paid for these kinds of crimes. That’s not to say the company couldn’t change in the future. But precedent suggested that it was a very attractive risk-reward.

We bought that company and it was very good. It’s a business in a state that is still regulatory-friendly to utilities. It’s a business that’s going to have an increasingly renewable component within it. With all utilities.

We like utilities in general, but it’s allowed us to buy a utility. We own two utilities in the portfolio. First Energy and PCG — in a less-regulatory-friendly state. But it’s better than it was given some recent changes in the regulatory environment here in California.

Able to buy these and own these two companies at deep discounts to the utility index. It’s still growing, nonetheless.

Let’s move onto another topic. Next slide, please. I’ll just preface by saying you sent over a few slides. I saw this slide and I was like, “Okay. This will be used as an example of the irrational exuberance — greed — euphoria — that’s taken over the markets.” Look at SPACs as the poser-child of the money-grab. The ducks are quacking, and Wall Street’s going to feed the ducks, and there’s a lot of crap there.

I’ll just leave it there and let you share what you’d like to share on SPACs.

SR: Yes. The prior slide showed the massive amount of dollars that were raised for blank-check companies. Thank you.

You had in the last 15 or 16 months, almost $200 billion raised by companies that were going to then go buy other companies and put leverage on them. We were talking about leveraging and raising more equity capital for bets. That $200 billion would hope to mean something on the order of $700 million to [70 billion] to a Billion dollars of purchases of businesses — both public and private.

That’s like fake-based investing that these sponsors are going to go in and find something for you to do. They were bidding them up at a point in time back in February — and you mentioned one of your other managers that owned these — they were very nimble and selling at a very good point in time. They were selling in February when the average premium was north of 20%. Maybe 25%. For the trust-value. The net-asset-value.

The unique thing about these Special Purpose Acquisition vehicles is that you raise the money and you don’t have to actually buy the company that they put in front of you. You can go and ask for your money back. To say, “Look. I don’t like this deal. Give me my $10.”

Then you go to the next page. Next slide. You can see the discount, where it gapped open at 25% in the first part of the year. It’s now hardly at a premium at all. It’s just a couple percent.

We had been buying a basket of SPACs and buying them all at-or-below their trust value. If our cash is earning us nothing, giving us zero, more or less, as a rate of return today — if we can go get even a 1% rate of return across this over the next year or so while these finite-like SPACs were around two years from original issue, on average —

If we can go and buy these SPACs at a discount and get the free options; that the sponsors are good — and they actually buy something that’s attractive — and they buy something that’s really good, one can see these SPACs trade up dramatically.

We have a basket of them. It’s still not a full position — and we continue to buy [the rest of these today] — but if you end up with half, to keep the math simple, of your portfolio trading up to a 10% premium — then we’re going to get a 5% return on this.

On the other hand, we may not get that bump at all. Maybe it’s at zero percent. We’re just not going to lose money.

If you can set something up where it’s hard to lose, and you have a chance of making something, then you may as well do it. That’s what we’re doing across that portfolio.

Given how many we own, it’s not going to be a huge rate of return. But I look at it with the upside optionality, and it’s something that’s better than a sharp poke. It’s better than cash. And I would argue it’s better than the high-yield market today.

Next slide segues into other areas of investment opportunity. This is certainly a more meaningful one than the SPAC position might be.

This is getting into your exposure and the evolution over time into a more global opportunity set. Investment opportunities that you’ve taken advantage of and that the team has. The numbers on this chart currently in our sleeve of the Alternative Strategies Fund — 3% in companies domiciled outside the US. Most of them are global. But that’s up from about 20% years ago.

Just briefly, what’s driven the geographical shift? Then maybe we can hit one or two interesting names. Or maybe just one, in the interest of time.

SR: I think the geographic shift has been driven by lower valuations outside the United States. Again, going back to the earlier statement of mine — own a better-quality business at a better price. There are more of those showing up outside of the US.

You made the point that they might be domiciled outside the US, but they’re global businesses. We touched on one — this is a company that we talked about yesterday. It’s one you might want to touch on during the call. It’s a larger position in the fund. Lafarge Holcim.

Lafarge is a cement company. It’s not that go-go-growth company. It’s a GDP-plus kind of grower that exists around the world. Although it’s based in Europe, they only have 30% or so of their sales coming from Europe. 25% of their sales come from North America. 20% or so comes from LatAm.

Then you’ve got emerging markets and Middle East and Africa providing the balance.

Here you have this global business that’s got a good management team. Better management team that has had a surge. It generates a tremendous amount of free cashflow that’s being reinvested wisely, we believe.

We think there are more opportunities in the future in front of this company. We’re still at a place where construction has slowed down around the globe. They’ve got some parts of the world that have been worse — like the Middle East and North Africa.

We think this company’s going to be a beneficiary of the improving economy. It’s not demandingly priced. It gives you a 3% dividend yield. Even though our stock is up 40-ish percent from purchase and maybe a little bit more, it’s something we still find relatively attractive.

It’s something that doesn’t have the sex-appeal that an internet stock has. We’re okay with that.

Jeremy: In the valuation, do you apply to a company like that, a material [GDP]-plus-grower —

I guess I’m getting at the discount rate. The cost-of-capital. How you clearly value that differently than you would a Google, with a higher growth rate.

SR: To keep it simplistic and just look at P/E — the P/E produced like this should be lower than a Google. The company will not grow at the same rate as Google for the next 10 years.

SR: If I had to pick one company that I’d own over the other and just have to go to sleep for 10 years, it would be Google over Lafarge. But that doesn’t mean that for the thoughtful investor, owning a business like this —

It’s undemandingly priced with that 10% free cashflow. With upside opportunity. I mean we should be buying businesses like that.

We don’t know as we look across our portfolio which one company is going to be the best performer. Nor do we know which is going to be the worst performer, for that matter.

But we try to be thoughtful as we look across the portfolio. We own a basket of different businesses in different industries in different regions, as well as owning certain different other asset classes, to try to create a portfolio that is robust in multiple outcomes.

Before we move on, related to this topic, but a question came in since we mentioned Google — getting back to disruptive businesses — FAANGs. Their dominance within the S&P 500. The concentration of the top-5 or top-10 for more than a quarter of the index. How they’ve driven the total-return for the market.

The question is, have you war-gamed scenarios where the FAANGs get disrupted? Where the concentration of the top 5 or 10 goes down in the future?

If you look at history, just as a follow-up, you have said we didn’t have companies like Amazon and Google and Facebook, 20 years ago. But Exxon — ATT — Intel — Microsoft. Every 10 years, there’s the top-10. Buffett showed this in his annual report.

The top-10 have changed every decade, except for Microsoft, for the past couple. How do you think about the potential for these amazing businesses to be competed away by the ingenuity of entrepreneurship and innovation? And regulations and anti-trust laws?

When there’s a disruption, I don’t know the question or who’s asking the question, but I’m presuming he means through other corporates.

It can come from government — right — that disruption. We’re very mindful that the world can change. It’s our job to constantly underwrite and re-underwrite and then re-underwrite again and always have in mind the key performance indicators as to what are the drivers of these businesses.

We look at these companies, and they’re disrupting each other. At first we had Google collecting the ad money. Then Facebook entered and started collecting the digital ad money. Now Amazon’s in there collecting digital ad money.

SR: I think it’s a fair question. It’s one that we have to constantly monitor. These businesses — no business is forever, as the questioner I’m sure realizes, and as you realize, as well — and made the point.

Yes, the question also is, “How might that happen?” Regulatorily is one. These are advertising companies. Trying to figure out who has the better mousetrap to get built. Then advertisers are going to go and find it.

It’s just not happening anytime soon. One of the things that’s happened with Covid is that your traditional advertising is —

Covid’s created a lot of changes. It’s pulled them forward in the form of advertising where people are in their cars less. The billboards aren’t as important. People aren’t listening to radio, as much. The streaming has been pushed forward. Streaming is mostly ad-free, if you’re paying a monthly subscription.

That advertiser’s got to find a way to get to the customers. This has really pulled advertising into the digital realm, and it was already going there. It just accelerated.

Google and Facebook — first-quarter numbers — blew everybody away. They were far better than the consensus. The consensus was much better than last year.

Right now, the trend is their friend, and that will continue to be the case until it’s not. We don’t want to put our heads in the sand and say, “It’s this way forever.”

I’m looking at the questions and somebody’s asking me to show my socks? I didn’t know you could see them!

Jeremy: I didn’t know you could see it. It’s probably someone who attended one of our face-to-face conferences when we’d sit up on the stage with our legs crossed. You had some striped socks one time. There you go! He’s going to do it! All right! I was going to save that for the end. I like the shoes, too!

Just for the record, the dare was for me to ask that, and I was ready to take it on. You know me. I’m not going to back away from that. Thank you, Steve.

Well, I was going to say that wraps it up, but no — we’ve got a few more minutes.

Let’s move on to fixed-income. From socks to fixed-income. Speaking of socks, that’s another Warren Buffett quote. Right? People like buying their socks on sale. But they don’t want to buy their stocks on sale. You can sound profound to your friends by saying that.

People hate when prices go down in the stock market. They’re not contrarian-value investors, of course.

Let’s talk about fixed-income. “Slim pickings,” comes to mind. That was a phrase from your old colleague. Not to call him “old,” but —

Jeremy: Yes. He’s still out there pounding the walls for someone to listen to him. Someday the world will come around, I suppose.

Putting that aside, what’s the fixed-income opportunity set? How bad is it right now?

SR: I think that it’s terrific if you have the opportunity set and like low yields with highly-leveraged companies with some of the weakest covenants you’ve ever seen.

SR: In all seriousness, you’ve got the high-yield market that trades at give or take — I don’t know the exact number — but around a 4% yield. That’s a gross yield. That doesn’t take into account some level of default.

When you kind of work through some level of default, some of these are in the low single-digits. That’s horribly uninteresting. That explains why our high-yield book is as small as it is.

We started boning up and really trying to put capital to work a year ago. Where the opportunity set really existed for maybe 7 trading days or less.

When you re-underwrite or underwrite all these companies — you have to be very sensitive to covenants. There’s a lot of “lender-on-lender violence.” People in different parts of the capital structure are trying to fight each other. Then you’ve got these poor covenants that give the borrower more rights than they’ve ever had in the past.

You end up with different assets being taken from you. Because they can. It can be the internet operation for a moribund retailer. It can be the online gaming operation for a casino company.

There’s a lot of this that happens. When you buy these assets, it’s hard to know what you’re getting or what you would get, ultimately, rather, in a restructuring.

One of the things that I think is particularly interesting today is something we can do some of and we’ve done some of is private credit.

I think private credit gives you a path to solving for to the issue. 1 — better covenants. Two — higher yields.

If you can get a higher yield in the low-teens, and you can do it with better covenants and you’ve got really good asset coverage that’s there, then you should do that. We’ve been doing a little bit of that in the portfolio. There have been some names that have flowed through there.

We’re kind of in this in-between place of trying to. We’ve turned down a lot more recently. But it’s been going down. It’s not a big part of the portfolio, anymore.

We have a loan to a company called BJ Services. BJ is the oil-service company that was an LBO. This business has not been —

It’s been impacted by Covid. Oil prices dropped to the floor. People stopped drilling for shale. Their business went. They didn’t make their numbers, to say the least.

When you own an asset — when you make a loan and you collateralize by hard assets — this is an asset-based loan — then we’re in the process of liquidating these assets — we’re going to come out whole in this. We’re going to have a return in a bankrupt company that’s going to generate someplace in the low teens.

We’ve been doing this for the last 10 years. We put across the portfolios that our team manages over $800 million to work in private credit. We’ve generated a yield of over 14%.

We’ve only had one loss along the way. That was one of our smallest loans that was[n’t] on the books, and I think we only lost 8%.

Let’s be clear. We’re not private-credit managers. It’s just an asset class that we have exposure to. We’re looking for places where we can participate.

I guess just to piggyback quickly on that, to highlight one of the advantages we believe our fund and the strategy you run for our fund offers. Providing that additional flexibility on wider bands. Unconstrained to an extent, in private-credit and private-investment opportunities. Again, it will never be a huge chunk. But just to let listeners know.

We talked about the 10% to 15% kind of maximum range for your sleeve, we’re very comfortable with that. You as one of five subadvisors — you’re pretty far from that, here. But there’s room if the opportunities are there, to really meaningfully —

It’s been a crazy year. I hope everyone on the call is personal-health-wise with family and friends — that goes without saying.

Let’s just focus on the investment markets. That realm here where we have the expertise.

Just curious of any particular surprises over the past year. And/or any lessons. Permanent lessons-learned that you’re implementing in your investment approach based on what you’ve learned and seen in this past 12 or 13 months.

The lessons learned were more affirmations of lessons we’ve studied and proved to be true. That just gave us more conviction in what we already believed.

Patience as an investor is incredibly important. Waiting for the right opportunity. Then if we own a good asset, the value of that asset appreciates over time. Just because it’s marked to market stupidly for a short period of time doesn’t mean it remains there.

I don’t want to call it a “great,” asset, but it’s a good asset. It had a book value at the beginning of 2020 in the mid-50s. The stock ended up trading down to intra-day under $17 a share. It didn’t make any sense at all to us.

It’s something that we ended up — we had a good-sized position in it. We let it increase in the portfolio. Now the stock’s back up to almost 49. That’s a pretty good proxy for being patient.

Patience has always been something we’ve stood by. It’s something we’ve talked about over the years. But it’s nice to be able to see that put into practice.

The world — I mean — this pandemic’s been horrible. It’s been challenging to all of us in many different ways. Potentially our businesses. Potentially our family and friends, et cetera. It’s hit us professionally and personally.

Then it kind of forces you to face your mortality. That can wreak havoc with your thinking. If you just look back to ’18, ’19 and ’20 and look at the Spanish flu, that influenza epidemic you had at the time, where 100 million people died globally — and you had less technology and science at your beck and call to get under control. We survived that and moved onto the roaring ’20s.

I think that the more the world changes, the more it stays the same. You have to always anchor yourself to find that place to say, “This is not so different.” I remember talking to Litman Gregory back in 2001 — about the Twin Towers and all this happening. What would happen to the economy, as a result.

I remember making the point then, “Look at Israel! Enemies at most of its borders. Its economy continues to grow faster than the US throughout the 1990s.” People will adapt.

Now your portfolio may have a marked to market, but as long as you have the stability and you’re not always trying to buy something or try to make money in the next year or two, you should be fine. If you have that longer-term timeframe.

Go back and look at the 1930s. Go through the depression. You lost money in stocks, on a nominal basis. But on a real basis, because of deflation that existed in the period, the world deflated at a rate faster than stocks went down over the 10 years. You actually made real dollars.

You increased your purchasing-power in your portfolio in the 1930s, buying stocks all the way through.

We’re always looking for those analogies. There’re not any great new lessons learned, but there were wonderful affirmations.

When you talk about lessons learned, it’s all evolutionary. The businesses that were great yesterday won’t be great necessarily tomorrow. That speaks back to that question of FAANGs getting disrupted.

I’m sitting here in my office building. Not a lot of people are here. We’re still only allowed in LA County 25% of capacity. We’re not even close to that in our offices.

We have people at our firm — we’ve learned to operate very well remotely — thankfully we have a wonderful IT department. We have two analysts moving to Texas. We’ve got one person that went to client services. We have three people in that department that have moved to Boulder, Colorado, Las Vegas, Nevada — one’s moving to Santa Barbara. Another is moving or already moved to Chicago.

We’d hired somebody along the way to help us from Kansas City. We have a new compliance person from New York. I don’t need this space.

What does that mean to the landlord? Will there be somebody else to come in and take our space when our lease is up? Who’s going to absorb this space, as people are more comfortable with the work-from-home scenario? What does that mean?

These are the questions we’re always grappling with — to understand how the world continues to evolve.

We’re a little past the hour. I think this was a great conversation. I benefited from it. I hope our listeners enjoyed it. If nothing else, I hope someone captured that screenshot of when you were lifting your foot up with the red and white socks.

SR: They’re pink! My daughter gave them to me. My daughter bought them for me for Father’s Day last year.

Once again, Steven Romick, thank you for playing. We appreciate your time. We’re as always keeping our eyes on you. Just as you have to keep evaluating the companies you own. I don’t want to express undying gratitude. But I was going to say we appreciate the partnership. We’ve benefited from long-term investment with you and your team. We try to keep you honest in our questions and due-diligence.

We appreciate the work that you do, ultimately, for our clients and shareholders in common.

Mike: Yes. Ditto. Thanks, guys. Appreciate the conversation and presentation. All of it. Everyone who joined us today — thanks a lot for spending the time. We really appreciate it. If you have any questions about the fund or any interest, by all means, please reach out to us.

Otherwise, thanks and until next time — we hope you can join us for the next webinar. Take care.

Commentary

Alternative Strategies Fund First Quarter 2021 Commentary

The fund continued to generate solid returns during the quarter, and since the market carnage of Q1 2020, the fund is up 20.14%. MORE

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Alternative Strategies Fund First Quarter 2021 Commentary

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