Robert L. Rodriguez was the former portfolio manager of the small/mid-cap absolute-value strategy (including FPA Capital Fund, Inc.) and the absolute-fixed-income strategy (including FPA New Income, Inc.) and a former managing partner at FPA, a Los Angeles-based asset manager. He retired at the end of 2016, following more than 33 years of service.
He won many awards during his tenure. He was the only fund manager in the United States to win the Morningstar Manager of the Year award for both an equity and a fixed income fund and is tied with one other portfolio manager as having won the most awards. In 1994 Bob won for both FPA Capital and FPA New Income, and in 2001 and 2008 for FPA New Income.
The opinions expressed reflect Mr. Rodriguez’ personal views only and not those of FPA.
I interviewed Bob last week.
In our previous interview, two years ago, you stated that monetary policy has distorted the capital markets and created a difficult time for value managers. Has anything changed since then? Can or should value managers adapt to an era of permanently distorted markets?
Monetary policy has gone from the ridiculous to the absurd. The Fed, in my opinion, is clueless and is driven by theories with little basis in reality. Why are they so tethered to a 2% inflation rate that will reduce purchasing power by 50% over 36 years? What is the magic of this number? If you may recall, former Chairman Ben Bernanke wrote a November 2010 op-ed for the Washington Post where he argued that Fed’s increased asset purchases would drive equity prices higher, creating a wealth effect and, thus, the virtuous economic cycle would take hold. At the time, I considered this a terribly foolish argument since it is not the job of the Fed to manipulate the equity market. It also had little to do with real economic capital formation. He also made another ill-advised comment back in the spring of 2007, when he said that there would be no financial contagion from sub-prime lending.
The Fed has been consistently on the wrong side of economic outcomes prior to the last financial crisis and also in its subsequent actions after it.
In my 2009 Morningstar keynote speech, I argued that the forthcoming economic recovery would be sub-standard. I quantified this assessment in follow-up interviews as 2% real GDP growth for as far as the eye could see. It would also be accompanied by substandard capital spending and productivity growth. In the 10 years yeas since that speech, real GDP has grown at approximately 2% and we’ve had the worst productivity and capital spending cycles since the Depression. The Fed did not see this scenario coming.
After nine years of intrusive, manipulative and insane QE and zero-rate interest-rate monetary policy, real GDP growth has barely responded. For much of this time, interest rates were at a negative real yield. So what is the Fed’s answer to today’s weakening economic data? It is and will be to lower rates again into a negative real yield level and then eventually initiate more QE. These policies did not work the last time, so to expect a different outcome from similar policies this time would appear to be the definition of insanity. These unsound policies have distorted the economic system by allowing zombie companies to survive, with little hope of true positive economic outcomes. Monetary policy has released a pernicious attack on prudence and financial discipline by those who save. The older generation’s income is under attack to foster these bubble-headed policies.
Debt leverage, in all areas, continues to grow and now we are at leverage levels, as a percentage of GDP, that are equal to or greater than where we were prior to the last financial crisis in 2007. We now have over $17 trillion dollars of negative yielding debt. Several countries have had negative yields throughout the last decade, which have done little to stimulate real GDP growth. Could it be that we are reaching debt levels where the marginal utility of it is approaching zero? As 13D Global Strategy & Research wrote in its August 29, 2019, commentary, “During the 1980s, a little over 50 cents of new federal debt was borrowed for each incremental dollar of GDP, but during the decade that ended in 2018, this rose to $1.50. In other words, the 75% decline in nominal borrowing costs since the 1980s may have made it easier to pile on more federal debt, but the increase in nominal GDP associated with each dollar of federal debt was cut by two-thirds.” I think this is the challenge we and other developed countries face going forward.
As for value managers, if one truly has a value discipline, how does a manager invest when the theoretical discount rate to determine long-term value is so totally distorted by central bank monetary policies? The central banks have created a casino-type financial environment that is now among the most egregious in history. Slow growth, accompanied by elevated levels of system-wide leverage creates a toxic atmosphere for long-term capital deployment. This produces an absolutely terrible environment for disciplined capital deployment. In the search for returns, true investment discipline has been lost by most and for those who continue to deploy it they are rewarded by massive client redemptions. Clients learned little from the last crisis since they were effectively bailed out by the Fed for their unwise capital deployment decisions.
Corporate credit quality as measured by the credit rating agencies has been in secular decline. Is it possible that the optimal capital structure has shifted to favor increased leverage?
When one believes the optimal capital structure is for elevated levels of leverage, one can be reasonably assured they are succumbing to the theory that “this time is different.” When this credit cycle ends, it will be among the worst, if not the worst, since the Great Depression. With such a high level of investment-grade corporate bonds hovering above a high-yield credit rating, in the upcoming recession, many fixed income fund investors will be surprised by how their “investment” grade bond funds perform poorly. They should gain a better insight about the credit quality mix of their respective funds NOW!
Larry Summers recently wrote that cutting interest rates will be ineffective or even counterproductive when it comes to stimulating growth. Has the Fed lost its power to reinvigorate the economy?
I believe this will be the case. There are other structural issues at play in the U.S. economy, as well as overseas, where monetary policy is a poor solution. Demographic population growth trends that are low or negative will likely have profound effects that monetary policy is ill-suited to address. Unless we get a major acceleration in productivity growth, which requires an accelerated level of capital investment, the likelihood that there will be a resumption of normalized real GDP growth in the next decade is small. Japan has been on the leading edge of this trend, with Europe now facing a similar situation. Yes, the Fed can lower rates but it will be surprised at how little bang for the buck it gets. As I stated previously, it is insane to believe a different outcome will be achieved this time by enacting similar policies.
But I believe I know what their answer will be: The solution will be one of being even MORE aggressive than the last time. They are absolutely nuts!
Corporate profit margins have historically been mean-reverting. Except for a brief time during the financial crisis they have stayed remarkably high. Is it possible that either the level or cyclicality of profit margins has permanently changed?
It depends upon what profit margins one is using. Yes, S&P profit margins have been high but they are in the process of eroding now. Additionally, they have been influenced by a small group of companies versus the broader composition. For example, a broader measure of profits is the National Income and Profit Accounts (NIPA). This is a measure of profits for both public and private companies. Since Q4 2011, its growth has been nothing to write home about. Its recent revision has profits essentially unchanged to where they were between Q4 2011 and Q1 2012. For 2016, 2017 and 2018, total profits were reduced by $305 billion. Even S&P profits, on a pretax basis, are now coming under duress.
Japanese economic growth and tis stock market peaked 30 years ago. What economic and investing lessons can we learn from their experience?
Japan threw the kitchen sink at its economy via debt leverage to stimulate its growth. What has it achieved? Very little. The one advantage it has is that over 95% of its debt is owned domestically but its sizable growth is becoming a growing burden on a declining population. How will the younger generation respond to it? Will they accept it or will there be a debt repudiation cycle since they were not around nor were they responsible for it when it was created? The younger generation will now have to pay for it via higher taxes. Will they? It truly sets up for a potential intergenerational conflict.
The critical lesson to learn is that you cannot dig your way out of a deepening hole of debt by taking on a growing level of debt. There is no free lunch, but central banks have effectively taught that there can be a free lunch with debt and deficits until the payment comes due. An age-old solution will likely be repudiation via inflation rather than a formal default in several cases.
What if any concerns do you have about Chinese economic growth, its banking system or its exchange rate? How might investors position themselves vis-à-vis these risks?
Obviously, China and its banking system have been growing debt leverage at a non-sustainable level. With GDP growth slowing to its lowest level in two decades, this sets up for a potentially volatile environment. Its system is opaque so it is difficult to truly see what the actual magnitude of excess has been. An obvious solution is to do infrastructure spending. But this has its limits, as Japan discovered.
The exchange rate could pose a challenge to the president’s tariff war. As the yuan depreciates, a partial offset to the tariffs takes place; however, this creates other issues for competing countries. A more aggressive currency devaluation process by China would be likely destabilizing to international economic trade and growth. The same goes for the U.S., should this strategy be deployed. These are potentially disruptive risks for economic growth and the capital markets.
The easiest method to protect against these risks is to maintain an elevated level of liquidity. However, this is not a popular strategy today, which means it is probably the right one to implement.
In the past few months we have read recommendations to own gold from Jeffrey Gundlach, Stanley Druckenmiller, Paul Tudor Jones and Ray Dalio. A few weeks ago, Mark Mobius added himself to the list of investing luminaries recommending gold. Do you have any thoughts on gold or gold mining shares you’d be willing to share?
I’ve been monitoring gold prices for some time. Back in 2013 I initiated a small position since I was completely disgusted with what I saw unfolding in our fiscal and monetary policies. I concluded that fiscal discipline was being thrown overboard and the Fed was clueless. However, upon reconsideration, I thought I was early so I reversed my position. I thought I would revisit the situation over time. In my 2009 Morningstar speech, I warned that, if we did not get our economic house in order by the end of 2017, an equal to or greater economic crisis could ensue.
During the past two years, we have witnessed three unsound fiscal initiatives, including the 2017 Omnibus budget, the 2017 tax cut and the two-year budget agreement of 2019. They have this in common: Debt and deficits will grow unchecked.
In light of this, gold has taken on a stronger bid and has broken out of a six-year trading range. It is still too early to tell whether this is the big move that so many gold bugs have been waiting for. I would like to see how it performs in the early stages of the oncoming recession. Prior to the financial crisis and recession of 2007-2009, gold began a price run from the $730 level to $1,000, before it fell back to this level in 2009. From there it began its big run to $1,900. Thus, I would like to see whether gold falls back into the $1,350-$1,450 range and then holds. If it does and monetary inflation fears become more prevalent, I could see a price run that could take out the prior highs. I hope that I will be wise enough to recognize this opportunity.
I have not considered gold mining companies since virtually all of them have destroyed capital over their entire existence. They tend to retrench when prices are low and expand and acquire when prices are high. They hedge when prices are low and then take their hedges off when prices are high. I would rather own a leveraged ETF than a gold mining stock. Having said this, over the next few years, pre-2025, given the consolidation and reduction in gold mining capacity during the past six years, the supply/demand relationship is probably the most attractive it has been in the past 50 years.
We have all read of increasing amount of debt that offers negative yields. How should value investors think about this trend and what is the investment strategy to deal with it?
Negative yielding debt is a concept that could only be considered rational by an academic. Given 4,000 years of human history, I’ll bet this is as faulty an idea as there ever has been and that it will be proven to be 100% hokum. Negative yields distort the entire capital asset pricing model. They undermine financial company profit models, pension fund liability assumptions, and seriously work to reduce the attractiveness of lending money and financial liquidity by eliminating the ability to do repo finance. But don’t worry, since the central banks will save the day by buying corporate debt. Isn’t that what the Japan’s central bank did, as well as the ECB? And what have these policies achieved in terms of real economic growth? Very little! And now we have members of the Fed actually discussing and agreeing that a negative rate can be effective and appropriate. In other words, penetrating the zero-rate boundary will broaden their policy options. Again, the Fed is clueless and is working with inadequate and ineffectual sets of econometric models.
Negative rate policies distort the economic and financial market systems. The unintended consequences from these policies will be significant and harmful. To deploy capital successfully, the potential list of companies is most likely very limited. At the very minimum, potential target companies should have extremely strong balance sheets to weather the oncoming economic and financial market tsunami. They should also have strong market positions. My guess few companies, with this limited set of criteria, would be attractively priced. Thus, a high level of liquidity is necessary. Finally, escaping to long-term bonds is similar to investing in equites, since their effective durations have volatility characteristics like those of equities.
What do worry about? What gives you cause for optimism? What specifically are you investing in personally to address these issues?
I worry about a lot, but I truly worry that the Fed has trained a new generation of politicians that debt and deficits don’t matter. We even have a new name for this absurdity, “modern monetary theory (MMT).” We can have debt and deficits without tears. And now we have a new cadre of potential political leaders who promise free stuff. Should these policies become more likely to be implemented, watch out, since their implementation will produce far worse economic and social outcomes. It won’t be pretty. But then again, governments have this ability to create messes and this affords them the opportunity to come to the rescue. They are rewarded by gaining even more power, which creates the opportunity for even greater mischief. It is an insidious cycle.
As for optimism, I would have some if I could see the insanity of the present monetary and fiscal policy environments changing for the better. But that seems like a very long, long shot. In the past two years, I’ve grown far more pessimistic, given what I see unfolding.
I have liquidated virtually 100% of my equity holdings and this occurred back in 2016 and 2017. I’ve always been early. I’ve deployed capital into 2-3 year Treasury bonds since I do not want to have any credit risk exposure in this distorted economic environment. As for risk assets, I’ve been acquiring rare, fully paid-for hard assets. I expect the latter to probably get hit in the coming recession but then they may well perform better in the ensuing monetary inflation. At least I don’t have to worry about managements leveraging their respective company balance sheets by buying back stock at elevated prices because the math works with these ultralow interest rates.
What are your reading these days? If you had one book to recommend for investors what would it be?
Given I have referenced the issue of unsound interest rate policy so many times in this interview, my obvious choice would be, A History of Interest Rates by Sidney Homer and Richard Sylla. It is now in its fourth edition.
I have been reading several books but they have nothing to do with the economy or the financial markets. They are historical books revolving about the period in the late 1700s since my colleague Tony Lopez and I have been conducting ground breaking research at the Argonne National Laboratory’s Advance Photon Source (APS) synchrotron. Our research project is the first one ever approved that was proposed by non-scientists to use the APS particle accelerator. It involved the testing of a very rare and expensive US 1792 silver pattern disme (dime). Three physicists conducted X-ray diffraction testing, over four different phases, during the past year. Our goal was to recover potentially important information that was burnished away from the coin’s surface. If successful we would recover a residual image from beneath the surface at approximately a depth of 20-25 microns. Other projects that have used this powerful technology have included the first X-ray diffraction of a mummy from Northwestern University in 2017 and also the scrolls of Herculaneum. Our coin’s investigation is part of a new area of research referred to as “cultural heritage research.” Over the course of the next year, we will write and then publish our findings. We believe we have made one of the major research discoveries in U.S. numismatics that relates to the very emergence of our nation’s first coinage. The X-ray diffraction images of the “lost” information are stunning. Stay tuned for updates.
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Robert L. Rodriguez was the former portfolio manager of the small/mid-cap absolute-value strategy (including FPA Capital Fund, Inc.) and the absolute-fixed-income strategy (including FPA New Income, Inc.) and a former managing partner at FPA, a Los Angeles-based asset manager. He retired at the end of 2016, following more than 33 years of service.