Continuation of content extracted from an interview with Steve Romick of First Pacific Advisors (Newsletter Fall 2010) published by Columbia Business School. Please see Part 1 for more details on this series.
Capital Preservation, Conservatism
“Most of our financial exposure is on the debt side. We were able to buy loans with very strong collateral, which we thought we understood reasonably well, and we stress tested the portfolios to determine what our asset coverage would be in a worst case scenario. We ended up buying things like Ford Credit of Europe, CIT, American General Finance, and International Lease Finance. We discounted the underlying assets tremendously, and in every case we didn‘t think we could lose money so we just kept buying.”
“The biggest lesson I ever learned from Bob is to prepare for the worst and hope for the best.”
Underwriting to an extremely conservative, worst case scenario helps minimize loss while increasingly likelihood of upside. This is similar to advice given by Seth Klarman in a previous interview with Jason Zweig.
Exposure, Intrinsic Value
“A lot of that has been culled back. The yield on our debt book was 23% last year and now it‘s less than 8%.”
The relationship between exposure and intrinsic value has been something we’ve previous discussed, nevertheless it remains an intriguingly difficult topic. Even Buffett ruminated over this in 1958 without providing a clear answer to what he would do.
Day 1 Asset 1 purchase for $100 Asset 1 is sized at 10% of total portfolio NAV Expected Upside is $200 (+100% from Day 1 price) Expected Downside is $80 (-20% from Day 1 price) Everything else in the portfolio is held as Cash which returns 0%
Day 2 Asset 1’s price increases to $175 Asset 1 is now worth 16.2% of total portfolio NAV (remember, everything else is held as Cash) Expected Upside is now +14.2% ($175 vs. $200) Expected Downside is now -54.2% ($175 vs. $80)
What would you do?
Not only has the risk/reward on Asset 1 changed (+14.2% to -54.2% on Day 2 vs. +100% to -20% on Day 1), it is now also worth a larger percentage of portfolio NAV (16.2% on Day 2 vs. 10.0% on Day 1)
Do you trim the exposure despite the price of Asset 1 not having reached its full expected intrinsic value of $200?
Steve Romick’s words seem to imply that he trimmed his exposure as the positions increased in value.
“You can protect against certain types of risk, not just by hedging your portfolio, but by choosing to buy certain types of companies versus others.”
Practice risk “prevention” by choosing not to buy certain exposures, versus neutralizing risks that have already leaked into the portfolio via hedges (which require additional attention, not to mention option premium).