Racing Toward Disaster?
You'd think that a money manager who races Porsches at speeds of up to 160 miles per hour for a hobby would be a daredevil when it comes to investing his clients' cash. But nothing could be further from the truth when the manager-racer in question is Bob Rodriguez, who has run FPA Capital fund for more than a quarter of a century.
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Rather than take big chances, says Rodriguez, he has always tried to handle his clients' money as if it were his own. So if too few companies meet his strict price criteria, he'll hold wads of cash in FPA Capital (symbol FPPTX), a concentrated stock fund. And he marches to his own drummer even if consultants tell him a stock fund should always be fully invested in stocks, and even if his customers don't like his approach and respond by withdrawing money. Rodriguez, 60, has taken a similar in-your-face tack with FPA New Income (FPNIX), a bond fund that, like Capital, he has managed since July 1984.
But as cautious as he is, Rodriguez wasn't able to escape the stock market's carnage in 2008. Despite having as much of 45% of Capital's assets in cash last year, the fund lost 35%, victimized by its heavy concentration in energy stocks and a series of purchases that began in the fall -- a few months too soon, as it turned out. Still, Capital's loss was two percentage points less than the decline of Standard & Poor's 500-stock index.
Capital, which is closed to new investors, has rebounded strongly this year, gaining 33% through September 1. And its long-term record is superb. From the time Rodriguez took over the reins on July 1, 1984, through September 1, the fund returned 14.5% annualized, beating the S&P 500 by an average of more than four percentage points per year. New Income earned 4.3% last year and has gained 2.4% so far in 2009.
After years weathering the vicissitudes of markets and the fickleness of his clients, Rodriguez is cutting back. At the end of 2009, he will begin a one-year sabbatical that will allow him and his wife to admire the winter beauty of Lake Tahoe, near their home in Nevada, then embark on an extended tour of Latin America and perhaps elsewhere. Dennis Bryan and Rikard Ekstrand will become co-managers next January and retain the title when Rodriguez returns in a supporting role in 2011.
Never one to mince words-- he moved to Nevada in 2006 in part to protest California politicians' "total lack of fiscal discipline"-- Rodriguez was his usual outspoken self when we visited him recently in FPA's Los Angeles offices. What follows is an edited version of the interview with Rodriguez and Ekstrand.
KIPLINGER'S: The stock market is up more than 50% from its March low, and many, if not most, economists think the recession has ended. Are we out of the woods?
RODRIGUEZ: No. I like to remind people that in the 20 years from 1989 through the early part of 2009, the Japanese stock market had 11 rallies of 20% or more and three that were 50% or more, yet the Nikkei Index set a new 26-year low this year. Essentially, the Japanese market experienced a lot of false starts. I expect similar false starts in the U.S. stock market.
So the question is, What are the fundamentals in this country that justify this stock-market rally? I don't believe the fundamentals have improved in the consumer area, nor, especially, with regard to the fiscal status of the federal and state governments. The U.S. government is adding to the federal debt at the rate of nearly $5.5 billion per day. The consumer has a large amount of retrenching and rebuilding to do, and that has significant implications for the U.S. economy.
So I think that the expectations for long-term earnings growth are too optimistic. It took us more than three decades to get into this mess. To think that we are going to get out of it in less than a year is both arrogant and foolish. So what's going on now is just an interlude; it's a rally in a bear market. As a result, we are still very much defensive. We haven't bought any stocks since early March.
Where are we in the economic cycle, in your view?
Rodriguez: We see it as a caterpillar economy, one that goes up, then comes down, then goes up, comes down and so on. The end result is that the economy doesn't go forward very fast. We couldn't continue the rate of economic decline that was occurring during the second half of 2008 and the first quarter of 2009, so we were bound to get some recovery or stabilization.
But we believe that consumer spending will be retarded for many, many years to come. This was a devastating downturn to the balance sheet of consumers and, more importantly, of high-end consumers. The middle-income guy got hammered because of declines in the value of his real estate. But this is the first time high-end consumers have been hit with both declining employment and declining asset values, especially in their investment portfolios, which for the wealthy usually represents a much higher percentage of their assets.
So this is a totally different decline than anything we've seen in the post-World War II period. Because of this, I believe we will experience substandard growth in gross domestic product over the next decade, in the neighborhood of 2% a year or less in real terms, unless we expand our exports.
What does that mean for stocks?
Rodriguez: With substandard GDP growth of 5% or less per year-that figure includes inflation -- we will be lucky to get annual returns of 6%, including dividends. It will take about ten years for the S&P 500 to get back to its 2007 peak.
Even the 6% return number I view as being quite optimistic because corporate profit margins were enhanced in this past cycle by excessive leverage and financial manipulation of earnings. Excessive leverage in the U.S. financial system allowed corporations to achieve higher levels of revenues than they otherwise would have. This led to record corporate profit margins, which were unsustainable. An example of this is in the housing arena, when home builders were able to report incredible earnings numbers from 2004 through 2006 before the rug was pulled from beneath them.
You run a bond fund, too. If you're so pessimistic about stocks and if interest rates are so low, where do you go to get good returns?
Rodriguez: I think a well-diversified portfolio will be a loser over the next several years, so you're really going to have to target where you deploy your capital. The destruction of the finances of the federal government is just an abomination. The fiscal mess we're in is accelerating. When you get concerned about the borrower, what do you do? You shorten maturities.
How do you explain Treasury bonds yielding 3.5% to 4%? There seems to be plenty of demand for them.
Rodriguez: [Federal Reserve Chairman Ben] Bernanke and the Fed have taken interest rates down to force people to take on more risk, whether it's buying junk bonds or stocks or long-term Treasuries. To stay at the short end of the curve right now truly hurts. But to protect capital, we will keep maturities short in the New Income fund-its duration [a measure of interest-rate sensitivity] is just over one year. If our investors don't like it, they can leave.
But where do you go to make money?
Rodriguez:I said you have to be targeted.
But what are the targets?
Ekstrand: We had been about 45% in cash in the Capital fund before deploying one-third of it from October 2008 through the first quarter. And two-thirds of that cash went into the energy area, primarily oil-services and exploration-and-production companies. We bought those companies because, first of all, the valuations were extremely depressed. We were able to buy them at about one-third of the replacement cost of their assets. On top of that, we think the fundamentals are very good for energy and much better than the fundamentals in other areas.
The natural decline rate for natural-gas fields in the U.S. past peak production is 30% a year. For oil, the rate is 9%. The recession has probably reduced demand for oil by about 2% to 2.5%. But that's not that large a number, especially when you factor in lower capital expenditures because of lower energy prices. As a result of these decline rates and lower capital spending, we believe we will face very high energy prices again when the world economy recovers.
Rodriguez: We want to be in the land of the tall trees, and only a few industries fit the bill. We also want companies with a large international component, although that, too, has its risks. In my opinion, the U.S. has to take exports from approximately 12.9% of GDP to something on the order of 18% over the next decade. If the U.S. doesn't, we will have another headwind against economic growth because we won't have something to offset the contraction in consumption.
What sectors of the economy are best positioned to lead the export charge?
Ekstrand: The second-largest sector in Capital is technology. We own Arrow Electronics and Avnet, the 800-pound gorillas of electronics distribution, and they derive about 50% of their sales through export. We also own Western Digital, a manufacturer of disk drives, which we added quite a bit of in the fourth and first quarters.
Rodriguez: Let me make it perfectly clear: There is virtually nothing we are buying right now. In fact, we have been selling into this rally.
What is Capital's current cash position?
Rodriguez: It's about 25%, up from 20% a month ago.
Last March, when the market was 55% below its record high, you couldn't find anything else to buy?
Rodriguez: The problem is that after the Fed arranged the rescue of Bear Stearns in March 2008, we crossed the Rubicon; we entered a new economic era with a new regulatory landscape. We do not know what the ground rules are or the shape of the playing field.
So even though 450 to 460 stocks met our criteria for cheapness last fall, we wouldn't buy them because we didn't know what the system was going to be like for financial services, or for the consumer, or for anything else. I wouldn't throw money at them. That's not investing. That's speculating. At least on the energy side, regardless of what happened, we felt there was some predictability.
Ekstrand: To give you a sense of why we focused on energy, take a look at Pride International, one of the stocks we were buying when the price was in the teens. It provides services to oil and gas exploration-and-production companies. We were basically getting the company at about 25% of the replacement cost of its assets, which include 12 semi-submersible rigs and about 25 jack-up rigs, half of them operating internationally under contracts with private or state-owned companies. It also owns two deep-water drill ships and four more that are being built.
The kicker is that when we were investing in this company, it had a contracted backlog of $9.6 billion. In this business, the legal precedents are that if the customers don't want to take the contract, the oil-services companies win in court. So that is a very firm backlog. And what's the value of that? Well, the value of the free cash flow the company will be accumulating from the backlog is right around $15 a share-about what we were paying for the stock.
Where's the stock now?
Ekstrand: It's moved up to $25. But still, when you think about the value of the backlog and a replacement value, net of debt of $60 a share, it is still undervalued.
This is a stock you continue to hold?
Rodriguez: Correct, we have not been selling it.
What is your outlook for inflation?
Rodriguez: Over the near term -- say, one to two years -- very subdued because of weak economies and excess capacity around the world. Inflation can come about because of a decrease in supply and an increase in demand for goods, but it can also result from printing too much money.
It's the latter issue -- the monetization of our debt -- that is my big concern. I don't trust the Fed, the Treasury, nor the executive and legislative branches of government, and I think some of our counterparties are nervous. Thus, there is risk to the dollar, which also has inflationary implications. Over the next five to seven years, the piper will have to be paid for our deficits. Should present trends continue, we see inflation likely rising to about 5%. Should U.S. finances get even more unbalanced, inflation could be even higher.
And yet Treasury-bond yields remain in the gutter.
Rodriguez: There is a bubble in Treasuries. I wouldn't lend money to the U.S. government for ten years at 3.5%.
How does the debate about health-care reform figure into your big-picture analysis?
Rodriguez: It's insanity. Before this country takes on another entitlement, we should deal with Social Security, Medicare, Medicaid and the prescription-drug program. If Congress enacts an expanded health-care program, I fear this would further raise anxiety among our foreign providers of capital, and it would probably encourage me to move a large percentage of my net worth out of the country.
That's strong stuff. Are you making a partisan statement?
Rodriguez: No, it doesn't matter which party is in power. Washington is fundamentally broken. Both the Democrats and the Republicans are fiscally irresponsible. The current administration, though well intentioned, is attempting to make major changes in how this country runs, and if it's wrong, there is little margin for error.
President Obama is trying to emulate the first 100 days of the Roosevelt administration. The difference is that when FDR came in, the ratio of outstanding federal debt to GDP in the U.S. was about 16%. This year it will rise to about 85%, and this does not include the present value of entitlement liabilities--Social Security, Medicare, Medicaid and prescription drugs -- or guarantees, such as those for Fannie Mae and Freddie Mac debt, that total an additional $5 trillion-plus. The words cut and eliminate are foreign to both parties. Our elected officials should be ashamed of themselves for what they are doing to the young and to future generations to come.
Although you've moved to Nevada, your firm is still based in California. Would you invest in California municipal bonds?
Rodriguez: I can look at the numbers and say that California general-obligation bonds are fine. But I also could have looked at Chrysler's numbers and said, "I'm a secured creditor; I'm fine." Yet the rights of secured creditors were thrown overboard in the Chrysler bankruptcy. So when the ground rules change in the middle of the game, you have nothing to hang on to. So, at this point in time, I wouldn't lend a dime to the state.
Corporate junk bonds have had a huge run-up this year. Is it too late to buy?
Rodriguez: High yield is a highly speculative area, and this year those who speculated won. But I go back to what I just said: If I can't determine what the ground rules are, how can I invest? If you can overthrow creditors' rights, as was the case with Chrysler, you add more risk to what is already a risky asset class.
Bob, you've criticized the fund industry over a number of issue, including the idea that funds need to hew to a particular style and be fully invested at all times.
Rodriguez: I have dealt with this issue for over 25 years and have tried to gain as much flexibility as possible. Nowadays, if you stray too far from a particular style box or hold too much cash, the consultants attack you for tracking error. And that makes it more difficult for you to raise money.
I've had investors redeem assets from FPA Capital because I let cash build to 45%. I had redemptions because I had too high a concentration in energy stocks, and the sellers wanted a more diversified fund. If it were up to me, there would be no style boxes, and the client would hire you to use your best judgment. But that is not the case in this industry today, and I do not see it changing anytime soon.