Sitting Pretty in Cash City

The Dow Jones industrials are on their way to a 200-point decline. But in his office near Beverly Hills, Bob Rodriguez is as cool and relaxed as his clothes -- a plaid shirt and khakis -- suggest. For the manager of FPA Capital fund, a collapsing stock market means opportunity, not angst. What else would you expect from an investor who has nearly half of his stock fund's assets off the table?

Rodriguez's approach to money management is quaint -- some might say archaic. Nowadays, most managers run their funds fully (or close to fully) invested. Not Rodriguez. If he can't find stocks meeting his rigorous price criteria, he goes on a buyer's strike. Rodriguez also runs a bond fund and takes the same approach to fixed-income investing. If bond yields aren't attractive, he converts FPA New Income into a quasi-money-market fund. And if investors don't like his style, Rodriguez says, they don't need to hang around.

Truth be told, Rodriguez, 57, doesn't seem to want new money. The $2.3-billion Capital fund (symbol FPPTX) has been shut to new customers since July 2004. First Pacific Advisors, which Rodriguez heads, charges front-end commissions on four of its five funds. But it doesn't levy those annoying 12b-1 market fees or, consequently, sell alternative share classes, which are usually designed to pay advisers to deliver their customers' assets and which often confuse investors. FPA doesn't employ a marketing director. It doesn't even have a receptionist.

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For marketing, Rodriguez need only let the funds' results do the talking. Capital's annualized return of 16.4% over the past 20 years to June 19 is surpassed only by that of a sector fund, Vanguard Health Care. Over the past five years, Capital returned 15% annualized, three percentage points per year ahead of the average small-company value fund. New Income (FPNIX) returned an annualized 5% over the past five years and 8% over the past 20. It has never had a down year since Rodriguez began running it (and Capital) in 1984.

KIPLINGER'S: You seem to enjoy it when the stock market sinks, don't you?

RODRIGUEZ: Yes. We are pretty well structured here.

What's it like to come in on a Monday morning and realize that nearly half your shareholders' money isn't on the table? It doesn't bother me. Nowadays, there's a sense that you're not really working, you're not really earning your fees if you don't invest all the money you control. But that's not how I view my job. If you're in an environment with a high level of substandard investment opportunities, are you really doing your shareholders a favor by deploying capital into marginal investments? I would argue that you're not.

But if you're wrong, you can quickly lose a lot of business. That's right. I had that very discussion with a friend of mine -- someone with a major growth-fund organization -- in January 2000. For the better part of a year, I had been talking about the rank speculation in the market. I was saying that any manager who invested in a dot-com should be fired. My friend said, "We've got to buy these things because if we don't and these stocks continue to rise, we will underperform and we will be fired." I responded, "If you buy those stocks and they and the market collapse, you will be fired as well." So door number one, you get fired; door number two, you get fired. What is the difference between the two doors? With door number one, you play the speculative game and you're fired because you destroyed capital and you also destroyed your investment integrity. With door number two, you get fired, but you retain your investment integrity.

Are things as loony today as they were in 2000? No. But when I screen stocks by my criteria, the number of qualifying companies with market capitalizations between $150 million and $3 billion -- the area of the market I focus on -- climbed during the selloff from 72 to 85 out of 9,440 companies. The lowest number I've ever gotten was 47 -- in March 1998 and January 2004. Well to me, 72 or 85 versus 47 is not a lot of difference. Normally, 250 to 300 companies show up.

So your big cash position is not a call on the stock market? No, it's for lack of investment opportunities.What are your criteria? I am not going to tell you exactly what's in the screen. My criteria take into account traditional measures of value, such as price-earnings ratios, market capitalization to revenues, price to book value, a leverage factor -- total debt to total capital. I'm looking for P/Es less than 15 and price-to-book-value ratios less than 2.

Do you base P/Es on past or estimated earnings? Trailing earnings. When you look at forward numbers, you're subject to bias and errors.

You make no allowances for the level of interest rates? Some people say that if interest rates are down, you should raise your P/E cutoff, and when rates are higher, you should lower it. The problem is, if you're constantly changing your parameters, you have no base case. Over the past 75 or 100 years, the average P/E for the stock market is about 15 to 16. That is my base case.

You have a significant chunk of your assets -- 18% -- in energy stocks. Why so much? I'm still very positive on energy long term.

So you think oil prices will stay high long term? Most of what we're involved with relates to natural gas.

But there seems to be a glut of gas. Isn't that why gas prices are 55% below their peak? That's because we had a very warm winter. If we have a very warm summer, that glut will get taken care of quickly. For about 12 years, from 1986 to 1998, we had an excess of natural gas, a bubble. After so many years of excess, combined with the rapid decline of our gas fields, I thought we might be approaching an inflection point. And then something happened. We went through a winter, we went through a summer, and the price of gas bottomed at a higher low than it had before.

You're a technical analyst at heart. Then in 2000 we had that period of higher prices because of shortages related to Enron and a few other companies. In 2001, when we got to the low-usage seasons, gas prices again bottomed at a higher level. That's really sending you a message. There is something changing here in the demand-supply dynamics. We get into July and August 2002, and what's happening? We're in a recession, industrial production is down, demand is down, and what does gas do? It bottoms at still another higher low even in the midst of a recession. We became convinced that demand had caught up with supply and that a demand-supply imbalance was in existence. We believed it would not be a short-run situation.

What about oil prices? Earlier this year, the consensus was that oil prices would be down, and the debate was whether oil would fall to the mid $50s per barrel or possibly into the $40s. Meantime, oil has been in the high $60s and low $70s for most of this year. We really won't be sure about oil prices until we get hit with an economic slowdown, and I'm looking for a good-size slowdown in the next 12 to 18 months. But at this firm, we believe that oil prices will continue to climb for a longer period than people expect.

Did all the energy stocks you invested in meet the qualifications of your screen? They passed the screen on the basis of price to book value but not on P/E because their earnings were down. At the time of purchase, we were buying them at below the companies' liquidation values.

With energy stocks having performed so well in recent years, shouldn't you be selling now? I've reduced some of our positions. For example, one large holding had been National Oilwell Varco, which makes equipment used for oil-and-gas exploration. I sold about 70% of our shares because the stock had just run so far. But the one stock we've bought aggressively in the past two years is also an energy company, Rosetta Resources. Our firm now controls 17.5% of the company.

What does Rosetta do? It's an exploration-and-production company with about half of its assets in California; it bought all of the energy assets from Calpine. We visited the fields in California and confirmed that there was drilling activity and production there. Rosetta also has some fields in Texas and Colorado, where the company is trying to expand production. I believe that the share price may not reflect all of the gas that the company owns.

What's the last new stock you bought? We just started buying one a few weeks ago, so I can't give you the name yet. All I'll say is that it's in the consumer area -- a type of retailer -- and the stock has been setting new 52-week lows. This is a turnaround situation and that entails extra risk. We monitored the company for approximately four years. It would not surprise me if the stock went down another 25%.

And before that, was your newest addition Mercury General? Yes. I call it a base-hit stock.

Not a home-run stock? No, not a home-run stock. Mercury General sells auto insurance, mainly in California. There were some question marks about the company -- about earnings, about its plans for multi-state expansion and about its new information systems. And it also had some issues dealing with the California state insurance commissioner. So all these things came together and the stock got down to the $52-to-$54 range, where it was yielding 3.5% and selling at about 11 times earnings. Plus, the company has a pristine balance sheet. So we started accumulating it with the idea that it wouldn't surprise us if it went down to the mid $40s, which would leave us as happy as a clam. But then rumors started flying that Warren Buffett was looking to make an acquisition. So the stock pops $4 or $5 in one day. If I were a trader, maybe I would have sold and then tried to buy it back at $53 or $54. But I'm not that smart. So I'll just sit tight and if it doesn't come down, I at least have a partial position.

You hold a stock for five or six years. That's a long time. What causes you to sell? I sell when I think I have a better alternative investment. Or if I've made a mistake. Or if I think the stock has gotten to an elevated level. Plus, I have 4.5% of our assets invested in a company that may be acquired. That would be another reason for selling.

You're talking about Michaels Stores. Yes.

When we interviewed you here nine years ago, you were just starting to investigate Michaels. Michaels Stores is an example of the kind of company I love to go after. No matter how badly they mismanaged the business -- arts-and-crafts supplies -- it had a wonderful franchise. How do I know it had a wonderful franchise? My colleagues and I all went out to different stores and did a simple survey of shoppers. We'd ask, "Do you like shopping at Michaels?" "No." "Okay, why don't you like shopping at Michaels?" "It's a mess, they are out of stock of everything and the service is nonexistent." These are strong opinions. "Why do you come here?" "Well, where else are we going to go?" That is a franchise.

Sounds perfect. Not quite. The company didn't have proper inventory controls -- in our staff meetings, I said Michaels never met an SKU [stock keeping unit] that it didn't like. Sure enough, the year before we got into the stock, the company finally took a sizable inventory write-down. Then it brought in a new CEO, Michael Rouleau, who had been at Lowe's. A few months after he came in, the company took another inventory write-down. And I said, they are finally getting rid of their old FISH inventory -- first in, still here. We visited headquarters to meet Rouleau, then went to Michaels' warehouses to gain a better understanding of its management-information systems. We concluded that it had a clean balance sheet, a great franchise and that Rouleau had a good idea of what needed to be done. So FPA Capital, another fund and our private accounts acquired north of a 10% position in the company. Since our initial purchase, the stock is up 16-fold. We recently trimmed our holdings in the high $30s because the stock rose in response to the company placing itself up for sale. We think an acquisition, if it occurs, will likely be for north of $40. [Editor's note: Michaels subsequently agreed to be bought out for $44 a share, or more than $6 billion.]

Turning to bonds, do you run New Income by making big-picture judgments? It has to be run that way. But it depends on what part of the bond market you're talking about. If you're talking about high-yield bonds, then you pick them more like stocks. But when you move over to the high-quality area, those bonds -- especially government and government-agency bonds -- are really commodities. And you have to ask, "What's that commodity going to do?" I have a simple calculation for helping make that judgment. When Treasury-bond yields fell about 3% in 2003, that was the equivalent of paying 33 times earnings for a stock. So my thinking was, if you're paying that much for bonds, you'd better be right about interest rates because you are getting a low return and extremely high volatility. That is not a good combination. I essentially went on a "buyer's strike" and cut the maturities of New Income dramatically.

But now you seem to be getting more optimistic and extending maturities. We're mostly in the two-year and three-year maturity area. We have toyed with investing in five- and ten-year maturities, but we're not there yet.

How high would yields on, say, ten-year Treasuries have to go for you to get interested? Assuming that inflation is somewhere between 2.5% and 3.5%, I would say a minimum of 5.5%, but probably closer to 6%. But I still have serious concerns longer term.

And those concerns are? Entitlements, for one. When Congress passed the drug-entitlement program, it created a present-value liability of $8.6 trillion, or more than four times the estimated Social Security savings that Congress debated last year. Putting this into perspective, this one program, on a present-value basis, has created a liability larger than the entire U.S. debt. Then there are energy prices, which I think will be at high levels for an extended period of time. Nearly half of our debt is held overseas. Putting these things together, it's not exactly positive. So on the fixed-income side, in particular, I spend a lot of time thinking about ROC squared -- that is, return on capital and return of capital. In this business, most everyone focuses on the first. For nearly four years, my main focus has been on how to preserve capital, because I believed there was virtually no value in high-quality, long-term bonds.