Reflections and OutrageMay 29, 2009Robert L. RodriguezPartner and Chief Executive OfficerGood morning.I want to thank Morningstar for this honor of speaking to you today. We go back along time, beginning in 1986, when Don Phillips became the very first analyst tocover my two funds, FPA Capital and FPA New Income. I am deeply grateful forhaving been selected three times for the Morningstar Manager of the Year award andbeing recognized for my work in both equity and fixed income management.For those of you who do not know, I will be taking a sabbatical beginning nextyear. My trusted partners, Dennis Bryan and Rikard Ekstrand will assume leadershipof FPA Capital Fund while Tom Atteberry will do the same for FPA New Income. Thesethree outstanding managers are here today should any of you wish to meet and speakwith them. Having a high degree of confidence in them as well as FPA, I will beleaving all my personal investments in the various funds and will retain my equityownership in the firm. Many executives say they have confidence in theirassociates but few demonstrate this in such a tangible way. I will return 2011 ina supporting role. My decision to take a sabbatical has nothing to do with thecurrent tumultuous market or my health. More than six years ago, I discussed thisas a possibility. I consider this step part of the process of succession planningand execution.This will complete my 39th year in the investment business, 35 of these being as amoney manager and analyst, with 25 at FPA. It has been a wonderful experience,though a humbling one at times. I believe I have found success because I have beendeeply aware of the need to balance the human emotions of greed and fear. In aword, DISCIPLINE. As a board member on the University of Southern California’sStudent Investment Fund program, I tell our students that discipline is a keyattribute to becoming a successful investor. I stress that, without a strong setof fundamental rules and a core philosophy, they will be sailing a course throughthe treacherous investment seas without a compass or a rudder. I also emphasizethe importance of integrity and tell them that they can spend a lifetime buildingtheir reputation and, if they are not vigilant, they can lose it in a day.I have always maintained my professional and personal integrity. I have neverwavered, despite having paid some very high prices. It seems as though it was alifetime ago in 1986, when I had few assets under management, and the consultantto my largest account insisted that, if I wanted to continue the relationship, Ihad to pay to play. I was shocked, dismayed and speechless. Though this wouldprobably have never become public, if I had agreed, how would I have ever livedwith myself? By not agreeing, it meant that I would lose nearly 40% of mybusiness. When I was fired shortly thereafter, this termination compromised myefforts in the raising of new money for nearly six years because I could not saywhy. Despite the pain and humiliation, there was no price high enough for me tocompromise my integrity. With the subsequent disclosures of improprieties at thismunicipal pension plan, the cloud of suspicion over me ultimately lifted. I notonly survived, I prospered.I relay this short story because it conveys some beliefs that will run throughoutmy speech today entitled, “Reflections and Outrage.” I will make some comments andobservations about our industry, the government and then provide a brief financialmarket forecast. These are my honest opinions for better or worse.
The Mutual Fund IndustryLet’s be frank about last year’s performance, it was a terrible one for the marketaverages as well as for mutual fund active portfolio managers. It did not matterthe style, asset class or geographic region. In a word, we stunk. We managers didnot deliver the goods and we must explain why. In upcoming shareholder letters,will this failure be chalked up to bad luck, an inability to identify a changinggovernmental environment or to some other excuse? We owe our shareholders morethan simple platitudes, if we expect to regain their confidence.Diversification effectively failed as a strategy. All asset classes, other thancash, gold or Treasury securities, lost money. If Morningstar will allow me asmall transgression by quoting Lipper Research, “Equity funds posted their worstone-year return in Lipper’s 49-year-old database.” It didn’t matter whether theywere U.S. diversified equity funds or world equity funds with declines of 37.5%and 45.8%, respectively--so much for decoupling. This is a concept we neversubscribed to at FPA.For the record, my own fund, FPA Capital, was not a stellar performer either. Itwas down 34.8%, although it did outperform the average diversified domestic equityfund and mid-cap value fund. In my latest shareholder letter, I discuss thereasons for this lousy performance and attempt to explain why I believe it is onlytemporary versus other types of performance declines that appear to be morepermanent.The same criticism can be leveled at fixed income managers as well, since domesticand world income funds lost money last year. Only Treasury and GNMA bond fundsprovided positive returns. Our bond fund, FPA New Income, however, did performextremely well by achieving a positive total return, our 25th year in a row duringour management, and its widest performance differential versus its peers.Did the industry try and prepare for this tsunami of a credit debacle? I don’tthink so. Whether in stocks or in bonds, it seems as though the same oldstrategies were followed--be fully invested for fear of underperforming and don’tdiverge from your benchmark too far and risk index tracking error. The industrydrove into this credit debacle at full speed. If active managers maintain thiscourse, I fear the long-term outlook for their funds, as well as their employment,will be at high risk. If they do not reflect upon what they have done wrong inthis cycle and attempt to correct their errors, why should their investors expecta different outcome the next time?Investors have long memories, especially when they lose money. As an example,prior to FPA’s acquisition of FPA Capital Fund in July 1984, the predecessor fundwas a poster child for bad performance from the 1960s era. Each time the Fund hita $10 NAV, it would get a raft of redemptions since this was its original issueprice and investors thought they were now finally even and just wanted out. Thistrend eventually stopped in late 1987, twenty years after the Fund’s founding. Ibelieve investors will react in a similar fashion after this market collapse.During the 1998-2000 performance derby races, a head long rush into speculationtook place when growth stock “investment” managers chased Monopoly money-likestocks called “dot com” and other types of technology stocks. The fear of beingleft behind by not owning them was quite evident and I was utterly shocked anddismayed by their capricious actions. Where was their discipline? What were theythinking and did they ever consider how they might destroy their client’s capital?At the time, I referred to dot com company valuations as, “not only discountingthe future but also the hereafter.” Did these managers learn anything and havethey reflected upon what went wrong and how they would change their investment
management for the better? The academic community wrote very little on this periodbut an original thinker and my late friend, Louis Lowenstein, did so in his paper,“Searching for Rational Investors in a Perfect Storm.” I recommend it. Why shouldindividual investors and others trust managers who threw investment caution to thewind? This type of recklessness undermines the basic justification for activeinvestment management versus simply being invested in Index funds.While technology stock and growth stock investing hysteria were running wild, wedid not participate in this madness. Instead, we sold most of our technologystocks. Our “reward” for this discipline was to watch FPA Capital Fund’s assetsdecline from over $700 million to just above $300 million, through netredemptions, while not losing any money for this period. We were willing to paythis price of asset outflow because we knew that, no matter what, our investmentdiscipline would eventually be recognized. With our reputation intact, we then hada solid foundation on which we could rebuild our business. This cannot be said formany growth managers, or firms, who violated their clients’ trust.We also did not run with the herd in 2005 and 2006, and thus, FPA New Income’sassets declined from $2.1 billion to $1.6 billion. This process began in 2003 whenwe deployed an extremely defensive portfolio strategy whereby we would no longerbuy any intermediate or long-term Treasury bonds because, in our opinion, theywere devoid of any investment merit. We considered the monetary policy beingimplemented by former Federal Reserve Chairman Alan Greenspan to be insane andthat it would create another bubble. Little did we know how big it would become.Because of the low yield environment, new types of securities were created to meetthe demand for an enhanced yield. We did not chase yield by purchasing thesehighly complex, purported to be high-quality, securitized alphabet soup labeledsecurities created by propeller heads. Reaching for yield, in a low yieldenvironment or because of competition, always leads to disaster, as reflected bythe carnage in so many bond and money market funds last year.It would be unfair of me to level criticism just at growth managers. Many valuemanagers have a lot of explaining to do as well, given last year’s poorperformance, driven largely by an overweighting in financial stocks. How did theymiss the greatest credit excess in the modern era? How could we have a pandemicbreakdown in loan underwriting standards and so many managers miss it? What werethey doing in their research? After the collapse of Bear Stearns, I reviewed thechanges in portfolio holdings of many value managers and saw additions to theirholdings in Fannie Mae, Freddie Mac, AIG, and Washington Mutual, to name a few.What were they thinking?In contrast to these actions, our firm expressed the view, in our March 30, 2008,website commentary, “Crossing the Rubicon,” that we had crossed over into a newfinancial system and new era that required great caution since a new set ofeconomic ground rules was being created and the shape of the playing field couldnot yet be determined. Because of the changed nature of our financial system, wefelt that a significantly higher hurdle rate had become necessary for mostfinancial stock and bond investments. For the industry in general, rather thandemonstrating caution, it seemed as though each week another “expert” was callingfor a bottom in financial stocks. If portfolio managers and analysts cannotrecognize the greatest credit blow-off in the last 80 years, when will they? Whatnew procedures and policies have they implemented at their firms to address thisnew environment and protect them from making similar mistakes in the future? Ibelieve these are questions that must be answered in order to regain and retaininvestor trust.I am not without shame. I wrote about my worst investment failure, Conseco, inFPA’s first website commentary in 2002. My failure was in not recognizing the
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Robert Rodriquez
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