Manager Foresaw the Crisis -- but Didn't Avoid Big Losses

Last year was a disaster for U.S. investors and the country's economy -- and Robert Rodriguez can rightly say he saw it coming.

As far back as 2005, the mutual-fund manager bemoaned the "investment foolishness" in the market and noted "financial strains" at Fannie Mae, Freddie Mac and insurer American International Group Inc. In December 2007, increasingly worried that a credit crisis would snowball into a severe recession, he declared a moratorium on stock purchases for the FPA Capital fund he has overseen since 1984.

Unfortunately, Mr. Rodriguez's foresight didn't do a lot for his stock fund's performance in 2008. The $920 million FPA Capital declined 35%.

That's two percentage points better than the Standard & Poor's 500-stock index total return and four points better than the average 39% decline of diversified U.S. stock funds tracked by Lipper Inc. -- but surprising for a bearish manager who had as much as about 45% of fund assets parked in cash in recent years.

Mr. Rodriguez's story holds an important lesson for fund investors: Even if a manager is correct about the big picture, he or she can still deliver disappointing results. The potential for even the smartest stock pickers to stumble is one reason that some investors prefer index funds that simply mirror the performance of a benchmark such as the S&P 500. (See a related article for a look at whether active funds or index funds are better for a market rebound.)

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Gary Hovland

Mr. Rodriguez, 60 years old, says even he underestimated the severity of this financial crisis. He believes we're entering uncharted territory in 2009. There is "no map," and even "our most negative scenario never envisioned" the meltdown that has unfolded, he says.

Another problem: While his astute calls on the housing market helped him avoid financial stocks, they weren't enough to sidestep blowups and steep declines in other industries. The fund is heavily exposed to energy-exploration companies, which tanked as crude-oil prices declined about 70% from a record high last summer. And the fund was adding to its Circuit City Stores Inc. holdings as recently as last summer. The electronics retailer filed for Chapter 11 bankruptcy protection in November.

Such issues have frustrated investors. "I've just gotten tired" of the fund's weak performance, and "my patience is kind of at an end," says Scott Greenbaum, founder of New York investment firm Life Goals Asset Management. As a result, Mr. Greenbaum says he has recently been reducing his clients' stake in the FPA Capital fund.

Ellen Weinstein

Mr. Rodriguez says his spot-on predictions couldn't help him in 2008 because he is bullish on areas like energy that could take several years to rally again. "It's all about time frame," he says.

Morningstar Inc. has dubbed Mr. Rodriguez "prophetic" and is considering naming him and his team their 2008 Fixed-Income Manager of the Year for the strong performance of the FPA New Income fund he also helps run. But "as far as stock picking [for FPA Capital] goes, it hasn't been a banner year for him," says Morningstar analyst Christopher Davis.

"We are concerned that... a bubble of massive proportions has been created in the housing market....[T]his bubble has infected many areas of the financial economy.

"Preservation of capital is paramount to us in this risky investment environment."

-- ROBERT RODRIGUEZ, June 2007

Mr. Rodriguez has lately grappled with challenges familiar to many individual investors. For instance, financial advisers warn against feeling an emotional commitment to one's stocks. It was hard for Mr. Rodriguez to sell struggling recreational-vehicle maker Thor Industries Inc. in part because he had grown close to Thor Chairman Wade Thompson over more than 20 years of investing in the stock.

"I felt like I was selling part of my family," Mr. Rodriguez says. "For many years, they called us a partner." FPA Capital had been reducing the stock for years. It then sold less than half its Thor stake by March 2008 and eliminated Thor entirely by September. The stock declined about 50% for the 12 months through September. However, Mr. Rodriguez says Thor "did a fabulous job" rising from $1 in the late 1980s to more than $55 in 2006.

Mr. Rodriguez is chief executive of Los Angeles investment firm First Pacific Advisors LLC, which recently had about $8.4 billion in assets under management. He is chief investment officer of FPA Capital, on which he is aided by co-managers Dennis Bryan and Rikard Ekstrand.

Raised in California, he joined the firm about 25 years ago and received undergraduate and graduate business degrees from the University of Southern California. He mostly works from his Lake Tahoe home and enjoys racing Porsches on desert tracks. Mr. Rodriguez says that hobby has taught him investment lessons like balancing risk and return. FPA managers hold investments for years and wait in cash for equally long if they don't see attractive buys. Managers also hold big personal stakes in the firm's funds, aligning their interests with shareholders'.

FPA Capital maintains a strong 10-year record, returning 6.2% a year on average -- 7.6 points more than the S&P 500 with dividends reinvested, according to Morningstar. That puts it in the top quarter of Morningstar's "mid-cap value" category. It was ahead of 70% of its mid-cap-value peers in 2008, despite its steep decline. The larger FPA New Income, with $2.3 billion in assets, returned 4% in 2008, ranking in the 15th percentile among intermediate-term bond funds. It has not lost money in any calendar year since Mr. Rodriguez took charge in 1984.

While FPA New Income has seen inflows, investors have not rewarded his stock fund's performance with cash -- instead, they've fled, much to Mr. Rodriguez's anger. His stock accounts, including FPA Capital, have seen $1.07 billion in net redemptions since January 2007. "The more you [increase your cash position], the more they take it away from you," Mr. Rodriguez says.

A Vision of Crisis

One reason is that many clients, especially institutions, have disagreed with Mr. Rodriguez's big cash position over the past few years. He has had many tense exchanges with clients who wanted him to be more fully invested, because that lets them control their cash exposure. One institution he declined to name redeemed $300 million from FPA Capital in the third quarter because of such issues. He's unsure when the fund, which is currently closed, will reopen to new investors.

Mr. Rodriguez has held big cash stakes because he has been forecasting the financial crisis for years. "We do not see a sufficient margin of safety," he wrote in a January 2004 note titled "Slim Pickings." By 2006, Mr. Rodriguez was identifying problems in the real-estate market. While the average stock fund was holding a record low 3.7% cash, FPA Capital was hitting a record high of about 45%. For that year, FPA Capital returned 5.4% -- more than 10 percentage points behind both the S&P 500 and the average mid-cap-value fund.

In June 2007, Mr. Rodriguez gave a speech called "Absence of Fear" to a financial-analyst group, outlining how the housing, stock, bond, private-equity and hedge-fund arenas were caught up in a speculative bubble. He increasingly came to believe that credit-market problems would spur unemployment in the broader economy and probably a recession in 2008. As last year began, he compared the credit crisis to the Depression in a shareholder letter -- an analogy many investors would only begin using liberally nine months later, when Lehman Brothers Holdings Inc. collapsed.

Trouble in Store

But even though Mr. Rodriguez was rightly pessimistic about the big picture, some of his firm's calls on stocks proved less prescient. By 2007, Mr. Rodriguez had sold retailers Michaels Stores Inc. and Big Lots Inc. By September 2008, he sold Ross Stores Inc. The three companies had appreciated between 200% and more than 2,000% while the fund held them, and Mr. Rodriguez's team figured their best times were behind them. But the managers thought they could identify other retailing gems that would survive the economic turmoil.

FPA had followed Circuit City for years but didn't like its management. When the retailer replaced its chief executive in 2006, the firm began taking a closer look. Among the attractions: limited debt and the potential to improve profit margins by selling audio, video and home-office products in a more cost-efficient manner. FPA Capital began buying Circuit City shares in the summer of 2007, when they traded around $13.

Last year, the fund pared retail stocks further. But it kept buying Circuit City, even though the retailer was struggling to smoothly turn around without disrupting store operations. Mr. Rodriguez's team thought the company could solve such issues quickly. That didn't happen -- and the stock now trades for pennies. The fund still holds it, but admits the Circuit City investment "undoubtedly has been a mistake," as Mr. Bryan wrote in the fund's Sept. 30 shareholder report. "Clearly we have been wrong about CC and its ability to turn around the business."

FPA Capital Fund declined 12% in the third quarter of 2008. Still, by October, Mr. Rodriguez was ready to jump back into the market. Nearly 450 companies qualified as cheap enough in his investment database of nearly 10,000 stocks -- the highest number in more than 20 years. He began buying Oct. 8, after the Treasury said it was injecting capital directly into the banking system, an approach FPA's managers had been hoping for. The fund has since spent more than a quarter of its cash, or about $150 million. This is the largest amount of money it has deployed in more than five years. The fund was down 30% in the fourth quarter.

Searching for Oil

A lot of the purchasing has been in energy. Since October, the fund has added to its holdings in explorers like Patterson-UTI Energy Inc., Ensco International Inc., Rowan Cos. and Atwood Oceanics Inc. It has also added a new position in Newfield Exploration Co. Many of those stocks have been declining since the summer. The problem is that unlike diversified conglomerates like Exxon Mobil Corp., such explorers are particularly sensitive to oil-price movements. Patterson-UTI and Rowan have fallen 55% since September, as crude oil plunged to end 2008 at $44.60 a barrel.

"In spite of his excellent overall timing record, the increase in equity exposure was way early this time," says Robin Carpenter, principal of CarpenterAnalytix.com, which develops investment tools for money managers.

Mr. Rodriguez says he is not concerned about these declines. He notes that he has been buying more exploration stocks since October. He thinks that as oil prices drop, it makes big oil-exploration projects in Saudi Arabia and Canada less attractive, forcing them to delay or shut down. This supply reduction will ultimately mean energy prices will spike even higher in the future, helping his holdings, he figures. As a result, he has added to Patterson-UTI and Rowan as they've declined. He recently wrote to one investor that the energy-stock declines are "of very little interest to us other than it is a temporary pain."

Despite his recent buying, Mr. Rodriguez's outlook remains bleak. In the fall, he updated Morningstar researchers on issues including how bad the economy would get. They were stunned, says Morningstar's Eric Jacobson, who adds, "The word 'sobering' doesn't do the conversation justice."

Mr. Rodriguez believes the government will run out of solutions soon, and stock markets will offer closer to 5% in coming years, rather than the 8.9% in real returns including dividends that have been the historical average from 1950 to 1996. As a result, he's committed to buying stocks that have strong balance sheets and hold a lot of cash.

Mr. Rodriguez's ultimate goal is simple. When this crisis is over, he says, "we have to make sure we're one of the survivors."

—Ms. Gullapalli is a staff reporter for The Wall Street Journal in New York.