Proceeding With Caution : To First Pacific Advisors' Rodriguez, Good Value Is Hard to Find

L.A. Times Archives

Nov. 26, 1996 12 AM PT

Robert Rodriguez is a rarity among money managers. As a principal at Los Angeles-based First Pacific Advisors, he manages both a stock fund (FPA Capital) and a bond fund (FPA New Income). And his record with both has been spectacular.

Rodriguez and FPA are rarities in another sense: They have by choice limited the sum of money they’ve been willing to manage, in the belief that massive cash influxes can murder performance. Rodriguez closed FPA Capital to new investors in May 1995, when it held just $280 million. FPA New Income, however, remains open to new investors.

Rodriguez, 47, was interviewed by Times staff writer Tom Petruno.

Times: Have you given any thought to reopening Capital?

Rodriguez: No. In fact, I just wrote my quarterly letter to shareholders, and it’s probably the most cautious letter I’ve written in 20 years. I just see many signs of speculative excess in the stock market: record highs in the number of initial public stock offerings, hyperbolic growth in the number of new investment clubs, and this argument that money won’t ever leave stocks because it’s invested through retirement accounts.

Times: Yet many bulls argue that stocks aren’t expensive relative to current corporate profits.

Rodriguez: But look at the valuation of the market relative to expected earnings growth rates. We’re at price-to-earnings ratios in the high teens for the average stock, yet we’re looking at slower earnings growth ahead.

Corporate profits in the 1990s have been favorably affected by three things. First, declining interest costs; second, all of the corporate write-offs that we’ve had have lowered depreciation costs; and third, there’s been a reduction in corporate tax rates compared with the 1980s.

Times: And you think those trends have largely played out?

Rodriguez: Yes. With interest rates, for example, to get the same benefit for companies that we’ve had so far in the ‘90s would require 10-year Treasury note yields to drop from the current level of above 6% to the low 4% area.

Times: You obviously don’t think that’s going to happen, which implies that you aren’t as sanguine as many people about inflation.

Rodriguez: People believe that inflation has been tamed, and so far it has. Even though labor wage rates have been rising for three years, the bulls will say that unit labor costs--the total cost of labor, including benefits--have been held under control.

I’m arguing that we’re at or near an inflection point, and that the beneficial impact [of modest benefit cost increases] is going to be less for companies. For one, it’s estimated that 50% to 60% of the work force at major corporations has already shifted over to health maintenance organizations. If I’m correct and we’re in for a change, and wage inflation does begin to flow through more, then costs to corporations will rise. Will they be able to pass those costs on, or will they have to eat them? If they eat them, that’s going to affect profits. If they pass them on, that’s going to raise questions in the minds of fixed-income investors [about inflation].

Times: But as bearish as you sound on the markets, your stock fund is up nearly 36% this year.

Rodriguez: Yes, but I honestly believe the returns I’m achieving I’m stealing from the next few years. When things move this quickly, it’s not a good market for people who invest the way I do.

Times: You are well-known as a “value” investor, and a patient one. What do you look for in stocks?

Rodriguez: I want low downside risk with great upside potential. And my target is a 50% return on my money over two years and 100% over four years. But right now I’m having a very difficult time finding prospective investments that can do that. I’ve got 34 stocks in the fund now, and cash is 26% of assets. If the market continues to fly, I will be driven out of a couple of our holdings soon.

Times: Let’s talk about some of the stocks in the fund that you still think have strong potential.

Rodriguez: OK, there’s Michaels Stores [$10.13, Nasdaq]. We now have 12.3% of the stock. This is a destination store in arts and crafts. [The firm also owns Aaron Bros.] Ask anyone who has kids in Brownies or in school, I guarantee they go there. But the company has been so screwed up for years.

Now they’ve got a new CEO, Mike Rouleau from Lowe’s Cos. [a major home-improvement chain]. And there are just so many ways for this company to make money now by doing nothing--just cutting down on inventory, for example. Before, they didn’t have a POS [electronic point-of-sale inventory control system]. So they didn’t know what was moving in the stores. At the end of September they rolled out a POS system--a real one. If they can cut inventory, they lower their cost of capital and they avoid having as much marked-down merchandise.

The warts on this company are that they’ll still have to negotiate their debt with their bankers, because they just announced a big loss, after write-offs. Still, to get this kind of franchise at a cheap price is real tough today. I think there’s potential for us to see a 100% to 300% return on the stock.

Times: You’ve had a lot of success with retailers. You still own Mac Frugal’s Bargains (parent of Pic ‘N’ Save) and Ross Stores.

Rodriguez: Yes. Mac Frugal’s we got in around $12. [It’s now $24.88 on the New York Stock Exchange.] Ross [$49.25, Nasdaq] we bought three years ago. They were earning 12% to 13% on equity in the worst environment in apparel retailing in California. We thought, “What could they earn when the economy finally turned?”

Times: Ross has gone from $18 to $49 just over the last 12 months.

Rodriguez: Yes. I think they can post 15% sales growth in 1997, with same-store growth and by adding new stores. The stock is trading at 15 to 16 times estimated 1997 earnings. So we feel that one still has more legs to run on.

Times: Reebok ($38.75, NYSE) is another big holding?

Rodriguez: When the company bought back 23% of its stock [in August, at $36 a share], I said people who tendered would be giving up bigger gains in the future. Reebok’s cash flow is just huge. If they can execute on new products and reduce debt, I can see how they could earn $6 a share. This could be an $80 to $100 stock in a few years.

Times: OK, let’s talk about the bond market and the New Income fund. You hinted earlier that you’re worried about inflation and interest rates in 1997.

Rodriguez: We still believe that economic growth will come in somewhat higher than expectations, so there will be upward pressure on rates eventually.

Times: You’ve got about half of New Income in mortgage-backed bonds, 31% in cash and just a relative few corporate bonds.

Rodriguez: As bond yields have come down, I see very little reward in taking risk today in corporates. I just believe you need a margin of safety, a margin for error. With this portfolio, my shareholders aren’t going to get killed [if market rates surge], and if bonds rally, they’ll participate.

I practice “guerrilla bond management”: I like to lie in wait, and when I get easy prey, I jump out and get it. Right now, I just don’t like the level of bond yields [relative to risks]. I see a growing level of risk taking by the public in bonds and in stocks. . . . We’re in a “brave new era” in the markets, and I have a problem with that.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Two Funds, One Honcho

FPA CAPITAL

Category: Value stocks

Min. investment: Closed to new investors

Assets: $545 million

YTD total return: +35.7%

10-year return*: +552%

Avg. general stock fund 10-year return*: +254%

Five biggest holdings

as of Sept. 30:

1. Green Tree Financial