Top Value Manager Even Gloomier on 2008
Friday December 21, 3:30 pm ET
By Christopher Davis

Just when you thought Bob Rodriguez couldn't get any gloomier, the highly regarded value investor has become even more downbeat.
Rodriguez, the hugely successful manager of FPA Capital (NASDAQ:FPPTX - News) and FPA New Income (NASDAQ:FPNIX - News), recently announced he put a halt to purchases of stocks and high-yield bonds at both portfolios on Dec. 14. His decision is a reaction to the subprime mortgage-induced credit crunch, which he expects to worsen in coming months. Rodriguez says he'll review his actions weekly, but he doesn't anticipate any change in course until February or March 2008.

Rodriguez's move is virtually unprecedented. Many investors, including Rodriguez himself, aren't shy retreating to cash when they're nervous. But few money managers have ever publicly foresworn stocks and bonds altogether.

The Los Angeles-based fund manager has been pessimistic for a while. Citing an absence of attractive values, Rodriguez has long held enormous cash stakes at both of his funds. For instance, cash currently accounts for a whopping 40% of stock fund FPA Capital's portfolio. And in 2003, Rodriguez declared a "buyer's strike" at fixed-income FPA New Income, stating that high-quality bonds had little or no investment merit. He's since loosened his stance a bit, adding short-term government bonds to his portfolio in 2006, but given his concerns over the fiscal health of the U.S. government and fears of higher inflation, he continues to stay away from longer-term bonds.

Rodriguez began sounding alarm bells over loose lending practices in the mortgage arena in 2005. He began to notice that his holdings tied to so-called "Alt-A" mortgages, loans to homebuyers with high credit scores but undocumented incomes, had begun to suffer increasing defaults, leading him to eliminate his bond portfolio's exposure to such investments. More recently, he questioned whether rating agencies had wrongly given risky mortgage-backed bonds high credit ratings. In his June 2007 report to New Income shareholders and in a panel discussion at Morningstar's annual investment conference in June, he said that rating agencies hadn't accounted for the risk of falling home prices in their models. With significant declines in housing prices, Rodriguez argued, even top-rated AA and AAA bonds would run into trouble.

Since then, Rodriguez's outlook has deteriorated further. He points to E*Trade's (NasdaqGS:ETFC - News) recent sale of its mortgage securities portfolio at only 20% of its original face value as an ominous sign. Rodriguez believes other similar transactions are in the offing, leading to more huge write-offs at other financial firms as they're forced to value their own holdings at fire-sale prices. He anticipates the impact will be felt in early 2008 as companies announce the big write-downs when they release year-end earnings. The losses would force financial institutions to shore up their balance sheets, further restricting lenders' ability to extend credit and spur economic growth. The credit crunch could spread beyond mortgages to other asset-backed securities and the fixed-income market as a whole.

Rodridguez certainly isn't alone in his prediction, though others envision a less-severe downturn. For instance, top bond investor Bill Gross, the manager of $112 billion PIMCO Total Return (NASDAQ:PTTRX - News), recently said he expected a mild, six-month recession next year.

As a result, Rodriguez's prognosis for the economy in 2008 is grim. In his September 2007 letter to FPA Capital shareholders, he wrote that the odds of a recession were 50% or greater. But in a conversation with Morningstar, he noted that as recently as a month ago, he would have placed the odds at 70%. Now he says the odds are closer to 100%.

Christopher Davis does not own shares in any of the securities mentioned above.