Q&A with Robert Rodriguez 2007

Sub-advisor to the Masters’ Select Smaller Companies Fund

The opinions and conclusions expressed herein are those of Litman/Gregory Fund Advisors, LLC (LGFA) and Robert Rodriguez at the time the material is written and may not be reflective of current conditions.

Bob Rodriguez, is the portfolio manager responsible for the portion of the Fund’s assets managed by First Pacific Advisors, LLC (“FPA”). Rodriguez joined FPA in 1983 where he manages equity separate accounts and the FPA Capital Fund. He is also the portfolio manager of FPA New Income, a bond fund, and CEO of the firm.

What first attracted you to the investment business?

As part of a classroom writing exercise, at age 10, I eagerly mailed a letter to then-chairman of the Federal Reserve, William McChesney Martin, inquiring about the role of the central bank. My recollection of the assignment was that we had to write to someone to get something back; and I wanted to find out about the people in charge of money and what they did with it. Needless to say the letter that arrived in response, along with the pamphlets on the Fed’s history had quite an impact on me. I have been interested in money and investing ever since.

On a more official note, I have been in the investment industry for approximately 35 years. Born and raised in Los Angeles, first generation, and always felt that if I wasn’t in the investment business I would have gone into the junk yard business. Generally, you buy things from people who don’t want them and then sell them to people who desperately have to have them. I find that philosophy very applicable to the investment field.

How did your investment philosophy develop?

It developed out of the carnage of the 1974 bear market. Prior to this period, I was more focused on growth stock investing. In the summer of 1974, I personally owned a stock that was collapsing in price. I kept buying it until I ran out of money. During this period, it fell from approximately $22 to $8, where I ran out of money. It eventually found a “bottom” at approximately 90 cents. I asked myself a profound question, “Am I doing something wrong?” I could not understand how the stock could be selling this cheaply. Nothing in my undergraduate education had prepared me for this outcome. Here was a stock that had $2 per share in cash and historical cost real estate of $3.50. I assumed the accounts receivable and inventory were worthless. The company had no short or long-term debt. In essence, one could buy cash at less than fifty cents on the dollar and get the real estate thrown in for nothing. This did not make sense to me so I went back to my alma mater, the University of Southern California, to use the library. While researching how this could occur, I found many books from the 1920s and 1930s on business. Among them was a book written by Benjamin Graham and David Dodd on security analysis. It changed my life and my investment philosophy forever. In it they described how to research a balance sheet and the importance of the balance sheet. It was a disciplined way of conducting investment research. At that time in the investment business, the total focus was on the income statement.

At the time, I had saved enough for my graduate education, and therefore, I could have purchased additional stock. I decided that, if I did not go to graduate school in the fall of 1974, I would never go. The upside from this was that I was able to write a major paper on the topic of modern portfolio theory, and I concluded that there were some significant shortcomings. My research and this experience from this period have guided me throughout my investment career.

Shortly after entering graduate school, the company tendered for nearly 25% of the stock at $5.50, with the last sale just over $1. The tender was oversubscribed. Less than two years later, the company sold this stock back to the public at $22.

This situation taught me about how far a stock could fall and that I should consider what my downside risk might be. In our investment deliberations, we always evaluate a stock, not only from how much it might rise but, very importantly, how much might the downside risk be, and are we getting paid sufficiently for the potential risk. My reading also convinced me that a value investing style was more likely to be a winner over the long term; however, if I chose this style, it was likely to be a very lonely way of investing. I have come to love that feeling, as do my investment partners.

By the way, the company was Executive Industries, a recreational vehicle manufacturer. The name “Executive” is now owned by Monaco Coach. Executive Industries leveraged up before the 1980-82 recession and, as a result, it filed for bankruptcy subsequently. The management apparently did not fully learn the importance of evaluating downside risk from their 1974 experience.

Can you briefly discuss the key elements of your stock picking discipline?

Our equity emphasis is on cheap and beaten-down stocks. We are drawn to small- and mid-cap leading firms, with dominant market share in their industries, selling at bargain-basement price multiples while concentrating our picks in a handful of sectors. We are attracted to industries and stocks that are unloved, hated and generally perceived to be out-of-favor. When we find an investment candidate, we practice the Charlie Munger philosophy of investing and that is, you don’t buy a little, you don’t buy a lot but rather, you back-up the truck.

We look for companies that are typically, in industries that are out of favor and unloved and, therefore, are selling at depressed valuations, such as low price/book value ratios, low price/earnings ratios, and low ratios of market capitalization to sales (that is, shares outstanding times the current price divided by sales). We also focus on cash flow so our valuation techniques encompass a number of different metrics to try and avoid errors from any one element. Companies must also have clean balance sheets and strong cash flows.

In the current market environment, rather than throwing money at overvalued stocks, I am content to stay on the sidelines until bargains materialize. We therefore have reduced our risk, by putting money away so that we can deploy it at a time when investments are more attractive. Patience is key. As Warren Buffett would say, “Be fearful when others are greedy, and be greedy when others are fearful.” We are awaiting the time when we can be greedy.

What factors have been most important to your success?

I learned from my father at an early age what it was like to lose everything. When he was a child in Mexico, the family lost everything in the revolution of 1910. He tried to convey that feeling of loss to my brother and me. Unfortunately, I had to experience 1974 to really learn first hand what loss felt like.

Throughout my life, I’ve always been underestimated. Because of this and a sense that others were better educated or came from better backgrounds, I always felt that I had to prove myself. In this way, I believed that I had to give at least 110% all the time.

My parents provided strong support and my father instilled in my brother and me that your word is your bond. Never, and he meant never, tarnish your good name. He said that anything in this life can be taken away from you except one thing, and that one thing is your name. You have to give it away. He taught us that personal integrity was one of the key attributes that one should have.

I believe that these elements helped to provide the basis to conduct an ethical and successful career. It has led to the building of an investment team and organization that represent the highest values. Trust, ethical dealing, treating people fairly and with respect have helped to form a fundamentally strong and stable organization. I would say that my team members have many of these attributes as well as others.

I have learned to focus on the long term and to use short-term disturbances to enhance both investments as well as the organization. I view chaos and uncertainty as companions that help in achieving long-term goals. Because my father and mother emphasized focusing on long-term goals, this transferred over into investing and organizational development.

I consider myself fortunate that I landed here at First Pacific Advisors since this organization had many of the personal values I already held. The former chief executive officer and great investor, George Michaelis, helped to form the company and culture within which I could grow and become successful, but also provided the foundation upon which my associates and I could further build and improve the organization.

Finally, I was fortunate to have received a good education and to work and associate with some highly talented individuals that helped in my educational and investment development. I thank all of them, and I thank my associates who have helped make me look better than I really am.

How do you and your team work together and how do the research efforts of the team contribute to the portfolio you run for Masters’ Select?

Together, we work as a close unit and exchange information informally during the course of daily interaction. Additionally, we typically meet on a weekly basis, or as needed, to formally exchange ideas.

We concentrate our research effort on very few opportunities while taking a detailed look at each company. The result is a few concentrated investments, in which we have very detailed knowledge. Some information may come from a cross over between our equity research teams and the fixed income research teams.

We work as generalists but each of us has experience or a depth of knowledge in different areas of the stock market. We pool our experience to enhance our decision-making. In many cases, we act as a wolf pack in attacking an investment idea. Generally, when an idea is presented to the team, it is very obvious to all since we are of a similar mindset.

Given that we already had a concentrated investment style, it was very easy to bring that philosophy of investing to the Masters’ Select organization.

As you and your team research companies, what are the most important sources of information?

Research may include information on the U.S. and world economies; information on specific industries, groups, companies, or other news affecting specific securities or markets; and technical and quantitative information. Research is received in the form of written reports, telephone contacts, personal meetings, research seminars, and access to computer databases.

Primarily we feel that we can know a lot more about a few companies and therefore, be more knowledgeable investors. As the number of companies increases, our ability to know them and understand them decreases significantly. We have found that investment managers, typically, lose their performance in down markets because they sell stocks during periods of fear. For example, over the last fifty years, in virtually every major stock market downturn, equity mutual funds have, typically, sold stocks to raise cash. The less you know about a company, the more likely you are to sell a stock out of fear during periods of adversity. A good knowledge base about a company helps reduce that risk. In other words, knowledge is power.

We also look at the new low list that appears everyday in The Wall Street Journal that is summarized in BARRON’s over the weekend. We also screen the stock market vigorously for various types of companies. At an industry level, we ask ourselves which ones are being severely hurt today and then start researching them to see whether the problems the industry is facing are of a long-term nature or a short-term challenge. Finally, we utilize Wall Street as an idea generator but, typically, our time frames are longer than theirs and so we usually end up using Wall Street analysts as consultants versus big idea generators.

How does running a very concentrated portfolio that is part of a diversified fund differ from running a more broadly diversified portfolio? How do you choose the 8 to 15 stocks you hold for Masters’ Select from your more diversified portfolios?

To begin with, our more diversified portfolios are only somewhat more diversified than the Masters’ Select portfolio. We have always concentrated our holdings, with the top ten representing anywhere from 35% to 70% of the total portfolio. On average, the top ten have averaged in the 40%+ range for our diversified portfolios.

The stocks we select for the Masters’ Select portfolio are those that we feel have the best combination of return versus risk of all the stocks we currently own. When a new stock is being proposed for our general accounts, the question is always asked, “Would this one be appropriate for Masters’?” Unless it has a better prospective return versus risk of the current holdings, it would not qualify.

We really do not think about how a concentrated portfolio differs from running a more broadly diversified portfolio since we always focus on picking one stock at a time. Unless we have difficulty acquiring a position, the number of companies we hold in a diversified portfolio will be limited.

Neither the information contained herein or the opinions expressed shall be construed as an offer to sell or a solicitation to buy any securities mentioned herein. Click here to view the most recent portfolio holdings of the fund.

The fund may invest in foreign securities, which exposes investors to economic, political and market risks and fluctuations in foreign currencies. The fund will invest in the securities of small companies, which subjects investors to additional risks, including security price volatility and less liquidity than investing in larger companies.

Any discussion of the Securities included in Robert Rodriguez’ Masters’ Select investment portfolio is as of the date of this piece and may not reflect current portfolio holdings.

To obtain a current prospectus for the Masters’ Select Funds at no charge, please click here or call 1-800-960-0188. The prospectus contains more complete information with respect to the risks, costs and expenses of investing in the Funds. Please read it carefully before investing.

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