FPA's Robert Rodriguez Likes Cash

Are you getting paid enough to hold stocks and bonds?

Robert Rodriguez doesn't think so. That's why he keeps raising the cash stake in his $2 billion ( FPPTX) FPA Capital fund. The California-based contrarian currently has more than a third of his portfolio in cold hard Treasury bills. The rest has been faring quite nicely in small- and mid-cap value stocks, and he has no qualms about holding more cash until valuations fall or risk premiums rise.

And it's not like holding the cash is hurting his performance. The fund has been a winner for over two decades and is up 14.5% this year, almost triple the Russell 3000 Value Index. Rodriguez also keeps a relatively low expense ratio of 0.85%, so it's hard to accuse him of charging too much for a glorified money fund.

Rodriguez chatted with The Street.com about the virtues of cash, as well as what it would take to get him back in the game.

What is your view on stocks at this time? Obviously, you are not too bullish.

I am not too optimistic. My mutual fund is going to all-time record highs in cash. Presently, we are at 37.5% liquidity, plus we have a takeover liquidating that will take us up to 39%. And then after that we have a pending takeover that will take us to 42%.

Does that bearish prediction include energy stocks? You have stakes in quite a few energy companies like National Oilwell Varco (NOV) and Patterson-UTI Energy (PTEN).

We think the energy rally is advanced. We have trimmed our positions in a couple of holdings, but we still view energy as a strategic area long term. What is going on in the energy sector is a multiyear phenomenon, not a two- or three-year occurrence. It's going to be a five- to 10-year phenomenon.

Also, there's a lot more talk than action in the energy sector. The weightings of financial services and technology stocks in the S&P are far greater than the weighting in energy. Energy is presently at one-third of the level of its 1980 peak at about 31% of the S&P index. Right now, technology is about 20% and financial services is also about 20% of the S&P. So if that is an indication of how enthusiastic people are, then we still have a long way to go for portfolios to get deployed in this area.

I'd say that energy is ahead of its fundamentals on a short-term basis, but on a longer-term basis there is quite a ways to go.

What is your view on financial stocks?

I'm at 35-year-low in financial services. We just had a takeover announced that Wachovia ( WB) is acquiring Westcorp ( WES) and WFS Financial ( WFSI), and we are their largest shareowner. And I've been involved with Westcorp for 18 years.

Financial service companies are taking on increasing levels of risk to maintain their profitability. With a flattening yield curve and the potential for an inverted yield curve, this would not be healthy for financial service companies.

It's the old idea of the DuPont Formula, whereby you make your profits either through margin or turnover. In the case of the financial service companies, the margin is the difference between the interest cost and what they can earn on the loans. Since that margin is shrinking, they need to increase the level of loans they are making to make up for the decline. That's not usually a good sign. It means that loan quality is probably suffering.

When you survey the investing landscape, what do you see as potentially being undervalued?

Right now the most aggressive thing that we've been acquiring has been Treasury bills. We select our stocks one stock at a time from the bottom up. We have only added a single new name in the last 18 months. And that occurred at the end of June. It was a 144 deal called Rosetta Resources that is in the process of getting registered. It's in the energy area. The company was set up to acquire assets out of Calpine ( CPN). It was a forced sale because Calpine needed the cash.

So you just don't see anything out there?

We just don't see anything out there. Three areas are showing up on our screens right now: financial services, which we talked about; housing, which we wouldn't touch with a 10-foot pole; and retail. A larger number of retailers are appearing.

How do you screen for stocks to buy?

We screen on a number of variables including price to book, price to cash flow, price to earnings, market cap to revenue. We also do screens on leverage ratios and debt coverage.

And what our screens keep turning up is the lowest number of qualifying stocks in years. And this has been the case now since January of 2004.

But is this just in your small- to mid-cap range? Is there a similar dearth of choices in the large-cap arena?

If I look at the marketplace in general, we see the market as being very flat in valuation. So therefore, the undervaluation in small- and mid-caps has effectively been eliminated in the last five years because of their superior performance vs. large-caps.

There may be some value in the micro-caps. But we still think that the earnings expectations are still overstated on average. We have been saying for a while that earnings in large-cap stocks will be disappointing, and you are starting to see that now.

What will it take to bring these valuations down?

Either prices have to come down and earnings remain unchanged. Or prices have to remain unchanged and we have to have considerably more earnings growth. The problem we see is that we do not believe the odds -- and all our decisions are based on probability -- as being terribly favorable that earnings will surprise on the upside. The reason being is that profit margins are at 50-year highs. We see problems in profit margins coming and that probably means the stock market is going to remain terribly volatile, and very frustrating for a while. Maybe every once in a while we'll find a stock to buy.

You hold cash in your fund, not bonds. Can you hold corporate bonds or agencies?

We can hold bonds, but we think long-term bond yields at the 4% level are a bad deal. They do not compensate you for the uncertainties of inflation of the massive deterioration in the fiscal integrity of the United States. And I do mean that. It is a travesty to witness what the federal government is doing to the balance sheet of the U.S.

From a contrarian perspective, what is your view on housing? I can't imagine it's too positive.

Maybe we have more to go on the upside, but the trends are not positive. In San Diego, less than 12% of the population can afford the median-priced home. In the state of California, it's less than 15% that can afford the median price of a home. I think there is a real problem brewing there.

Also, we've been doing some work on the bond side, and we believe there are some real credit problems on the horizon. Interest-only adjustable-rate mortgages, for example, have created massive speculation in this area. There have been excesses in loan underwriting and this is dangerous.

You're starting to scare me. Is there any credence at all to the bull case?

Hey, we could be wrong. A value manager and a contrarian ask whether they are getting adequately compensated sufficiently through a low enough valuation or a high enough yield to compensate them for the uncertainty of the future. We've come to the conclusion that the compensation is not sufficiently high enough either in equities in general or bonds in particular.

So cash is king?

Yep, cash is king. You can look at it this way: the opportunity cost of holding cash is very low. The S&P is up around 2% year to date, which is almost identical to the yield on the three-month Treasury bill. So for all the risk that people have taken holding equities this year, they have not been adequately compensated.

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