The following is the complete question-and-answer session with Morningstar.com readers from Conversations' Ask the Expert forum. The session is organized loosely such that bond-related questions are first, and stock-related questions follow.

Though I would have liked to have won this additional award, I feel very honored to have been included in the short list of nominees. I feel that Bill Nygren was a great selection. He has done an excellent job of managing his funds over the last several years. His five-year record is better than mine. I believe it is very difficult to make these selections since all of the nominees have distinguished themselves in their respective categories. I am proud of the fact that I was nominated in both categories. This is the second time Morningstar has highlighted both of my funds simultaneously. I feel these recognitions reflect very favorably on all my associates that have worked very diligently these last several years.

There are three other associates that work with me on FPA New Income. Tom Atteberry focuses on both the high-quality and high-yield segments. Tom has been with me for five years. He has contributed greatly to the performance of the fund. Like everyone else at FPA, he also brings an equity background with him. Steven Geist and Steven Romick assist in the management of the high-yield segment of the fund. Both work on equities as well as high yield. Each of the members chooses to focus on a security of their own choice. Generally, we try to leverage the work we do on equities into the high-yield/broken-convertible portion of the portfolio. Steven Geist has been with FPA for 10 years while Steven Romick has been here six years. All have business experience that ranges from 17 to 20 years.

Capital preservation is very prominent in our management thinking. Unlike stocks, bonds tend to be very homogeneous, i.e., they tend to rise and fall together as a group. Because of this, the fund's portfolio duration tends to be shorter, on average, than the Lehman Brothers Government/Credit Index's duration. This is especially true now with interest-rate levels so low. When we believe we are being sufficiently compensated to risk capital through higher yield levels and higher spreads to inflation, we will then consider extending the portfolio's duration. Utilizing this strategy, FPA New Income's worst quarter of performance was a negative 0.9% in Q3 1987 versus the Lehman Index's negative 2.91%. The Lehman Index's worst quarter was a negative 3.13% in Q1 1994, versus FPA New Income's positive 0.28%.

I have a very cautious outlook for interest rates. We recently wrote to our clients that we anticipate that the 10-year Treasury-bond yield will rise into the 5.6% to 6% range over the next 12 to 18 months. Our best guess is that the Fed will start taking back part of the liquidity it provided sometime around midyear. It would be after that period when we would begin to see a rise in short-term interest rates. We are maintaining a short portfolio duration of approximately 2.2 years. Short-term liquidity totals approximately 13% of the portfolio. Most of our attention is focused on high-yield debt securities currently, since this is where we think we can add real value in a low interest-rate environment.

We do not agree with you that stocks look like a better investment than bonds. In both my bond and equity funds, I have expressed the opinion that investment returns from stocks and bonds will likely approximate one another over the next five years. It is our goal to outperform the general market of bonds and stocks over this timeframe.

Yes, we do buy high-yield debt but rarely do we buy straight preferred stock. If we buy preferred stock, it generally is a convertible security. Most investors are at a competitive disadvantage in purchasing preferred stock since corporations get a dividend-tax exclusion that allows them to pay a higher price than the average investor does. This consideration is less important in the case of high-yield preferred stocks. In those cases, we generally favor the straight or convertible debt.

We feel a targeted portfolio of high-yield bonds is attractive currently, since high-yield bond spreads are extremely wide by historical standards. In the last three months, these spreads have been gradually narrowing, but they still have a long way to go. Recent optimism about an economic recovery has been a contributing factor to this spread narrowing. Another has been the positive cash inflows into high-yield bond funds. Should the economic recovery begin to fade or stop, high-yield spreads could widen again.

In FPA New Income, we believe in a highly targeted approach rather than owning a widely diversified portfolio of these securities. We have mixed them into the portfolio at various times to help enhance return as well as to moderate portfolio volatility. Typically, the high-yield market and the high-quality bond market are on two different cycles, which means they help to offset each other's volatility. There are some excellent managers of high-yield bond funds. I would recommend that you target those who have long track records of success through difficult market environments.

FPA New Income is allowed to hold up to 25% in securities that are rated less than AA. Over the last 18 years, the lower-quality segment has ranged between 2% and 25%. Currently, we have allocated 20% toward lower-quality bonds. We have found this mix very helpful in moderating portfolio volatility. Typically, the high-yield bond market is on a different cycle from that of the high-quality bond market; therefore, they tend to offset each other's volatility. On average, our portfolio of government/agency and high-yield securities has resulted in higher total returns and lower-than-average portfolio volatility.

The correlation between the high-yield bond market and the S&P 500 is significantly greater than that between a large, diversified REIT index and the S&P 500. A key reason for including high-yield bonds as a component of an investor's bond portfolio is that this sector does not correlate well with other sectors of the bond market. Their inclusion dampens portfolio volatility while enhancing long-term return. The REIT market tends to correlate with those segments of the bond market other than the high-yield sector. For this reason, it is our view that an investor should substitute a portion of their high-quality bond portfolio with high-yield bonds. This substitution should be larger during periods of economic expansion and smaller during periods of economic contraction.

We are great believers in TIPS (treasury inflation protection securities) since we have approximately 32% of FPA New Income invested in them. As long as their implied inflation rate is lower than the current inflation rate, they provide value. A diversified high-quality intermediate bond fund is likely to generate a higher total return since it has the benefit of not only earning the implied inflation-rate spread but also the credit-quality spread. TIPS also have the benefit of being less volatile than high-quality intermediate bonds.

We try to balance these two considerations--inflation and credit-quality spreads--in our bond fund. When yields are low, as they are today, TIPS can provide principal protection from rising interest rates. Generally, rising interest rates are anticipating the likelihood of higher inflation, a positive for the TIPS. The one case where TIPS do not work as well would be in a deflationary environment. This scenario could also hurt high-quality bonds because credit-quality spreads might increase, thereby offsetting a portion of the appreciation in bond prices, due to potential concerns about corporate profitability. A high-quality bond fund could mitigate some of these potential negative effects.

We still like TIPS. As long as their implied inflation rate is lower than the current inflation rate, they provide value. We usually like to acquire them when investors have an optimistic outlook for inflation. Invariably, this view is generally too positive. When this occurs, investors place very little value on the embedded inflation-call option that is part of the TIPS' valuation. When inflation returns, they again generally overreact and assume that inflation will remain at this higher level for a sustained period. This process encourages investors to place a higher value on the inflation-call option. A rising-call option value contributes to the TIPS' superior performance versus their nominal bond counterpart, in an increasing-rate environment.

Bond prices appear to be less sensitive to changes in interest rates because the range of interest-rate shifts has narrowed considerably this past year. During 2001, the 10-year Treasury bond began the year at 5.11% and closed the year at 5.05%. The range between high and low was 134 basis points. However, we recently had one of the worst weeks and months in the history of the bond market. The 10-year Treasury bond generated a negative 6.84% total return when its yield rose from 4.18% to 5.20% in seven weeks. Should you own long duration bonds when rates rise, you will notice how quickly they react in a negative way. No, things have not changed.

We like Oregon Steel Mills 11% debt for a couple of reasons. First, these are first mortgage bonds that are backed by the most modern part of their steel mills. We consider the value of the assets to be greater than the bond's value. Second, their business is considerably different from other steel companies. They focus on specialty grades of steel that go into natural-gas pipeline-construction projects for a large portion of their business. They are one of only a few companies in the U.S. that provide this product. They are also one of only two U.S. companies that produce rail track--the other is Bethlehem Steel. Currently, the company is fully backlogged for its pipeline-steel capacity. These bonds are likely to be refinanced before their maturity.

Municipals are the primary fixed-income alternative for a high-tax-bracket investor. A possible alternative might be convertible and high-yield bonds. In both cases, they can achieve a higher after-tax total return. Currently, convertible bonds have very low initial yields and, therefore, I would be quite cautious about utilizing them. We generally focus on "busted" convertible bonds. This means that the bond price has declined significantly because of a decline in the underlying common share price. One has to be very selective in this area. High-yield bonds start off with a substantially higher yield but this return comes with a much greater credit risk. There is no free lunch.

Given that I do not know much about your personal life--such as whether you have a pension plan, own your home, have family obligations, or have a well-paying job--I will assume that you are a middle-class working person, and not a senior executive or an owner of an enterprise. In that case, I would recommend allocating only a small portion of your retirement portfolio, less than 30%, to fixed-income securities. I would concentrate in higher-quality securities since you already have a large portion of your retirement invested in equities. We view high-yield securities as having many of the risk characteristics of equities. At your age, this recommended fixed-income allocation is higher than I would normally suggest, because I view equities and high-quality bonds as having similar return characteristics in today's capital markets.

Should equities rally briskly from present levels, I would then shift a portion of your equity allocation into intermediate-term, high-quality bonds or a good intermediate high-quality bond fund. On the other hand, should equities fall sharply, I would then take a portion of your fixed-income portfolio and shift it into equities. This is a concept of selling strength and buying weakness, i.e., being a contrarian investor. Over time, this strategy tends to generate a higher return with lower volatility. One last consideration, don't have your equities concentrated in one style. Consider adjusting the allocation between growth and value once every three to four years by rebalancing the mix and emphasizing the underperforming style.

Before answering your question, you comment that without investigating FPA Capital Fund's holdings, it is very difficult to get a sense of how I think. An easy way is to read the shareholder letters I write. I spend a considerable amount of time developing and writing these letters. In the September 2000 shareholder letter, I wrote an explanation of our investment management style so that, when the fund reopened on January 1, 2001, any new shareholders would have a better idea of what to expect from us. In answering your list of questions, I have consolidated some so as to keep this answer to a reasonable length.

We consider both risk and return when initially considering a new investment. Generally, we like to think in terms of how the potential upside return compares to the downside risk in the form of a ratio. In considering risk, we evaluate not only the stock-market risk but also the company-specific risk. Some industries we feel considerably more confident about than others. In order to minimize business risk, we evaluate both the company and its competitors. This requires visits to companies and management interviews. We typically follow a company over an extended period of time before making an initial investment. We think in terms of time horizons of three to five years. Our goal is to double our investment over five years. Since July 1984, when I began managing FPA Capital Fund, its average turnover rate has been slightly less than 20% or about a five-year holding period. Its average annual total rate of return from July 1, 1984 through December 31, 2001 has been 18.45%.

We focus on several measures of valuation for a stock, such as the P/E ratio, its price/book value ratio, and its price/cash flow multiple. We rarely consider companies that sell at more than one times revenues. If one pays too high a multiple of revenues, the future plays too much of a part in the company's valuation. Typically, our companies are experiencing company-specific challenges or industry sluggishness. Because of this, we want our companies to be financially strong in general. During these periods, investor expectations tend to get overly pessimistic. We want more of the stock's value to be predicated on near-term considerations. We never plan on expanding P/E ratios to justify an investment nor do we expect the stock market to be our savior. Our process focuses on one company at a time. During a typical year, we add from one to five companies to the portfolio.

Our companies are typically market leaders in industries that are viewed as being out of favor by the consensus. A good example of this was when we added three oil-service companies to the portfolio during August and September of last year. Insider ownership is important but it is not the most critical criteria. We have had a number of investment successes where management ownership would have been considered small, while in other instances we have experienced the opposite outcome. We use both qualitative as well as quantitative measures in our decision selection process. Sometimes it just comes down to a gut-level reaction. We ask the question, "Is this a management team that we would like to have manage a portion of our client's assets?"

Both Benjamin Graham and Warren Buffett have had considerable influence on my investment thinking. In 1974, I personally owned a stock that declined from $20 to $1. I did not understand how it could have gone so low. At that time, it had $2 per share in cash and $3.50 in historical-cost, Orange County, California real estate that had been purchased 20 years earlier. There were virtually no current or long-term liabilities. I could not understand how cash could sell at a discount net of debt. I was just entering graduate school at the time and nothing we were reading could explain this unusual situation. It was then that I became aware of Graham's book on investment analysis when I "discovered" it in our research library. It meant a lot to me. I became aware of Warren Buffett through my graduate investment-analysis class at the University of Southern California, when his sidekick, Charles Munger, would guest lecture. Through his discussions, the investment landscape seemed to take on a far more logical view.

Warren Buffett has been quoted in several publications in the last two years saying that equity-investment returns are likely to be 6% or 7% for the foreseeable future. I, too, wrote about this potential scenario as far back as 1997. In 1999, that forecast was not looking terribly brilliant. In fact, I felt that many were viewing me as the village idiot. In light of this expectation, we endeavor to be even more circumspect in our stock selection process. Since we do not believe that a great "bull" market will bail us out of our future mistakes, we are more inclined not to pay valuation premiums to own stocks. Higher market valuations mean that you tend to have fewer potential investment opportunities; therefore, one has to exercise greater patience than during periods when stocks are on the bargain-basement counter. Because of this, we are tending to hold liquidity for longer periods of time while awaiting an attractive investment opportunity. We feel very little pressure to put capital to work immediately.

We do expect P/E ratios to decline over the next several years. The combination of moderately higher interest rates and rising equity-risk premiums are likely to offset a considerable portion of future growth in corporate earnings. This is why we are anticipating stock-market returns of 5% or less over the next five years. Our goal is to better this level. We feel that investment returns in the 7% to 9% range should result in the top-quartile performance. Typically, investor frustration with low investment returns encourages many of them to reach for additional return by taking on more risk. Because of this, they tend to make more mistakes. We hope to benefit because of the patience and discipline we exercise in our investment decision-making process. Hopefully, we do not experience large fund redemptions because of this frustration. During 1999 and 2000, fund redemptions complicated our investment process.

Since the stock market's rapid runup from the September 2001 lows and the rediscovery of companies other than technology, it has become more difficult to uncover attractive investments. For example, in a value screen that I did on September 26, 2001, 225 companies out of the 10,000 plus companies in the Compustat database qualified. As of January 14, 2002, only 81 qualified. It appears that stock prices are running considerably ahead of improving operating fundamentals. This typically occurs at the inflection point of economic recoveries. Even considering this aspect, we do believe that investment opportunities are becoming scarcer. It is a challenge that I expect my associate team members and I to successfully overcome.

Over the years, I have come to respect the talents of the investment professionals that guide the Pacific Financial Research Clipper fund CFIMX. I also think that Bill Nygren of the Oakmark funds has done a superb job. For many years I enjoyed reading and watching Michael Price and his team at the Mutual Shares funds. I also think that Bill Miller and his team have done an extraordinary job in outperforming the S&P 500 over the last 11 years. I have not always agreed with their definition of value investing, but they have demonstrated discipline and judgment over these years. I have had the privilege and honor of meeting all of these people. Some I know better than others. They all have demonstrated one similar trait and that is the ability to independently evaluate a situation and then make a nonconsensus decision. They are not trend followers. Successful long-term investing requires the judgment and conviction to take investment positions that are considered unpopular by the consensus. I believe that consensus investing tends to be more comfortable, but it is not terribly rewarding over the long run.

I thank you for this set of questions because they are both thoughtful and insightful.

FPA Capital has generally averaged approximately 35 stocks since I first began managing the fund in 1984. We believe in having a fairly concentrated fund because this forces us to focus more on our best ideas while still maintaining a degree of diversification. We consider this important since one is less likely to get seduced out of a holding where there is high knowledge content. We closed the fund once before in 1995 at $280 million, when we expected that too much money was likely to flow in too rapidly. We do not have any particular amount in mind currently.

We expect a substandard economic recovery in 2002. Earnings and stock-market performance forecasts are too optimistic, in our opinion. We do believe that the recovery will show strength in the second half of the year, but it will be considered substandard when compared with other initial periods of economic recovery. We also believe this trend will extend into 2003. We are cautious since we are of the opinion that the aftereffects of the last cycle's capital-spending excesses will remain with us for a while longer. Though this might sound positive for bonds, we anticipate that the economic recovery will exert pressures on interest rates since they are so low. It does not take much of an interest-rate rise to eliminate a considerable portion of your annual total rate of return. Because of this potential risk, FPA New Income continues to maintain a short portfolio duration of 2.2 years. When comparing stocks versus bonds for 2002, we would give a slight nod to stocks in the performance race.

For those of you who do not know what Conseco is, it is a midsized insurance company and the largest financer of manufactured housing. The stock has been under severe selling pressure due to its exposure to the manufactured-housing industry, which is experiencing the sharpest and most severe business decline on record. In light of this, credit-quality trends at Conseco have been deteriorating for the last two years. We believe the industry has bottomed and is now in the process of beginning a gradual recovery. Kevin Clayton, CEO of Clayton Mobile Homes CMH--the third-largest manufacturer and most profitable company in the industry--recently commented that he thought the industry had bottomed as well.

We believe that there has been a large amount of unbalanced and misleading information communicated about this company. In our background checks on the new management, we have received nothing but very positive appraisals. There is no question that they are working through some difficult loan issues. We believe the company has the resources and the cash flow to recover. Since several competitors have exited the business in the last two years, finance spreads are at their widest levels ever. These wide spreads should allow the company to deal with its prior problem loans. If we are correct about the industry bottoming, typically, credit-quality trends start to improve about six months after this process begins. This means that Conseco's credit-quality trends may begin to show signs of improvement in the June quarter. In light of this, we recently increased our common-stock position substantially while also establishing significant holdings in Conseco's 2002 debt securities. We are at a profit in the bonds, and our average common-stock cost is approximately $5.50 versus a current share price of $3.40. We think this stock has a very positive ratio of reward versus risk. One caveat: should the economy fail to recover this year and begin to decline rapidly, we would then have to re-evaluate our investment position.