Robert L. Rodriguez, Principal and CEO

February 23, 2004

Good evening.

It is a pleasure to be here tonight and I would like to thank the Wharton School of the University of Pennsylvania for this honor. It is always enjoyable meeting young professionals who are on the verge of beginning their careers. I envy all the anticipation and excitement you must be feeling, remembering how I felt at this stage of my life when my journey began. It has now lasted almost thirty-four years, and it continues to be exciting and exhilarating. What I love about my field is that each day is different — filled with challenges and competition. Uncertainty rules and chaos is normal.

By way of background, First Pacific Advisors has been in existence for fifty years. We manage approximately $6 billion of institutional and mutual fund assets with thirty-three employees. We are proud of the fact that during the last twenty-five years, we have not lost a senior investment professional to another competing organization. Many of our funds are counted among the top performers of their respective areas of investment. We are known as dedicated value investors both in terms of equities and bonds. We are contrarians at heart and soul.

In thinking about tonight's talk, I am sure you have had many great speakers share their wisdom and insight. I hope that what I have to say will prove to also be of value to you and that it will enhance your understanding of the investment field.

I can still remember my first day of undergraduate school at the University of Southern California and how apprehensive I felt since I was the first one in my family to attend university. I am a first generation American, my father having emigrated from Mexico speaking no English. I thought most of the other students came from better neighborhoods, schools and were probably smarter than I. You could say I had an inferiority complex. Despite this, I felt that if I worked harder, studied harder and focused more intensely than my competition, I could outperform them. This is the same conviction I have maintained throughout my career, and it has served me well. Words I always keep at the forefront of my thinking are Intensity, Focus, Discipline — and always Integrity.

My emphasis tonight will be about Discipline, as it pertains to investing, and the state of mind it requires. What I will be speaking about is the result of observations that have helped to influence and guide me in my journey.

My story begins by saying that I am an investment junky. I got hooked at an early age when, at ten, we were given a school assignment that required us to write to someone we did not know in order to elicit a response by mail. I did not know what to do so I asked our librarian for help. She asked me what my interests were and I said that it was MONEY! (I was an avid coin collector at the time and was able to make more money at this than working.) She showed me a book titled, The Federal Reserve System. I decided to write to Chairman William McChesney Martin since he had signed the introduction page. I received a nice letter from him informing me that I was to receive the Federal Reserve Bulletin and, as such, I would become their youngest subscriber. Following this, at twelve, I saw a movie about the New York Stock Exchange and thought, "This looks like the greatest casino in the world." The excitement and potential for profit really caught my attention. This was something I had to learn more about.

My undergraduate education confirmed my interest in the investment field, which I entered in 1971 after knocking on many doors. My first career position was that of an equity trader, then moving on to analyst and portfolio manager at the same firm. Initially, I thought one should be able to earn a 20%-25% return per year — how foolish I was. (Remember this is after the "go-go" period of the 1960s.) I did not realize that my judgment was being colored by the optimism and greed of the time. I was impressed by how many smart people there were picking stocks at this firm. They must be right because they had far more education and experience than I. I was at a growth/aggressive-growth style investment firm. There was no question in my mind that this was the way to go to become a successful investor. Let the good times roll! It was not apparent to me that there were flaws in this methodology and that first impressions are not necessarily the best.

During that memorable year of 1974, I witnessed capital destruction of the likes that had not been seen since the Great Depression. The last half of that year was one of chaos and extreme fear. I was fortunate not to be managing much money at that time; however, I was not spared from this pain in my personal account. It was during this collapse that I really began to question the growth/aggressive-growth style of investment management. It really hit home when I had my largest personal investment position collapse. I began buying this stock at $22 and averaged down all the way to $8, where I ran out of money. It eventually bottomed at $7/8. At that point I asked myself a very basic question, "Am I doing something wrong?" Nothing in my educational or business experience had prepared me for this situation. The investment books of the time did not address what I was witnessing. Here was a stock that had $2 per share in cash, $3.50 per share, on a historical cost basis, of Orange County, California real estate that had been purchased nearly twenty-two years earlier. There were no current liabilities or long-term liabilities because management had paid them off, in response to their industry's terrible business conditions. In summary, you could buy cash at less than fifty cents on the dollar and get the real estate thrown in for nothing, yet the marketplace did not see this as a value. How could this oversight occur?

In trying to comprehend this situation, I sought out old business texts and soon discovered one that would change my investment world, Security Analysis by Benjamin Graham and David Dodd. It helped me to understand what was going on at the time in the stock market, and I decided to write a paper on this issue for my graduate investment class. In doing my research, I found fifty-two other companies that had these same characteristics of the one I just described. My study raised some serious questions concerning basic elements of Modern Portfolio Theory and the Efficient Market Hypothesis that we were studying at the time. In an efficient market, how can cash sell at a discount?

My problem stock eventually turned out to be a successful investment. With the stock at $1, the company tendered for 25% of the outstanding shares at $5.50. Two years later, they were able to sell this repurchased stock back to the market at approximately $22. Executive Industries was a recreational vehicle company and, at the time, I did not understand the implications of the oil embargo. In retrospect, I don't feel too bad or too dense since the stock market went on to a new high AFTER the oil embargo began.

Following this experience, I asked myself, "What have you learned from this experience?" and it dawned on me that I had let emotion get in the way of sound judgment and discipline. RV stocks were a "hot" area for investing in 1973 and I was caught up in the hype. These companies were growing rapidly and the sky was the limit. I had to acknowledge that greed and excitement had taken over my thinking process. Through this enlightening introduction to risk and potential loss, I made a commitment that I would fight to maintain sound unemotional judgment for the rest of my career and that I would be on constant watch for these negative human characteristics both in terms of my investing and in the management of my business.

As an analyst, I began to appreciate how decision-making in business and the field of investing are both heavily influenced by emotion. Over the years, I have watched how industry after industry has fallen into the trap of emotional decision-making. Virtually every industry that I have studied has demonstrated a willingness to expand at the top of its industry cycle, only to be followed by a contraction at its bottom. At the time of the key decisions, it did not seem as though emotion was involved.

The 1979-1981 period further supported my conclusion that the unbridled emotional factor runs counter to a disciplined investing methodology. This was the time of the second oil crisis and oil and gas prices were soaring. Many "experts" were forecasting oil prices of $100 per barrel within ten years. Energy stocks were being valued as growth stocks and represented nearly 31% of the S&P 500's market capitalization. For several years, I had held a large energy exposure that, at its peak, represented over 40% of my portfolios. In early 1979 while I was at Transamerica, a high-level executive meeting was held where the implications of this crisis were discussed. We had the heads of the life, property and casualty and consumer finance companies as participants. Our senior research analyst gave a presentation on the long-term outlook for energy prices, and his conclusion was that oil would be at $80 per barrel in ten years. I asked each of the executives to assume that his analysis was correct and, if so, what were the implications for their respective companies. All of them agreed that within four to seven years, their companies would be bankrupt. Dissecting this situation in a disciplined unemotional manner allowed me to see that this was a highly unlikely scenario and that the analysis was overly negative and downright wrong. My associate came to the same conclusion.

Why was this energy lunacy so clear to my associate and I? It occurred to us that, if all our financial operations were likely to be bankrupt before the ten-year termination period, this forecast was not likely to be correct because, if it were, the economy would sustain substantial damage. We were convinced we were right because our companies were financially stronger than the average company in their respective industries. We reasoned that the economy would be severely impaired by this outcome and, therefore, the slowdown in economic activity would work to constrain the rise in energy prices.

We walked out of that meeting and began a two-year liquidation program of all our energy stocks. Many oil and gas companies appeared to reach the same conclusion as our senior analyst did since there was a high level of acquisition activity at that time. There were over 5,000 rigs working to drill for oil and gas. Tax shelters were very much alive and well in funding this accelerated drilling. The path to riches was thought to be in owning oil and gas stocks or reserves. At no time did it appear that the consensus questioned whether any of this made long-term economic sense. In the end, we witnessed large-scale capital destruction with virtually every bank in the state of Texas going bankrupt by 1987.

Without question, this was a period of mass speculation and hysteria. Minimizing the emotional aspects of our decision-making allowed us to see the situation more clearly and thus, we avoided severe capital losses. It also allowed us to see another opportunity, the bond market, where we were able to deploy significant amounts of capital, as yields were being driven to record high levels because of rising inflationary expectations. In the aftermath of the energy price break, we were handsomely rewarded in both equities and bonds for having invested at extremely attractive valuation levels.

Shortly after this period, I joined Kaufman and Broad with the purpose of helping to turn around the investment portfolios and the insurance operations of its subsidiary, Sun Life of America, which subsequently became known as SunAmerica. It was 1982 and the homebuilding and insurance industries were in a state of depression. Our mission was one of getting the investment portfolios back to par that were then trading at approximately 60% of par, within a reasonably short period of time. The insurance industry was insolvent and going broke but many did not realize it at the time. Gary Rollé, my mentor, friend and associate, and I decided that the only solution was to expand our equity holdings. We would use the profits realized from our stock investments to offset the losses from our bond portfolios. This would allow us to gradually climb out of the hole we were in without having to pray for a major bond market rally. This strategy was a radical one for the time. We liked it because it appeared that no one had considered doing this before. To us, stocks were more heterogeneous than bonds and therefore, stock selection was of greater significance than in the case of bonds. It was a wonderful time since most stocks were selling at six or seven times earnings. We were severely criticized by the rating agencies since they felt that we were taking on excessive risks by expanding our equity holdings. We viewed the issue from a different perspective in that, if things remained the same, our company would eventually die. If the level of interest rates declined, we would get a leveraged appreciation from our equity holdings since equities are essentially infinite-duration securities. Within two years, the portfolios were within one percent of parity, while the rest of the industry was still approximately twenty points below par. Again, by reducing the emotional aspects of the decision-making process, it led to a far better analysis of the situation. It was interesting to see the insurance industry come to a similar realization, but nearly twenty years later. At the time of the market peak in 2000, the life insurance industry had a record high exposure to equities. This was considered acceptable, despite P/E ratios being in the 30s, while our decision was considered to be one of "capricious risk taking," when P/E ratios were substantially lower. I think the outcome tells a different story.

The last seven years have been a further validation that emotion hampers disciplined investment decision-making. In 1997 I attempted to take a long-term view of what the potential return might be for the U.S. equity market. I concluded that one should get ready for single digit investment returns for the foreseeable future and expressed this point of view in my client and shareholder letters. The emergence of what appeared to be a growing speculative investment environment worried me. By the spring of 1998, I was requesting from our clients greater flexibility in the level of liquidity that could be held. All granted this request. Liquidity levels in my mutual fund, FPA Capital Fund, grew to 33% because a record low number of qualifying companies were being generated from my computer screens. My associate, Dennis Bryan, reached the same conclusion when he did his screens. This decision was completely out of step with much of the investment industry. In retrospect, we had identified the peak of the broader stock market. Again, we reached our conclusion in a very quantitative, unemotional, and disciplined way.

As the major indexes peaked in the spring of 2000, my March 2000 shareholder letter compared the Nasdaq Index's valuation to that of the stock market of 1929 and concluded that the Nasdaq was far more expensive. One would have thought this conclusion would have been an obvious one, but it was not to most investors. If it were, we would have witnessed a far different outcome. I still cannot believe the magnitude of foolishness that permeated the investment field. Whether it was investment management companies, pension funds, mutual funds or pension-consulting firms, I believe most failed their missions. Despite their having among the best-educated, technology-proficient analysts with access to the timeliest information, there was little movement of capital away from higher-risk investment strategies. Allocations to equities by pension funds and the household sector were at record levels. Between 60% and 70% of all equity fund net inflows in 1999 and early 2000 were into growth and aggressive-growth funds. We value managers were under heavy redemption pressure from most of our clients, as they shifted their assets to more growth-oriented investment styles. We experienced virtually no client rebalancing inflows from these higher-risk investment strategies. The only thing I can conclude is that there was mass greed driven by emotion. If this were not the case, we would not have witnessed the greatest capital destruction in the history of man.

As I said before, my investment world changed after "discovering" Graham and Dodd in 1974 and, in particular, meeting Charlie Munger that same year. I soon realized that value investing requires great self-discipline and a dedication to reducing the emotional aspects of investing to as small a level as is humanly possible. It became crystal clear to me that to outperform my competition, I would have to walk a lonely road. I still remember the day that Charlie Munger spoke about his "lemon meringue pie" theory of investing. He described how a bakery had a special sale of fifty cents per pie. This was fantastic since he loves lemon meringue pie. Not only could he buy a pie, he could buy the entire production. A production snafu had led to the bakery over producing lemon pies and, therefore, the baker was looking for a way to get rid of them. Charlie appeared to be magnanimous because he said he would take the entire lot and that he would return with a truck to pick them all up. Why would he do this? It seems that down the road there was another town that had a craving for lemon pies and the people there were willing to pay $3 per pie. The moral of the story was, when you find your lemon-pie investment opportunity, don't buy just a little, back up the truck and buy everything. I have never forgotten that story throughout my career.

A modification of this story that I tell my associates and clients is that we are in the business of making investments in the land of tall trees. By that I mean we will have concentrated investments in both companies and in industries. As Charlie would say, and this is an approximate quote, "diversification is the hobgoblin of small minds with little confidence." In light of this, we spend a huge amount of time looking and researching. We want to make a limited number of investments per year and hold them for an extended period of time. We are not traders. Over the last twenty years, my average portfolio turnover has been less than 20%. Typically, we hold between 30 and 35 stocks, with the top 10 representing 40% to 60% of the average portfolio. We will typically have between 35% and 50% in two industries. I have found that this is about as concentrated a level that the average institutional client can withstand. This is also the case for my equity mutual fund. We are willing to accept greater portfolio volatility because of investment concentration so as to have a better understanding of our investments than the average holder.

Concentrated investing forces one to focus on the best ideas and eliminate many of the distractions that come with highly diversified portfolios. Furthermore, I believe that one is less likely to get seduced out of an investment situation if one has a good understanding of what one owns. I have come to this conclusion by watching what "professional" investment managers have done over the last thirty-four years. In every major stock market decline, I have witnessed wholesale selling that resulted in liquidity levels rising for both pension funds and mutual funds. This is a perfect example of closing the barn door after all the animals have run out. How wonderful it is to be in a business where, when something goes on sale, most everyone runs away. It is fantastic because it creates investment opportunities for those who are disciplined, patient and decisive.

The big challenge in value investing is that you will be generally investing against the consensus. As you can imagine, it is an extremely lonely investment style. Your logic as well as your sanity will be questioned. At the end of the 1990s, we value managers were being denigrated because many thought that we did not understand the "new" investment environment. We were old and out of date. At the time, I said, "I get it, but I just didn't want it." Had the critics read Graham and Dodd's 1934 edition, they would have learned about the "new-era theory" of investing that prevailed at the end of the 1920s. The most extreme form of this unsound thinking involved internet stocks. At the beginning of 1999, I began writing that their valuations were not only discounting the future but also the hereafter. Obviously, this was not a popular point of view. The magnitude of capital that was thrown at this area by so many constituencies still astounds me. Those who did were oblivious, or chose to be oblivious, to the fact that there was virtually no investment merit in any of these companies. This was mass speculation masquerading as investing. At the time, I told my clients that, if they had any investment managers deploying capital into public internet stocks, they should fire them because it was obvious that these managers could not discern the difference between investing and speculating. This was a time when many were speculating with OPM. You know, Other People's Money.

To guard against the emotional aspects of investing, we follow some general metrics and assiduously avoid following the crowd. The key attributes of this style are the following:

1. Focus on market leadership or niche companies that are in industries that are perceived to be out of favor and unloved — a bottom-up strategy.
2. Select companies that have strong balance sheets — typically with total debt to total capital of less than 40%.
3. They must be at a significant valuation discount to the market and its historical valuation parameters.
4. Acquire them at modest premiums to book value and at less than 1x revenues.
5. They should be on or close to being on the new low list.
6. Have a long-term investment time frame — typically three to five years.

Examples of this strategy have been:

1. Our California "play" companies purchased during the depths of the 1990s recession. One of our long-term holdings, Ross Stores, is still in the fund today with a gain that is over twenty-fold.
2. In our March 2000 Shareholder Letter, we compared Centex's valuation to that of the Nasdaq. This comparison helped to show how there was a major disconnect in valuations and that one of these two examples was severely mispriced. We argued that it was the Nasdaq as well as the other major stock indexes. We recently sold our Centex position, after capturing a nearly six-fold gain, while the Nasdaq has declined approximately 60%, by comparison.
3. A new area for us is in the energy-service industry. We are in the process of making energy a new strategic investment area for us. This is a major change for me since, after selling virtually all of my energy stocks between 1979 and 1981, I did not purchase another until early 1999. Our average portfolio exposure is currently 16%.

As I speak to you tonight, I believe we face one of the more difficult periods in which to make rational investments. The equity investment landscape is one of fairly high valuations accompanied by very little differentiation between the various market capitalization sectors. On January 18, we published a piece on our website, www.fpafunds.com, entitled "Slim Pickings." It describes the challenging situation we face today. As an example, look at the new low lists, as reported by the Wall Street Journal. Just recently, there were no new lows on the New York Stock Exchange, while there were a total of four for the Nasdaq and the American Stock Exchanges combined. My response to this has been to let my equity mutual fund's liquidity grow to nearly 29%, and it will likely increase to 32%, when a pending acquisition closes in April. Given the current rate of cash inflows and anticipated stock sales, I see this level rising to between 35% and 45% by June.

This cautious outlook makes it very difficult for us to take on new business. We are operating like the Marines — we are looking for only a few good accounts. In the last six weeks, we turned down the opportunity to manage a $225-million account. They wanted us to get invested virtually immediately. We were unwilling to take on this business because of the potential for disrupting our investment thinking. We are accepting only new accounts that give us sufficient flexibility in capital deployment. By managing our business in a disciplined manner, we believe it will lead to long-term success for our clients and us. Those companies that do not have discipline are bound to experience difficulties that could jeopardize their success. I believe a lack of business discipline was a contributing factor to the problems that surfaced in the mutual fund industry recently.

We also deploy a very disciplined value methodology in fixed income management. I came to the field of fixed income investing between 1979 and 1980, when high-quality bond yields were commensurate with the long-term returns from common stocks. Bond managers were becoming universally pessimistic because of rising inflation. As yields rose, they became progressively more defensive. Unless you believed the economic system was likely to unravel and that we were about to become a "banana" republic, why would one want to become so defensive? Little did they know that we were on the verge of beginning a twenty-three year decline in yields. This was but another example of fear overcoming reason and rational investment thinking.

I believe the bond market is currently positioned diametrically opposite to how it was in 1980. My associates and I see virtually no value. One has to take on too much credit or interest rate risk to achieve any type of return. It is analogous to a stock market, with a very high P/E ratio, that is discounting an optimistic scenario. Our intermediate bond fund's portfolio duration is the shortest ever at 1.12 years. We felt so strongly about our point of view that we published a piece last June entitled "Buyer's Strike." Our clients and shareholders know that we will not risk their capital until we believe that we are being sufficiently compensated to take on risk.

Again, we believe that we must do something different to differentiate ourselves from not only our competition but also from the market.

The result of this disciplined investment process has led to FPA Capital Fund becoming the top-performing diversified domestic-equity fund for the twenty-year period ended December 31, 2003 (out of 234 funds meeting the criteria) (Dallas Morning News, January 27, 2004). I have been managing it for all but six months of this period. From the inception of my management in July 1984 to December 2003, its compound annual return is 18.13% (at net asset value, excluding sales charges). By comparison, the total returns for the Russell 2000 and the S&P 500 are 11.03% and 13.63%, respectively. In the case of my bond fund, FPA New Income, its total return from July 1984 through December 2003 is 10.27% (at net asset value, excluding sales charges) versus the Lehman Brothers Government/Credit Index's total return of 9.67%. During this period, the fund has been able to outperform the index with only about one-third its volatility while never having had a down calendar year of performance. This trend extends to 29 years, when we include the record of the previous manager.

During the past year, FPA Capital Fund has had its long-term performance highlighted by both Forbes magazine and the Dallas Morning News. During the fifteen-year period measured in the Forbes study, 75% for all funds failed to outperform the S&P 500. For the twenty-year period measured by the Dallas Morning News, 89% failed to outperform the market. These are damaging statistics for anyone who is considering entering the active money management field. It is damaging since this period covers a time when we have had the most educated, best access to timely information and greater understanding of how the economy works than any other generation of investment managers. With these competitive advantages, I would have to say that most in the field of active management have failed the test of justifying their existence. If this negative trend continues, I believe a logical outcome is for passive investment management to gain a considerably more significant share of investment portfolios. Those investment managers that add value with distinctive and differentiated products will be survivors. In a way, I hope all portfolios go to indexation, with the exception of those at my firm, because it would make for a wonderfully inefficient market environment where extraordinary investment returns could be earned.

I believe my firm does provide products and services that our clients value. As an example, we are currently talking to them about the challenges we see in the investment landscape today. We are again asking for greater latitude in holding liquidity. We are also telling them that they should consider amortizing last year's equity investment performance over a period of four or five years, so as to be on the conservative side with regard to their pension assumptions.

Both in bonds and equities, we are taking extraordinary measures to protect capital, since we believe we are in a period of diminished investment returns. When I try to imagine looking back at this period from the perspective of ten or twenty years from now, I would like to be able to say that, when others were unwilling or incapable of judging the risks that were in the system at that time, we took the appropriate actions. It is this willingness to step away from the crowd that I believe separates my firm from the vast majority out there today.

Before closing, I believe that a brief word should be said regarding the difficulties that the mutual fund industry is facing today. Our troubles are of our own making. I believe arrogance, greed and a lack of business discipline have led to this sad state of affairs. For those professionals and organizations that have betrayed their client's trust, they should be prosecuted to the fullest extent of the law. I am proud of the fact that my firm was one of the very first to comment on the difficulties facing the industry. On October 31, 2003, we published on our website "Comments on Transgressions in the Mutual Fund Industry," which has been referred to by several publications. The changes that are being considered to improve the industry's operations and governance have been standard fare at my company for years. I believe our conservative and disciplined way of managing our company has cost us business over the years. Despite this, our goal has always been to be among the best firms in the industry and not one of the largest. We view our clients and shareholders as partners and not as customers. First Pacific Advisors is managed with an investment focus and not a marketing focus. Finally, never sell your reputation. It takes a lifetime to build one and only one day to lose it.

With that final commentary, I would like to thank you again for the privilege of speaking with you tonight. I hope I have provided you with some useful insights and that I have stimulated your thinking about the investment field. Good luck to you all in your future careers. Should there be any questions, I would be more than happy to try and answer them.