Manager Takes Over Financials Fund at Tough Time

JEFF ARRICALE, a mutual fund manager at T. Rowe Price (TROW), left Baltimore in March and took a train, the subway and two airplanes — all told, a 20-hour trip — to ultimately arrive at a makeshift burlap lean-to in Morocco at the starting line for the Marathon des Sables, one of the most grueling races in the world. Runners cover 156 miles in the Sahara Desert and traverse massive sand dunes and hard flats littered with jagged rocks. And they do it while enduring scorching 120-degree temperatures. Arricale spent months training for the event and eventually completed it in six days. Later, he said it was "one of the most humbling experiences of my life."

Arricale may seem like a glutton for punishment, especially considering what he was experiencing back at work. Twelve months prior to running the race he was promoted to manager of the $350 million T. Rowe Price Financial Services fund (PRISX), giving him a front-row seat to the unprecedented tailspin that industry experienced. He may have crossed the finish line out in the desert, but by many accounts he is far from putting the chaos at work behind him. Indeed, as he took control of the fund he watched as seemingly overnight some of the companies he owned wrote down the value of billions of dollars of assets and, in the case of Bear Stearns, ceased to exist after eight decades on Wall Street. All that was enough to make a run through a barren wasteland seem like a nice break.

Arricale had put together successful stints as an analyst at T. Rowe and as co-manager of the firm's well-respected Capital Appreciation fund (PRWCX), helping steer that charge to a top 10% position in its Morningstar category. In his new job he helps oversee a team of analysts whose research on financial-services stocks finds its way into the hands of the firm's marquee managers. In other words, there is a lot riding on Arricale and his team getting it right. That means doing homework — lots of it. As many talking heads speculate on TV about whether financials have hit bottom, Arricale has quietly stuck by the tried and true research methods that have been the hallmarks of his employer for over 70 years. And that seems to have stemmed the bleeding just a bit. The fund lost 9.4% last year and is down 19.8% in 2008. This year's tally beats 70% of the competition, according to Morningstar.

With that in mind we conducted several interviews with Arricale over a six-month period to get his thoughts on the lessons he's learned from the protracted credit crisis and which financial-services stocks will be left standing when the smoke finally clears.

SmartMoney: Why did you compete in such a grueling race?

Jeff Arricale: I was raising money for Opportunity International, the Maryland Chapter of the Special Olympics and Johns Hopkins Children's Center. I have two kids with a lung disease who have been treated [at Hopkins]. I want them to see their mom and dad being healthy and active. I want them to aspire to do the same even if they have some physical limitations. We have raised $70,000 and we aren't done yet.

SM: When you started this job the market took a turn for the worse. What was your first inclination?

JA: It was to be defensive. I took down some positions in banks and I added more cash. I also included some nonfinancials in the portfolio. General Electric (GE) and Tyco (TYC) were big contributors over the last year. I have since taken those positions down to 2.5% of the fund from 10% as financials have increasingly become compelling values. I eliminated GE at an average price of $38.42.

SM: Price/book failed when you couldn't value some assets. What happened?

JA: I use price/book a lot in financials. And I think in most sectors price/book works. However, during times of distress at financial-services firms their assets are inherently fragile. Companies were awash in liquidity in 2005 and 2006. But when there is no market for those assets you can't sell them. Contrast that with an oil or gold company. It's easy to put a price on a barrel of oil or an ounce of gold. Liquidity is now front and center [for us]. A perfect example of that is Sallie Mae (SLM). Sallie Mae is a great buy if the securitization market for student loans opens up again. If it doesn't, it's a terrible stock. I am waiting to buy it.

SM: Can you give us your take on the troubles at Fannie Mae (FNM) and Freddie Mac (FRE)?

JA: We cut our losses to them. The problem with the GSEs [government-sponsored enterprises] is we really have no way of handicapping what the ultimate government solution is going to be and with the majority of those solutions it doesn't bode well for equity holders, although fixed-income shareholders should be fine. When Freddie ultimately raises the $5.5 billion of capital it has committed to raising, we will take a fresh look.

We are getting our housing-related exposure through home builders and regional banks. With the home builders we feel there is some real estate and some actual dirt there — real assets that have some value. And with the regional banks we feel like a lot of the companies that have raised capital and significantly increased their loan-loss reserves are good buys.

SM: What have been your biggest mistakes during your first year as manager?

JA: I weighed into the bond insurers. At one point I had over 2% of the fund in bond insurers. I no longer own any of them. I can sit here and defend my investments in Citigroup (C) or Merrill (MER). I can't defend my investment in the bond insurers. I got it wrong.

SM: You also owned Bear Stearns.

JA: We started buying Bear Stearns after some of its hedge funds blew up last summer. We saw an investment bank that had been around for almost 100 years starting to trade at a huge discount to book value. We thought it would just ride out the credit storm like it had in the past. It turned out it was a huge mistake because counterparties lost confidence and the Fed was forced to act to the detriment of Bear Stearns' equity holders in order to shore up the financial system. We sold the investment at around $6 a share.