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Fund Spy

Two Funds Fit for Royalty

This manager is off the radar but on the mark.

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When Steven Scruggs was in the market to buy a boat engine a few years ago, he found a bargain the way the thrifty value manager uncovers a stock. Scruggs discovered that an engine model called the Evinrude Ficht had a bad reputation; models made in the late 1990s didn't work properly. He also learned that the manufacturer fixed the flaws but continued to market the engine under the same name. Sales slumped, because although improved, the engine had been permanently tainted with bad publicity. Scruggs searched online and found the improved version of the engine for a song.

That kind of thoughtfulness, tenacity, and nose for a bargain reflects the way Scruggs picks stocks for the two value funds he runs: Queens Road Value (QRVLX) and  Queens Road Small Cap Value (QRSVX).

Starting Small
During our recent visit to his North Carolina office, Scruggs told us he started the small-cap fund first, because he knew that historical studies showed value investing beats other approaches over the long haul, and he learned that the greatest disparities between price and value exist in the small-cap value realm.

"The asset class with the best historical returns and the highest percentage of firms yielding healthy amounts of free cash flow to the firm relative to price is small-cap value," Scruggs said. "It's the most inefficient part of the market."

Scruggs also watched how the best practitioners picked stocks and ran their portfolios. Investors he admires most, he said, include John Rogers of the Ariel Funds, Robert Perkins of the Perkins Funds, and the managers at the Royce Funds.

Scruggs hatched the funds while working for a family-owned advisory business, Bragg Financial Advisors in Charlotte, N.C. The firm was begun by J. Frank Bragg nearly 40 years ago. The second generation of Braggs--Frank Bragg's three sons, John, Benton, and Phillips--share in the business now. Scruggs, who has known the Bragg brothers since high school, married their sister. He works most closely with Benton Bragg, and the two serve as the "interested" directors on the fund's boards.

"Steve thinks a little bit differently from the Braggs, but we were happy to let him run with starting the funds," Benton Bragg said.

The funds haven't accumulated a lot of assets, but long-term performance has been impressive even though they've lagged in the strong rally of the past few months. The small-cap value fund has delivered an 85% cumulative return from July 1, 2002 (nearly its inception date), through July 31, 2009. Over that period, the average small-value fund has delivered 31%, and the Russell 2000 Value Index has returned 29%. The large-cap fund, created in 2004, has also outperformed. From May 1, 2004, through July 31, 2009, the fund has gained 2% cumulatively, which beats the 1% loss of the S&P 500 Index, the 0.5% gain of the Russell 1000 Value Index, and the 2% loss of the average large-value fund.

Looking Beyond the Screens
Scruggs' straightforward investment process starts with simple screens for statistically cheap stocks. Scruggs said he knows that screening can be rigid and imprecise, though, so after the screens generate some candidates, Scruggs conducts more exhaustive research, trying to estimate the firm's normalized rate of free cash flow and making sure that the balance sheet is in decent shape. He also tries to incorporate various margins of safety into his estimates, including discounting them at rates that provide some protection if he's been too optimistic.

Though not all his picks have worked out, overall Scruggs has been able to keep mistakes to a minimum--thanks in part to his attention to debt levels on balance sheets. The large-cap fund suffered a painful 33% loss in 2008, but that was better than the 37% drop in the S&P 500 Index and good enough to land in the top quartile of the large-value category. In that fund, the skeptical Scruggs mostly avoided the exposure to large commercial banks that burned some of his peers, with only a small (1.29% of assets) position in  Bank of America (BAC) early in the year. As the year wore on, Scruggs did add some shares of American International Group (AIG) before the extent of the firm's credit default swap business was known, and he bought  American Express (AXP),  Legg Mason (LM), and  Wachovia (WB) as well. None of these positions, however, made it into the portfolio's top 20 holdings.

"Steve was walking around the office telling everyone in mid-2008 that a lot of the large banks could be worthless," Benton Bragg says.

In the end, Scruggs' skepticism and attention to balance sheets kept the fund from suffering serious permanent capital impairment.

Stewardship
An evaluation of a fund doesn't stop with performance and process. It's encouraging, therefore, that preliminary observations of Queens Road's stewardship also are favorable.

First, one reason the funds are tiny in terms of assets--$15 million in Queens Road Value and $27 million in Queens Road Small Cap Value--is that Bragg Financial has resisted the temptation to steer its advisory clients' assets into the funds. In fact, many of the firm's clients got wind of the funds only through local press coverage.

Second, the fees on the funds are reasonable. While Queens Road Value's 0.95% expense ratio isn't particularly cheap for a no-load domestic large-cap fund, it's not too steep for such a tiny offering, and the fund has a breakpoint that will bring down that cost if it accumulates $250 million in assets. (There's another breakpoint at $500 million). Scruggs and Bragg have also recently lowered the expense ratio on Queens Road Small Cap Value. It's now 1.26%, according to the most recent prospectus, putting it in the cheaper half of no-load small-cap funds.

Finally, Scruggs and Bragg reported having the vast majority of their investable assets in the funds. Investing side by side with a fund's shareholders firmly aligns the manager's interests with those of shareholders. Doing so also demonstrates in a tangible way how strongly the managers believe in their investment process.

A Solidly Built Road
Altogether, the Queens Road funds offer a solid combination of thoughtful investment process and good stewardship. And the Charlotte base seems to serve Scruggs and the Bragg clan well. They're not bothered by what Warren Buffett has described as the "overstimulation" of being in a major investment center, where it can become difficult to concentrate on a few, simple good ideas. Being off the radar can have its benefits, in other words. But putting these funds on your radar would seem to make sense.

A version of this article previously appeared in MorningstarAdvisor magazine.

 

John Coumarianos does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.