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Mutual Fund Q&A: 
Diligent and Disciplined
Queens Road Small Cap Value Fund
Management: Steve Scruggs

Author: Manish Shah
Last Update: 8:55 AM ET January 11 2011


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Careful stock picking is just as important as a disciplined investment approach. Steve Scruggs, portfolio manager of the Queens Road Small Cap Value Fund, remains permanently focused on fundamental valuations in search of better investment opportunities.

 
Q:  What is the history of the company and various funds?

A : The history of the fund dates back to the early 1960s when it began as a family business founded by Frank Bragg. Since 1998, Bragg Financial Advisors started offering asset management to individuals, institutions, trusts, foundations and corporations with a disciplined approach to investing. At present we manage $20 million in large-cap and $40 million in small-cap value strategies.

Q:  How would you define your investment philosophy?

A :
The investment in both funds seeks long-term capital growth. The small-cap fund typically invests at least 80% of its assets in equity securities of companies with market capitalization no more than $2 billion. The advisor pursues a value-oriented strategy and seeks to identify companies whose stocks sell at discount to normalized earnings, price-to-and normalized free cash flow. We are also looking for companies with strong balance sheets and experienced management teams. Additionally, we are screening the investable universe for companies trading at a discount to their intrinsic value.

Q:  What is the lower limit for the small cap market in your fund?

A :
We generally consider all those companies whose market capitalization ranges from $100 million to $2 billion at the time of purchase, and sometimes the upper limit can extend to $3 billion.

Q:  Would you highlight some of the traits that differentiate your fund from others in this space?

A :
Our asset management company is a small, family-owned business and we feel that our diligent, patient and disciplined approach gives us a cutting edge.

When we say diligent, we are very careful in our research and screening while looking for candidates. When we say that we are disciplined, we stick to our principles at all times and do not change the way in which we select securities. Additionally, patience gives us the capacity to wait in the long term before we find out if our findings have been corroborated by the market by rewarding the names in our portfolio.

At times the market may focus on valuations in the fundamentals and at other times it may simply start ignoring them, but we focus all the time on the valuation of the fundamentals. In this way, when the risk premium is priced into the market, we do really well, and, when there is no risk premium priced into the market, we stay just below the index. Generally, we find that when we do really well, it more than compensates for the drop in less successful periods, and this is where being patient helps tremendously.

Q:  What is your investment process?

A :
We have a disciplined process of looking for ideas in the small-cap field from almost anywhere. Once we have formed ideas, we screen the names to look for those names that meet with our search parameters. What we look for in a company is a strong balance sheet that is not dependent on outside access to fund markets for its existence. In other words, we search for companies that generate sufficient free cash flow for its existence and expansion needs. This factor alone eliminates most of the names under review.

After we separate those names, we run the data on an in-house model based on some characteristics such as revenue growth, operating margin, working capital needs, capital expenditures the company requires, and compare the results with our return on investment requirements to arrive at the volatility of revenue and operating margins. The model also helps us compute a discounted cash flow using historical data to arrive at an intrinsic value.

At this point, we are ready to construct our portfolio in time by picking names that are trading at a discount to the value, which gives us some downside protection right from the beginning.

Q:  Could you give some examples?

A :
Last year we bought Immucor, a company that develops, manufactures, and sells reagents and systems used to detect and identify cells and serum components of human blood prior to transfusions. Immucor is the leader in the blood bank development automation systems. The company’s substantial income comes from the sale of reagents that are used in identifying cells and serum components of human blood. Similar to the razor and blade business, the company has steady revenue from the reagents.

Immucor has great margins in this system and the management, which has been the same since they went public more than a decade ago, is very stable. The company’s balance sheet is strong with lots of free cash flow that the company is able to reinvest.

Even though Immucor does not have high growth in this business, we found both the volatility of revenues and margins were very low. Consequently, in our estimate we felt that we were getting good returns for the amount of risk that we were taking.

Another example is Tellabs Inc, a company that provides backbone communications services to Internet access providers. Tellabs is firmly entrenched in this market. Their cutting edge technology, which they provide a lot cheaper than others, is getting a lot of revenue for the company that is growing with the expansion of the market. Even though they are by no means a very big company, they reinvest a major portion of the free cash they generate in their research and development to stay ahead of others.

AT&T, one of Tellabs’ largest customers, recently announced in June that they are going to work with one more company as an additional service provider and the stock fell nearly 20% to 25%. But on a deeper research we found that they recently acquired a company that is a leader in facilitating in 3G and 4G communication for mobile applications. We felt that an additional player would in no way affect the earnings of this company, which had the wherewithal to grow earnings on the strength of their developments alone.

Q:  What is your benchmark?

A :
Our primary benchmark is the Russell 2000 Value Index.

Q:  How many names do you usually keep in the portfolio?

A :
We normally between 50 and 60 names across as many sectors and industries as possible. The initial investment in a stock is between 1.5% and 2%, but it can go up to a maximum of 5%. We trim the allocation once the position size exceeds 5% to limit the exposure to a name.

As mentioned earlier, we stay disciplined in our approach but if we do not find enough names as we would like, we could end up with less names and carry as much as 15% cash that can be used at the time some other opportunity presents itself. Once we acquire a stock, we would like to be patient and hold it at least for a period of three years to get the benefit from the growth.
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