Fund name: Intrepid Capital (ICMBX)

Objective: The fund seeks long-term capital appreciation and high current income. The Fund invests primarily in small and mid-capitalization common stocks (the median market cap is under $3 billion) and high-yield securities (about 30% of the portfolio), with an average credit quality rating of "B" (speculative). It pays a quarterly dividend.

Adviser: Intrepid Capital Management, Inc. The adviser was started in 1994. Its clientele has historically consisted primarily of high net-worth individuals and charities, but it also advises the four Intrepid funds: Small Cap (ICMAX, 5-star rating from Morningstar as of 2/10), All Cap (ICMCX, not yet rated), Capital (ICMBX, 5-star) and Income (ICMYX, not yet rated). The Adviser currently has approximately $630 million in assets under management, of which $500 million is in its mutual funds.

Manager: Mark Travis, Eric Cinnamond and Gregory Estes. Mr. Travis is the lead manager, Intrepid’s president and CEO, and he’s been managing investments for 24 years. Before founding Intrepid, Mr. Travis spent a decade as a Vice President of the Consulting Group of Smith Barney. Mr. Cinnamond is Intrepid’s director of research and the lead manager of the very fine Intrepid Small Cap fund. Before joining Intrepid in 1998, he co-managed Evergreen Small Cap Equity Income Fund. That fund was ranked in Barron's Top 100 Funds for two consecutive years while Mr. Cinnamond was co-manager. Mr. Estes oversees All Cap. Before joining the firm, he oversaw a quarter billion in private investments for the Bank of America.

Management’s Stake in the Fund: Regrettably modest. Mr. Travis has something between $50,000 and $100,000 while Messrs. Cinnamond and Estes have under $10,000.

Opening date: January 3, 2005. The fund follows the same strategy as their "balanced" separate accounts, which they’ve been managing since before 1999 (though I can’t tell exactly how long before). The Intrepid funds were launched as a tool to allow the advisor to move their smaller investors out of the separately managed accounts and into a pooled investment vehicle.

Minimum investment: $2,500 across the board

Expense ratio: 1.49% after annually-renewable waivers. There’s also a 2% redemption fee on shares held for under a month.

Comments: Investing in balanced funds is good. They, like Curious George, do things that you don’t do. They maintain exposure to a variety of asset classes, and not just this week’s hot offering. They rebalance and reallocate resources with some discipline. They entail less paperwork, and sometimes lower costs, than maintaining your own multi-fund portfolio.

Investing in balanced funds is bad. A classic Monty Python routine, "Vocational Guidance Counselor," captures the core of their problem when counselor John Cleese offers this analysis of his client, Mr. Anchovy:

The mass of balanced funds, to quote Thoreau, "lead lives of quiet desperation." They invest in the same large cap domestic stocks and government bonds. Few risk a distinct "value" tilt and fewer still are growth-oriented. It’s not surprising that so few of them – about 25% -- add enough value to earn back their expenses and outperform Vanguard’s spectacularly pedestrian Balanced Index (VBINX).

The managers’ reply is predictable: "we’re not paid to take risks; we’re paid to be the steady one." Unfortunately, "steady" translates to "high price index-huggers."

There is an alternative: invest unconventionally. The heart of modern portfolio theory is that uncorrelated, risky asset classes can be combined so that the whole is greater – and more stable – than the sum of its parts. Two obvious candidates for higher return sub-classes are smaller cap stocks and high-yield bonds.

The case for small, and in particular, small value stocks is well-known. Over very long periods, smaller tends to trump bigger and cheaper tends to trump pricier. Folks are less comfortable with the case for high-yield bonds. These are bonds issued by companies with troubled balance sheets. Those troubles make bond investors demand a higher coupon in order to compensate for the risk that the company will not be able to make its interest payments. The argument for high-yield is pretty straightforward:

• Long-term investment grade bonds barely beat inflation. Bill Bernstein, in the Four Pillars of Investing, dismisses that as "a sucker’s bet – they are quite volatile, extremely vulnerable to the ravages of inflation, and have low long-term returns."



• In contrast, high-yield bonds offer about 80% of the stock market’s return for about 50% of its volatility. That’s because these bonds pay, on average, 300-400 basis points more than investment grade bonds. That huge yield advantage is driven by the fact that investors tend to overstate default risk (the consensus for 2008 was 20%, the reality was under 10%) and demand excess return.



• High-yield bonds are uncorrelated to the bond market as a whole (the R-squared for high yield funds to the bond aggregate is in the single digits) and only modestly correlated to the stock market (R-squared somewhere in the 50s), which means they diversify effectively. Unlike investment grade bonds, rising interest rates pose a limited risk to high yield debt.

This leads to two interesting observations: (1) almost all balanced funds avoid these asset classes and (2) the few who invest in them tend to be winners.

Of the 300 or so "moderate allocation" funds in Morningstar’s database, less than a tenth offer substantial exposure to lower-rated bonds. Even fewer, about 20, offer substantial exposure to small and midcap stocks. Combine those criteria and you end up with precisely four funds that have exposure both to smaller cap stocks (at least 40% stock, average market cap under $10 billion) and high yield bonds (at least 20% bonds, average credit quality below "A"). It’s intriguing that 75% of those funds are rated as five-star (Changing Parameters, Greenspring, Intrepid) by the good folks at Morningstar.

The list of balanced funds with the best ten year records and highest Morningstar ratings tends to be dominated by funds with distinctive (read: "risky" profiles) – Bruce, FPA Crescent, Greenspring, Leuthold Core, Mairs & Power Balanced, Manning & Napier Pro-blend, Oakmark Equity & Income, T. Rowe Price Capital Appreciation.

Intrepid Capital is on the short list of balanced funds that can justify their own existence. ICMBX invests in small- to mid-cap companies, but mitigates the risk of such investing by imposing very conservative financial criteria (low debt, high free-cash flow, predictable revenue streams, high barrier to entry) along with a conservative "buy" threshold (the firm must sell for less than what a private acquirer would rationally pay to buy the whole company). They own about 30 stocks and don’t hesitate to sell when the stock appreciates. They had abnormally high turnover in 2009 (about 90%) because they bought vigorously in late 2008 and saw a lot of their holdings blow through their price ceilings. Normally, their turnover would be about half as great.

The fund also invests in high-yield bonds, typically with a fairly short duration (two to six years). Because most institutional investors avoid the thousand or so issuers in the trillion dollar high-yield market, inefficient pricing is common and the managers believe they can add value by doing all of their own research, while assiduously ignoring Wall Street’s opinions.

The strategy seems to work. The fund’s trailing three- and five-year returns are in the top 2% of its category. It consistently beats its benchmark (60% S&P 500/ 40% ML High Yield index). To control for the fact that the fund’s market cap is far lower than the S&P’s, I constructed an alternate benchmark featuring a small- to mid-cap index (Vanguard Extended Market) and a high yield fund (Vanguard High Yield Corporate). The fund beat that benchmark and the moderate allocation average in three of the past four years and did spectacularly better during the 2008 meltdown (losing 16.7% to the benchmark’s 31.7%). It’s also beaten several of the balanced funds that I’ve profiled, including Mairs & Power Balanced (MAPOX), which also dabbles in lower-rated bonds, in each of the past four years.

Worry-warts might reasonably note that the fund has a fairly short track record, just five years, though the separate accounts whose strategy it implements have a ten-year record and those accounts very consistently beat their benchmark. The fund’s expenses are rather higher – 1.49% -- than ideal, but not ridiculous for a small, distinctive fund. And the fund offers negligible international exposure (about 3% of its portfolio). The manager appears fairly apprehensive about the current state of America’s finances, which is reflected both in the anti-Obama cartoons festooning his quarterly newsletter and the fund’s 25% cash stake.

Bottom Line: While this is not an ultra-conservative, "ain’t never gonna lose no money," fund, Intrepid does a nice job of illustrating why earning more than Wall Street offers requires thinking differently than Wall Street does. For folks who are interested in a fund that offers most of the stock market’s thrills with only a fraction of its chills, Intrepid Capital is worth a closer look.