FBR Small Cap: In Search of Compounding Machines

This may finally be the year of large-company stocks. Year to date through May 16, the Russell 1000 index of large-cap stocks returned 8%, more than three percentage points better than the Russell 2000 index of small-company stocks. But instead of chasing returns and leaving your allocations all out of whack, make sure you keep a reasonable helping of small-company stocks in your portfolio.

One fund we've grown to like is FBR Small Cap (symbol FBRVX), a new member of the Kiplinger 25, a list of our favorite no-load funds. And what's not to like? Run by Chuck Akre of subadviser Akre Capital Management since 1996, FBR Small Cap has returned an astounding 19% annualized over the past decade. But what's really unusual about Akre, who's situated in Middleburg, Va., is that he's a growth manager who adheres religiously to value-investing principles.

Akre says he focuses on three elements when picking stocks. First, he seeks an attractive business model, which may be demonstrated by a company's consistently high return on equity (ROE is a measure of profitability). Next, he looks at the "people model" -- meaning whether the company's managers act in the interests of investors. "We want the people running the business to be partners with shareholders, even though they don't know them," he says.

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Finally, he studies the "reinvestment model." Here, Akre determines whether the businesses have attractive opportunities to invest excess cash and profits in order to keep compounding shareholders' capital. When he finds those elements, he's uncovered what he calls a "continuous compounding machine." (We should add that, like any good value investor, Akre is also a stickler for buying at the right price.)

It may not surprise you that Akre swings at few pitches: His portfolio turnover is a microscopic 3% a year, and the top ten holdings account for a highly concentrated 78% of the fund. But when he does swing, he tends to hit home runs. For example, his top four holdings (a third of the fund) -- Penn National Gaming (PENN), American Tower (AMT), Markel (MKL) and CarMax (KMX) -- have all been grand-slams.

Despite the fund's name, FBR Small Cap is sometimes categorized as a mid-cap fund because so many of the stocks have seen their market values blossom over time. "We don't have to sell winners," explains Akre. "I'm trying to compound our fellow shareholders' money at above-market rates with below-market risk."

To read more about FBR Small Cap, see Hello Again to a Top-Notch Fund.