Morningstar Advisor - August/September 2009 - 55

Steve thinks a little bit differently from the Braggs, but that’s not necessarily a bad thing, and we were happy to let him run with starting the funds. Benton Bragg discounting them at rates that provide some protection if he’s been too optimistic. Scruggs isn’t afraid of cyclical stocks or buying businesses when their earnings are at a low point in a cycle, especially in the small-cap fund. For example, Scruggs is sticking with Hurco HURC, a company that makes computerized machine tools and software products for companies in the metalworking industry. The firm has seen revenues decline in recent quarters, but Scruggs thinks that the stock is being priced as if they will never recover. The firm has no long-term debt on its balance sheet, however, and it can likely withstand an extended economic storm. Scruggs added to his position in late 2008, and the stock has risen more than 20% in 2009 through mid-June. Scruggs hasn’t had to wait long for Horsehead Holdings ZINC, a zinc producer. Zinc is sensitive to the economic cycle, and the firm’s revenues declined from $546 million in 2007 to $445 million in 2008. Still, the demand for zinc isn’t likely to evaporate completely. The stock plunged around 72% in 2008, and Scruggs started a position late in the year. He doubled his stake in early 2009, and the stock has gone on a torrid run since late February, far surpassing even the hot market averages. Another feature of Horsehead is its balance sheet, which sports more cash (nearly $100 million) than total liabilities (around $55 million, including very little long-term debt). Where Scruggs has stumbled before is with companies that have taken on huge amounts of debt. For example, truck-maker Osh Kosh OSK took on nearly $3 billion of debt in 2007, at the very end of the cheapest credit cycle in recent memory. Now that the recession has caused a decline in sales, the firm has had trouble covering its $40 million quarterly interest payment with operating earnings, even after adjusting for non-recurring charges. Scruggs began trimming the position early in 2009, according to filings. Overall, though, Scruggs has been able to keep mistakes to a minimum, thanks in part to 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 and good enough to land it in the top-quartile of the large-value category. In the large-cap fund, the skeptical Scruggs mostly avoided large commercial-bank exposure, with only a small (1.29% of assets) position in Bank of America BAC early in the year. As the year wore on, Scruggs added some shares of American International Group AIG before the extent of the firm’s credit default swap business was known and shares of American Express AXP, Legg Mason LM, and Wachovia WB. None of these positions, however, made it into the top 20 holdings of the portfolio. “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 clients got wind of the funds only through local media coverage, and they wanted to know why Bragg didn’t recommend the funds to them. Second, the fees on the funds are reasonable. Queens Road Value’s 0.95% expense ratio is enough to put it in the third quintile of no-load large-cap funds, but it also has breakpoints. If the fund should accumulate $250 million in assets, the fee will come down to 0.85%. If the fund should accumulate $500 million in assets, the fee will be 0.80%. At the first breakpoint (0.85%), the fund would be in the second quintile of no-load large-cap funds. Scruggs and Bragg have also recently lowered the expense ratio on Queens Road Small Cap Value to 1.24% from 1.35%, putting it in the cheaper half of no-load small-cap funds. Finally, Scruggs and Bragg report having the vast majority of their investable assets in the funds. They’re both young, so the amounts probably aren’t very large, but as the brothersin-law get older and the funds become more successful, their stakes should grow. Altogether, the Queens Road funds seem to be a solid combination of thoughtful investment process and good stewardship. The Charlotte base serves Scruggs and the Braggs well, too. They’re not bothered by what Warren Buffett has described as the “overstimulation” of being in a bigger investment center, where it can become difficult to concentrate on a few, simple good ideas. And when things do get busy, Scruggs can always escape to his boat—to figure out quietly which stock he’s going to fish for next. K John Coumarianos is a mutual fund analyst with Morningstar. Preliminary observations of Queens Road’s stewardship are favorable. First, the funds are tiny in terms of assets—$13 million in Queens Road Value and $21 million in Queens Road Small Cap Value. Bragg Financial has refrained from jamming them full of assets from their advisory clients. In fact, many of the firm’s MorningstarAdvisor.com 55

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Morningstar Advisor - August/September 2009

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