From the December 2004 issue of Investment Advisor • Subscribe!

A Five-Star Performer

Chip Carlson uses a combination of "inefficiently priced" stocks and "busted convertible" bonds to forge Greenspring Fund's highly effective investment strategy

The characteristics of the Greenspring Fund (grspx) might be a little hard to grasp at first glance. S&P calls it a "hybrid U.S. flexible" fund, a classification that lacks the clarity of, say, mid-cap value or large-cap growth. Whatever you call it, from an objective performance viewpoint the fund looks pretty good. It's dramatically outperformed its style peers in every measurable period for the last decade. S&P gives it a five-star rating overall, as well as for the one-, three-, and five-year periods. Morningstar echoed that endorsement when it raised the fund rating to five stars on November 2 of this year.

The advisor to the Greenspring Fund is Corbyn Investment Management, an employee-owned firm based in Lutherville, Maryland, that also offers separately managed accounts for high-net-worth individuals.

The firm takes a balanced approach to its investments both for the Greenspring Fund and its individual clients with the combined goals of preserving capital and providing consistent returns regardless of current conditions in the bond and equity markets. Fund manager Charles "Chip" vK. Carlson, who also serves as Corbyn's chairman and president, isn't afraid to park the fund's money in cash alternatives if that's what it takes to keep his shareholders from losing money in an unfriendly environment. It's a strategy that has paid off over time, allowing the fund to offer its investors consistent returns and above-par performance even in difficult markets.

Let's start by talking about the background of the Greenspring Fund and the investment philosophy behind it. The fund is distinctive in many ways. We are not part of a family of mutual funds. This is the only fund we manage and we are totally focused on a single investment philosophy. I think that's a point that separates us from many other mutual fund companies. In style the fund takes a very hard-core value approach to both stocks and bonds. We're a balanced fund. Lipper calls us a flexible portfolio fund, which means we're not mandated to be within a certain range of stocks or bonds. With our equities, we like to focus on what we call inefficiently priced stocks as well as fixed-income securities.

With so many options to choose from, what screening do you perform to arrive at the right portfolio? As far as equities are concerned, we search through what we call the "inefficient" sector. These are companies that are not well covered or sufficiently followed by the investment community. Consequently, most of the investments that we end up buying are in the small- to mid-cap area, but we certainly have some large-cap stocks as well, ones that we feel are mispriced.

We've always done a lot of our own homework because, by definition, if a stock is inefficiently followed, the research coverage isn't very deep or thorough. I think the trend on Wall Street with a lot of the major investment banking firms dropping analysts and cutting back on their research staff bodes well, in a competitive sense, for the Greenspring Fund because we're used to doing our own research.

The stocks that are not well covered by the investment community tend to be inexpensively valued on the basis of a company's earnings, or cash flow, or free cash flow. Free cash flow in particular is a characteristic that we like to focus on when we're researching a company. We like companies that have a good industry position, have a strong management team, have the ability to generate free cash flow, and have exhibited a history of making wise allocation decisions with that free cash flow.

So we like to find stocks that are inexpensive relative to their industry and to the market overall. Ideally these stocks will provide positive performance to the fund, regardless of what the overall stock market is doing.

When it comes to gauging your own performance, what do you use as a benchmark? That's always been a challenge with the Greenspring Fund. My benchmark has always been positive performance. I want to outperform a risk-free rate of return, in money market funds or whatever. We are very much focused on providing steady, consistent performance to our shareholders. That's a concept that has become more popular the last few years with the sharp decline of the Nasdaq and some of the major indexes, but it's something the Greenspring Fund has always focused on. If you look at our track record since inception, we've always done very well during difficult stock market environments. Admittedly that same style may cause us to underperform during strong market environments, but that's okay with us. We preach to our shareholders and potential shareholders that we are going to try and preserve capital during difficult market environments. That's what Greenspring Fund has always striven to achieve, and it's done a pretty good job of it in the past.

When constructing the portfolio, do you have an optimum percentage of equities that you shoot for? We are not top-down asset allocators; we are very much bottom-up investors. We will invest our shareholders' assets in those securities that we feel have positive risk/reward characteristics. If we find enough equity ideas that meet our criteria, then we'll be heavily skewed toward equities because typically they will be able to provide superior performance to fixed-income securities. We've always taken pretty much a balanced approach to the portfolio.

Both Morningstar and S&P list the fund as having 40% to 45% of its holdings in equities and about an equal amount in corporate bonds, or "other." Could you talk about your non-equity holdings? What you are referring to are convertible bonds. Morningstar for some reason lists convertible bonds as "other." It's not like convertible bonds are some exotic asset class. We buy what we call "busted convertible bonds," which are more bond-like and less equity-like. It's sort of a hybrid between a bond and an equity, but it's certainly more bond-like, the way we buy them.

Why do you call them "busted bonds?" Let me stress first of all that busted means that the conversion option has been busted, not that the company is busted or struggling financially. That's an important distinction to make. Busted convertible bonds fit in very well with our desire to provide steady, consistent performance for our shareholders. Just like most bonds, they pay interest twice a year and hopefully will mature on the maturity date, and they provide a steady stream of income to the fund. That steady stream, typically with some capital appreciation, will be achieved regardless of what happens in the stock market or in the bond market. It's been a very important ingredient in our ability to provide steady, consistent performance over the last several years in some difficult market environments.

When we buy busted converts, we invest in companies that have very strong balance sheets, yet their common stock price has declined significantly since the time the convertible bond was issued. Consequently the ability of the holder to convert that bond to common stock has become less valuable; i.e., it's been busted. At the time we buy the bonds, they have more interest as a straight bond than as a way to participate in the equity movement of the company.

There are several different ways you can make money with busted converts, which is one of the things we like about them. Just like a regular straight bond, if you sit back and clip the coupon and let the bond mature, you will achieve a certain annualized yield of maturity. In addition, with busted converts you can make money if the common stock does rebound significantly in price, which helps drive the price of the convertible bond higher, and that can benefit us. Additionally, several of our holdings have been redeemed or "called" by the issuing company, the result of which is a higher annualized return than we anticipated at the time of purchase. Furthermore, many convertible bonds, if not most, are issued with what is called a change in control put, whereby if the company that issues the convertible bond is acquired by another company, holders of the convertible bond have the right to force the acquiring company to buy the convertible bond from them at a stated price, usually at a premium to par. That's something that's happened in the past with the Greenspring Fund's convertible bond holdings and can be a sharp windfall. Many of the companies whose convertible bonds we own have been in the marketplace retiring their debt, buying back their bonds on the open market. There's been a tremendous movement in corporate America to improve [companies'] balance sheets. For many of the companies whose convertible bonds we own, their convertible bond might be their only bond issue outstanding. There's been some upward price pressure driven by corporate repurchase of these bonds, which is something else that can allow a busted convert to achieve positive performance or flat performance even when bonds in general have been moving lower.

What does it do to the fund when a company calls its bonds early? Typically, what happens is that the actual annualized return ends up being higher than the anticipated annualized maturity at the time that we purchased the bond. For example, the anticipated annualized return on the bond portion of our portfolio today is around 6%. If we just sit back and collect the coupons and let the bond mature, we will achieve about a 6% annualized rate of maturity on our bond portfolio. If a bond is called early by the [issuing] company, typically it's called at a premium to par, which means that the annualized return for the holding period ends up being higher than we anticipated at the time of purchase. This helps us in the short run, but then we're faced with the challenge of turning around and reinvesting that money.

Will a change in interest rates have any effect on how you allocate your assets? In our bond portfolio, which is 100% busted converts, our duration is very short. Currently our duration is less than 2.5 years. Our busted converts are not very sensitive to movement in interest rates, [which can be] either positive or negative. We feel that the next movement in interest rates will be higher, not lower, so we feel that having a short duration is a safe move to protect our principal. If you believe that interest rates are going to decline significantly, however, you'd want a longer duration. We have a short duration, and have had a short duration over the last couple of years.

How about cash on hand? Currently we're at about 6%. Over the life of the fund we've certainly held higher cash reserves than many mutual funds. Again, it's because we're bottom-up investors. If we can't find ideas that we think meet the fund's criteria, we won't hesitate to park that money in cash or cash alternatives. It goes to our strong desire to preserve capital. If we don't have an idea we feel very strongly about, we'd rather get a positive return, although it's minimal, from a cash alternative than force an investment in a stock or bond we don't feel comfortable with. That comes back to our conservative nature and our desire not to take undue risks or subject the portfolio to much market volatility.

It seems that this fund has a higher turnover rate than most of its peers while maintaining a higher return. How's that work? A major reason why our turnover is higher than what you would expect is because of our bonds, which are low duration. In addition, many of the bonds we have held over the last couple of years have been called early by the issuing companies. The turnover of the bond portion of the portfolio has increased the fund's overall turnover rate. Our turnover rate in the stock portfolio is significantly lower than our overall turnover ratio.

Let's talk about the fund's largest holdings, starting with the equities. Our largest equity investment is in a company called USI Holdings, which we've had for a while but have just increased our stake. It's an insurance brokerage stock and I think it's a pretty good example of how we look for ideas at the fund. There's been a lot of negative press about the situation of Eliot Spitzer going after Marsh & McClennan and some of the larger insurance brokerage companies. Consequently, the stocks of just about all of the insurance brokerage companies have come under pressure and declined. We believe USI Holdings is going to be relatively unaffected by the fallout from Spitzer's investigation, yet the stock has declined about 25% since the investigation was announced. As of close last night [Nov. 2, 2004], USI Holding was trading at about $10/share. We think in 2005 the company is going to earn about $1.15 or so, on a P/E basis that makes it trading at about 8.5 times earnings, whereas its industry is trading about 10.5 to 11 times. And that P/E is much lower than it was a month earlier. The P/E in the industry in general is depressed, based on this unfavorable recent news. We think there's a very minimal downside in USI Holdings and if the company is able to report the kind of earnings that we anticipate, the stock will move steadily higher.

What about some of the larger bond holdings? One of our larger holdings currently is a company called Akamai Technologies. It provides the infrastructure so that corporations can depend on their Internet traffic being processed efficiently and consistently. For example, Akamai works for Microsoft and when Microsoft needs to send out its Windows critical update feature, Akamai's system will make sure that all those messages get out; if 500,000 people decide to download their update at the same time, the system won't crash. Akamai also has a very strong balance sheet and has retired probably two-thirds of the issue that we own by buying back the bonds in the open market and tendering for the bonds. Currently it provides an annualized yield to maturity of about 5.5%. If the company calls the bond early, which we think is very likely, the average annualized return will approximate 10%, depending upon when exactly the bond is called. It's a situation where the return can move sharply higher, if the bond is called early.

I noticed that you hold some E-trade bonds. What's attractive about them? That's a similar story. E-trade is very profitable and has a strong balance sheet. It has several different debt issues. We own the 6% convertible bonds, which are the first bond in E-trade's capital structure to mature. That's something that we look at very carefully when we're analyzing convertible bonds. As the first bond to mature, it's been a focus of the company to retire that particular debt issue. Companies in general don't want to wait until the last minute to take care of paying off debt. In this particular situation, the company recently called approximately half the issue and it had already been retiring bonds in the open market prior to that. There are 185 million bonds, out of the originally issued 650 million bonds, outstanding. So the company has repurchased about 35% of the issue. The company is profitable and cash-flow positive, so we're very comfortable owning our E-trade bonds.

When are they scheduled to mature? In February 2007. There's very little interest rate sensitivity. If nothing else happens, we'll get about a 5% return. That's not particularly exciting, but we think the bonds will be called early, in which case the average annualized return from today's price will move up even higher. It's a return that will be achieved regardless of what the stock market does. If the stock market moves lower, we'll still get our 5%-plus average annualized return.

Do you have a lot of your own investments in the Greenspring Fund? Yes. My holdings in the fund are by far my greatest personal investment, and I would think that's the case with most other employees here as well.

How important is the advisor channel in bringing this fund to investors? The advisor channel is important to us and increasingly so, with the dynamics of how mutual funds are going these days. The Greenspring Fund has always been the kind of fund that focused most of its efforts on providing a good investment product. We've never been particularly aggressive in the marketing end of things, but we've always provided very personal service to those advisors who are aware of the fund. If you pick up the phone and call the Greenspring Fund, you don't get a bank of operators on standby, you get a live employee who's very familiar with the fund and can answer any question that you have. If you need to talk to an analyst or to me, the portfolio manager, that's a choice that is available.

Staff Editor Robert F. Keane can be reached at bkeane@ia-mag.com.

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