April 2011 IssueLong scroll reading

Prospector Capital Appreciation (PCAFX)

By Editor

Objective

Seeks capital appreciation by investing globally in a combination of stocks and “equity-related securities,” though they have latitude to invest in a broad array of distressed debt. Their activities are limited to the U.S. “and other developed markets.” They look for firms with good long-term prospects for generating total return (appreciation plus dividends), good managers, good products and some evidence of a catalyst for unlocking additional value.

Adviser

Prospector Partners Asset Management, LLC . Prospector was founded in 1997 and manages about $2 billion in assets, including $70 million in its two mutual funds.

Managers

John Gillespie, Richard Howard and Kevin O’Brien. Mr. Howard, the lead manager, was the storied manager of the storied T. Rowe Price Capital Appreciation Fund (PRWCX, 1989-2001). Mr. Gillespie spent a decade at T. Rowe Price, including a stint as manager of Growth Stock (PRGFX, 1994-96) and New Media (1993-1997). Mr. O’Brien comanaged Neuberger Berman Genesis (NBGNX). All three have extensive experience at White Mountain Insurance, whose investment division has Buffett-like credentials.

Management’s Stake in the Fund

Each of the managers has over $100,000 invested in the fund and into their other charge, Prospector Opportunity, as well. The fund’s officers and board own 17% of the shares of PCAFX. Mr. Gillespie and his family own 20% and Mr. Howard owns almost 7%. They also own a majority of the advisor.

Opening date

9/27/2007

Minimum investment

$10,000 across the board.

Expense ratio

1.5% after waivers on assets of $36 million, plus a 2% redemption fee on shares held fewer than 60 days.

Comments

Most investors folks on two sorts of securities — stocks and bonds. The former provides an ownership stake in a firm, the latter provides the opportunity to lend money to the firm with the prospect of repayment with interest. There are, however, other options. One, called convertible securities, are a sort of hybrid. They have bond-like characteristics (fairly high payouts, fairly low volatility) but they are convertible under certain characteristics into shares of company stock. That conversion possibility then creates a set of equity-linked characteristics: because investors know that these things can become stock, their value risks when the value of the firm’s stock rises. As a result, you buy a fraction of the stock’s upside and a fraction of its downside with steady income to boot. The trick, of course, is making sure that the “fraction of upside” is greater than the “fraction of downside.” That is, if you can capture 90% of a stock’s potential gains with only half of its potential losses, you win. Successful convertibles investing is a tricky business, undertaken by durn few funds. The few that do it well have accumulated spectacular risk-adjusted records for their investors. These include Matthews Asian Growth & Income (MACSX), a singularly excellent play on Asian investing, T. Rowe Price Capital Appreciation (PRCWX), which consistently beats 98% of its peers over longer time frames, and, to a lesser extent, FPA Crescent (FPACX). You can now add Prospector Capital Appreciation to that list. Prospector’s prime charms are two: first, it has a sensible strategy for the use of convertibles. The fund starts its investment process by looking at the firm, then seeking convertibles which can offer a large fraction of the gains made by a firm’s stock with substantial downside protection. It buys common stock only if the firm is attractive but no convertible shares are to be had. Six of 10 largest buys in the first half of 2010 were convertibles. Because the market lately has favored lower-quality over higher-quality stocks, the fund has been able to add blue chip names, an occurrence which seems to leave him slightly dumb-struck: “we continue adding recognized high quality stocks to the portfolio . . . this seems almost surreal. We are used to buying mediocre companies that are getting better or good companies that few have heard of, not recognized quality.” At the moment (late 2010) about a quarter of the portfolio is in convertibles, about 13% in international stocks, a bit in bonds and cash, and the remainder in US stocks. The manager’s value orientation led him to include three gold miners in the top ten holdings but to avoid, almost entirely, tech names. The second attraction is the fund’s lead manager, Richard Howard. Mr. Howard guided T. Rowe Price Capital Apprecation is a spectacular performance over 12 years. He turned a $10,000 initial investment into $42,000, which dwarfed his peers’ performance (they averaged $32,000) and gave him one of the best records for any fund in Morningstar’s old “domestic hybrid” category. For much of that time, he kept pace with the hard-charging S&P500, lagging it in the bubble of the late 90s and making up much of the ground before his departure in August 2001. He posted only one small calendar-year losses in 12 years of management. He seems not to have lost his touch. The fund just passed its third anniversary and earned a five star rating from Morningstar, posting “high” returns for “average” risk. Moreover, he’s outperformed his old fund by about a third, lost noticeably less in 2008 and has done so with less volatility.

Bottom Line

Conservative equity investors should look seriously at funds, such as this, which seem to have mastered the use of convertible securities as a tool of risk management and enhanced returns. The investment minimum here is regrettably high and the expense ratio is understandably high. The primary appeal over Price Cap App is two-fold: Mr. Howard’s skills and the tiny asset base, which should give him the availability to establish meaningful positions in securities too small to profit the Price fund.

Fund website

Prospector Capital Appreciation homepage

Fact Sheet

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