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Fund name: FBR Pegasus Small Cap Growth (FBRCX)

Objective: The fund pursues long-term capital appreciation by investing in companies with market caps under $3 billion. The fund mostly invests in US firms but can invest overseas. It also reserves the right to invest up to 20% in larger cap stocks. At least 25% of the portfolio will always be in tech stocks. In all instances, the portfolio is built bottom-up with high-quality, stable small cap stocks.

Adviser: FBR Fund Advisers of Arlington, Virginia. In one of those typically complex corporate structures, FBR/FA is a subsidiary of FBR Capital Markets Holding Group which is a subsidiary of FBR Group. As of January 31, 2009, their nine funds had $1.1 billion in assets plus, $200 million in other accounts.

Manager: Robert C. Barringer. Mr. Barringer has managed this fund since inception, as well as the Pegasus and Pegasus Small Cap funds. From 2001 until he joined FBR in 2004, Barringer managed the Citizens Core Growth fund.

Management’s Stake in the Fund: Mr. Barringer has investments in each of his three funds. He has under $10,000 in each of the small caps and between $50,000 and $100,000 in Pegasus. In addition, his compensation package is structured to reward him for performance and asset growth.

Opening date: The fund launched as a small cap tech fund on January 20, 2004 and relaunched as a diversified small cap growth fund with a tech bent on May 30, 2008.

Minimum investment: The minimum initial investment is $2,000. For an investment in an IRA the minimum initial investment is $1,000.

Expense ratio: 1.46%, after waivers, on assets of $6 million. There’s also a 1% redemption fee on shares held under 90 days.

Comments: Mr. Barringer runs three tiny, perfectly admirable funds: Pegasus, Pegasus Small Cap and Pegasus Small Cap Growth. They all use the same discipline in constructing their portfolios. As of January 2010, both Pegasus and Small Growth were ranked as five-star funds by Morningstar, while Small Cap had not yet received its first rating.

Mr. Barringer’s funds share two characteristics which make them worthy of serious attention. First, they focus on high-quality companies, which most commentators argue is the most compelling market segment at the moment. Many argue that it’s always and only sensible to invest in quality companies (see entries under Graham, Dodd and Buffett). Mr. Barringer explains the process this way:

In uncertain times, investors tend to prefer fundamentally higher quality companies . . . Our investment process is specifically designed to weather this kind of economic environment. Our focus will remain on companies whose business models and growth are sustainable and funded from existing cash flow generation, not access to outside capital. We seek to identify the fastest growing industry leading companies that are poised to benefit from improving secular or cyclical growth trends. These companies must meet our strict criteria for investment including (but not limited to) strong balance sheets, low debt, high returns on equity, robust business models and reasonable valuations.

Second, he quietly and consistently delivers the goods. All three of his funds show the same pattern of performance:

All have substantially outperformed their benchmarks since inception. As of their last annual report (12/08), Pegasus had an annualized loss of 2.9% since inception while the S&P 500 had a loss of 9.6% for the same period. Small Cap had an annualized loss of 10.6% while its benchmark had lost 29.3%. The comparison for Small Growth is messier, since it spent four years as a tech fund then two as a small growth fund which makes it hard to find an appropriate benchmark. Benchmarked against the NASDAQ, Small Growth posted a loss of 3.2% while the NASDAQ lost 5.3% annually.

The comparison through the end of 2009 is more striking. Small Growth turned $10,000 at inception into $12,200 while its small growth peer group earned $10,800. In other words, the appreciation in Small Growth is about three times greater than the appreciation experienced by its peers. Its 2009 return – about 38% -- also modestly led its group.

Over the course of the downturn, Small Growth declined 47% while its peers dropped 54%. Over the last six months of the decline, Small Growth earned 2.4% while the small growth group declined 3.2%. That downside protection is reflected in Morningstar’s “below average” risk score for Small Growth. By FBR’s own calculation, Small Growth has 92% of the market’s upside but only 82% of its downside. The same pattern is reflected in the fund’s MPT statistics: against the small growth peer group, Small Growth has a beta of 0.86 and an alpha of 2.94. For those who don't live and breathe stats, here’s the quick translation: these are mild-mannered funds that produce unusually high returns. Mr. Barringer puts it modestly when he says, “We believe that a commitment to [our] investment approach, over time, can deliver the potential for upside participation with a degree of downside protection.”

There are a couple issues that you’d want to consider before committing money to any FBR entity. FBR stands for Friedman, Billings, Ramsey & Co. One of the reasons for hesitating might be the wretched behavior of the firm’s founder, Emanuel Friedman. In 2006, Friedman and his chief compliance officer personally, and FBR corporately, were slammed by a series of sanctions for misconduct. The violations surrounded investments in a new investment vehicle called a PIPE, for “private investment in a public entity.” The settlement with the SEC cost Friedman $1.25 million, the compliance officer paid $110,000 and FBR got hit with $7.7 million in fines and civil penalties. Friedman was suspended for two years. As usual, none of the miscreants admitted or denied anything. So far as I can tell, none of this had any bearing on the funds, but it does have a sort of lingering, acrid moral odor.

The more-recent departure of star manager Chuck Akre, and his decision to create a direct competitor to his former charge, FBR Focus, adds to the sense of unease. Mr. Akre seems to have left in a huff and FBR lured away his senior staff in a counter-huff. It seems hard to imagine that this spat isn’t a distraction for everyone concerned.

Bottom Line: In the long term, small caps should substantially outperform their larger brethren. The problem is that small caps are typically far more volatile than larger stocks, which means that many investors dabble in small cap investing but flee in the midst of painful losses. The approach taken by funds such as FBR Small Cap Growth is fundamentally sensible: they offer most of the upside without much of the gut-wrenching volatility. It’s hard to find managers who can consistently pull it off. Mr. Barringer seems to be one of those people, and he deserves a serious look by folks looking for core small cap exposure.

Fund website: FBR Funds homepage. From the “FBR funds” link in the middle of the page, pick the fund and then the topic that interests you.