Better Know a Stock Picker

Welcome, Fools, to part 32 of our several-thousand-part series, "Better Know a Stock Picker," which is loosely, but not too loosely, based on Stephen Colbert's "Better Know a District" from The Colbert Report.

Like Stephen and his thorough investigations into America's congressional districts, each week I take a look at a fund you may want to own. What's on tap this week?

Pennsylvania Mutual (PENNX)

Expense ratio

0.90%

Fund size

$3.70 billion

1-year return

14.78%

5-year return

14.61%

10-year return

14.34%

Source: Royce Funds

Top 5 Holdings

Company

% of Assets

AllianceBernstein (NYSE: AB  )

1.6%

Lincoln Electric (Nasdaq: LECO  )

1.1%

Claire's Stores (NYSE: CLE  )

1.0%

Florida Rock Industries (NYSE: FRK  )

1.0%

Brady Corporation Class A (NYSE: BRC  )

1.0%

Source: American Century

Meet Chuck Royce
The fightin' team at Pennsylvania Mutual is led by Chuck Royce and three assistant portfolio managers who stick it to the stockinistas by betting on small-cap superstars. Smart move. Pennsylvania Mutual has returned 14.7% annually over the 25 years ended on Dec. 31 -- nearly 3% a year better than the Russell 2000.

But that's only half the story. Royce took over Pennsylvania Mutual in 1972, at the height of one of the worst bear markets in history. Ongoing pessimism pummeled the fund's portfolio initially, but Royce -- a patient, Foolish investor -- waited out the market, and it's been mostly uphill for Penn Mutual since. Eat that, Wall Street.

But there's more to Royce than mere performance. What makes him superstantial is how little he resembles the typical I'll-take-a-half-caf-decaf-no-foam-no-whip-don't-touch-my-BMW Wall Streeter. He's a sweater and bowtie guy who's completely unwilling to play by the same rules as everyone else south of SoHo.

Consider how he evaluates small-cap winners. As he said in a recent interview with one of his in-house publications, "We have a pronounced preference for high-quality small-cap businesses, which I would define as those with strong balance sheets, consistent patterns of earnings, and the ability to generate free cash flow. I also regard the ability to pay dividends as another key indicator of quality."

Dividends?!? Perish the thought! Or so says the average broker.

How he invests
That must give Royce a well-earned chuckle. Some of his best performers are big dividend payers. Take money manager AllianceBernstein, which yields a little more than 4% right now. Over the past year, the stock is up roughly 40% versus 10% for the S&P 500.

But that shouldn't be surprising. We're witnessing the re-emergence of large-cap stocks, right? Surely Royce and his team will turn their attention to these more fertile fields of growth, or will they?

Don't bet on it. "Some of the analyses that we have been examining indicate that the more quality-laden portion of the small-cap universe has lagged a bit," Royce says. In other words: Some small caps are still cheap.

Penn Mutual's portfolio mirrors this view. Recently, Royce and his team have recently added to positions in payments provider eFunds (NYSE: EFD  ) and building products maker Simpson Manufacturing (NYSE: SSD  ) .

Is this fund for you?
Could Royce be the next Peter Lynch? With all due respect to Lynch, that's probably the wrong question. Lynch, after all, got his start a few years after Royce. And while his returns over 13 years atop Fidelity Magellan are superior, Royce's three decades of successful investing is best compared to John Neff, the legendary former manager of Vanguard Windsor.

Plus, any investor who's able to generate near 15% returns over 25 years deserves a seat in the investing hall of fame. Or, short of that, a place among the superstars who've come to dominate the Motley Fool Champion Funds portfolio.

Royce has. Pennsylvania Mutual was singled out in the April issue and is down versus the Russell 200 by about 3% since. But I've no doubt it will rally to be one of advisor Shannon Zimmerman's many winners, including two other funds from Royce's shop, one of which is up more than 23% versus the bogey. (Want to find out who these winners are? Click here to get 30 days of free access to Champion Funds.)

And that's today's profile. See you back here next week, fund nation. Good night.

For more Foolish coverage of small-cap stars:

Think you can't beat the market with funds? Think again! The selections in Shannon Zimmerman's Motley Fool Champion Funds portfolio are up an average of 28% vs. just 19% for their comparable benchmarks. Ask us for an all-access pass to get an unfettered look at all of Shannon's picks, manager interviews, and model portfolios. Go ahead; it's free for 30 days and there's no obligation to buy.

Fool contributor Tim Beyers, ranked 1,542 out of more than 19,700 in Motley Fool CAPS, is a regular viewer of The Colbert Report. (Stay the course.) Tim didn't own shares in any of the stocks or funds mentioned in this article at the time of publication. Get the skinny on all of the stocks in Tim's portfolio by checking his Fool profile. The Motley Fool's disclosure policy is always championship caliber.


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