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High Quality, Low Risk

High-quality businesses are hard to come by, especially in a sluggish economy. But through disciplined investment management, this fund is able to pick up solid companies at discount prices.

Eaton Vance Atlanta Capital SMID-Cap R (MUTF:ERSMX) consists of high-quality holdings handpicked by a trio of fund managers who purchase solid businesses run by honest and capable management teams.

“It’s critical to see a proven and consistent track record of earnings, as well as the competitive edge that has historically driven earnings growth,” said portfolio manger Chip Reed, noting that the key challenge is to remain patient and buy in at favorable prices.

The fund has underperformed slightly year to date, though its performance remains in line with consensus expectations. While the fund tends to participate in rising markets, management positions the portfolio conservatively to preserve capital when markets are on the downswing, leading Eaton Vance Atlanta Capital SMID-Cap R to underperform since the markets bottomed out in March 2009. But the fund performed relatively well during the downturn, which means it doesn’t have as much lost ground to make up compared to its peers.

The fund’s conservative positioning has provided it with stability in rough markets--a strategy that’s paid off for investors with a long-term approach. The fund’s three-year returns ranked in the top 2 percent of its category, and its five-year results put it in the 92nd percentile.

The fund’s managers believe that investors must temper their expectations in today’s market. Unlike high-flying markets seen in previous decades, the current situation represents a new reality in which growth will be more difficult to achieve--an opinion voiced by prominent financial minds such as bond guru Bill Gross.

Reed noted that although credit markets have improved substantially, they won’t return to levels seen in the last decade. As a result, the fund’s management focuses on businesses that can generate sufficient cash flow and can continue to grow without seeking funding from capital markets. These firms tend to dominate small, but attractive and growing, niches.

Mergers and acquisitions (M&A) activity should also return. The fund historically lost about 10 percent of its portfolio to M&A activity. But M&A slowed to a virtual standstill during the financial crisis. With corporate balance sheets improving, M&A activity should regain momentum in the not-too-distant future.

The fund has its largest weightings in the industrials and consumer-discretionary sectors. During the downturn, several companies cut their capital expenditures, but corporate balance sheets are much stronger today and cash flows are improving. And as enterprises face up to pressure to become more efficient, they will regain the confidence to invest.

“If you look outside the US, it’s no longer a pure arbitrage play between cheap labor in Asia and the higher cost of workforces in North America or Europe. They too have to be efficient,” Reed said.

China, for example, has historically built its manufacturing might on the back of low-cost, but inefficient labor. But with new upstarts such as Vietnam vying to beat China at its own labor game, Chinese firms are spending large sums of money to build efficient manufacturing capacity. This should be a boon to industrial companies.

“As a high quality manager, it’s a way for us to leverage an improving economy,” Reed said.

Consumer-discretionary stocks are a cyclical area of the economy and the managers are starting to pare back their investments in this space. These investments are generally an offensive play, and today’s valuations are less attractive than they were when the fund originally bought into these stocks.

One of the fund’s top holdings in this sector is O’Reilly Automotive (NSDQ: ORLY), a leading auto parts retailer. O’Reilly boasts a large commercial business that services automotive repair shops. That business line performed well during the downturn as consumers held off on new car purchases, opting instead to repair their older vehicles. O’Reilly is also acquiring firms to expand its distribution network.

Another top holding is LKQ Corp (NSDQ: LKQX), the biggest owner of junkyards in the US. The firm sells car parts and services to auto shops across the country. Along the way, LKQ has picked up incremental market share, and the company recently established a relationship with one of the country’s largest auto insurers, Allstate (NYSE: ALL), which bodes well for LKQ’s future profits.

Eaton Vance Atlanta Capital SMID-Cap R is the lowest-risk small-cap manager in the country and a solid choice for investors who want high-quality names at favorable valuations.

“Quality is as cheap as it has ever been,” Reed said.

Hannah Hsu is Research Editor of Louis Rukeyser's Mutual Fund

Disclosure: no positions