Chip Carlson, Greenspring

We value your feedback. Send comments, questions, and criticism to advisorquest@morningstar.com.

Headquartered between Wall Street and Washington--in a genteel suburban office park in Lutherville, Md.--Greenspring Fund GRSPX has seemed miles away from the fray. Of course, nothing escaped the year's market maelstrom. That said, the fund's 14% loss for the year through November was less than half that of the typical moderate-allocation fund (not to mention nearly 24 percentage points better than the S&P 500). This is the kind of performance shareholders no doubt hoped for from a fund that positions itself as a defensive play on the stock market. Now the fund is on the offense.

On Nov. 21, the day after U.S. automakers were sent home from D.C. with hats still in hand--and the S&P 500 plunged to its lowest close since 1997--manager Chip Carlson and first lieutenant Michael Fusting were in good cheer. In an interview from the small conference room in the company's modest suite, Carlson enthused, "The adrenaline is pumping! This market is certainly challenging, but every day, we are improving the portfolio." As hedge funds meeting margin calls fueled selling frenzies, Carlson and Fusting were snapping up short-term corporate bonds and convertibles at double-digit yields.

Immune to the Bailout
This may sound too good to be true to today's twice-shy investors, but Carlson brings clarity and confidence to the moves. "It's hard to envision how this is not a successful strategy--as we've been pursuing it," Carlson says. "We do balance-sheet analysis for significant cash reserves, and much of the portfolio is in bonds of companies that could write a check to cover their total debt now if they wanted to. Whether the Washington bailout succeeds isn't going to affect these investments."

Fusting adds, "With a bond that's due in a year, you don't have to have as much insight into the future as you do with one due in 10. And at least 90% of the bonds in the portfolio are the next bond or two to mature in the company's capital structure. If the company has bank financing, it is due after the bond."

In other words, these companies can pay back the debt Greenspring holds whether or not they have access to increasingly scarce credit.

Advisor Drew Tignanelli, president of Hunt Valley, Md.-based Financial Consulate, who has invested with Greenspring for a decade, agrees. "Their strategy is the right way to go. These are corporations with clean balance sheets, companies that can pay their debt even in dire times. You can get 10% to 17% yields as other institutions liquidate, and Greenspring has a tremendous opportunity: It is small enough that it can take advantage of a $10 million bond."PAGEBREAK

Size isn't the $277 million fund's only advantage. Carlson and Fusting are grateful that they have had money to spend. Even as some funds have had to sell across the board to meet redemptions, Greenspring's loyal advisors and shareholders have contributed net infl ows.

This base includes Neil Paolella, president of Arbor Asset Management in Ann Arbor, Mich. Although Paolella pulled most of his clients substantially out of stocks in June, he did not sell Greenspring. "This is the only fund with stock exposure that I didn't sell, which tells you how I feel. Their strategy today is a huge winner, and I'm buying more and expect to do so over the next couple of months."

Riding Convertibles
Carlson and Fusting aren't veering into uncharted territory. The fund has never held the standard assortment of large-cap stocks and Treasuries that the typical moderate-allocation fund holds. The aim is to unearth value in inefficient sectors, which has meant primarily small-cap value stocks for the equity half of the portfolio and corporate and convertible bonds on the fixed-income side. "We don't buy Treasuries," Fusting says. "We never have. We want diamonds in the rough, just like our stocks, and the goal is to get an equitylike return."

Sepracor, Inc. convertibles, which the fund has bought and sold for years, exemplify the fund's opportunities today. Sepracor has a hit product in sleep-aid Lunesta and a sparkling balance sheet with more than $1 billion in cash. "During October, some convertible hedge funds had margin calls going out all over the place and people were just blowing some of these bonds out," Carlson says. "We bought bonds with an October 2009 put at up to 18% yields because someone needed to get out in a hurry. There is no concern on our part whether Sepracor can pay these bonds. There is a saying to the effect that 'the margin clerk doesn't know P/E.' Well, he doesn't know yield-to-put either!"

Digital River convertibles, new to the portfolio in September, provided a similar opportunity. The software company also has more in cash than debt, and its bonds were trading at par until the stock plunged with the market. The fund was able to get fat yields on bonds puttable in January 2009. Similarly, Fusting says, CIT bonds were trading at "ridiculous yields for bonds that will mature in 2008."

With such opportunities as these, Greenspring is now tilting toward bonds. "There are tremendous stock values today, but the risk is that they will be even more undervalued tomorrow," Carlson says. "With an undervalued bond, the risk is diminished because you will realize your return if you did your homework right and the company pays the bond off at maturity or at the put date. You don't need Mr. Market to agree with you."PAGEBREAK

The Stock Side
That said, the fund's fixed-income stake is unlikely to exceed 60%. Carlson and Fusting are scrutinizing their stock holdings to confirm that there are no big risks, such as excess leverage, and they are deciding whether to buy more as prices plummet.

Top stock holding FTI Consulting FCN, in the portfolio since 2003, is certainly well positioned should this economic environment persist: It provides services to companies needing to reorganize, as well as economic consulting. As Carlson jokes, "Their problem is that they can't hire fast enough." Of course, Fusting says, "the risk is that their assets walk out the door every day at 5:00." But FTI has built a strong business that generates a tremendous amount of cash flow, with no capital requirements.

Carlson's confidence in Michael Baker BKR and its engineering-services segment, which is bolstered by a roster of government-funded projects, prompted him to add to the position when troubles in the energy business depressed its price. Hedge fund blowups spelled opportunity here, too: Tontine Associates (which liquidated two of its portfolios in November) was the biggest holder of Michael Baker. "When we saw the stocks going down five points in 10 minutes," Carlson says, "we thought, that must be Tontine. The bottom line is that the company is debt-free, not a penny, a big cash-fl ow generator, and priced at a very attractive multiple earnings."

Four insurance stocks make up a significant sector stake (8% of assets at the end of September), but Carlson and Fusting say that none has had dangerous levels of exposure to mortgage-backed securities. The largest business of Assurant AIZ is creditor-placed homeowner's insurance, so foreclosures are good for business. Financially strong reinsurer PartnerRe PRE habitually buys back stock. "We prefer companies that have the luxury of being able to do so," Carlson says. W.R. Berkley WRB, one of few providers of casualty insurance such as product liability, is reinvesting excess capital, as well as buying back stock. United America Indemnity INDM has also bought back shares. Although the specialty insurer has suffered from recent management turnover, the fund has built its position at a deep discount to book value.

As for new purchases, the fund might add some blue chips, given rock-bottom prices. "In the last couple months, we've said we may end up owning stocks we never would have had the opportunity to purchase in the past [given our focus on inefficient prices]," Fusting says. "I wouldn't want to come into the office every day knowing I have to be fully invested in mid-cap value stocks, or any other section of the style box."PAGEBREAK

Where It Fits
The fund's broad mandate and unusual portfolio may make it difficult to plug neatly into a portfolio segmented along style-box lines, but Greensping's longtime fans consider it a core holding for a variety of clients.

Gary Schlaffer, of Reston Va.-based financial-services firm Alexander Randolph, believes the fund's value orientation makes it less risky than a traditional 60/40 fund and fitting for more-conservative portfolios. He also uses Greenspring in aggressive portfolios for the quirky convertible exposure. "I can't think of another fund that's similar in terms of special situation bonds."

Schlaffer is not currently directing new money to Greenspring because he is drawn to more dramatic high-yield plays, but "this will remain a core holding for us. For an advisor who does not hold the fund and wants to divert money from Treasuries and blue chips, this is an excellent option," he says.

New shareholders may need to check their expectations once the market heads back up. "We've tried for years to educate shareholders about what to expect from us," Carlson says. "We are defensive and we hope to do better in down markets, but we won't do as well in up."

Greg Schultz, co-owner of Asset Allocation Advisors in Walnut Creek, Calif., is one relative newcomer (he first bought in 2004) who was drawn to the fact that management is "ever mindful of downside risk," making the fund an appropriate core holding for his retiree clientele.

That said, it's easy to get excited about the virtually risk-free double-digit yields Greenspring is buying today. Of course, it all depends on Carlson having done his homework right--and his 20-year record at the helm suggests that he has. Although exposure to financials led to a loss in 1998, the fund's overall record of moderate volatility and category-beating returns justifies Carlson's unique approach.

Laura Lallos, a former Morningstar analyst and editor, is a frequent contributor to the magazine.