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Kevin O'Boyle, Presidio

Whether hes uncovering beaten-up small caps or running his tiny Presidio Fund, you won't find Kevin OBoyle in a crowd.

Christopher Davis, 11/03/2008

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

In his light-filled office near the San Francisco waterside, Presidio Fund PRSDX manager Kevin O'Boyle displays a handwritten 2001 letter from a prospective investor who had heard of O'Boyle through a friend he uncharitably characterized as a "dim light bulb." Fortunately, the investor concluded that O'Boyle's bulb burned much brighter, and he cut a check to Meridian Value MVALX, the fund that O'Boyle led before striking out on his own in 2005.

A Bright Start
O'Boyle certainly is no dim bulb. During his June 1995 to December 2003 stint at Meridian Value, the fund returned 22% per year, more than twice the gain posted by the Morningstar U.S. Market Index over the period and nearly 9 percentage points better than the small-blend category average, the group in which the fund resided during most of that stretch. Presidio, which recently celebrated its third birthday, has also been a success. Through August 2008, the fund was up 8% annually over the trailing three years, versus 3% for the typical small-blend offering. Yet despite this success, Presidio remains relatively unknown, with a skimpy $67 million in assets.

O'Boyle's City-by-the-Bay digs reflect Presidio's diminutive size; they are no larger than a one-bedroom apartment and could very well have been one in an earlier life. The office, located in the gentrifying Marina neighborhood, is more than a 30-minute walk from the city's financial district, home to giant firms such as Charles Schwab and Dodge & Cox. The out-of-the-way locale allows O'Boyle to avoid pricey rents, but it also means that he doesn't hobnob much with other money managers around town. That's a feeling he's probably gotten used to. Scoping out potential investments at industry conferences, O'Boyle finds that the companies he's researching are the ones whose representatives are presenting to sparsely filled rooms.

No, O'Boyle isn't antisocial. His investment process draws him away from companies getting all the attention. While many investors consider failing to meet or beat Wall Street analysts' earnings expectations for a quarter or two to be a cardinal sin, O'Boyle looks for firms that have suffered at least three consecutive quarters of earnings disappointments. His approach seems counterintuitive at first blush--why would you want to invest in struggling companies?--but it's designed to take advantage of investors' tendency to overreact to bad news and incorrectly extrapolate the recent past into the future. By owning stocks that have been punished too harshly for their troubles and where expectations are too modest, the fund can reap outsized gains.

The crux of O'Boyle's strategy was developed by Rick Aster, the founder and comanager of Meridian Value. Aster noticed that companies often rebounded sharply after a spate of disappointing earnings. He had O'Boyle, who had joined his firm as an analyst in 1994, test the idea further using historical market data. Back tests suggested that the strategy of buying disappointing companies and holding them as they rebound could be successful, but both Aster and O'Boyle thought that they could increase their odds of success with research and by concentrating their best ideas. In mid-1995, Aster added O'Boyle as a comanager, responsible for day-to-day stock-picking.PAGEBREAK

This isn't a strategy O'Boyle was necessarily born to practice. Unlike many money managers who tell you they were checking the stock tables before the sports pages as kids, O'Boyle didn't get the investing bug until college. Studying economics as an undergraduate at Stanford University sparked his interest, and getting his MBA (also at Stanford) deepened it. His father, a civil engineer by training, charted stock prices, but Warren Buffett's Berkshire Hathaway shareholder letters had more formative influence. (O'Boyle has read all of them.) O'Boyle's office shelf is filled with books about the Oracle of Omaha, in addition to another legendary value investor, John Neff, the former manager of Vanguard Windsor VWNDX. You might think that he's got the reading habits of a dyed-in-the-wool value investor, but O'Boyle also cites Common Stocks and Uncommon Profits--perhaps the bible of growth investing--as having a big effect on his thinking, too. This is the sort of reading list you'd expect from an investor who's built his career buying beaten-down growth stocks.

Aster, however, has left the biggest mark on O'Boyle. A successful investor himself, he taught O'Boyle to focus on the economics underlying companies' business models. "How does a company earn an attractive return on its businesses?" and "Is it sustainable?" were the key questions on which Aster focused, O'Boyle says.

His Own Man
O'Boyle hasn't departed much from the strategy that he employed at Meridian, though he's used his experience to introduce some tweaks. For example, he more consciously avoids companies in declining industries because he's found that it's tough for even good management teams to turn a business around in adverse environments. Still, O'Boyle isn't dogmatic. Weyerhaeuser WY, a recent addition to Presidio's portfolio, has suffered amid a weak environment for paper products. But O'Boyle argues that investors have undervalued its timberlands and other business lines, and he points out that the company is divesting its nonstrategic paper and container board units.

Although O'Boyle doesn't make bold top-down calls, he lets macroeconomic factors influence his thinking to a greater extent than at Meridian. Dozens of banks meet his down-three-quarters criteria, for example, but the credit crunch and the tanking housing market has kept him away. (That said, he's compiling a list of potential picks so he can pounce when housing prices stabilize.)

Scores of consumer-oriented companies also meet his initial screens, but because he worries that reduced access to credit markets will hurt sales of pricier durable goods, he's avoided names such as Home Depot HD and CarMax KMX.

More controversially, he's devoted a small slice of the portfolio to precious metals as insurance against a falling U.S. dollar. "The financial system is broken," O'Boyle says, "and the means by which it will be repaired are likely to be inflationary" as the Fed attempts to prop up ailing institutions by injecting the economy with more cash.PAGEBREAK

Thanks to Presidio's svelte asset base, a key distinction from his peers is that O'Boyle enjoys much more flexibility to invest in small names. He benefited from such freedom for much of his time at Meridian Value, but a torrent of new money flooded the fund in 2001, leaving him hamstrung. (Assets grew from $285 million at the end of 2000 to $1.1 billion a year later.) O'Boyle invests across the market-capitalization spectrum at Presidio, but the fund's size allows him to easily invest in small- and micro-cap stocks, which fueled his best years at Meridian Value.

Opportunity Knocks
If there's a time when investors should expect Presidio to struggle, O'Boyle says that this is it. With few earnings improvement stories to come by, he finds recessionary environments the toughest time to run his strategy. Yet his fund has held up much better than its rivals in the most recent downturn, just as Meridian Value did in the 2000-2002 bear market. The tough times also have given O'Boyle more buying opportunities. Nearly a thousand names now populate his list of companies that have disappointed at least three quarters in a row, a couple hundred more than usual.

To be sure, investing with a tiny operation like Presidio comes with unique risks. O'Boyle hired one person to handle trading (he worked at Meridian in the late 1980s and early 1990s) and another assists him with administrative duties. But Presidio is largely a one-man show. While still doing some administrative duties himself, O'Boyle says that he spends more than 85% of his time researching stocks. And he's the only one doing the research. (O'Boyle hired an analyst in early 2007, but he left at the end of the year for personal reasons). O'Boyle didn't have any analysts during most of his tenure at Meridian, either.

A bigger challenge could come from growth. Presidio hasn't been inundated with assets, but that could change if performance remains strong. When Meridian Value swelled with new assets in 2001, O'Boyle struggled to put the money to work. Because the stock market was tanking in 2001, having a lot of cash didn't hurt, but O'Boyle might not be so lucky next time around. O'Boyle says that he won't hesitate to take action if money started coming in too quickly--something Meridian failed to do. As models, he cites Longleaf Partners and First Pacific Advisors--two extremely shareholder-friendly shops that have closed funds to new investments over the years.

Presidio still has a lot to prove if it wants to be included in the same elite rank as those two firms. Still, with talented, proven management, Presidio is one of the small-cap world's bright lights.

Christopher Davis is a mutual fund analyst with Morningstar. He is editor of Morningstar's Fidelity Fund Family Report, a monthly newsletter that offers independent guidance on the fund family and helps investors find the best Fidelity funds.

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

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