Less Is More for FBR Focus 
by Liana Madura | 11-24-10

We recently caught up with David Rainey, co-portfolio manager for  FBR Focus FBRVX. He spoke to us about the benefits of concentration and which industries look attractive today. He also discussed the fund's transition to a new management team, how they are positioned the fund to withstand another asset bubble, and the case for holding  Bally Technologies BYI.

1. How do you try to seek diversification within the confines of a focused fund, if that matters to you at all?
Conventional investment wisdom dictates that diversification is the holy grail of risk reduction, and the more diversified the better. However, academic research shows there is a diminishing effect to the benefits of portfolio diversification. Recent research indicates that a 10-stock portfolio may eliminate 80% of unsystematic or company-specific risk , and a 20-stock portfolio eliminates about 90% of this risk. Yet the typical mutual fund holds more than 100 stocks--way more than is necessary for adequate diversification.

We believe that investors who concentrate their assets in fewer stocks have an important advantage compared with the typical highly diversified mutual fund. With fewer securities, an investor can dedicate more time and effort to researching each individual investment. This enables better understanding of the risks and opportunities associated with each investment prospect and the key drivers of long-term value creation, which should ultimately lead to better investment decision-making. So, we believe diversification does have a cost, and that cost is steep. The cost is the dilution of the best investment ideas by marginal ideas and a limited understanding of each of the securities in the portfolio.

We believe that good investors occasionally have to challenge conventional wisdom. We have always understood the trade-off between diversification and specialization, which is why we attempt to strike a balance with about a 20-stock portfolio representing a wide range of industries. With the current portfolio construction, we enjoy just about all the benefits of diversification while still maintaining an important informational advantage in our investments.

2. In your annual report you pointed out that this decade has been hit with two large asset bubbles: the Internet-telecom and real estate asset bubbles. Are you forecasting or concerned about a near-term asset bubble given all of the talk about debt and large deficits?
As we pointed out in our annual letter to shareholders, one of the benefits of focused investing is the ability to avoid entire sectors of the market that most other funds are forced to embrace. We do not know where the next bubble will arise, but we are ever watchful and steer clear of sectors that we suspect are vulnerable to unsustainable demand. While we largely avoided the permanent losses suffered as recent bubbles burst, many of our stocks traded down under the tremendous market-selling pressure that followed the events of 2008. The fund suffered a down year in 2008, but since then our holdings have come back nicely. Today we largely have the same top positions in the fund that we had in 2007, and many of these businesses are posting record results.

One common advantage many of our companies enjoyed at the beginning of the Great Recession was a strong balance sheet, often the strongest in their industry. This financial strength enabled many of these companies to invest in new assets at favorable prices as the bubble burst. Our holdings were able to increase market share and presence during the downturn as they expanded geographically and purchased weakened competitors at distressed prices.  O'Reilly Automotive  ORLY purchased a financially distressed CSK Auto,  American Tower AMT expanded aggressively into India as cell-tower valuations were halved, and  Penn National PENN continued to expand its casino-development pipeline.

Each of the last two major bubbles provided opportunities for our portfolio companies and for us as investors. We expect the next bubble--wherever it may arise--will do the same. The most obvious concern in the market today is the specter of unanticipated inflation driven by the Fed's second round of quantitative easing, and the potential for a third, fourth, or fifth round if employment does not improve. We are not forecasting a bout of inflation, but we do guard against this eventuality by focusing our shareholders' capital in businesses with sustainable competitive advantages and proven pricing power.

3. You have indicated that your strategy is to play defense, avoid troublesome areas first, and then find winning stocks. In which sectors do you see these winning opportunities, and which sectors are you avoiding today?
As one example, we have recently added a new holding in the insurance-brokerage industry because we believe a number of factors have aligned to create winning opportunities here. The confluence of a soft insurance market affecting pricing, a weak economy reducing exposure units, low short-term rates depressing float income, and modest valuations on trough earnings create an opportunity to invest anew in this industry. While we believe that some, if not all of these levers will turn up in the next few years, we generally want to invest in companies that are capable of creating their own success independent of macroeconomic conditions. Even in the absence of an improvement in the aforementioned industry factors, we believe we have found an opportunity in  Aon AON to generate strong returns for our shareholders, with a margin of safety.

While we wait for the insurance pricing and economic cycles to turn, Aon has numerous internal cost-cutting and efficiency initiatives that should help drive earnings higher. Aon's CEO, Greg Case, has streamlined operations and repositioned the company during his five-year tenure, so we expect that he will continue to deliver for shareholders. Even in the absence of an upturn in the cycle, we believe fund shareholders own a very good business with increasing earnings at a discount price.

The second part of your question is best answered by stating that we generally avoid industries that possess the inverse of the characteristics enjoyed by the insurance-brokerage industry and Aon. We attempt to protect the fund shareholders' capital by eschewing businesses with rapid technological obsolescence, valuations that require aggressive forward-growth assumptions, or commoditized product offerings. The fund has not generally held investments in capital-intensive industries (such as heavy equipment, automobile manufacturing, or aerospace), leading-edge (bleeding) technology companies, or energy-related industries. Capital outlays are immense, competition is fierce, returns on invested capital are uneven, and balance sheet leverage is unsettling.


4. What has changed in the fund since longtime manager Chuck Akre departed to start a rival offering?
When Brian Macauley, Ira Rothberg, and I transitioned to the role of co-portfolio managers, we promised the fund's shareholders that we would maintain the same investment philosophy and analytical rigor that we employed as analysts, while making a few subtle refinements. The three of us worked together as the fund's analyst team for six years and have more than 26 years of cumulative experience with the fund. So at the time of our transition, after having made our mark on the fund under Chuck's watchful eye, it was generally populated with our best investment ideas, sized and allocated very much to our liking. We have all worn many hats during our investment careers, and moving to the portfolio-management role was very straightforward.

Across the individual holdings, we made a few changes after the transition. We sold out of about a half-dozen small and moderately sized holdings. In several cases we were not confident of their business prospects coming out of the Great Recession, and in other cases we already owned a leading light in the same industry and found the position redundant. For much of the past 10 years, the fund would own as many as three or four companies in the same industry. Our belief is that these redundant positions added little value and did not optimally diversify the fund. So going forward, you will see us concentrate our time and energy in identifying the very best opportunity in each of the industries in which we choose to invest.

We have continued to apply the same common-sense investment process, emphasizing risk control and capital appreciation--defense first, then offense--that has worked so well for the fund's shareholders over time. We trust that our shareholders have been pleased with the performance of the fund since the time of our transition in 2009, and we will continue to do our best to protect and grow their investments.

5. You continue to be very bullish with one of your top investments, Bally Technologies. What economic moat does this company have in which you see opportunity?
Along with  WMS Industries WMS and  International Game Technology IGT, Bally Technologies is one of the world's largest slot machine design, manufacturing, and gaming-systems companies. Combined, these three U.S.-based firms dominate U.S. casino slot floors with more than 85% market share.

Gaming devices and software systems are heavily regulated by state gaming authorities, so much so that all new titles and systems upgrades must be independently tested and authenticated by each state before they are approved for sale. The infrastructure required to maintain and garner state-regulatory approvals is substantial and significantly reduces the likelihood of new competitors. Fifty years of title-development experience, software-systems leadership, and worldwide reach ensure Bally's economic moat will continue for many, many years.

Bally has three lines of business: game sales (which are currently running below trend), games out on lease (very profitable with steady revenue growth), and enterprise-class casino-gaming systems (very profitable and the worldwide market leader).

Both the games-out-on-lease and the casino-software-systems businesses have a high degree of recurring and predictable revenue and operating profit. But during the last few years, casino operators have substantially curtailed new slot machine purchases as a result of many factors. I believe this pullback in new game sales is temporary. With its full range of offerings, Bally continues to take casino floor market share in the U.S. and is building a growing presence in rapidly expanding international jurisdictions in Asia and Europe.

Bally continues to innovate and improve the player experience. Its newest-generation games feature play levels and functionality found in today's latest computers and game consoles. These developments quickly render older slot machines obsolete, stoking a continuous upgrade cycle.

Bally Technologies has been a top 10 holding in the fund for quite some time. As of Sept. 30, 2010, we had placed 7.90% of the fund's assets in Bally with the expectation that management will compound owner earnings per share at a midteens or better rate for many years to come. At today's valuation, Bally trades around 13 times the next 12 months' earnings. The firm is able to internally fund growth-oriented capital expenditures and has been buying in shares with excess cash for the last two years.

Investors should consider the investment objectives, risks, charges and expenses carefully before investing. This and other information can be found in the fund's prospectus. To obtain a free prospectus please call 1-888-888-0025 of visit www.fbrfunds.com. Please read the prospectus carefully before investing.

The non-diversified nature of the Fund may subject investors to greater volatility than other diversified funds. Investing in mid- and small cap companies can involve risks such as less publicly available information, higher volatility and less liquidity than in the case of larger companies.

The FBR Funds are distributed by FBR Investment Services, Inc., member FINRA/SIPC.

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Liana Madura does not own shares in any of the stocks mentioned above.

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