Despite a cautious approach to stockpicking, FAM Equity Income has had a rough time lately. By Stacy Rapacon, Online Editor May 22, 2008 Under normal circumstances, FAM Equity Income is like warm milk for investors who can't sleep because of the market's gyrations. But the past year has been anything but normal, so Equity Income and its shareholders have suffered. Thanks mainly to a large slug of financial stocks, Equity Income lost 13% over the past year through May 21. That trails both Standard & Poor's 500-stock index and Morningstar's Midcap Core index by six percentage points. The long-term record is more impressive. Over the past ten years through April 30, Equity Income (symbol FAMEX) gained an annualized 7%. It beat the S&P 500 by an average of three percentage points per year, although it lagged the S&P Midcap 400 index by about 2.5 percentage points per year. Managers Thomas Putnam and Paul Hogan apply four principles as they look for small and midsize, dividend-paying companies. First, they stick to what they know. "We must find a business we really understand," says Putnam. This generally nixes technology stocks. It also keeps big-picture economic trends as distant as New York City, 150 miles south of Fenimore Asset Management's upstate Cobleskill home, which Putnam calls a "nice place to think clearly and not be bombarded by all the things on Wall Street." Advertisement Second, they prefer companies with little to no debt and plenty of free cash flow (earnings plus depreciation and other cash charges, minus capital expenditures). They want to be sure a company can "finance its own growth," says Putnam. Third, superior management is essential. "The management team is responsible for motivating the employees and setting the tone for the company," says Hogan. He, Putnam or Fenimore's six analysts visit all the companies held by the fund at least once a year. They also visit promising prospects to get familiar with the top dogs and other employees. Putnam likes to ask managers: "How do you describe your corporate culture?" Then, he'll take the long plant tour, "watching employees as management passes through," to see if the responses hold true. He'll stop and ask someone, "What do you think of management?" At least once, he heard the response, "They don't listen to us." He decided that that company wasn't his cup of tea. Finally, the managers invest only if they think a stock is selling for less than the company is worth. Sounding a lot like Warren Buffett, Putnam says, "Always looking to buy companies at discount builds in a margin of safety in order to protect the capital of the shareholders if we make a mistake." Advertisement The result of all this is a portfolio of roughly 25 stocks. Although most have market values of $2 billion to $5 billion, Equity Income currently holds stocks with market capitalizations as small as $300 million (Courier Corp) and as big as $370 billion (General Electric). "Larger holdings have only come into play since they've been out of favor for the past few years," says Putnam. He and Hogan typically hold a stock for seven to eight years. Ross Stores, the second largest discount retailer of clothing and home goods, has been one of the fund's best performers this year. The company's leaders "really understand how to increase intrinsic value over time," says Hogan. With stores in only 26 states, he adds, Ross (ROST) has a lot of opportunity to expand. FAM Equity Income's shining hour occurred during the 2000-02 bear market. From March 24, 2000, to October 9, 2002, it returned 31%, beating the S&P 500 by a whopping 78 percentage points. Not surprisingly, the fund owned no technology stocks during the downturn. Performance during the most-recent market downturn wasn't so stellar. Hogan and Putnam shunned lenders of subprime mortgages, but the fund, at last report, had 38% of its $103 million in assets in financial stocks. From last October 9 through March 10, Equity Income lost 21%, lagging the S&P 400 and S&P 500 by three and four percentage points, respectively. The managers remain confident that their financial stocks - including top-ten holdings White Mountains Insurance Group (WTM), Westamerica Bancorp (WABC) and Protective Life (PL) -- remain solid long-term investments. Advertisement Putnam has run FAM Value (FAMVX) since 1987; John Fox joined him in 2000. Value has lost 11% over the past year and, like Equity Income, has gained an annualized 7% over the past decade. Value is also a bit cheaper, charging annual expenses of 1.18%, compared with Equity Income's 1.32%. Value has a minimum initial investment of $500. Equity Income requires $2,000 (but only $500 within retirement accounts). Despite their recent travails, these are by no means second-rate funds. We like the managers' level-headed approach to picking stocks and, in particular, we think Equity Income, with its focus on dividend payers, should provide a relatively calm ride should the market once again become turbulent.