1st Source Fund Quietly Beats the Competition

ASK MOST PEOPLE in the U.S. the significance of South Bend, Ind., and they will probably mention the University of Notre Dame and its storied football program. Even though the Fighting Irish haven't won a consensus national championship since 1988, its 100-year-plus tradition is ingrained in the minds of millions of pigskin fans.

Some savvy investors, though, are keen on South Bend for another reason. Of course, it's not a financial hub. Visitors are still likely to see corn fields and cows rather than suits throwing around billions of dollars of cash. But the town is home to something Wall Street can't claim: one of the best mutual funds in the industry. And its track record has nothing to do with whether it prays to Touchdown Jesus or not.

You've probably never heard of 1st Source Monogram Income Equity (FMIEX) or its manager, Ralph Shive. Indeed, at last month's Morningstar conference he sat on a panel dubbed "Undiscovered Managers." But Shive and his fund should be on your radar screen. Over the last 12 years he has used a strict value-stock-picking strategy — albeit, one that's a bit eclectic — to earn an enviable track record. The fund holds the top spot in its Morningstar category over the trailing three-, five- and 10-year time periods. In addition, it charges reasonable annual fees and gets high marks for tax efficiency. If you're looking to round out your portfolio or start one from scratch you would have a hard time finding a better candidate than this fund.

"[The fund] is a hidden gem," wrote Morningstar's Andrew Gogerty in his latest report on it.

The parent of this offering, 1st Source Corporation, operates 75 banking centers in Indiana and Michigan. Shive was managing a private family portfolio in Dallas when the company hired him in 1989. Now, as chief investment officer of the company's investment arm, he oversees $3 billion, including this $635 million fund and other portfolios throughout the firm. He also manages a staff of six analysts/managers.

Shive is a contrarian, to say the least. Even the fund's name, Income Equity, goes against the grain. (Most of his competitors use the term Equity Income.) He employs a deep value strategy that involves narrowing a universe of stocks based on broad investing themes and good old-fashioned research. The themes can include global food demand or aging baby boomers, for example. When it comes to valuing a company he and his staff will look at everything from price/earnings ratios and competitive advantage to historical metrics and growth rates. He wants the portfolio to have a dividend yield 1.5 times that of the broad market. Shive does like to see his favorite stocks trading at a steep discount when he buys them. But unlike some other managers, he doesn't fret about whether it's down 20% or 30% or 40% before he reacts. And he will let some stocks run even if they've surpassed a certain price target.

"I like to remain flexible," he says. "I will use every tool I can."

That one-two combination — looking at themes and valuations — and a little bit of a gut feeling have enabled him to avoid many of the tricky market conditions of the last decade. The fund trailed during the tech boom, a testament to the euphoria surrounding growth stocks at the time. But according to Lipper, since 2000 Shive has beaten the broad market every year. More recently, he sniffed out the subprime and credit crises after a couple of long conversations with his fixed-income specialist. Shive became skeptical of many financial stocks when he couldn't make sense of some of the investments on their balance sheets that have since tumbled in value. He attributes that healthy dose of skepticism to having lived through the S&L crisis in Texas. Like many great investors who learn from market calamities, the memories of that time came roaring back last year.

"It was garbage," he says of some of those investments. "I could see the storm cloud coming in."

Combining all that together makes for a rather eclectic portfolio. Shive invests up and down the market capitalization spectrum. According to Morningstar, the fund has 77% of its assets in large-cap stocks, another 17% in medium-sized firms and 3% in small-cap companies. He also keeps cash on hand. Top holdings include General Electric (GE), American Electric Power (AEP), Novartis (NVS) and Verizon (VZ).

One stock he is buying is Archer Daniels Midland (ADM), the large agricultural processor. In 2007, shares of this firm increased over 40% thanks, in large part, to the boom in ethanol. Shive likes it for its exposure to rising food demand in emerging markets across the globe. The stock has pulled back this year. Indeed, it's trading at its lowest levels in 30 months. And Shive is prepared for a rough ride in the short term. Overall, though, he thinks it's cheap at eight times earnings and a winner over the long haul.

"I didn't buy it for quarterly earnings," he says. (Click on the video on the right side of this page to watch Shive talking about this stock.)

He also likes energy. According to the fund's latest filings, the portfolio includes natural gas infrastructure firm Spectra Energy (SE), Marathon Oil (MRO) and Chevron (CVX). "There have been some spiky earnings but this [rally] is being driven by growth in emerging markets," he says. "I continue to be bullish on energy."

One place he's taking a wait-and-see attitude is financials. He's not trying to call a bottom just yet. He admits, though, that he also doesn't want to miss out on the inevitable comeback. Currently, he's been playing the sector through insurance names like Allstate (ALL) and diversified companies like Lincoln National (LNC). He's been adding to his position in Old Republic International (ORI). Meanwhile, he's keeping other names on a watch list. "I want something to light up on my screen when they start to get going," he says.

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