A Superb Low-Risk Fund

T. Rowe Price Capital Appreciation (symbol PRWCX) offers an ideal combination that makes investors' mouths water: It delivers solid performance with below-average risk.

Let's start with the returns. Over the past five years through March 11, the fund returned an annualized 8.1%. That's an average of 2.4 percentage points better than Standard & Poor's 500-stock index. As for risk, the fund has been about 30% less volatile than the S&P 500. That paid off, at least on a relative basis, during the 2007–09 bear market. While the S&P plunged 55.3%, Capital Appreciation fell 41%.

Other pluses: Expenses, at 0.71% per year, are relatively low, and David Giroux, 37, who has piloted the fund since mid 2006, is a first-rate manager.

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Capital Appreciation is not a pure stock fund. Currently, it has a little more than 60% in stocks. Since Giroux took over the reins, that number has been as high as just over 70% and as low as a little more than 50%. Giroux bases his allocation not only on how cheap or dear stocks look, but also on the opportunities he sees in bonds.

Right now, he views the stock market as "fairly valued to slightly overvalued," but he thinks most bonds are ridiculously expensive. Most of the fund's bond holdings are investment-grade corporate IOUs with short maturities. The maturities are so short that they have virtually no interest-rate risk. (Bond prices move inversely with interest rates; the longer a bond's maturity, the more sharply its price swings as rates change.)

Like many other market watchers, Giroux believes that Treasuries, investment-grade corporate bonds and high-yield bonds are all headed for huge losses. Interest rates "are going to rise. I don't know when they'll rise, but they're going higher," Giroux says.

What's more, he says, a lot of high-yielding stocks are also overpriced. In that category are most utilities, telecommunications issues, real estate investment trusts and other high dividend payers; such stocks are priced for perfection "because of investors' hunger for yield," he says.

What happens next won't be pretty, he adds. Investors will migrate away from bonds only after they suffer painful losses. At that point, they'll embrace stocks, only to discover that rising rates pose a headwind for equities.

Giroux is focusing on stocks that should do well when rates rise. For instance, State Street (STT) makes most of its money by taking custody of assets for large institutional investors, such as pension funds, mutual funds and hedge funds. It profits partly from the small spread between what it can earn and what it pays those firms on cash. When rates rise, so will State Street's profits. The stock trades at $59.38. (All prices are as of the March 11 close.)

AutoZone (AZO) is another Giroux favorite. The auto-parts retailer doesn't pay a dividend, but he says the firm buys back 7% of its shares every year. Says Giroux, "What's the difference?" In his view, a company is returning cash to investors whether it pays a cash dividend or buys back its shares. AutoZone's stock, at $388, trades at 13 times analysts' estimated earnings for the next 12 months.

One surprising holding for this low-risk fund: Google (GOOG). Giroux doesn't think the company's growth is closely tied to the economy's ups and downs. He says Google has been consistent in executing its core business strategy and has made good acquisitions. At $835, the stock trades at 16 times analysts' estimated earnings.

Don't buy Capital Appreciation thinking it's immune from market disasters. The 41% loss in the last bear market should disabuse you of that notion. Giroux bought stocks aggressively as they plunged in value during the bear market. Until the market hit bottom, that accelerated the fund's losses. And he'll do the same thing the next time stocks collapse.

But Capital Appreciation makes an excellent core holding. It gives you exposure to bonds and large-company U.S. stocks in one package — and, unlike balanced funds, handles tactical shifts for you. All it lacks are domestic small-company stocks and foreign stocks and bonds.

Steven T. Goldberg is an investment adviser in the Washington, D.C. area.