Although the Berwyn Funds are best known for Berwyn Income (BERIX), a conser­vative allocation fund that we’ve profiled in previous years, their strict value approach to security selection has also worked exceed­ingly well for the equity-oriented Berwyn Fund (BERWX).

The fund’s seasoned manage­ment team screens for under­valued stocks with solid funda­mentals by employing valuation metrics such as price-to-book and price-to-cash flow ratios. Because such an approach tends to yield names that are out of favor with the market, management then studies the company and industry in detail to determine what sort of catalysts could lead to a turn­around. The fund’s team hopes to identify stocks with above-average growth potential over the ensuing three-to-five year time period.

Management mines the small-cap universe for such plays by fo­cusing on stocks with market capitalizations between $125 million and $1.2 billion. That results in a portfolio that’s more heavily tilted toward micro-cap names than its category peers.

Over 68 percent of the fund’s portfolio is allocated to micro-cap stocks, a weighting further evi­denced by the fact that the fund’s average market cap is just $474 million. Favoring such small com­panies has led the fund to have an outsize exposure to the technolo­gy sector at 26.1 percent of assets, which is more than double both its small-cap Russell 2000 bench­mark and the average fund in its category.

These characteristics have all the hallmarks of an extraordinarily volatile fund. But even with a fairly concentrated portfolio, manage­ment’s value discipline has en­abled it to keep the fund’s vola­tility slightly below its small-cap benchmark over long-term peri­ods. Even so, this small-cap fund is still substantially more volatile than the broad market.

Additionally, management pur­sues other risk-reduction mea­sures, such as raising cash when stocks appear overvalued and avoiding companies that are highly leveraged. At the outset of the sec­ond quarter of 2011, for example, the fund had 12.6 percent of assets idling in cash, which was fortuitous timing considering the market tu­mult that subsequently followed. The fund’s mandate also allows it to allocate as much as 20 percent of assets to fixed-income securi­ties, though management does not appear to have availed itself of that option in recent years.

Management’s adherence to its methodology has produced ex­traordinarily strong performance data, with the fund ranking in or very near the top decile of funds in Morningstar’s small-cap val­ue category over the one-year, three-year, five-year and 10-year trailing time periods. Even better, Berwyn Fund trounced the S&P 500 by 3.8 percentage points an­nualized over the past decade. It also outpaced its benchmark by 1.5 percentage points annualized over that same period.

By keeping a lid on volatility, the fund tends to moderately lag its peers in years like 2009, while beat­ing them by a wide margin during downturns. In 2008, for instance, Berwyn Fund lost 27.1 percent, which was more than 5 percentage points less than its category and 10 percentage points less than the broad market.

Berwyn Fund’s long-term out­performance and careful attention to risk mitigation make it an ideal holding for investors who need to fill out their portfolio’s small-cap sleeve.