The CEO of Knott Capital, Michael Barron, thinks investors have become complacent. In spite of 18 months of Fed tightening, the economy has perked along with few visible signs of distress, lulling share owners into a false sense of security. Credit spreads, which are remarkably narrow for this point in the cycle, are just one of the symptoms of this nonchalance; high stock prices are another. That’s why he and his partner, Charles Knott, have been raising cash.

It’s not the first time they have exercised caution. In 2001-02, they held as much as 22% of their assets in cash equivalents; before September 11, 2001, they had a 13% cash position.Today they have about 11% of assets in cash, up from 3%-5% on average in 2005. Last year their equity accounts were up 12.5% net of fees, compared to the paltry 4.9% gain in the S &P 500. Note that these gains did not rely on the use of leverage.

Messrs. Knott and Barron have been managing money together since 1999 and have compiled an enviable record. Since inception, their firm has earned an annualized return of 9.7% after fees, compared to 1.69% for the S &P 500. Perhaps as impressive, they have done so with below-average volatility, and have been up in six of seven years, compared to the S&P, which was down in three of those years.

They claim never to have lost an institutional client. At present, they are managing about $750 million, and have turned away what they describe as “hot money.” Instead, they have built their business slowly and carefully, much as they invest.

Knott Capital is also the sub-adviser for Quaker Capital Opportunities Fund, a mid-cap manager that Morningstar gives a two-star rating. Results for the fund have not been as rewarding. Also, turnover and fees have been higher for the fund.

Their approach is to decide the outlook for interest rates and the economy, determine how various sectors will fare within the forecast framework, then select stocks that will perform well in those sectors. Mr. Barron explains: “We do our own in-house forecast because we need to know where we are compared to the consensus. Also we look at sectors, since we know that 80% of a portfolio’s returns are the result of sector weightings.”

The Knott team is small, but because of its top-down approach, it doesn’t need legions of analysts combing through the S &P cellar looking for good ideas. Once it has identified an attractive industry group,it can zero in on a few names.

At present, the duo is looking for a slowing of the economy, and is slightly more pessimistic than most forecasters. It is closely watching the Federal Reserve, and eagerly awaiting the March 28 meeting.That will be the first oppor tunity for investors to get a good look at the new chairman’s style and economic expectations.

“History shows that the Fed almost always overdoes,” Mr. Barron says. He assumes Chairman Bernanke will continue to raise rates, to more than 5%, which may well cause economic growth to fall to less than 3%, below most forecasts. This causes caution on a number of fronts, but Knott Capital, like many others, views housing as particularly vulnerable. “The last four years, housing has been the engine of the economy,” Mr. Barron says.

Nonetheless, the team is sticking for the moment with their long-term investment in St. Joe (JOE $62), a major land development company in Florida. St. Joe has been viewed as a timber play, and as a way to invest in the housing boom.The Knott folks, who have gotten to know the company well, consider that St. Joe is both of those, and a land bank to boot.They feel St.Joe is uniquely positioned to take advantage of the endless stream of retirees moving to Florida, and hold the stock even as it has come off its 52-week high of $85.

Similarly, despite their concerns about a drop-off in the housing sector, they still favor Pulte Homes (PHM $40), which, according to Mr. Barron, is “priced for disaster.” The outlook for Pulte, which is selling at a forward P/E of below seven times earnings, has to do with the consolidation taking place in the homebuilding sector, which allows Pulte and others to increase their market shares and enjoy economies of scale. Mr. Barron says, “The housing market is slowing. It doesn’t mean the end of the world.”

The Knott team also favors Lowe’s (LOW $69), another stock generally viewed as vulnerable to a housing slowdown. The company is an intelligent merchandiser, and has targeted women as being the predominant purchasers of household items.

So where is Mr. Barron taking profits? The team has been overweight energy stocks for six years, with names like ConocoPhillips (COP $61), XTO Energy (XTO $43), and Chesapeake Energy (CHK $31). Of late, the Knott group has been taking some profits. Though it still views the long-term outlook for the energy sector as attractive, it does not see any new price highs for oil or natural gas this year.In a year-end forecast, Mr. Knott predicted that oil would average $57 a barrel during 2006, while natural gas prices would come in at $8.75.

It is also underweight the financial sector and technology.In a period of rising interest rates, it is skeptical of most financial companies’ ability to record substantial growth.As for technology, it struggles to find companies that meet its overall requirements of growth, reasonable valuations, and pricing power.

It is also light on large pharmaceutical companies, despite considerable optimism about the health care sector. Because of myriad problems which arose early in the decade for large drug companies, Mr. Barron and Mr. Knott sought out companies that would benefit from the industry’s need to outsource, and targeted testing companies such as Pharmaceutical Product Development (PPDI $36).The stock has traded up for the past two years, and is currently selling near the top of its 52-week range.

Overall, the Knott Capital team is cautious, which fits its mantra: “Opportunities come again and again; your investment principal comes but once.”