• / Free eNewsletters & Magazine
  • / My Account

Related Content

  1. Videos
  2. Articles
  1. When Stocks Are Safer

    Data show that the longer investors held stocks (and stomached short-term volatility), the safer they became for meeting portfolio objectives, says Morningstar's David Blanchett.

  2. Top Investment Ideas for Retirement

    Retirement Readiness Bootcamp Part 5: Morningstar strategists share their top fund, ETF, and dividend stock picks to fill your retirement portfolio.

  3. Morningstar's Dividend Playbook

    DividendInvestor editor Josh Peters walks investors through his drill for uncovering sustainable and growing dividends in this special presentation.

  4. Prudent Strategies for a High-Flying Market

    Investors queasy over market valuations may consider rebalancing, augmenting their cash stakes, and tilting toward undervalued pockets and proven flexible managers, says Morningstar's Christine Benz.

Appleseed Fund

To make the fund's cut, companies must meet sustainability measures--and be cheap.

Ilana Polyak, 06/01/2009

We value your comments. Make your opinions known at the end of every MorningstarAdvisor.com article.

Video: Morningstar analyst Michael Breen discusses Appleseed's strategy with co-managers Josh and Adam Strauss.

Investors have come to expect certain things of the companies in socially responsible portfolios: Strong environmental stewardship, fair working conditions, and conflict-free materials sourcing are just some of the biggies. But low price/sales ratios and copious free cash flow? Not so much.

Socially responsible funds tend to cluster around growth stocks and go heavy on tech and alternative-energy names where carbon footprints are small and workers are treated well. But valuations can be stratospheric.

"A lot of the SRI funds screen out the more industrial areas," says Scott Secrest, chief investment officer with Natural Investing, a San Luis Obispo, Calif.-based registered investment advisor that specializes in social investing. "The funds have found it easier to be growth managers."

A small amount of the $44 billion invested along socially responsible principles is parked in the value style. Seeing an opening, Chicago-based Pekin Singer Strauss, an investment management firm, pounced in 2006 with the introduction of its open-end value SRI mutual fund, the Appleseed Fund APPLX.

Value investors since 1990 in their separate accounts business, the five portfolio managers of the $18 million Appleseed Fund first dipped a toe in the SRI waters at the behest of clients.

"We'd have clients say 'I don't want tobacco or alcohol or defense,' " says Josh Strauss, one of the five and a senior vice president. "Then we started doing some research and realized that there are lots of opportunities for this type of investing."

Go Anywhere, Sort Of
Having two sets of constraints puts certain limits on the types of businesses that can be included in the portfolio. At times, the managers find themselves outsiders of both the value and SRI camps. "If it's a cheap tobacco company or an expensive solar company, we're not going to have that," Strauss says. But he stresses that there are plenty of opportunities elsewhere. "We do not find that we're restricted all that much," he continues.

Part of the reason the team feels unfettered is that it invests all along the capitalization spectrum, from giants like drugmaker Pfizer PFE to tiny names such as John B. Sanfilippo & Son JBSS, a peanut and almond seller with a market cap of just $55 million.

Stock ideas are generated in a variety of ways. Sometimes a manager or an analyst has an idea; other times the crew hunts for stocks that meet specific criteria. Regardless, all the names in the portfolio share certain attributes: They do not derive revenue from the sale of tobacco, alcohol, gambling, weapons, or pornography. In addition, they should also be businesses that have solid human rights and environmental records and invest in their communities.

Having made sure the sustainability measures are met, the team then drills down into the financials. "We're big balance-sheet guys," Strauss says.

Among the characteristics the five look for are low amounts of debt, plenty of free cash flow, and a defensible competitive advantage, characteristics that happen to play well to today's treacherous market environment. They particularly like companies that have stumbled recently, yet not so much that the missteps have impaired their free cash flow. This research process is identical to the one they use in the $500 million separate accounts business.

The value and SRI restrictions seem to be a winning formula, at least lately. For the 12 months ended April 17, Appleseed is in the top 1% of mid-cap value funds tracked by Morningstar, with a negative 5.6% return. (The fund's large-cap names together with its tiny ones average out to a mid-cap weighting.)PAGEBREAK

Value Helps a Lot
Much of the fund's recent strong showing can be attributed to the value orientation that steers the managers to businesses with low debt and ironclad balance sheets.

"When the capital markets blew up, anyone who had any debt had their stock blow up because suddenly the market got worried that they would not be able to refinance that debt," says Michael Breen, the Morningstar analyst who follows the fund. "The companies that had a lot of cash and no debt held up better."

The stocks in Appleseed generally don't have such financing concerns. Case in point is Gaiam GAIA, maker of organic clothing, including yoga gear. The company's commitment to environmental stewardship (the firm has a carbon-neutral shipping program) and social responsibility (the company purchases fair-trade materials) make it a shoo-in. When the value screen is applied, the stock looks even more appealing. The firm has a sizable cash cushion on its balance sheet for its $130 million market cap and a price/book ratio of 0.5. And there is no debt. Then there's the hidden gem that makes value hounds like the Appleseed managers giddy. In addition to the clothing business, Gaiam is also the majority owner of Real Goods Solar RSOL, an installer of solar panels, giving Appleseed an entree into the richly priced alternative-energy sector.

"It's a backdoor way to play solar," Strauss says. "There has been a bubble in all energy-- including alternative energy--and this is one way we could participate in the sector at a reasonable valuation."

Regardless of whether Gaiam is an alternative-energy stock, a purveyor of healthy living, or a dirt-cheap security, its stock is up 17.3% for the year to date through April 17.

Concentrated Portfolio
With just 23 names, Appleseed is one of the most concentrated portfolios around. "That's a sword that cuts both ways," says Secrest of Natural Investing, who began investing in Appleseed in January. "Anytime you have a manager who is running the portfolio that way, you want to have a high degree of confidence in his or her ability to pick stocks."

Morningstar's Breen agrees, especially because the managers have no qualms about taking sizable positions in small-cap and micro-cap fare. "You have a better chance of being wrong on a tiny company," he says. "On the flip side, no one else is covering the stock, which gives you a huge advantage if you're right." To the minds of Appleseed's managers, the focused approach gives shareholders access to the managers' best ideas. "There is more risk in having a larger portfolio full of names we don't know well," Strauss says.

And they certainly know their names well.

Take top holding John B. Sanfilippo & Son, the nut producer. The stock meets the SRI criteria ("nuts are a good source of vegetarian protein," Strauss says) and the valuation is right ("the stock trades at less than half of book value," he adds). The team may have included it in the portfolio on this basis alone. But the managers had an even higher degree of confidence in their ability to analyze the stock.

Ron Strauss, firm president and father of Josh and comanager Adam, was a sell-side analyst at Chicago-based William Blair in 1991 when the firm took John B. public. The elder Strauss has followed it ever since, owning it when its price was deemed cheap enough, such as the $5.20 a share that it now trades at. The Appleseed managers are so comfortable with the stock that it's the fund's largest holding at a whopping 16.8% of assets.

The fund is full of these high-conviction names because it takes a lot to actually gain entree into the portfolio. Four out of five of the managers must agree on inclusion before a name is added. "It takes a while for stocks to come before the committee," Josh Strauss says. "So, by the time they get there, we have a two-thirds pass rate."

Overweight Financials
The fund got a big boost from one surprising area: financials.

Like other value managers, Appleseed's management became concerned about inflated housing prices in 2005 and sold off its housing-related names. In late 2007, the managers began to dump big banks because of concerns about off-balance-sheet financing.

The managers turned their attention to mortgage real estate investment trusts as a way to profit from an impending housing collapse beginning in 2006. Two names the fund holds are Annaly Capital Management NLY and Anworth Mortgage Asset Corp. ANH, both mortgage REITs with similar businesses.

Annaly is a spread lender: It borrows money on a low-cost, short-term basis and reinvests it in higher-yielding, longer-term securities. "We had a slightly inverted yield curve then," Strauss says. "We thought that eventually the Fed would have no choice but to cut rates and the yield curve would normalize."

That's what happened. Over the past 12 months, the stock is down 4%, handily beating similar names and the S&P 500. "Anytime you cut rates like that, it's like crack cocaine for mortgage REITs."

Anworth, meanwhile, invests in mortgage-backed securities issued by government agencies such as Fannie Mae FNM and Freddie Mac FRE. Most investors would prefer to carve a mile-wide no-investment zone around these entities, but the Appleseed team sees things differently. For one, they see little credit risk in Anworth's portfolio because of the implicit federal backing. Plus, the stock trades close to book value. "If they were to liquidate their portfolio, they would be selling the second-most-liquid security in the world," Strauss says.

At $6.33 a share, Anworth has an 18% dividend yield. Its profits of $1.15 per share a year are more than enough to support the $1 dividend, Strauss reasons. The REITs also pass SRI muster. "They invest in things that prop up the housing market," he says.

That proves that value and social responsibility can go hand in hand.

Ilana Polyak is a freelance financial journalist.

We value your feedback! Add your questions, comments, or criticism by clicking the link below.

©2017 Morningstar Advisor. All right reserved.