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How One Fund Played Defense After the Downgrade

Appleseed managers share their picks and advice for investors.

Russel Kinnel, 08/22/2011

When the stock market goes off the rails, you may wonder what's going on at fund companies. I checked in with a couple of managers to see how they were reacting and also to hear what advice they have for worried investors.

Today, I'll share my discussion with Appleseed APPLX managers Joshua Strauss, Billy Pekin, and Adam Strauss. They run socially responsible rising-star Appleseed, which was down just 8 basis points year to date after last Thursday's sell-off, but that leaves them well ahead of their peers. Over the trailing three-years, they've produced an annualized 11% return that is tops in their category.

Q. The markets went haywire after the downgrade. What did you do during that week of wild swings? Were you buying bargains or waiting for the dust to settle?

A. Appleseed Fund is a go-anywhere value mutual fund that strives to outperform the S&P 500 over the long term. We welcome volatile investing environments because it allows us to invest in companies that have been severely mispriced in the short term. These are the times when active contrarian value managers like us discover attractive investment opportunities. We put a fair amount of money to work during the week after the credit downgrade of the U.S. government. We added to several of our existing positions that were unfairly punished, and we built new positions in two companies--Staples SPLS and SK Telecom SKM.

Staples is the strongest office supply provider in the world due to its scale and to its capable management team. Staples generates high returns on capital, and it should be able to grow revenues and profits even in a slow economy by taking market share from its weaker competitors. Due to persistently high unemployment and near-term challenges in the company's European business, Staples is trading at a valuation level that is even lower than it was during the depths of the 2008-09 bear market. We were buying Staples stock last week at a free cash flow yield of 10%-plus and a dividend yield of 3%-plus.

SK Telecom is the dominant wireless telecommunications company in South Korea with 50%-plus market share. While admittedly there is not much top-line growth to this business, the valuation is extremely attractive, as the stock trades at a discount to tangible book value with an unleveraged balance sheet, at a 6 times P/E multiple, and at nearly a 7% dividend yield. Should the value of the dollar fall considerably more, owning a stock denominated in a relatively healthy currency like the Korean won should provide investors with downside protection.

We believe that our recent investments in SK Telecom and Staples should significantly outperform the market over the next three to five years. In addition, we still have a fair amount of cash to serve as dry powder should the market provide us with further buying opportunities in the near term.

Q. Where are you finding bargains? What makes them bargains in your eyes?

Russel Kinnel is Morningstar's director of mutual fund research. He can be reached at russel_kinnel@morningstar.com.
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