A Different Apple in the SRI Orchard

Michael Breen: Greetings, this is Mike Breen from Morningstar, and I'm here with Adam and Josh Strauss from the Appleseed Fund, a Chicago-based SRI fund that actually has a unique combination of SRI and uses a value style, where most SRI funds are growth. Welcome, gentlemen.

Josh Strauss: Good to be here.

Adam Strauss: Yes.

Michael: Maybe if you have a moment, you could just sort of explain this sort of anomalous situation in terms of the SRI - socially responsible funds - where you're kind of the outlier, using the value strategy.

Adam: Well, SRI and value have a lot of common characteristics. Both styles tend to out-perform the market over long periods of time. In the Appleseed Fund, we don't put a stock into the portfolio unless it passes our value screens and it also passes our SRI screens.

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Michael: And I found you, actually, due to a stock that you owned - John B. Sanfilippo, an Elgin-based small, micro-cap company that makes nuts, and ran across that in some screens with some other managers and then ended up contacting you folks. Maybe you can develop that. It's an interesting holding, a micro-cap about maybe 12 percent of your assets, so not something anyone else really owns in our database - a few people, and not at that level. So, what makes you comfortable owning that particular stock to that level?

Adam: Well, John B. Sanfilippo is our favorite stock idea. It's a stock that we have followed for decades. As you mentioned, they're in the nut business. They own the Fisher brand of nuts, and they're also the largest private label nut producer in the United States. First of all, we love the space. There's a lot of research that's growing every day, documenting the health benefits of nuts as it pertains to heart health. So, we think that there's a long-term market growth opportunity. And then within the nut space, John B. Sanfilippo is growing much faster than the market, because consumers are trading down to private label.

In addition, they just built a super-efficient manufacturing facility that they moved into in the last 12 months. And we think that gross margins could double from FY '06 levels as a result of that.

Michael: OK.

Adam: Then, what we really like about it, above and beyond all that, is the valuation. The stock's at $6 a share. Tangible book value is at $15 per share. Over the last 12 months, the company's generated $3 a share in free cash flow. And it's trading at about a four times forward PE. So, we love the stock.

Michael: So, the market is not efficient in your opinion with the stock trading.

Adam: There is no sales side research on John B. Sanfilippo. Everybody seems to be ignoring it. And while everybody's been ignoring it, we've been backing up the truck.

Michael: All right, great. We have another name we'd talked about before, Annaly Mortgage, I believe. I actually am not an expert on SRI. So maybe how does that mortgage read fit into the SRI component, and also the thesis just for it as an attractive stock?

Josh: Sure. Well, Annaly is an agency mortgage read. On the one hand, they invest in Fannie Mae-Freddie Mac mortgage bonds on the long end of the curve. They borrow at the short end under the curve, and they make their money on the net interest spread. Annaly faces virtually no credit risk, because Fannie Mae and Freddie Mac agency bonds are implicitly backed by the US government. Stock is 14; book value is 15. They were acquired, as a read, to pay out all their earnings in the form of dividends. The dividend yield is about 15 percent today. We find the stock very attractive from a valuation perspective.

Certainly, there is a lot of negative sentiment towards mortgage originators who engaged in predatory lending practices. Annaly is not a mortgage originator. Annaly buys plain-vanilla, conforming mortgages with no credit risk.

In fact, during the housing bubble, Annaly was telling anybody who was willing to listen, the massive risks that are involved with these creative financing techniques and the impact they would have on our economy when the shoe dropped. I only wish that more people listened to Annaly at the time.

The primary risk with the Annaly thesis is the eventual narrowing of their net interest spread, which is incredibly wide right now. That will occur when the Federal Reserve begins to raise rates. Given the weak economic environment, we don't see that happening anytime soon.

Michael: So right now, they're actually kind of an anomaly. They're able to pick their spots, and they don't have a lot of competition, due to all those head winds. Maybe that will eventually change, but it will sort of be after the fact, after they've been able to put up some good results and benefit from the current situation.

Josh: That's exactly right. They're operating with a conservative level of leverage right now. Earnings are terrific, right now. We're clipping a really nice dividend.

Michael: Great, guys. I appreciate your time, and we'll keep in touch.

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