The Appleseed Fund is dashing the notion that limiting one's investment universe to socially responsible companies might impede an investor's returns. Even though it was launched less than a year before the bear market hit, this SRI offering was the top performer in Morningstar's mid-cap value category for the three years ended December 31. In 2009, it climbed 60%, when its S&P 500 bogey rose by only 26.5%, and amid the decline in 2008, it fell less than half as much for the year as the S&P. Assets have swelled from less than $20 million a year ago to just over $100 million today, with new inflows coming not only from traditional SRI investors-but from those simply drawn to performance.

The fund's five-member investment team, which includes father Ron Strauss and sons Adam and Joshua, seeks undervalued, well-run companies with socially responsible business practices to produce market-beating returns. Its holdings span the investment spectrum from small companies with less than $100 million in public value to industry giants such as Coca-Cola, Novartis and Pfizer.

Despite its Morningstar categorization as a mid-cap, Appleseed is really a "go anywhere" fund whose managers pay attention to preserving capital. The management firm that runs the fund is the Chicago-based Pekin Singer Strauss Asset Management (which has $700 million in assets under management, most of it in separately managed accounts). The firm has its own incentive to keep client losses at a minimum in the Appleseed Fund: Its five partners started the portfolio with their own money and continue to own a substantial stake in it.

The firm currently has an ample stake in cash equivalents, recently ranging from 15% to 20%, which reflects the scarcity of compelling values after the rapid rebound in 2009 and the substantial inflows into the portfolio. In another defensive position, the firm allocates nearly 15% of assets to gold through exchange-traded funds. Now that the financial panic has abated and the recession shows signs of waning, the gold stake would provide an effective hedge if the economy expands and inflation heats up, says 40-year-old fund manager Adam Strauss, who joined his father's firm in 2004.

Gold might be a surprising choice for a socially responsible fund, since the mining industry has a tarnished reputation on environmental matters. But Adam Strauss maintains that gold ETFs are indeed suitable for his portfolio.

"There is a difference between owning stock of gold mining companies, which are subject to government corruption and negative environmental issues, and owning shares that represent stores of the metal purchased on the secondary market," he says.

With concerns about inflation, the fund has been emphasizing investments that will either benefit directly from rising prices, such as gold ETFs, or companies that can raise prices, such as Coca-Cola. The beverage giant has a stock that is attractively valued, and it has shown its ability to produce consistent revenue through a variety of economic cycles. It also takes steps to minimize its water usage, using recycled water for instance.

Another company the fund likes is PetSmart, a leader in an industry without much competition. PetSmart boasts ample pricing power, since pet food and medication are necessary items for animal owners, costs that can't be cut. The company also donates to pet charity and pet adoption causes.

Many of the stocks in the Appleseed Fund don't come from the traditional value industry sectors like industrials and financials; to buy in, Appleseed's managers simply have to consider a stock undervalued, and Morningstar agrees enough to label the firm a value fund. The value orientation, however, contrasts with those of most socially responsible fund offerings, which tend to favor growth stocks. Adam Strauss says the value discipline and the commitment to SRI go hand in hand because they help the firm avoid companies violating the law or marketing products of questionable value that might later require costly litigation.
To be included in this highly concentrated portfolio of 20 to 25 names, a stock must have the potential to appreciate at least 50%. The investment management team meets twice a week to review new ideas and current holdings. Once the team members find a stock they like, they aren't afraid to build a substantial position-the most recent year-end fact sheet shows an 11% stake in top holding Pfizer, and the top ten holdings represent 58% of the assets.

"Just remember, its concentrated portfolio will stumble at some point, torpedoing near-term results," warns Morningstar analyst Michael Breen. "But over the long-term, expect this fund to remain a winner."

Free cash flow tops the list of the Appleseed portfolio's valuation screens, but the managers also look at other value gauges of a company, such as its book value and what prices investors have paid for similar private entities. The fund views earnings with some skepticism, since companies can easily manipulate them. It favors a company with low levels of debt whose own managers hold a hefty stock ownership, working in an industry where it has a defensible competitive advantage and its rivals face high barriers to entry. Appleseed will sell a stock once it reaches its intrinsic value or once the fund managers' estimate of that value changes. Appleseed will also sell when a company's SRI profile worsens, or when the portfolio managers find better opportunities elsewhere.
To achieve the SRI reputation in the first place, companies must fit the Appleseed team's definition of what a good corporate citizen is, and have strong records on the environment, human rights and community investment. Transparent reporting and a prudent allocation of capital are also musts. The fund eliminates companies that generate substantial revenues from tobacco, alcohol, gambling, weapon systems or pornography, as well as those with operations or direct investment in Myanmar or Sudan.

While it's difficult to pinpoint exactly how much the fund's sustainability criteria have aided its performance, the screens clearly helped in 2007 when Appleseed eliminated its large position in Citigroup. "We started reading reports about off-balance-sheet liabilities and the losses the bank was taking," Adam Strauss says. "The decision to sell came a few days later, when third-quarter earnings came in well below expectations. It became apparent at that point that Citigroup and other banks would take a huge earnings hit and need to raise capital." Although other fund holdings fell in 2008, many held up better than the overall market. Appleseed's overweight position in defensive health care stocks, along with its cash positions of up to 10%, also stemmed losses.

In 2009, however, those same health-care positions dragged down performance, at a time when concerns over health care reform have been growing. Another hindrance was the fund's cash position, which reached about 20% by midyear and has remained close to that ever since. Still, those problems were eclipsed by the solid showings of the fund's other stock picks-a few of which turned out to be home runs.
Among the latter was John B. Sanfilippo & Son, the owner of the Fisher nut brands and the largest private label producer in the United States. The stock, a longtime favorite that Ron Strauss began buying in the early 1990s, fell precipitously in 2008 when hedge funds and mutual funds unloaded it. But the Appleseed managers held on and added to the position in 2009 while it traded at a stunningly cheap two times free cash flow. They liked the stock so much that at one point last year it accounted for more than 17% of the fund's assets.

"Even today, it's trading at well below tangible book value," says Adam Strauss. "It also has a free cash flow yield of 15% to 20%. We get excited with a 10% cash flow yield." As far as the socially responsible aspect of Sanfilippo's business, Strauss points out that it uses fewer resources to grow protein products than it does to raise cattle or chickens.

Other winning fund picks in 2009 were the call center operator ICT Group. Appleseed's managers added this company to the fund in early 2009 and had more than doubled their holdings by the end of the third quarter. Appleseed also added Schering-Plough, which was acquired by Merck.

With more than one-fifth of its assets invested in pharmaceutical companies, the fund is taking a favorable stance on an industry that many investors view cautiously in an era of health-care reform. But Adam Strauss believes an aging population and consistent product demand make the stocks a good, cheap defensive play this year.

"Pharmaceuticals lagged in 2009, and that's one of the reasons we like them now," he says. "These companies conduct business around the world, so health-care reforms in the U.S. won't have a significant impact. And regardless of what happens with reform, someone-whether it's the government or the consumer-will need to pay for drugs." A recent addition to the group, Novartis, was added late last year when the stock sold at just 11 times earnings. Adam Strauss likes the company's drug pipeline and its diversified product offerings.

Mingling with the giants Novartis and Coke are less-well-known companies such as longtime holding Gaiam, a maker of lifestyle products ranging from green home furnishings to yoga wear. Gaiam also owns a majority stake in a company that installs solar panels, which gives the Appleseed Fund a backdoor exposure to alternative energy. Another less-well-known holding, Female Health Company, makes female condoms that government agencies distribute to women in developing countries to curb the spread of sexually transmitted diseases. As a result of the significant increases in government funding, the demand for Female Health's products should increase by a compounded growth rate of at least 20% over the next five years, says Adam Strauss.