Q:  What’s the investment philosophy of Ave Maria Growth Fund?

A: We believe that the way to outperform in the growth equity world is to operate with a very structured, disciplined approach. We have a long-term view and our goal is to exceed the returns of the S&P 500 index over a full economic cycle.

The fund is 100% invested in common stocks of U.S. incorporated companies. We carefully select the securities through a bottom-up process and we diversify among eleven economic sectors as defined within the S&P 500. Overall, we’re trying to find the companies with the highest return on equity, highest earnings retention, and lowest relative price. We rely on an information system that ranks our universe according to the companies’ attractiveness over a three-year time horizon.

In our philosophy, market capitalization is irrelevant. We have mid-cap stocks in the portfolio, such as Graco with $2.6 billion market cap, and large-cap stocks such as Stryker or Harley Davidson with market cap of more than $15 billion. We go where we find attractive returns regardless of market caps. Over time there are attractive and unattractive big and small companies.

Another important aspect of our philosophy is that we avoid companies that are offenders to Catholic values and principles, even if those securities are attractive. For example, we think that Pepsico is attractive but it’s not in the fund. In other words, we avoid companies that have anything to do with contraception, abortion, pornography, offering corporate benefits to unmarried couples and others.

Q:  How do you select the companies you invest in?

A: Our information system ranks a universe of 200 common stocks in order of risk-adjusted expected return. Based on the current price, an estimate of the interim dividends, and a terminal liquidation price, we are able to compute the discounted cash flow rate of return. The next step is adjusting that return for the risk.

We differ from other fund managers because we don’t pay too much attention to beta. The risk-adjustment process takes the historical standard deviation of the actual returns of the stock and compares that to the historical standard deviation of the average stock in the S&P 500. Then we adjust the computed rate of return for the relative risk.

After the 200 companies are evaluated, we divide them into four sets of fifty companies. The top fifty companies are the top quartile of our ranking; the second and the third sets represent the hold zone; and the fourth set of 50 companies consists of securities that are much lesser attractive and are candidates for selling. We monitor and measure our performance every day and, at present, 80% of our equity assets are in the first two quartiles and only 1.2% of the assets are in the fourth quartile.

Q:  What guidelines do you follow in your research process? Could you give us an example of an idea that became a holding?

A: One of the things we do is screen for companies with good earnings track record, but it’s not all numbers. For example, we have Graco in the portfolio, a company that does something very ordinary. It makes pumps that move fluids for grease guns and paint sprayers or pumps that move liquids that need to be sterile that are used in the bottling of wine or milk, for example.

Years ago the company attracted our attention as a company that was not in a super hi-tech industry or in retail. It is in a seemingly ordinary business, which they do very well. Graco has return on equity of 46.3% and it sells at a multiple of 15.9 times earnings. It generates 41% of its sales overseas but it is incorporated in the U.S. and we don’t have to worry about foreign accounting, the instability of foreign governments, or the currency exchange.

Q:  When you generate an idea, do you take the decision solely based on the publicly-available information and the numbers? Do you visit the companies?

A: Years ago I used to visit companies and I never learned anything negative. It’s all positive and the only way to learn something useful is to go to the manufacturing site, for example, to see what the housekeeping is like, talk to the people on the line, or to the competitors and suppliers.

In the case of Toro, for example, I went to a large dealer who’s been in the business for years. We discussed his opinion on the management and he described several positive things, positive, so that reinforced the decision to purchase Toro. But we don’t do that with every investment decision.

We like to make our own decisions and we don’t purchase decision-making from sell side analysts because we’re tied to our own beliefs, process, structure, and discipline. Our rankings have a rational basis to distinguish between the most attractive and the least attractive stocks.

Q:  Do you adjust the earnings that you use for ranking the universe?

A: Yes, we adjust earnings. For example, if you look at the research services that provide information on Kellogg, you’ll find that return equity is very, very high. But that’s not only because the company’s business is doing well so we feel a need to adjust it. When a company buys in its own shares, its cash goes down and there’s a negative adjustment in the net worth section of the balance sheet. So when a company buys its stock over long periods of time, the net worth section can be notably reduced and that’s the denominator for computing return on equity. The result is that the return on equity increases without the returns actually increasing.

We’d rather have adjustments on the asset side to account for the buybacks. To offset the decreasing cash we would prefer an entry called, “Investment in Company Stock”. So we divide the absolute level of net income by the net worth, which is adjusted by putting back the dollars used to purchase the stock. Some people may say that we’ve unduly depressed the rate of return, but after our adjustments Kellogg still cleared the bar as an effective security and turned out to be a buy decision.

Q:  So you don’t consider stock repurchases to be a positive factor. Is that correct?