C) and other financial stocks. As it became clear that the mortgage problems would take a big toll, the portfolio managers dumped their bank holdings -- avoiding the big losses that occurred when financial stocks collapsed. Then as the markets approached the trough, the fund began buying agency mortgage REITS, such as Chimera Investment ( CIM). The mortgage REITs borrow money and use it to buy mortgage-backed securities. With investors steering away from anything that had to do with mortgages, the REITs sold at rock-bottom levels and paid double-digit dividend yields. Appleseed took advantage of the panic, buying REITs that invested in mortgages backed by government agencies. The investments proved to be big winners in 2009 as mortgage prices rebounded. "We figured that the mortgages were backed by Uncle Sam, so they had to be good," says Appleseed portfolio manager Josh Strauss. Whenever the portfolio managers can't find any bargains, they hold cash. At the trough of the market in 2009, the fund had little cash because there were plenty of cheap stocks. But with markets reviving in the last three months, the managers have been selling fully priced shares, and now the fund has 18% of its assets in cash.
Although the cash has been a drag on returns lately, Strauss expresses no second thoughts. "It is hard to find values now," says Strauss. "We don't feel that we have a mandate from our investors to stay fully invested when the market is expensive." These days Strauss is bullish on health stocks. He says that the shares are cheap because investors worry that profit margins in the sector may be hurt by the new health care legislation. Strauss says that the fears are overdone. "There could be margin compression, but at the same time you'll see revenue expansion because of the new consumers that will have insurance for the first time," he says. The fund's biggest holding is pharmaceutical giant Pfizer ( PFE). Strauss says that health reform will have a limited impact on earnings since most of the company's sales come from abroad. Some investors worry that Pfizer will show little growth because it faces patent expirations. Strauss concedes the point, but he argues that the shares are a bargain, selling at a forward price-earnings multiple of 7. "Earnings will be flat, but the valuation is ridiculously low," he says. A microcap holding is Albany Molecular Research ( AMRI), which performs contract research, developing drugs for large pharmaceutical companies. Sales and earnings have slumped because drug companies are tightening their belts and outsourcing fewer research projects. But Strauss contends that the shares can't fall much further. The company has $1.94 in cash per share, a sizable cushion for a stock that trades at $6.31. Besides seeking bargains, Appleseed looks for companies that are considered socially responsible. The fund will not invest in businesses that profit from tobacco or weapon systems. It also avoids banks that are too big to fail. Such behemoths are dangerous investments and hazards for the economic system, says Strauss. By steering away from such companies Strauss hopes to limit risks and be prepared for the next time that the market sinks.