Picking stocks that are increasing dividend payouts and growing in price, while meeting the moral requirements of a Catholic investor base, is George Schwartz’s daily challenge. Today, he describes several names, including two of those companies in detail.

Kate Stalter: Today, I am speaking with George Schwartz. He is the president and CEO of Schwartz Investment Council and also the manager of the Ave Maria Funds.

George, specifically, it’s the Ave Maria Rising Dividend Fund (AVEDX) we’re going to talk about today. Give us a little bit of the background of the fund and what your investment objectives are.

George Schwartz: Sure. The Ave Maria Rising Dividend Fund is a fund that we started almost six years ago as part of a family of Catholic mutual funds under the banner Ave Maria Mutual Funds.

But the Rising Dividend Fund—which happens to be five-star rated, by the way, by Morningstar—it’s a fund that is co-managed by me and Rick Platte, one of my colleagues. The objective is long-term capital appreciation.

Specifically, this is not a high-yield fund. This is not an equity income fund. A lot of people think it is, but indeed, it’s a fund that invests for capital appreciation in stocks of great companies that have had a long history of rising dividends—in other words, of increasing their dividends year after year.

Most of the stocks in this fund are companies that have paid dividends for 25 years or more and increased the dividend every year for 25 years or more. That’s what’s important…the increase.

A company that can increase its dividend year after year is a strong company. Typically, it will be a company that has increasing sales and earnings, too. And typically, it’s a company with a high return on equity with low debt, so they have real control of their own destiny, and they have the ability to increase dividends out of the earnings.

So, this is a fund that I think has a terrific future, primarily because of the valuations today. The stocks in our portfolio are very cheap by historical standards, by typical metrics—typical fundamental metrics like price-to-earnings ratios, price-to-book values, and payout ratio of the companies involved in this fund.

So I’m very optimistic about the outlook for the performance of this fund—which has been excellent, by the way—and I think it’s a fund that more and more people are going to be attracted to as time goes on.

Kate Stalter: George, the distinction that you made, which I think is an important one: You’re not necessarily looking at this as an income fund, but more for capital appreciation…but also how the increasing dividends factor into that.

George Schwartz: Right, right. The dividends in this fund are in the neighborhood of 2.5% or so. So again, it’s not a high-yield fund.

We have no utilities in there. We don’t have big bank stocks that tend to pay big dividends when they’re earning money. A lot of the big banks are not earning money right now; but a company that pays a 6% or 7% dividend probably is not going to grow very much, because they’re probably paying out most of their earnings in the forms of dividends.

Our companies have a low payout ratio—more in the neighborhood of 20%, 25%, 30%—and they’re plowing most of their earnings back into the company to finance their growth. They’re self-sustaining and have very sustainable business models that allow them to increase their sales and earnings and dividends every year.

And because these stocks are cheap today—many of them selling at ten or 12 times earnings for these great companies—I think they’re selling at extraordinarily cheap levels or bargain levels. That reduces the risk, of course, for anyone buying into this fund, because the stocks are not overpriced.

Kate Stalter: There’s something else that you said that I wanted to follow up on, which is the Morningstar five-star rating. I think a lot of people might instinctively believe that a fund with some sort of faith-based or social value at its premise might not be able to achieve that level of return, but you are able to do that. Can you say a little bit about that?

George Schwartz: Yeah. Well, this is sometimes considered a faith-based fund or socially responsible fund. I don’t consider it a socially responsible fund;  I consider it a morally responsible fund.

What makes it morally responsible—from the point of view of Catholics, anyway—is that we screen out companies that support abortion and pornography and a few things like that, including companies that contribute to Planned Parenthood. Planned Parenthood is the biggest provider of abortions, as you may know.

These screens screened out about 150 companies of the Russell 3000. So there’s only about 5% of the universe that we typically invest in that’s screened out. It still leaves 2,850 companies for my staff of analysts and portfolio managers to select from in finding good investments for all our Ave Maria mutual funds, including the Ave Maria Rising Dividend fund.

But we’ve had no trouble picking good stocks, and we’ve had very good appreciation. That’s why Morningstar has put us in the five-star category.

Kate Stalter: Let’s talk a little bit, then, about some of the top holdings in the fund. I noticed that, for example, Exxon Mobil (XOM) would be among those?

George Schwartz: Yes, it would be. That’s one of our largest holdings.

Exxon Mobil may be the best-managed company in existence today. They’ve increased their sales and earnings and dividends almost every year for 25 years or 26 years, something like that. They’ve increased profitability in good times and in bad.

Besides having an enormous amount of oil in the ground and other natural resources, including natural gas, they have terrific refining capabilities and enormous cash flows. And they’re using that cash flow to pay dividends, of course, and increase the dividends regularly.

And they’ve been buying back stock, which I find to be a very good allocation of capital. They’re buying stock back today at nine times earnings, ten times earnings, and they have been doing that consistently for the last several years. In fact, one of my analysts made a calculation that if they continue to buy back stock at the rate they bought back stock in 2011, and if they could buy it at that same price, in 15 years there wouldn’t be any shares left outstanding, which is kind of silly to think that could happen.

But the point is as they continue to shrink the outstanding shares, it leaves a bigger slice of the pie for the remaining shareholders. They’re enhancing intrinsic value for their remaining shareholders, those who don’t elect to sell their stock back to the company.

They are literally buying billions of dollars worth of stock in the market every year. That’s a smart thing to do for management or for boards of directors, if the stock is selling below its intrinsic value.

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And I believe Exxon today is way below its intrinsic value. The stock is in the mid-$80s, but I think the intrinsic value is way north of $100—maybe $125 or $150 a share. So if they can buy it back in the mid-$80s, they are really making an investment on behalf of the remaining shareholders in the company itself.

It’s kind of hard for a lot of people to get their mind around that concept—that shrinking the outstanding shares is good for the shareholders—but it’s all a question of the price the company has paid when they buy back their own stock. If they’re buying it back at a discount to intrinsic value, that’s a good thing for the remaining shareholders.

Kate Stalter: I’m looking at some of the other holdings in the fund, George, and it seems that you focus on large cap, maybe S&P 500 components. Is that the general direction that you tend to be investing?

George Schwartz: In this fund, that’s the case, yeah. This is what I would call a large-cap value fund; others have called it large-cap blend fund, multi-cap blend fund…but I consider large-cap value.

They are primarily big companies, the recognizable names, but that’s not why we buy them. We buy them because they’re attractively valued in the market today.

Other companies in this portfolio, like 3M (MMM), Abbott Laboratories (ABT), Kellogg Company (K), Ross Stores (ROST), Stryker Corporation (SYK)…these are recognizable names, but the thing that attracts us to them is their bulletproof balance sheets, their high levels of profitability, and the excellent track record.

Most important are the prospects for future increases in earnings and dividends. And the single most important thing is the valuation—the price at which they are selling at today in the marketplace. That’s why they’re in this portfolio, because they’re undervalued, by our analysis.

Kate Stalter: You just rattled off a few names there. Any other holdings that you can tell us a little bit more about today? We have a couple more minutes.

George Schwartz: Okay. Ross Stores is a fabulous company. Are you familiar with Ross Stores?

Kate Stalter: Oh, absolutely.

George Schwartz: The company is uniquely well managed in the retail space. A friend of mine—a competitor, actually, of Ross Stores—says that those stores aren’t really women’s retail shops. They’re really above-the-ground gold mines.

He’s making a joke about how profitable they are and how successful they are. But they are extraordinarily profitable. They’re very well managed.

They’ve had a long history of excellent capital allocation, prudently investing in new stores in good areas. And they manage their inventory superbly and sell high-quality merchandise at prices that their customers consider to be attractive prices for the goods. And they have increased their dividends for I think 30 or 35 years, year after year.

So I think it’s an exceptionally fine company, and even though the stock has more than doubled since we bought it in this fund, we continue to add to that holding as more money comes into the fund. We bought it at $21. The stock is $51, and I think it’s going to be a $100 stock in the next three or four years.