Article in Smart Money

The Path of the Profit

http://www.smartmoney.com/mag/index.cfm?story=february2007-path

By Nicole Bullock
January 10, 2007
ON AN AUTUMN morning in Bellingham, Wash., an eclectic audience of scholars, bankers and investors gathers in a conference room at Western Washington University. The topic is Islamic finance, and the sponsor is Saturna Capital, a Bellingham company whose Amana mutual funds have invested in accordance with Islamic law since 1989. Outside, the sun bathes the tree-lined campus, and inside, the mood among the conferees is relaxed and collegial — at least until Mahmoud Amin El-Gamal, the first speaker, starts shaking the foundations of their financial beliefs.

Some interpretations of Islamic law, or Shariah, impose strict limits on borrowing money and earning interest, putting America's Muslims at a disadvantage in everything from buying a house to saving for retirement. Many people in this room have designed financial products to try to ease this so-called Cost of Being Muslim. But El-Gamal, a professor of economics and statistics at Rice University, isn't satisfied with their results. By trying to apply Shariah to the complexities of the markets, he argues, these loans and funds wind up being inferior to the products they aim to replace. And when their architects present them as the only legitimate way to invest, they merely compound the problem. They imply that "you will fry in hell if you use conventional tools," says El-Gamal. "There is something very unseemly about using religion that way."

Such criticism isn't uncommon when mutual funds try to marry religion and investing. But the Amana funds can rebut it in a way that a lot of religious funds can't — with a remarkable track record. Indeed, while thousands of mutual funds scramble to show even ho-hum returns, Amana Trust Income and Amana Trust Growth have become two of the top-returning funds available, period. They've done so even though they have to shun companies that profit substantially from such industries as alcohol or pork processing, and even those that carry a lot of debt. Together, the rules put almost half of the stocks in the market off-limits. Nonetheless, over the past three years, each fund is the No. 1 performer in its style category, according to fund tracker Morningstar, with the growth fund and income fund posting annualized returns of 20 and 21%, respectively, over that span.

Curiously, the man behind these stellar returns has no Islamic beliefs whatsoever. (One clue: his impressive wine cellar, a no-no for any devout Muslim.) A career portfolio manager, Nicholas Kaiser brings a lot of ingenuity to the table; when Amana launched its funds 18 years ago, for example, Kaiser didn't like the record-keeping software on the market, so he wrote his own. As for matters of faith, Kaiser says that after being raised Episcopalian, he is "more of a skeptic" now. "It's what makes me a good investor."

To be sure, the funds struggle to satisfy some observers, especially Muslims who disagree with how the funds' mission incorporates the principles of the faith. Similar issues surround most religious funds, a small but growing niche these days with $16.4 billion in assets. The funds as a group have slightly underperformed their peers over the past one, three and five years; they often face higher trading and administrative costs than bigger funds, while religious screens rule out many good stocks. "It's the challenge of having one hand tied behind your back," says Morningstar analyst David Kathman. But in Amana's case, he adds, at least some religious values coincide with smart investing.

SATURNA CAPITAL OCCUPIES a small, gray building across the street from the food co-op in the center of Bellingham. Here, only the subtlest clues signal that the company differs from its secular peers. The receptionist's desk looks like every other receptionist's desk in America, but the woman behind it is reading a guide to Islamic investing. Seemingly unfurnished spaces double as rooms where observant employees adjourn for prayers — the paper kneeling mats are a tip-off. And in a frame above the door in Kaiser's office is a line of Arabic text. "It says buy low, sell high," Kaiser explains, very seriously. Then he laughs. "Actually, I have no idea what it says." Only later does a visitor learn that it's a quote from the Koran.

Yaqub Mirza, a physicist and prominent figure in the U.S. Muslim community, got the idea for the Amana funds while he was running an Islamic investing club in the 1980s. Mirza recruited Kaiser, who had proved himself as a capable value investor while running the Unified Management fund family. Kaiser embraced the opportunity, but he insists that the Islamic angle has little impact on his thinking: "I manage the portfolio — this is a business." While Kaiser takes care of the stock picking, Monem Salam focuses on religious compatibility. Salam, whose family moved to America from Pakistan when he was nine, used to manage money for wealthy Muslim clients of Morgan Stanley. He still plays that role at Saturna, but he also consults with clerics and members of the funds' board to figure out which companies are off-limits.

Amana's recent success isn't due exclusively to religion; for example, the funds have outperformed the Dow Jones Islamic fund, which also uses Islamic screens, by at least eight percentage points a year over the past five years. Once the list of candidates is whittled down, Kaiser digs into the stock picking, and in recent years he has deftly spotted some market darlings. Once, on a ski lift at Whistler, B.C., he overheard a woman saying that her daughter had paid $3 for a head of organic lettuce. Kaiser already liked organic stores because their margins are higher than those of traditional grocers. Eventually, he bought Whole Foods for around $16; when he sold it three years later, it had soared into the $40s. Kaiser was also quick to recognize the user-friendly appeal of Apple computers, installing them in Amana's offices. He started buying Apple in 2000 at $25, and now, trading north of $90, it's his growth fund's largest holding. Kaiser is a buy-and-hold investor, and it's just as well: Under Islamic law, frequent trading is seen as a form of gambling. Not surprisingly, Amana funds give up little of their returns to taxes and trading costs. At the growth fund portfolio, turnover, a measure of how frequently the funds buy and sell stocks, hovers at an amazingly low 5%.

At least one of the fund's religious principles, the Islamic aversion to debt, translates into sound investing sense. "We buy companies that don't have a lot of debt," Salam says. "Warren Buffett does that." The Amana screen's limit on debt — it can equal no more than 33% of a company's market value — has also saved the funds from some painful losses. After all, Kaiser is a manager who sold Enron for a profit. "They piled on the debt before they piled on the lies," he says. Amana also sold AOL right after the Time Warner merger. "We had a lot of calls from shareholders concerned about the Internet and pornography," says Kaiser, "and I had to tell them: 'No, actually, the debt is the problem.'" That transaction wasn't nearly as painful as selling Target a few years ago. The retailer's fundamentals still looked great — but the stores started selling wine.

According to the Koran, loans are charity that will be repaid in the afterlife. That's why Amana funds avoid companies for whom interest is a primary source of earnings, a principle that rules out investing in conventional financial companies. This ban has hurt Amana in the past. In the years 1996 through 1998, when financial firms rallied, the Amana funds trailed the market by double digits. Kaiser acknowledges that markets are cyclical and down years could easily happen again — that's the drawback of a system that screens out an entire sector of the economy for religious reasons.

ON A RECENT FRIDAY at weekly prayers, Muzammil Siddiqi, an expert on the interpretation of Shariah for American Muslims, spoke with Saturna employees and board members about intention and action. "If you conduct your business with the right intentions," Siddiqi tells the group, "it is an act of worship." But later he warns the audience to avoid "the gray." "Boundaries," he says, "are where you can break the rules."

Amana does sometimes go gray when it comes to "sin stocks." For example, its screen filters out companies that derive more than 5% of revenue from businesses like pornography or pork processing. But if pork is haram — forbidden — then why is it acceptable to invest in a company that makes any money from hot dogs or ham sandwiches? Salam explains that Islam allows some minor involvement with something impermissible, as long as the greater objective — in this case, saving for the future — is worthy and necessary. "It is definitely not okay to sin a little bit," says Salam. "But if it can avoid a much bigger sin later, then shouldn't we allow it?"

Not all faith-based fund managers agree. The Catholic-oriented Ave Maria funds advocate an all-or-nothing stance; for example, they can't invest in companies that derive any revenue from providing abortions. Still, even such absolute bans can lead investors into murky areas. Manager George Schwartz admits that if he were considering buying a company that makes bar-code labels, he wouldn't drill down to find out if any labels were earmarked for bottles containing RU-486, the so-called abortion pill. "You wouldn't be able to live your life," he protests.

The principal figures at Amana face challenges beyond investing — some more serious than others. Not long after 9/11, cofounder Yaqub Mirza attracted scrutiny from federal investigators, after nonprofit organizations with which he was involved came under suspicion of links to terrorism. Mirza has since resigned from Amana's board; he has not been indicted and denies any wrongdoing. Salam has taken up his own post-9/11 challenge. He's trying to earn his pilot's license, a goal that raises eyebrows among his peers: "Every Muslim I asked and still ask thinks I'm crazy," says Salam. To raise awareness about American Muslims and the obstacles they now face, Salam is working on a documentary film about his licensing quest — directed by Kaiser's son, Max.

Back on the ground, Salam and his colleagues are laying the groundwork to keep the funds growing. Saturna aims to have $1.5 billion under management by 2010, up from $500 million today, and Salam is touring the country, marketing the Amana funds to potential investors at mosques and Islamic schools. Already, investors outside the Islamic community have woken up to their track record: Assets have grown more than tenfold since 2003. But Amana's future depends on the loyalty of core investors like Moazzam Ahmed, a Dallas software engineer. Since he started investing with Amana Growth three years ago, his stake has doubled. He used to put in hours of research to make sure that stocks he liked, such as Microsoft and Oracle, were in accord with his beliefs. Now, Ahmed says, he's relying on Amana: "They are doing the homework for me."