Rafe Resendes has one investing pet peeve. Investors often conflate the terms "value" and "valuation," but the distinction between the two makes all the difference between investing in stocks that are simply cheap and identifying companies that are trading below their intrinsic value.

That's the short explanation for what distinguishes the $294 million Applied Finance Select Fund (ticker: AFVLX) from most large value funds -- and why the nearly five-year-old fund has returned an average of more than 16.7% a year over the past three years, better than 96% of its peers, and 4.8 percentage points a year better than the Russell 1000 Value index.

It also helps explain why seemingly expensive stocks like $Apple Inc(AAPL.US)$, $Alphabet Inc-CL A(GOOGL.US)$, and $MasterCard Inc(MA.US)$ are among its largest holdings -- and why Resendes thinks $Facebook Inc(FB.US)$ is a "screaming value" despite its high price/earnings multiple. "This stock is priced as if it will have negative 5% sales growth going forward, and to me that just seems insane, " he says. "They haven't even begun to monetize WhatsApp and Oculus," which makes virtual-reality headsets.

Resendes, 56, has always been comfortable going against the grain. The son of immigrants was born in a small town in Oregon after his parents, a lawyer and a school administrator, fled Cuba after the revolution, eventually settling in California's Central Valley. After studying finance at the University of California, Berkeley, Resendes headed to business school at the University of Chicago, where he met his classmate and future business partner, Daniel Obrycki.

In 1995, the duo started Applied Finance with the goal of creating a better model for measuring companies' economic performance. They initially operated as a capital-advisory firm that worked behind the scenes to help large companies understand the economics of complex transactions, capital investments, and compensation plans. As independent consultants at Arthur Andersen, they helped General Motors set cost-of-capital hurdle rates globally and created an internal stock market within DaimlerChrysler to value its more than 100 divisions.

Resendes and Obrycki eventually pivoted their business to investment research and quickly gained a following among fund managers, hedge funds, banks, and other institutional clients. In 2004, they created a model portfolio of 50 large-cap stocks trading below their intrinsic value and run by management teams with track records for compounding wealth.

That was the basis of the Applied Finance Select fund, which launched in early 2017 and has an expense ratio of 1%. The fund, which is sector-neutral, always owns 50 stocks, which the Resendes and his team identify based on quantitative factors -- namely, intrinsic-value rankings within each sector -- and fundamental research.

One of the key inputs of their intrinsic-value ranking is what they call "economic margin," or the difference between a company's return on capital relative to its cost of capital. Most quantitative-value models don't properly account for the relationship between company investments -- such as in research and development, or technology -- and long-term profitability, says Resendes. A better way to measure intrinsic value, he says, is to ask whether management is creating or destroying value, and to what degree.

For example, in 2011 the team added Google's parent company, Alphabet, to the model portfolio when it was trading at an above-average P/E ratio -- but their intrinsic value estimate suggested the stock was undervalued. Shares have since increased more than 900%, but Resendes argues the stock is still undervalued, offering more than 13% upside.

"Our goal since the beginning has been to answer two questions: What's a firm's economic performance, and what is the firm worth?" says Resendes, whose own employee-owned firm is based in Chicago, though most of its staff began working remotely well before the pandemic.

Broadly speaking, Resendes doesn't think the market is as pricey as many investors -- and especially value investors -- insist. "If we were to look at the intrinsic value of every stock in, say, the Russell 3000 and compare it against where the market is trading, we would say the market is toward the expensive side, but certainly not to the point that we would be making drastic portfolio changes," he says.

The fund's turnover is incredibly low. Seven of its top 10 holdings have been in the fund since inception. When the team makes that rare decision to sell, it's typically because a stock's intrinsic-value ranking falls below the 50th percentile for its sector. (This alone won't automatically trigger a sell; the analyst covering the stock also weighs in.)

In August 2020, for example, the team made the call to sell longtime holding Nvidia (NVDA), which they added to their model portfolio in 2011 when the stock traded at about a split-adjusted $3.50 a share. "We still think Nvidia still has a great future, but the expectations built into it became too rich for us," he says. They sold the stock when it traded around a split-adjusted $132, versus $129 for their intrinsic-value estimate at the time.

In its place they added semiconductor equipment supplier KLA (KLAC). "Thinking about the Gold Rush days of California, if Nvidia, Intel [INTC], and Texas Instruments [TXN] are the gold miners, KLA would be Levi's," he says. At the time its shares traded around $208, and its intrinsic value suggested it was worth $271. The stock recently traded around $320, but KLA's intrinsic value has also increased, putting fair valuation at $420, as the company pairs equipment sales with consulting services that provide high recurring revenue.

It's a similar story with auto-parts maker Aptiv (APTV), which the fund bought in early 2018. Here, too, the stock has gone up, but it trades at a 20% discount to intrinsic value. "We don't know who will ultimately emerge as winners in the electric-vehicle market, but regardless, we believe Aptiv provides a relatively high-return, low-risk way to invest in the EV transformation of the global auto industry," Resendes says.