Jan 09

“Patient Opportunism”, Quarterly Letter, Q4 2012

Fourth Quarter Letter 

Market Comments

Benjamin Graham, the father of value investing, once theorized that speculators prosper through ignorance, as knowledge is not necessary during bull markets and experience acts simply as a handicap. If experience cannot help investors, then logically Graham concludes that there is no such thing as investment in common stocks and that everyone interested in them should self-confess himself as a speculator. Without history as a guide, the typical experience of the speculator is one of temporary profit and ultimate loss.

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The dictionary says that “speculate” comes from the Latin “specula”, a look-out or watch-tower. Therefore, a speculator is one who looks out ahead from an elevated position. With regards to stock investments, the speculator emphasizes future expectations in generating a return on capital rather than safety of principal and a return of capital.

Graham began his career on Wall Street in 1914. In 1915, a company called Computer-Tabulating-Recording Company (C-T-R) came public and was listed on the New York Stock Exchange. At that time, C-T-R leased out the Hollerith machines, which comprised of card-punches, card-sorters, and tabulators—tools and applications unknown to the business world at the time, as the Hollerith’s chief application served the Census Bureau. Graham, who had worked the two years prior with the U.S. Express Company on a research project that involved Hollerith machines was one of the few people in the financial industry with a firsthand working understanding of the company C-T-R. In early 1916 Graham went to the head of his firm and suggested an investment in C-T-R, which was trading at $45 per share at the time. The company consisted of 105,000 shares outstanding and carried a market capitalization of roughly $4.7 million. The company earned $682,500 in net profits, or $6.50 per share, for a price-to-earnings (P/E) ratio of 6.9. C-T-R’s book value was $130 per share for a price-to-book value (P/BV) of 0.35. Additionally, the company just initiated a $3 per share annual dividend for a dividend yield of 6.7%. Perhaps more importantly, Graham thought highly of the company’s products and future potential growth prospects.

As Graham later recalled, his boss looked at him pityingly and said “Ben, do not mention that company to me again. I would not touch it with a ten-foot pole. Its 6% bonds are selling in the low 80s and they are no good. Everybody knows there is nothing behind it but water.” In that era, “water” was the ultimate condemnation of a company on Wall Street, meaning the assets on the company’s balance sheet were fabricated or fictional. In other words, the valuation of a company that held no real assets on its balance sheet only had its future earnings power and future prospects to back the current price of the stock. No self-respecting investor would dare speculate on such a reckless endeavor unless it was backed by tangible assets rather than “water” (otherwise known as goodwill). Graham was so chastened by his boss’ sweeping criticism of his investment idea that he personally never bought a single share of the Computer-Tabulating-Recording Company.

In 1925, C-T-R changed its name to IBM. And yet Graham’s former boss was entirely correct – goodwill (“water”) did constitute a large portion of the company’s assets. In fact, IBM’s goodwill amounted to $13.6 million and exceeded the company’s tangible owner equity, or book value, of $11.7 million. Despite this amount of “water” on the balance sheet, the company, under the leadership of Thomas Watson, Sr., saw its net income increase from $682,000 in 1916 to $3.7 million in 1926. IBM had 378,000 shares outstanding rather than the 105,000 shares outstanding in 1916, but the company still generated $6.40 in earnings per share and paid out an annual dividend of $3 per share. During that year, IBM’s stock price traded as low as $31 and as high as $59 for an average price of $45—the same level as in 1916. At the average price of $45, IBM sold at the same 7x multiplier of earnings and the same 6.7% dividend yield as it had done in 1916.

Despite IBM’s strong fundamental performance from 1916 to 1926 the market provided no incremental benefit to its valuation, as the old-time perceptions of risk still held sway over investors. However, the philosophical viewpoint changed in the bull markets of the 1920s and subsequent collapse in the Great Depression of the 1930s. Graham examined IBM’s subsequent performance over the next thirty-two years. To summarize, in 1936 IBM’s net income expanded to twice the 1926 figures but the average earnings multiplier (P/E ratio) rose from 7 to 17.5. From 1936 to 1946 net income increased 2.5 times but the average earnings multiplier remained at 17.5. Post World War II the change of pace changed dramatically. By 1956 IBM’s earnings increased fourfold that of 1946 but now the earnings multiplier was 32.5. And in 1958, the market now paid an earnings multiplier of 42 times the company’s growing net income. At a P/E ratio of 42 in 1958, the market was willing to wait 42 years for each $1 of current earnings per share generated by IBM. The market clearly thought very highly of the company’s products and future potential growth prospects and was willing to speculate that the future would hold even greater promise.

After his analysis, Graham decided that, “the one-time scandalous water, so prevalent in the balance sheets of industrial companies, has all been squeezed out – first by disclosure and then by write offs. But a different kind of water has been put back into valuation by the stock market – by investors and speculators themselves. When IBM now sells at 7 times its book value, instead of 7 times earnings, the effect is practically the same as if it had no book value at all.” Graham concluded that the speculative aspects of large industrial companies seemed to diminish significantly when they possessed a strong balance sheet, conservative capital structure and expert management”—an investment observation that still holds true and one we willingly employ at St. James when the opportunity presents itself.

Today we observe that the one-time scandalous water of companies with strong balance sheets, attractive products and future potential growth prospects has been replaced by the new scandalous water of false confidence in a system dominated by central bank intervention. Wall Street is renowned for being bullish and forecasters are not holding back for 2013. Drilling down into the average Wall Street price targets of each company in the S&P 500 translates into the index rising to 1605, a gain of almost 15% from 2012 year-end levels.

Those arguing that the stock market is going to rally have to rationalize two serious headwinds. First, corporate earnings appear to have peaked in this business cycle; and second, investors are unlikely to pay higher multiples for declining earnings in an environment fraught with macroeconomic uncertainty. Of course, Wall Street continues to accept this water of false confidence so amply supplied by the latest edition of quantitative easing from our Federal Reserve central bank. In the United States, a country in which the consumer is responsible for roughly 70% of the gross domestic product (GDP), we often wonder where this growing “recovery” often cited by Wall Street and Washington is going, because the trends in household savings and personal wages do not inspire confidence in us.

Although sentiment surveys show that Americans feel better about the economy, small business owners certainly do not share the same sentiment. According to a recent Gallup poll from Wells Fargo, small business owners show the biggest drop in confidence since the fall of 2008. The quarterly index, based on responses from 600 business owners, dropped 28 points as more businesses reported declining revenues, payrolls, and capital investment, both in the last 12 months and in their expectations for the year ahead.

We assume the silver lining in this survey, as noted by Wells Fargo, is that there is no sign yet of small businesses missing loan payments or defaulting at a higher rate. And though the term “fiscal cliff” is an abstract problem for most people, it is a very real concern for small business owners. Small businesses take enormous risks – starting companies, investing in expansion, and hiring new workers. In order for our economy to grow, we need risk takers.

For an investor, the general idea is that a company’s profitability should represent an acceptable rate of return on an investment. When one invests in a common stock, one is buying the business. If that business is not making enough money to give the investor an acceptable return on investment, then common sense dictates that the investor is overpaying for the company. Another way of looking at this is to understand that a business derives its value from the amount of cash flow it is capable of generating for its owners, or shareholders in the case of a publicly-traded company. We employ the word “cash flow” to represent the amount of money the business is making for the owners.

Assume that a private business pays the owner $100,000 a year of income consisting of salary, dividends and bonus distributions. Furthermore, assume that this business provides a guaranteed $100,000 per year in income, because there is no risk and no growth. Likewise, assume that the business owner operates in a mythical land with no taxes – our focus is on the principles of valuation and not reality.

Now imagine a scenario where, at some point, a business owner grows tired of dealing with the growing burden of government regulatory oversight and decides to sell his business. Naturally, the pivotal question is what price will the owner accept for the sale of his business? The rational answer is at some reasonable multiple of one year’s worth of the owner’s earnings. In other words, if a business generates a predictable annual income stream, it has a value greater than that income stream, even if the business operates with zero growth. Why? If the owner sold the business for only $100,000, or 1x earnings, he would be out of money in one year. Therefore, in order to sell, the owner would need a multiple of one year’s earnings that he can use to provide himself a similar future income stream in retirement. If the owner values his business using a multiple of 15, or a P/E ratio of 15, he would receive a selling price of $1,500,000.

Consequently, the owner now needs to invest the $1,500,000 into a passive investment portfolio (i.e., a bond, CD, dividend paying stock, etc.) in order to generate a future stream of income that replicates his former earnings as a business owner. To achieve this goal, the owner needs a yield on his passive investments of 6.67% ($100,000/$1,500,000 or 1/15), but is this investment rate of 6.67% achievable?

In order to provide some comparisons for discussion, we must first address historical valuations. While Wall Street traditionally uses a market P/E multiple based on one year’s earnings, we believe the Shiller P/E is more accurate measure of the market’s value because it uses the average of the prior 10 years of trailing earnings, adjusted for inflation. In other words, traditional P/E ratios measure what an investor pays for one year’s earnings while the Shiller P/E measures what an investor pays for the last 10 years average real S&P 500 earnings. The Shiller P/E currently stands at 21.1, half of the peak multiple reached during the 1999-2000 stock market bubble but still 28% higher than the average 16.5x reaching back to 1881. Long-term interest rates currently stand at 1.75% or 62% lower than the historical average of 4.66%:

Using average historical yields from 1950 – 2012, we find that our retired business owner could potentially own a fairly conservative investment portfolio (25% stocks + 75% bonds) that reasonably achieves a yield of 5.3%. If we factor in potential capital gains, as represented by the earnings yield of 5.3% (1 ÷ 18.7), our business owner could generate a total return of 6.67%. Coincidentally, perhaps this provides some insight into the underlying reason for a typical P/E of 15 – the historical average annual return on stocks has been approximately somewhere between 6-10%. Therefore, the return of a 15 P/E investment represents both a believable and a historically achievable objective. Consequently, both the seller and buyer in our analogy achieve a reasonable return. The seller can take the proceeds and generate a future return adequate enough to provide a comfortable retirement, and the buyer simultaneously earns a reasonable return on their investment in the operating business. The point is that the income stream is driving the value, and it is the income stream that derives a business’ worth, whether the business is a publicly traded stock on the New York Stock Exchange, or a private company. Having established a baseline of valuation using a hypothetical example that guaranteed a static income stream with no risk and no growth, we turn to the real world, where a business’ income stream is neither static nor guaranteed.

In reality, the more volatile the income stream, the more risk associated with achieving the desired investment rate of return. Intuitively, we realize that the notion of faster growth is harder to achieve than slower growth, and consistent growth is generally considered more predictable and attractive than cyclical growth. Although risk will tend to reduce the valuation a prudent investor willingly pays for a given investment, a higher rate of earnings growth tends to increase future value. Therefore, risk and earnings growth rates represent counteracting forces affecting valuations (P/E ratios). This only partially, and somewhat crudely, explains why a consistent 3% grower (less risky to achieve) might command the same valuation P/E of a more volatile 12% grower (riskier and harder to achieve).

When we examine today’s investment environment, we understand the dilemma facing business owners as well as all investors, particularly retirees. With the current Shiller P/E at 21.1 and stock market dividends yielding a little over 2%, coupled with bond interest rates that trade around 1.75%, our hypothetical business owner’s conservative allocation mix may not even yield 2%. How does the business owner make up the difference? Countless investors and institutions face that question today. Unfortunately, today’s markets are now filled with Graham’s former “scandalous water”, courtesy of the world’s central banks, the Federal Reserve in particular. Central banks have created the illusion of confidence in a market where money printing lifts all asset prices. Through our research, we do not see many truly compelling investment opportunities and our sense is that investors have already largely priced in the nearly unlimited amount of central bank “water” that has entered the investment landscape.

Then again, we could be wrong because we fail to understand the new “water” that fills our markets. San Francisco Federal Reserve President, John Williams, recently stated: “In terms of how far you can go, I don’t think that we’re anywhere near any kind of limit” (for quantitative easing, aka – money printing). Perhaps most investors naturally believe this has all the makings of a happy ending…we do not.

The commonly used expression, “Those who ignore history are bound to repeat it” is actually a misquotation of the original text written by philosopher and poet, George Santayana, who, in his Reason in Common Sense, The Life of Reason, wrote “Those who cannot remember the past are condemned to repeat it.” In turn, Santayana’s quote was a slight modification of an Edmund Burke statement, “Those who don’t know history are destined to repeat it.” Market history is filled with euphoric gains fueled by dramatic excesses followed by steep market sell-offs which “no one saw coming”. As the Federal Reserve promotes further excess on an unprecedented scale, students of history remain in short supply.

Investment philosophy

“The market is not a very accommodating machine; it won’t provide high returns just because you need them.” 

– Peter Bernstein

 Howard Marks is the cofounder of Oaktree Capital Management, a private equity company with a focus on distressed debt. In his book, The Most Important Thing, we believe chapter thirteen may one day rival chapters eight (“Mr. Market”) and twenty (margin of safety) in Benjamin Graham’s Intelligent Investor in educating investors. Chapter thirteen, titled “Patient Opportunism”, lays out the deceptively simple strategy of waiting for bargains. An opportunist buys things because they are offered at bargain prices. There is nothing special about buying assets when prices are not low. At any point in time, the investment environment is a given, and we have no alternative other than to accept it and invest within it. There is not always a pendulum or cycle extreme to bet against. Sometimes greed and fear, optimism and pessimism, credulousness and skepticism are balanced, and thus clear mistakes are not being made. Rather than obviously overpriced or underpriced, most things may seem fairly priced if only roughly. In that case, there may not be great bargains to buy or compelling sales to make.

Howard Marks cautions that it is essential for investment success that we recognize the conditions of the market and decide on our actions accordingly. The other possibilities are (a) acting without recognizing the market’s status, (b) acting with indifference to its status and (c) believing we can somehow change the market’s status. All three choices are unwise. What is wise is when we invest appropriately for the circumstances with which we are presented. Nothing else makes sense.

One of the great things about investing is that the only real penalty is for making losing investments. Naturally, there is no penalty for omitting losing investments, just rewards. But where does the penalty for missing winners enter the equation? For professional investors paid to manage other people’s money, the stakes are higher. If a professional investor misses too many opportunities, and if their returns are too low in good times, the manager comes under pressure from clients and eventually loses accounts. Of course, a lot depends on how clients have been conditioned. We have always been explicit about our belief that missing a profitable opportunity is of less significance than investing in a losing environment. We place risk control ahead of full participation in gains backed by “water”.

Waiting is the hardest part of investing. An investor must wait long enough to buy a good idea. And once the investor commits capital to the idea, they have to wait long enough to see it play out. Currently, we are waiting for compelling ideas. That is the price of Howard Marks’ patient opportunism. As Seth Klarman of Baupost Group so succinctly states, the value of cash is as an option. Cash is an option on future, lower stock prices. As stock pickers, cash is an option on future, lower stock prices for specific companies rather than the market in general. Those stocks of specific companies may get cheaper in the future. If they do, we may buy them. Otherwise, we patiently wait for other opportunities to appear.

Kind regards,




Robert J. Mark

Portfolio Manager

The opinions expressed are those of the Fund’s portfolio manager and are not a recommendation for the purchase or sale of any security.

The Castle Focus Fund’s prospectus contains important information about the Fund’s investment objectives, potential risks, management fees, charges and expenses, and other information and should be read and considered carefully before investing. The investment return and principal value of an investment in the Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. You may obtain a current copy of the Fund’s prospectus by calling 1-877-743-7820. Distributed by Rafferty Capital Markets, LLC-Garden City, NY 11530, Member FINRA.

The risks associated with the Fund, detailed in the Prospectus, include the risks of investing in small and medium sized companies and foreign securities which may result in additional risks such as the possibility of greater price volatility and reduced liquidity, fluctuations in currency exchange rates, and political, diplomatic and economic conditions as well as regulatory requirements in foreign countries. There also may be risks associated with the Fund’s investments in exchange traded funds, real estate investment trusts (“REITs”), significant investment in a specific sector, and non-diversification.

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