Jan 18

Portfolio Manager Commentary — Understanding Cash

The Castle Focus Fund (MOATX) finished the year 2012 up 2.57% while the S&P 500 was up 16.00%. Some of our underperformance was attributable to our cash position. We started 2012 with a cash position of 27.90% and ended the year at 21.78%. Although we do not enjoy underperforming the market in a given year, we recognize this to be a likelihood from time to time given our patient approach. Ideally, we would love to be 100% invested in a concentrated portfolio of high quality companies. However, when we cannot find stocks with the required margin of safety – we remain in cash.

Every investor has their own particular way of investing and we believe that most investors diversify more than we do. Admittedly we maintain low standards when it comes to diversification but require high standards when it comes to stock selection, as our desired rate of return on each fund position is 10%. If we do not believe we can make 10% a year in a stock – we do not buy that stock. Therefore, we employ a rate of return hurdle. As for value, we need to know that the stock we are buying is – conservatively calculated – worth more than what we are paying. More importantly, we require clear and convincing evidence that we are buying a company’s stock at a level that implies a discount to what we would pay if we were taking a company private. Just as we utilize a hurdle in terms of return and value, we also need a safety hurdle. We must be comfortable with the industry, the organization, the management, and the balance sheet. In other words, we want to maintain a very low risk of catastrophic loss (Click here for more on our Investment Process).

To download a PDF of this report, click here.

We would never consider companies where we think there is a possibility of losing 50% of our investment. As a result, we avoid the large money center banks. Over the last few years, there were many “cheap” banks and perhaps there still are some today. Regardless, we believe many of them have a real risk of catastrophic loss (See entry “QE, Bank Balance Sheets and Relative Performance”).

One of the great things about investing is that the only real penalty is making losing investments. Naturally, there is no penalty for omitting losing investments, just rewards. However, 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” (See entry “Patient Opportunism”).

Waiting is often 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, which 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.

To reiterate, our cash position is a function of our ability to find attractive companies that pass our required hurdles – not a view on the macro picture. So, with that in mind, we present several charts that illustrate the difficulty in finding individual investment opportunities in a market that is brimming with optimism.

Remember Spain? The yield on the 10-year Spanish government bond has been in a downward trend since last July and is now close to a 52-week low.

Inflation fears? The Expected CPI (the yield on the 10-year T-Note minus the yield on the 10-year TIPS as calculated by Fuller Money) moved higher in reaction to the Fed’s “QE3″ announcement last September, but it remains just below the highs of the past 5 years. The consensus suggests a general perception that the Fed is creating significant “inflation”, but not problematic “inflation”. In other words, we have “goldilocks” inflation.

The Volatility Index (VIX) just made a new 4-year low.

Spanish government bond yields at 52-week lows….plus inflation expectations stable at a moderately high level….plus the VIX at a multi-year low….equals no worries. The markets are not worried about debt default in the euro-zone, “inflation”, “deflation” or a large stock market decline.

Historically, sentiment is a solid contrary indicator in the financial markets. When the crowd becomes convinced that the future is going to unfold in a particular way and bets accordingly, it changes the odds such that betting on the popular outlook becomes a losing proposition. We have no clue as to what will happen over the next few months or quarters. But we do know that inflation expectations are unlikely to remain at current levels. Inflation expectations are more likely to break out to the upside in response to the Fed’s money printing or fall sharply in response to fear that economic weakness will push prices downward in a deflationary panic despite the Fed’s ‘best efforts’.

Either of these outcomes will break the complacency that currently dominates the financial markets. We also know that stock market volatility is unlikely to remain at such a low level for much longer. As a result, we contend our cash has true value as an option on future lower prices.

Fund Performance as of 12/31/12


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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