Apr 23

Our Conservative Approach to Discounted Cash Flow

Our goal is to outperform the broad market over a full market cycle. While stocks can be very expensive at times, conversely they can be very cheap. When stocks are ‘expensive’ we expect that we will compound but under perform as the upward market momentum causes us to sell our positions that approach or meet our conservative estimate of their fair value. When stocks are ‘cheap’ we are generally reducing our cash position as we are able to buy companies that are trading at significant discounts to our estimate of their intrinsic value. The Castle Focus Fund held 28.17% of cash and cash equivalents as of 3/31/14.

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We have given much thought as to the reason why it is so difficult for us to find attractive investment opportunities in today’s environment. One obvious impediment is the discount rate we employ to value companies, using a discounted cash flow methodology. As we do not subscribe to the capital asset pricing model, we typically take a more conservative approach to managing the Castle Focus Fund and use a 10% rate or higher to discount future cash flows. We suspect that with the ten year U.S. Treasury only yielding 2.65%, many market participants are employing a discount rate of less than 8%. While only a 2% difference in discount rates, the outcomes can be enormously different. For example, we may value EMC Corporation at $27-$28 per share by using a 10% discount rate and insist the stock trade 35% below that fair value before making a purchase. However, other investors may use 8% or less to discount future cash flows and determine fair value is closer to $40 — and may be comfortable buying EMC’s stock up to $36 per share, implying only a 10% discount to their estimate of intrinsic value. Therefore,our approach is to be conservative when estimating fair value, and to patiently wait for an entry price that provides us with a significant discount to our estimate of fair value.  This wide difference of opinion regarding what proper discount rate to employ is rooted in the principles of Austrian economics.

Austrian Business Cycle Theory (ABCT) implies that the credit cycle is in fact the business cycle: booms and busts are caused by artificial and unsustainable expansions of debt by the financial system that exceed the underlying savings in the economy. Savings-induced growth is sustainable, while artificial credit expansion cause the boom-bust cycle. When the supply of credit is artificially expanded, entrepreneurs and consumers receive false signals about the state of the economy and make unsustainable decisions, otherwise known as a “clustering of errors” or “malinvestments”. We believe that the true market rate of interest is at least 10% based on the supply/demand of savings (also called “loanable funds”), but the Federal Reserve is currently artificially fixing the rate to near 0%. Meaning, nearly every discounted cash flow (DCF) and net present value (NPV) calculation appears attractive relative to our far more stringent (and we believe more accurate) cost of capital, or loanable funds.

In terms of broad capital allocation, ideally we prefer to more aggressively commit client capital when our estimate of the portfolio’s overall discount approaches 30%. Clearly, we continue to move in the opposite direction — valuations are growing increasingly unattractive. Either we acquire new opportunities that exhibit more attractive discounts to fair value or the overall market pulls back and thereby by default increases the portfolio’s discount to fair value. Consequently, our cash position continues to increase as we further reduce and eliminate positions that trade through our estimate of fair value.

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

As of March 31, 2014, the Fund did not own any shares of EMC Corporation (EMC). 

The Fund’s investment objectives, risks, charges and expenses must be considered carefully before investing. The prospectus contains this and other important information about the Fund , and it may be obtained by calling 1-877-743-7820, or visiting www.castleim.com. Read it carefully before investing.

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, different financial and accounting standards, 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. Technology companies held in the Fund are subject to rapid industry changes and the risk of obsolescence.

Distributed by Rafferty Capital Markets, LLC-Garden City, NY 11530, Member FINRA.

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