Oct 13

“A Combination Of Gumption And Patience”, Quarterly Letter, Q3 2014

Quarterly Overview

At quarter end, the Castle Focus Fund held 21 stock positions while cash and cash equivalents (“cash”) represented 34.60% of the Fund’s assets. During the third quarter of 2014 we added four new positions to the Fund and eliminated three long-time holdings as they approached our estimate of fair value.

To download a PDF of this report, click here.


During the third quarter we did more trading than we normally do. The three stocks that we eliminated from the portfolio — CVS Health Corp., Molson Coors Brewing Co., and Novartis — were positions we began building more than three years ago.

  • CVS Health Corp. –We initiated our position in CVS in August of 2011 with an average purchase price of $34.76. We trimmed the Fund’s position in CVS as it approached our estimate of fair value and had an average selling price $68.14.
  • Molson Coors Brewing Co. –We built the Fund’s position in Molson over a fourteen month period beginning in February 2011. Our average purchase price was $42.83. We sold our position from May of 2013 through July of 2014 at an average sales price of $64.37.
  • Novartis — Our average cost on Novartis was $54.39 and we sold the position at an average sales prices of $88.84. The Fund owned shares of Novartis for more than four years.

We added four new positions to the Fund during the third quarter:

  • Rayonier Advanced Materials, Inc. — 2.16% of Fund assets as of September 30, 2014.
  • Sanofi SA, ADR — 2.01% of Fund assets as of September 30, 2014.
  • Liberty Media Corp. — 1.09% of Fund assets as of September 30, 2014.
  • Silver Wheaton Corp. — 0.92% of Fund assets as of September 30, 2014.


We think of cash as a source of future opportunity and not as a detriment to current relative returns. We are focused on absolute returns rather than relative returns. A by-product of our patience and discipline is that at times we will hold a sizable cash position. Cash gives us optionality and allows us the opportunity to be buyers when the market is crowded with sellers. As we believe that entry price is a key determinant of total return, we are only willing to put cash to work when we can find ‘obvious bargains’ — stocks that meet our strict criteria for investment. The Fund’s cash position has grown to 34.60% as the broad markets have continued to advance. We have a shopping list of stocks we’d like to own, but only at the right price.


 “Explain to me how increases in paper pieces can possibly make a society richer. If that were the case, explain to me why there is still poverty in the world. Isn’t every central bank in the world capable of printing as much paper as they want? And do you then think that society as a whole would be richer?” — Hans-Hermann Hoppe

Despite the Federal Reserve’s easy money policies, the real economy still appears far less dynamic than normal. Perhaps this explains corporate America’s hesitation to allocate money to capital investments designed to grow their business. Rather, companies today continue to focus on allocating capital towards financial engineering designed to boost earnings-per-share growth. Since 2004, IBM has generated $131 billion of net income, spent $124 billion repurchasing its own stock but dedicated only $45 billion to capital investments. Meaning, IBM allocated almost all of its earnings into stock repurchases—almost $3 towards its own stock for every $1 of capital investment. Furthermore, 90% of IBM’s capital investment simply covered depreciation and amortization of its current asset base. And while IBM was repurchasing company stock on the open market, not a single corporate executive at IBM purchased any stock over the past six months; however, company insiders did sell almost a quarter million shares of stock. IBM recently reported declining year-over-year revenue for the ninth consecutive quarter. If interest rates were at more realistic levels, there would be less incentive to financially engineer earnings growth and more incentive to invest, increase productivity and grow revenue rather than engineer reported earnings-per-share.

Not to single out IBM, but U.S. companies are buying their own stock back at the strongest pace since the credit crisis. Corporations repurchased $338.3 billion of stock in the first half of 2014, the most for any six-month period since 2007. Unfortunately, the same cannot be said for company executives: 7,181 insiders bought their own company stock this year through September, while 23,323 company executives sold stock. The ratio of buys to sells is the lowest since 2000. To summarize, U.S. companies are issuing record levels of debt to conduct share repurchase programs, at valuations that we consider seriously expensive. Simultaneously, companies continue to shortchange their capital investment outlays while company executives sell their personal company stock at a pace not seen since just prior to the technology bubble of 2000.


Despite claims to the contrary, we think that there has been little deleveraging in the United States. Instead, the Federal Reserve’s promotion of leveraged speculation and the government’s deficit-spending reinforces the upward trend in credit. Consequently, in terms of total debt, the U.S. economy is more levered today than it was in 2007. Therefore, we fail to see how it will be possible for interest rates to normalize without creating an economic contraction.

U.S. Treasury yields peaked at 15.8% 33 years ago. Currently sitting at 2.5%, U.S. Treasury yields can still go lower—German yields are at 1.0% and Japanese bonds yield 0.5%. However, at some point, if we actually operate in a functioning market, we believe interest rates must normalize. At that point, we think no amount of QE and financial repression by the Federal Reserve can keep yields on the current $12 trillion of publicly held U.S. Treasury debt at negative (inflation-adjusted) rates indefinitely. Our central bank must know that this is a problem. In 2013, U.S. interest payments cost taxpayers $416 billion, less than 2007 interest payments of $430 billion. However, in 2007 U.S. debt totaled just $9 trillion compared with $16.7 trillion at the end of 2013, but in 2007 the average annual interest rate of U.S. Treasury debt was 4.9% versus just 2.0% in 2013. Therefore, in 2013 the U.S. carried a much larger sum of debt but benefited from exceedingly low interest rates. The Congressional Budget Office (CBO) calculates that if interest rates normalize by 2020 — meaning 10-year notes at 5% (versus 2.5% today) and three-month T-bills at 3.7% (versus 0.1% today) —annual interest payments will jump to $840 billion, or double what we currently pay.


Low interest rates not only support greater levels of government debt but also underpin Wall Street’s bullish argument for capitalizing corporate earnings at rates well below historical averages. Wall Street somewhat simplistically assumes that low interest rates justify higher valuation multiples on company earnings. To understand how Wall Street values the stock market, one needs only two inputs: 1) company earnings, and 2) interest rates. When considering just these two inputs, Wall Street unsurprisingly still sees substantial upside in U.S. stocks. Bulls argue that over the past fifty years the stock market’s price to earnings (P/E) ratio averages 18.9 [current price ÷ trailing twelve month reported earnings]; however, the P/E level depends significantly on interest rates. When rates are low, like today, stocks trade at higher valuation levels. Conversely, when interest rates are high, think early 1980s, stocks trade at lower P/E levels.


As the table shows, interest rates can significantly impact stock prices. When interest rates are high, bonds appear attractive relative to stocks. When interest rates are low, Wall Street believes that there is no alternative—investors find bonds unattractive, and so they must buy stocks, regardless of price. The bullish argument states that the S&P 500 currently trades for a P/E ratio of 19.7 [=1990÷101], above the historical average, but only if one ignores interest rates. Wall Street believes that with current interest rates this low, stock market P/E ratios should continue climbing to much higher levels. If the market’s P/E ratio moved to its historical average, based on current interest rates, and earnings continued to grow as analysts expect, stocks could potentially return 66% by the end of 2015. When interest rates are this low, Wall Street bulls believe that stocks are the only game in town.

While we wish it were so, we believe John Wayne summed it up best when he said that “Tomorrow hopes we have learned something from yesterday.” In fact, on Wall Street tomorrow has never learned anything from yesterday. A quick glance at the chart below clearly illustrates that Wall Street analysts are persistently overoptimistic when estimating future company profits.


Fittingly, that reminds us of another John Wayne quote; “I couldn’t hit a wall with a six-gun, but I can twirl one. It looks good.” Indeed, Wall Street cannot come close to accurately projecting future interest rates or profit estimates, but they sure look good making those projections. The fact is that if an economic recession unfolds, the market’s P/E ratio will serve as a poor measure of valuation. The denominator of the P/E ratio, earnings, grows too erratic during a profits recession. Although stock prices of publicly traded companies fluctuate widely, the values of the underlying businesses change far less—the exact reason Benjamin Graham used average earnings over a period of 7-10 years to value companies. Average earnings not only smooth the peaks and valleys of the business cycle, they also correctly adjust for late-stage peak earnings.

While P/E ratios serve as a poor valuation tool during a typical profits recession, when much of the bad news is delivered over a shorter period of time, the ratio of price-to-sales per share (P/S) provides better insight during these instances. The P/S ratio avoids the confusing issue of which earnings measure to employ (estimated earnings, forward operating earnings, reported earnings, adjusted earnings, normalized earnings, etc.) by comparing the index price against total revenue generated by the companies in the index. Because revenue numbers are restated far less often than earnings, this metric provides a more stable value in the denominator of the P/S ratio.

The chart on the following page reinforces our valuation assessment using P/E ratios that are based on multi-year averages of earnings, or earnings that take into account the entire economic cycle—the stock market is dangerously overvalued. Much like P/E ratios, markets have peaked and bottomed at different P/S levels. Since 1955, using weekly data, the median P/S ratio at market peaks has been 1.0. Correspondingly, markets bottomed at a median P/S ratio of 0.7. Beginning in 1996, the P/S ratio began to disconnect from its historical boundaries. Still, if we assume that a level of 1.0, which formerly marked bull market peaks, now represents market bottoms, a price-to-sales ratio of 1.0 is meaningful. A price-to-sales ratio of 1.0 also makes for simple math. The current revenue per share for the S&P 500 is $1142, and the S&P 500 closed the third quarter at 1975.


To date, there has been no evidence in the S&P 500 price action that any pullback is more than a minor setback, although valuation and sentiment levels remain at dangerous extremes. The chart below puts the current sentiment situation into perspective. Based on the Investors Intelligence survey, the ratio of bullish advisors to bearish advisors is at its highest level in twenty years. This does not mean that a large decline is about to begin; it means that sentiment is sufficiently extended into optimistic territory. Historically though, such complacency typically sets the scene for such a decline.



In general, frustration is a feeling that arises when events do not unfold as expected. We mitigate our frustration by altering our expectations. In the financial markets, frustration usually results from being emotionally or financially committed to a particular short-term outcome. Accordingly, short-term speculators should move to the sidelines when faced with any significant deviation from their intended plan. Conversely, long-term investors should remain focused on the fundamental considerations that drive their investment decisions and avoid any expectations regarding how markets will perform in the near-term.

As long-term equity investors, we avoid frustration by understanding that we make money from stocks in three ways: 1) receiving dividends; 2) buying stocks at a discount to intrinsic value and waiting for the market to recognize the gap between price and value; 3) growth in intrinsic value. Ideally, we want to benefit from all three sources of return; however, in the current market, we suspect that most gains will come from growth in a company’s intrinsic value. When managing a portfolio, we avoid frustration by selling stocks trading above our estimate of fair value and ideally replacing them with other stocks trading sufficiently below our estimate of fair value.

Intrinsic value can increase over time as companies generate free cash flows, grow their earnings, and raise their dividends. If future estimates of company cash flows are exactly correct (they never are correct), one would expect a company’s fair value estimate to increase in line with the assumed cost of equity embedded in a discounted cash flow model—generally 10% for our holdings. In order to continue improving our portfolios’ intrinsic value, we must continuously sell overvalued stocks and replace them with undervalued stocks. Perhaps more importantly in today’s elevated markets; we must focus on investing in companies that will compound their intrinsic value over time.

When asked about the secret of Berkshire Hathaway’s success, Charlie Munger, Warren Buffett’s business partner, responded: “I think we have had a temperamental advantage: Warren and I know better than most people what we know and what we don’t know. That’s even better than having a lot of extra IQ points… People chronically misappraise the limits of their own knowledge… Knowing the edge of your circle of competence is one of the most difficult things for a human being to do. Knowing what you don’t know is much more useful in life and business than being brilliant.”

Charlie Munger further noted that Buffett sees nothing worth investing it in right now and has not initiated a new investment in his personal account for at least two years. Buffett is waiting for an irresistible bargain to appear. Successful investing, concluded Mr. Munger, requires “this crazy combination of gumption and patience, and then being ready to pounce when the opportunity presents itself, because in this world opportunities just don’t last very long… It’s waiting that helps you as an investor, and a lot of people just can’t stand to wait.” Likewise, we patiently remain waiting to buy good companies trading at cheap valuations.

With 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 Fund does not own any shares of IBM.

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.

Performance data quoted represents past performance; past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the fund may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by calling 1-877-743-7820. 

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. The Fund is non-diversified, meaning it may concentrate its assets in fewer individual holdings than a diversified fund. Therefore, the Fund is more exposed to individual stock volatility than a diversified fund.

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

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