January 5, 2021
Happy New Year!
We hope that you are doing well. As we turn the page on 2020, we wanted to reach out early in the new year and provide you with a brief overview of what was a very active year for the Castle Tandem Fund (TANDX). The investment team at Tandem Investment Advisors is putting their year-end thoughts together now and we will share that with you in the next few weeks. But first, a cursory overview of 2020 and the performance of the Castle Tandem Fund.
If you are a shareholder in the Fund — or a financial advisor who uses the Fund — we thank you for your trust in us and hope the following pages help you understand why the Fund performed the way it did in 2020. For those of you who are contemplating an investment in the Fund, we thank you for your consideration and hope this provides you with a good overview of how the Fund’s investment process works and what we hope to accomplish for shareholders. (spoiler alert: lower volatility with attractive returns).
Historical Total Returns (%)1
As of 12/31/20
Year in Review
If 2020 were a dramatic play, we’d be inclined to divide it into three acts. Like any three-act play, Act One is expository and introduces the characters and the conflict. Act Two involves ‘rising action’ and an attempt to answer the dramatic question introduced in Act One. Finally, Act Three has the main tensions resolved and the dramatic questions answered. While this analogy does not fit perfectly, it’s still a good fit in our view. We’ll go over each “Act” of 2020 individually and let you know how the Fund performed, what the investment team was doing and what they were thinking during each of those Acts.
Act One: January 1, 2020 to February 18, 2020
January 2020 sure seems like it was a long time ago, doesn’t it? It does to us.
As we mentioned earlier, the first act serves as the set-up. The set-up introduces characters as well as the dramatic question that drives the rest of the play. In Act One of 2020, many of us were introduced to Wuhan province for the first time, a city that is “only” the 5th largest in China, but sports a population that is more than double that of Los Angeles. On January 23, 2020 Wuhan entered a lock-down phase or stay-at-home order due to the Covid-19 outbreak. Following our three act play analogy, this led many in the United States to the dramatic question: “What does the future look like if the virus spreads to the United States?”.
The S&P 500 — the Fund’s benchmark — started 2020 from what many perceived as a position of strength. In 2019, the S&P 500 was up 31.49%, and started 2020 near an all time high. It moved up another 4.57% from the first of the year through February 18th, 2020. The Castle Tandem Fund was up 4.22% over the same period. Greed was seemingly driving the market and fear seemed to be in short supply. The Fund’s investment team, however, was receiving sell signals in a number of its stocks and as a result was positioning the Fund for future buying opportunities by trimming specific positions and using the proceeds to raise Fund cash levels.
What we were thinking at the start of 2020
On January 6, 2020, Billy Little, CFA wrote: “In managing the Castle Tandem Fund, we have seen our cash position increase over the last several months. As many buy signals as we had in December 2018, we are getting an equal number of sell signals today. Discipline drove our investment actions a year ago with us putting cash to work and it’s that same discipline that drives our actions today. Patience will ultimately be rewarded and without dry powder available, it’s hard to take advantage of attractive opportunities when they arise.” Read the rest of the January 6, 2020 commentary here.
We don’t share the above commentary to imply that Billy or anyone at Tandem has a working crystal ball. Instead, we share it to show that they do have a well-defined investment process that they follow through all market environments. We believe that process helps them maintain discipline and eliminate emotion when making investment decisions for the Fund. The Fund started 2020 with 23.79% in cash or cash equivalents. The amount of cash — or dry powder — that the Fund holds at any one time is not a “market call” on valuations. Market calls are steeped in emotion and have no part in Tandem’s process. Instead, cash is simply an outcome of the process: when Tandem’s investment model indicated late in 2019 and early in 2020 that some of the Fund’s holdings were expensive, they trimmed those positions. At the same time, their model presented fewer buying opportunities (companies that met their qualitative criteria and were trading at a discount). By following their process, they sold more than they bought during this period, and the Fund’s cash levels increased to 29.32% on February 18, 2020.
Act Two: February 19, 2020 to March 23, 2020
We won’t rehash this period too much as all of us no doubt remember this extraordinarily volatile time. The S&P 500 fell 33.79% during this period while the Castle Tandem Fund experienced a more muted series of events and was down 24.33%. In 24 trading days, there were 15 days where the S&P 500 fell or moved up more than 3%. Why did we lose less than the S&P 500 during this period? First, the Fund’s cash position helped to dampen some of the volatility and lessen the blow of the dramatic drop. Second, some may define the type of company that we own as ‘quality’: our companies must have a history of growing their earnings through any economic cycle and they must pay and grow their dividend. Quality companies often do better than the overall market during periods of volatility and decline. Third, the Fund’s cash position during this period also allowed us to be a shopper in a market full of sellers.
As Billy Little, CFA noted on January 6th, “without dry powder available, it’s hard to take advantage of attractive opportunities when they arise.” With markets selling off steeply, the team’s investment model presented them with several attractive buying opportunities in individual companies. They took advantage of this period and lowered the Fund’s cash position from 29.3% on February 18th to 18.6% on March 23, 2020. A few specific examples of their opportunistic buying include:
Blackrock: Tandem added Blackrock to the Fund’s portfolio on February 28, 2020 at $456.61 per share, 19.2% below the stock’s February 18th closing price. Blackrock’s stock price closed 2020 at $721.54, 58% higher than our initial purchase.
Essential Utilities: On March 11, 2020 the Fund made its first purchase of Essential Utilities at $40.21. It’s stock was trading at $54.07 just a few weeks earlier on February 18, 2020. Essential Utilities closed 2020 at a price of $47.29, 17.6% higher than our initial purchase price.
The Walt Disney Co: On February 28, 2020 Tandem initiated a position in Disney. This was a company that met all of their qualitative and fundamental requirements: It had a history of growing it’s earnings and cash flows through any economic environment, and it paid and grew it’s dividend. Tandem made the Fund’s first purchase at a price that was nearly 18% below Disney’s closing price on February 18, 2020. More on this stock later.
What we were thinking during this incredibly volatile period
On March 19th, The Tandem Investment team wrote: “The current sell-off is likely to be much worse and speedier than what took place during past recessions. On the flip side, the recovery could very well be equally as fast”. Read the rest of the March 19, 2020 commentary here.
Act Three: March 24, 2020 to December 31, 2020
Incredibly, the equity markets roared back… and, almost as incredibly, perhaps “roared back” is not a strong enough superlative. We’re at a loss for words to describe the markets in Act Three. From the market bottom on March 23, 2020 to the end of the year, the S&P 500 rose 70.18% while the Castle Tandem Fund moved up 43.35%.
This period featured almost daily discussions on CNBC of “Why the stock market is not the economy”. It had Tesla (TSLA) climbing more than 700% in value during the period. It had Zoom Video Communications (ZM) becoming an everyday staple of many businesses and ending the year with a market cap nearly twice the size of General Motors (GM). It was a period in which many service-based businesses questioned whether they would need rented office space in the future. It led to the newly-hatched idea of a “K-shaped” recovery. Sadly, we saw business closings soar while many other small businesses struggled to stay afloat.
We began Act Three with 18.60% in cash and ended the year at 25.90%.
Buys and sells in the Fund were not nearly as robust as they were in Act Two. However, let’s revisit the Fund’s position in Disney. As we mentioned earlier, Tandem bought Disney in the throes of the market volatility of Act Two because it met all of their fundamental requirements and it was suddenly trading at what they viewed as an attractive price. However, in early May the company announced that it was suspending its dividend. Tandem didn’t find fault with Disney’s management for the decision — as they believed it may in fact have been the right thing for Disney to do. However, the process that Tandem follows is designed to eliminate emotion from their investment decisions. A fundamental requirement of any company in the Fund is that it pays and grows its dividend. Disney’s suspension of its dividend was a fundamental violation of the process and necessitated that Tandem follow its discipline and liquidate it from the Fund’s portfolio — which they did shortly after the company’s announcement.
In dramatic fashion, the year ended with the news of two vaccines and some clarity to the political landscape for 2021. Shortly thereafter, in Mid-November 2020, the Tandem investment team shared their thoughts on the road ahead via their podcast, Tandem Talk:
Earnings & Corporate Margins
I think a better way of looking at 2021 is not so much to look at what earnings were like this year- 2020 – but to compare it to the end of 2019. If the vaccines are successful and we get back to normalized life, now I think you can get back to where S&P 500 earnings were at the end of 2019 — about $165. But what’s different now versus the end of 2019 is that the market is up 12 to 13 percent in price. Additionally, interest rates on the 10 year Treasury are about 100 basis points lower today than the end of 2019. So there might be a little bit of support there, but that is assuming a lot because it also assumes that margins in 2021 will be similar to where they were at the end of 2019. Company margins were a little bit higher this quarter than they were in Q2 2020, but that’s because of layoffs leading to lower wages. But what you’re also seeing is changes to the cost structures of many companies. That to me is the biggest question for 2021 — what do margins end up doing? You’ve got producer prices that just recently were up 0.60% month over month. That’s higher than the 0.50% they were up in September. So they’re accelerating. Consumer prices are coming down, and you just saw retail sales that disappointed, that were decelerating. So you’re seeing input prices increase, and you’re not seeing demand on the other side. That’s not good for margins. A lot can happen between now and the end of the year. But I think getting back to 2019 earnings levels will be quite the hurdle, and it seems that that is what the market is expecting right now.
And we will give Ben Carew, CFA the final word, from his Notes from the Trading Desk published on December 21, 2020:
What becomes concerning in a marketplace like today’s is investor sentiment… In the most recent Bank of America Fund Manager Survey, they noted that cash levels had fallen below 4%. Traditionally, BofA has indicated that this level of cash within the survey should be viewed as a contrarian sell signal. The last time we had such a signal was this past February.
Elevated sentiment and extreme valuations can often become problematic for markets, especially in the face of a decelerating economy. In the short run, some economic measures like Retail Sales and the ISM Non-Manufacturing Activity Index have begun to roll over. However, there are plenty of economic positives to highlight. New orders continue to build and accelerate. New Business applications have strongly rebounded from their March lows. Finally, while the employment picture is not as rosy as it was back in February — the unemployment rate has dropped precipitously from its April highs to just 6.7% this past November. There are promising developments throughout the economy. Couple these green shoots with the economic potential following wide-spread vaccine rollout and it’s not too hard to find reasons to be optimistic from an economic standpoint.
2020 was certainly an interesting year and we look forward to working with you in 2021. Please don’t hesitate to reach out to us with any questions you may have on the Castle Tandem Fund.
Happy New Year!
Caeli Andrews Andrew Welle
Managing Director Managing Director
The opinions expressed are those of the Fund’s Adviser and Sub-Adviser and are not a recommendation for the purchase or sale of any security.
The Fund’s position in BlackRock, Inc. (BLK) as of December 31, 2020 represented 2.81% of Fund assets. The Fund’s position in Essential Utilities, Inc. (WTRG) as of December 31, 2020 represented 3.09% of Fund assets. As of December 31, 2020 the Fund did not hold a position in other companies mentioned in this report — Tesla, Inc., Zoom Video Communications, Inc., General Motors Co., or The Walt Disney Co.
The Standard & Poors 500 Index (S&P 500) is an index of 500 stocks.
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. Distributed by Rafferty Capital Markets, LLC Garden City, NY 11530.
The risks associated with the Fund are detailed in the Fund’s Prospectus. Investments in the Fund are subject to common stock risk, sector risk, and investment management risk. The Fund’s focus on large-capitalization companies subjects the Fund to the risks that larger companies may not be able to attain the high growth rates of smaller companies. Because the Fund may invest in companies of any size, its share price could be more volatile than a fund that invests only in large-capitalization companies. Fund holdings and asset allocations are subject to change and are not recommendations to buy or sell any security.