Editorials

1st Quarter Ending March 30, 2016

I think it was Mark Twain who uttered “the rumors of my death are greatly exaggerated.” One could say the same of Value investing, the discipline I practice hopefully diligently for my clients. Value Investing as a style has greatly underperformed momentum strategies over the last several years. Merely tying ones rope to the wagon of the S&P or other index would have achieved greater returns. However are those returns illusory?


One can only use the past as measurement since the future is unknowable. The S&P 500 is most easily measured by the PE ratio or how many times earnings you are paying for this basket of investments. For instance a PE of 10 would tell us that your are paying 10 times yearly earnings for a given investment. If buying a business with stable cash flows this would be an attractive entry point. However the basket of US stocks currently sells for 23 times earnings. In other words buying the S&P today one would need 23 years to get your money back. Not a terribly attractive fact.


It has been higher before. In fact on a couple of occasions preceding 1999 and 1929, it was quite a bit higher. What's interesting is the historic rates of returns that soon follow such valuations. Had one invested at 23 times earnings in the past your 5 year rate of return would have been negative.


Having presented this anecdotal evidence one might be prone to hold on to their money and maybe wait for another day. However as I'm going to show you our clients investments all have characteristics that in the total are not shared by the high falutin S&P or Dow or most mutual funds for that matter.


Our first criteria is financial strength. If your investment can't withstand a disruption in the financial world or cannot access cash when needed it doesn't matter how cheap it is. One can look in the dustbin of financial history and find hundreds of companies that became history themselves because of too  much debt etc. Our top investments are financially strong. In fact a couple are financial fortresses with balance sheets most company managements can only dream about.


Second we only buy into our investments when there is a significant margin of safety. In other words if we're wrong what is our backup plan. Are there assets that are worth more than our stock price? A great example is one of our largest holdings which has net assets that sum up to more than twice the current stock price. And we have already made almost 3 times our initial investment on this particular holding.


Price or how much we pay plays into this margin of safety principle. Almost any investment can be attractive at a low enough price. Conversely we will not over pay  even for the most loved investments. Are indexed investors and mutual fund investors overpaying today???? Just remember the price you pay dictates your rate of return over time. Buying right can absolve a litany of other sins.


Third we like to invest in companies where management has a significant investment themselves. Do they have skin in the game? Are they buying their own stock? How much of their net worth is invested in the company they run. If management is selling it might be a sign that we should run ourselves. For example one of our portfolio investments has a management team that averages 30 years of service to the company. Very unusual in corporate America today. There's no question they are engaged for the long term. They think in terms of 10 and 20 years not 3 or 6 months like most of their competitors.


There are more but you get the idea. The point is we have a discipline and we follow it. Periods of underperformance are part of the business and the process. In fact we should be excited because periods of underperformance are followed by periods of overperformance. And as I will show you the disparity between the price and quality of our investments and the S&P 500 and the Dow is very wide.
My hope is over the next 5 years our investments will not mirror the indexes but will indeed highlight how our disciplined approach adds tremendous value over time.


Let's briefly talk about some industries that are interesting.

OIL and GAS

The recent volatility of the oil and gas industry is a reminder that investing in that industry can be quite difficult and fraught with peril. Exploration companies levered up during the good times by borrowing more and more money to finance larger projects. Many of these companies issued debt at the peak and are now paying the price. If you own high yield bonds you might pay the price also as it is estimated that the oil and gas industry represents nearly 25-30% of the high yield debt market. This is why we exited that market long ago and will wait till there is a significant “cleansing” before we re-enter.
One only has to read Marin Katusa's book The Colder War to realize what an important asset oil is politically and will continue to be so for several decades. It only takes one political event for prices to skyrocket again. Our companies are well financed and the net assets are multiples of the current depressed stock prices.

 

GOLD and SILVER

Our natural resource stocks have been our best performers this year with our largest position up 100%+ so far. I think now is the time to invest in gold if you haven't already. The last time gold was this cheap relative to a basket of currencies the GDX (an ETF of gold shares) shot up over 500% in the subsequent years. Like our other positions we only own gold and silver stocks with very strong finances. Also we look for companies that have low all in sustaining costs (AISC). AISC is the amount per ounce that is the break even point for the company accounting for all out of pocket expenses. For instance Barrick Gold has one of the lowest AISC in the industry at $862. They can be profitable at that price or above.


I also like royalty companies. Royalty companies have much different characteristics than most natural resource stocks. They in essence lend money to gold and silver explorers in return for a royalty on an operating mine. They are a low risk way of investing in gold. An exploration company might have a big discovery but doesn't have the finances to extract the gold from the mine. The royalty company will do its due diligence, inspect the site and determine how many ounces can be extracted. They will then loan the gold miner the money to develop the property and in return they get a 3% royalty for the next X amount of years. The royalty company doesn't have to invest in heavy equipment and has very little overhead. Silver Wheaton, a silver royalty company operates with less than 10 full time employees. In fact several royalty companies are so well financed they pay a nice quarterly dividend.


Since I'm running out of space that's the end of my opening comments. From here on out we will talk about our portfolio companies individually hopefully you will see how our investing style gives us a clear advantage over mutual funds and indexing. Underperforming over short time periods is OK, I sleep very well at night and hope you do to understanding the thought process behind our core investments.


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