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 One year down, fifty to
go.
Thinking
Hard About Retiring
The Tarpon Folio increased by 90.6% in
its first year compared to an increase of 35.4% in the S&P
500. Over that same period the portfolio outperformed the
S&P 500 by 55.2%.
Over the next few decades as a portfolio manager,
I may never have another year like this one. So,
I'm thinking hard about walking away at the top of my game and starting
up a frozen yogurt stand.
Kidding, people. With our first year now in the
books, though, it does seem
like a good time to step back and examine where we are. While
I'm
thrilled the portfolio has done so well this first year, I am also very
aware of the market's tendency to punish the overconfident.
Where We Are Today For most people, investing serves one of two
purposes; you're either attempting to grow your wealth or
you're trying to preserve it. When it comes to preserving wealth, broad
global diversification, asset allocation and working with a team of
experts often makes the most sense. It's my opinion that applying that
same approach when you are trying to grow your wealth,
however, will drive you insane long before you're ever able to
retire.
I view a portfolio as a collection of assets built
to maximize the long-term earnings of its owner. I also believe this
kind of investing - growing wealth as opposed to preserving it
- is best done by a single unbiased person having as few distractions
as possible. That person doesn't have to literally be on an island,
like I am, but he should be on an island in the metaphorical
sense. In investing, he who thinks the clearest wins.
I have considerable faith in the processes I use
to grow our portfolio's value, in everything from finding attractive
companies to analyzing them to accumulating positions. It is a
systematic approach
driven by a long-term business owner's mindset, and I'd like to think
it pretty clearly showed its worth this year. I hope you share some of
my faith in those processes now, too.
I
also want to remind everyone of a simple truth about value
investing:
It
works best over years, not months.
Some of our newest investors have seen lackluster
returns in Tarpon the past few months. Hang in there with me. Those
returns are also consistent with how the process typically works. While
I have no idea what will happen in the market in the next few months, I
have recently been taking new positions in some impressive
businesses the market is overlooking. I have also effectively staked my
own net worth on the expectation that their intrinsic value will
eventually be recognized. There is no telling when that will happen -
it could be within months, like we saw in 2009, or it could be years -
but in either case it's important to have faith in the process.
Despite this year's returns, the performance of
our portfolio in some ways was less than ideal. During the year I sold
some holdings that I would have preferred to hold forever, all things
being equal, because their share prices went too far beyond what I
estimated them to be worth. I also cost us even better performance by
selling American Express in March. I am comfortable that the process I
went through prior to selling those shares was sound, and given the
same circumstances, I would have sold again, but the reality is that
those shares have quadrupled since that decision. I imagine the feeling
is similar to the record producer who decided not to sign the Beatles.
That said, you should know that I don't intend to
change a single part of my approach based on our recent success,
economic predictions, the market's trajectory, federal deficits, the
phase of the moon or any other reason. That's why it's a system, after
all - to produce consistently superior results over time. If the
process is sound, and I believe mine is, and if it's followed
methodically, which sometimes takes a lot of caffeine, then the results
will eventually take care of themselves - whether you're training for
the Olympics or managing a portfolio.
So, the state of the Tarpon is strong. Now about
the
year ahead.
My Expectations for Tarpon in 2010
Expectation #1: Outperformance.
The spoke fund model is not subject to the same
limitations that box in mutual fund managers. As such I believe it is
reasonable to anticipate outperforming the market again. In an absolute
sense, the return I shoot for every year is 15% and my goal in 2010 is
no different. It's also important to understand that I am willing to
tolerate volatility and short-term underperformance in exchange for
long-term outperformance. I'll take a lumpy 15% annual return over a
smooth 11% return every time.
Expectation #2: Slightly less
correlated
returns.
I expect that Tarpon's performance over this
coming year will better answer the question that I sense may still lurk
in the back of some people's minds:
"Is he good, or he is lucky?"
I think I know the answer, but I suppose I should
be objective about that sort of thing. So, into the numbers I dove.
In September I did a statistical comparison
between the monthly returns of Tarpon and our benchmark, the
S&P 500, from November through August. I found the correlation
between Tarpon and S&P 500 returns over that period was 0.943.
For you less geeky readers, that means the returns of Tarpon were
strongly positively correlated with the returns of the overall market.
I admit my ego was hoping to see a lower
correlation. I feel our companies are truly wonderful businesses, and
I'd like to think the performance of their share prices would be more
independent of a broader market which contains a lot of lower quality
companies.
A regression analysis indicated that this
correlation might be a bit unreliable, though. (More specifically, the
data had a high standard error, indicating that it is uncertain how
useful the regression is predicting future correlation.) Also, the
analysis (R squared, for the stat geeks) indicated that about 89% of
the variation in Tarpon returns could be attributed to the change in
S&P 500 returns. The remaining 11% of the variation could be
attributable to "other factors" - like knowing what the heck I'm doing.
So the results seemed to point to this conclusion:
While luck in the form of the timing of the fund's
launch last year clearly played a large role in Tarpon's performance,
so did the skill of its portfolio manager. Moreover, that little bit of
skill added a very significant amount of excess return to the portfolio.
Now back to the point in bold above. The Tarpon
Folio now is more concentrated than it has been at any time during the
last year. Our top two holdings - Paychex and Contango - represent 20%
of the portfolio. As a result, Tarpon's returns this year will be
correlated closer to the stock prices of those two companies in
particular than the more equally-weighted portfolio we held earlier in
2009. So while next year's correlation probably won't differ
much from that of this year, that 11% number above shows that it
doesn't necessarily have to be, either, in order to significantly
outperform the market.
Some of you may have noticed this already.
Tarpon's returns are now slightly less sensitive to the overall
market's returns than they were a few months ago. And to be
clear, that is an intentional result of recent changes I have made in
the portfolio.
While our returns will no doubt continue to be
influenced strongly by the direction of the broader market, I believe
they will be slightly less correlated than in the past. I view that as
a good thing, particularly if we are trying to outperform a market that
is no longer undervalued.
Expectation #3: Inflation will
return.
I am not attempting to divine the future inflation
rate here, but I am underscoring the need to ensure that we are
protected from inflation however strong or weak it may be. High
inflation is an invisible tax that can cripple businesses. For
long-term investors, inflation's impact on a portfolio should be
considered at all times, however, and not just when the pundits start
getting nervous.
As I have written previously, while I don't intend
to ever seek direct exposure to gold or commodities through ETFs,
derivatives, or other managed funds, we do own companies that would be
beneficiaries of increasing commodity prices caused by inflation, like
Contango and Compass Minerals. We own them because they are good
businesses with moats, however, not because they produce commodities.
I believe we are relatively well-protected from
inflation both through owning companies like those above, as well as
those with pricing power and/or which would benefit from increased
interest rates. (The Fed will increase interest rates to combat
inflation.) Paychex is a prime example of the latter, because it will
earn more interest on its float - cash balances resulting from the lag
between when it receives payroll-related funds and when it pays them
out - when interest rates rise. And owning good companies that have
pricing power is important because if their costs rise due to
inflation, they can then pass those higher costs on to their customers
and avoid crimping margins.
The threat of inflation really underscores the
value of owning companies that set prices in their industries rather
than react to them. In other words, moats always matter.
Expectation #4: An increase in the
probability that the market will make me look dumb at some
point this year.
The share price of each of our companies in 2009
went up significantly, with a handful of doubles and several even
tripling in price. That's not how value investing normally works,
however. We will probably buy shares this year that will go down in
price after we purchase them - in some cases dropping
significantly. That's okay, though, assuming the investment
case is still strong, because I'm confident in the reasons we own each
of our companies. I will most likely buy more shares on those dips.
That said, I concede that watching me buy more
shares of a company you aren't familiar with as it drops in price could
be pretty nerve-wracking. If it really bugs you, just pick up the phone
and we'll discuss my rationale. If nothing else, though, I'd ask you to
remember that it's my net worth at stake, too.
When there are fewer truly great, seriously
undervalued businesses we can buy shares in, I have two options as your
portfolio manager:
1 - Leave a lot of cash in Tarpon.
To me, leaving a high percentage of cash in our
portfolio for an extended time is lazy. There is always value somewhere
in the market, and if you're not finding it, it's because you're not
looking hard enough. While billion dollar funds may at times hold cash
because they can't take a meaningful position in any suitable
companies, we don't have that problem. If you invest in Tarpon, I
interpret that to mean that you're paying me to find good
companies, not to be a savings account.
2 - Find the next-best companies I can.
At a very high level, there are just
two criteria for the companies we invest in. Each must have a
competitive advantage, or moat, and each has to be cheap.
I will not invest in any company that is not cheap
- or more specifically, that does not have a large margin of
safety. That means during times like we're in now, when the market
appears fully valued, our pool of potential investment candidates will
expand to include companies with smaller moats, but never any companies
that appear overvalued. Only one of those two key
criteria can vary.
The share prices of companies with narrower moats
are in general more volatile than those with wide moats. So in 2010,
the prices of our narrow-moat companies could fluctuate quite a bit,
and as a result, I very well may look dumb at some point.
I'd like to think that should it occur, however,
it won't be a chronic condition.
Expectation #5: We will continue to
benefit
from unexpected events.
As I write, there is still a tremendous amount of
uncertainty about the outlook for the economy. The market hates that
uncertainty, which is one reason why you can't step off your front
porch without hearing another Wall Street expert predict everything
from a market correction to a double dip recession to the beginning of
a new bull market. History has shown repeatedly that in most cases,
though, it's all just noise.
I don't spend much time trying to guess the
direction of the market. To paraphrase Warren Buffett, the key to
investing is not trying to predict the future but to determine the
long-term durability of a company's competitive advantage.
By definition, the only time good businesses are
cheap is when the market has low expectations for them. If I'm right in
my analysis, then the businesses we own will eventually show some
unexpected positive developments, and we will be rewarded accordingly.
Five
Other Things To Keep In Mind
As you think about your own financial future next
year, I'd also ask you to remember these things:
1. Wall Street destroyed our economy.
Why people continue to lend any credibility to the
banks, analysts, rating agencies, and mainstream financial media
baffles me. And don't confuse free markets with Wall Street.
2. The economy is cyclical.
While it doesn't feel like it today, the economy
will improve eventually.
3. History shows it is a mistake to bet against
America and its best businesses in the long-term.
We had a scare a year ago, but capitalism will
survive. See Warren Buffett's recent acquisition of the Burlington
Northern railroad company.
4. Beware of anyone saying, "This
time it's different."
There is always an ulterior motive.
5. Incentives
matter.
The financial incentives and motivations of those entrusted to manage money
make a difference. Without exception, the best portfolio managers I
know work at independent firms. Be a steward of your own wealth, not a
consumer of financial products.
A
Final Note
Lastly, I couldn't be more biased when I write
this, but so be it:
The mutual fund model has failed investors. It was
a good idea that has run its course. Its many faults are being
overshadowed
these days, however, by the moral bankruptcy of
Wall Street. Nonetheless, all investors need viable alternatives to
mutual funds. I think spoke funds should be one of those options. I
hope you do now, too.
Thank you again for all the support this past
year. On to the next one.
- Cale
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Cale's
Notes: 
