I made more changes to the Tarpon Folio in September, as
described below. But first, an update on our investor meeting,
a special article included in this letter, and then a note on changing
fees and account minimums.
Plans for our investor meeting on January 30th continue to
move ahead. I'm pleased to announce that we will be joined
at our meeting by Ken Peak, the CEO of Contango Oil & Gas. You
recall that I wrote about Ken and Contango in my March
Ken will be coming to the meeting to update us on the many things going
on at Contango and answer any questions you have. He is a
world-class operator and I think you'll really enjoy meeting him.
understand that airline tickets are cheap right now, so book 'em as you
see fit for the meeting. Some of the most impressive
oceanfront resorts in town include the soon-to-re-open Cheeca Lodge, Casa Morada, The Moorings,
Resort and The
Give me a call if you want other lodging ideas, too. I'll be posting
more details about the
meeting in the next few letters and on my
blog under the "Annual Meeting" category.
Rather than the usual "Get To
Know Your Company" section in this letter, I've included an article I
discussing the valuation of the broader market. I'm
getting the sense that many
investors are feeling pressured by the financial media and various
pundits to get back into the market now to avoid missing this
continuing rally. Unfortunately, one of the reasons often cited as
jusification for rushing back in - "the market is still cheap" - does
not hold up under closer scrutiny. As I discuss in the article,
commentators making that conclusion based on "operating earnings" and
not real reported profits are doing individual investors a huge
disservice. Read on to learn more. And a special thanks to Kirk Kinder
of the fee-only firm Picket
Fence Financial who had the idea for the article to begin
with. You may soon see an expanded
version of the article including additional thoughts from Kirk
floating around the internet.
Lastly, a word on fees. I'll be
raising both our fees and our account minimums for new investors in the
Tarpon and Gecko Folios on January 1, 2010. All indications are that
we'll have an amazing year for both portfolios in 2009, and
that we've got something to talk about, it's time to start really
growing this business in 2010. Not to worry, though, if
you're currently an investor. Anyone invested prior to January
1st will be grandfathered, so your fees will stay at the same
0.90% per year for life - even on additional future contributions you
And if you're not currently an investor
with us, but would like to learn more, please drop me a line.
Until January 1st, I will continue to waive our management fee for one
quarter for new investors, too.
Now, about September...
- Your Portfolio Manager, Cale Smith
to Get Excited About
The Tarpon Folio increased by 7.0% during
September compared to an increase of 3.6% in the S&P
500. Since inception last November,
the Tarpon Folio is up 92.3% through the end
of September, and is outperforming the S&P 500 over the same
Since I last wrote, I have sold all of our holdings in Blackbaud.
Like the two companies I sold last month, Blackbaud
shares increased uncomfortably far beyond what I
think they're currently worth. The company's flagship Raiser's
Edge software will likely continue to dominate the nonprofit market,
and should the stock decline precipitously in the future, we could
conceivably own shares again. For now, though, there
are better opportunities for us to realize larger gains over
the next few years.
The sale of those shares increased the cash we held in Tarpon to about
30% of our portfolio at one point during the month. While I have since
started putting much of that cash to work in new companies, I admit I
was surprised that we outperformed the market again in September
despite having a large percentage of the fund in cash, earning nothing.
Fortunately, CarMax put up impressive numbers in its second quarter
results, causing shares to jump, and I sold Blackbaud at the
apex of its 52-week high. Sometimes it's better to be lucky than good.
I have been investing our money in several new companies. I'm finding
value in telecommunications companies, which as a
sector lagged the broader market in this year's rally. I'm
particularly impressed with the moat around the business of Neutral
Tandem, an oddly-named company with some serious network effects. The
company has solved an epically dysfunctional aspect of
telecommunications that I first became aware of long ago when
I used to provision ciruits at an internet service provider.
Shares had recently sold off due to a fundamental misunderstanding
about the business, and I believe our timing will be fortuitous. More
about Neutral Tandem soon.
While good cheap moats are harder to find these days, I'm also pleased
to be adding Compass Minerals to the portfolio. Like our
other additions, recent bad news - in this case a weak near-term
outlook for corn prices - has made shares attractive. You
might be surprised at how impressive a business can be built by selling
rocksalt and fertilizer. So if your eyes glazed over when you
read "telecommunications" above, not to worry. Compass is another
simple, boring, but wonderfully advantaged business that I'll be
discussing in more detail before too long.
I'm also pleased with the other companies we have begun to nibble at in
the portfolio, and will pass on more info about each once
we've reached the position sizes I have in mind. Several of those
companies' shares began to increase in price before I could take full
advantage of lower prices, which annoys me to no end. But, I suspect
we'll see some better prices again before too long if this year's
volatility continues. In the meantime, I'm happy to wait.
So, there will be more changes to Tarpon to discuss in next month's
letter. While October could be a volatile month in the
market, I intend to tune out the noise as usual,
except when we can take full advantage of it. In the
interim, a special article I wrote follows which
may help frame some of
the things you may be hearing about this continued market rally.
Get To Know Your Company's Profits
Report on The Quality of Earnings
Most investors probably would not think that
something as straightforward as the definition of a company's earnings
could be controversial. Welcome to Wall Street, where obfuscation is
intentional, clarity is rare and earnings are not always earnings.
Publicly traded companies in the U.S. are required to publish their
financial results in accordance with generally accepted accounting
principles, or GAAP. A company's profit under GAAP rules is considered
to be "reported earnings." However, many companies emphasize a
different version of earnings to their investors. Management teams
often refer to "operating earnings" under the pretense of better
capturing the underlying trends in their businesses.
That idea makes sense when intentions are sincere. Referring to
operating earnings in lieu of true reported earnings isn't necessarily
a bad thing, as the GAAP definition of earnings does include some slop.
More specifically, GAAP earnings can include items such as write-offs,
gains on asset sales, restructuring charges and goodwill write-downs
that are one-time events with no bearing on the company's core
operational results. So when it comes to gauging a company's true
progress, GAAP earnings aren't perfect.
The problem with relying on adjusted operating earnings, however, is
that they can be seriously misleading. There is no industry standard
that defines the term. Management teams can literally exclude whatever
they'd like to in the operating earnings figures they publish.
An overemphasis on operating earnings, sometime called "Street
earnings," "core earnings," or "pro-forma earnings" is not new.
Analysts usually exclude items that are not part of a company's normal
operations in analyzing the businesses they follow. Since the early
1990's companies have often emphasized operating earnings over reported
earnings to their investors. What is new, however, is that the
operating earnings of many public companies now appear to be either
excluding items that they should not be or that are not really
non-recurring – to a historic degree.
In other words, companies are claiming things that happen routinely are
one-time events in order to prop up the earnings figures they highlight
to their investors.
Lately, many individual investors have felt pressure to get back into
the market out of fear they will miss out on further gains. Much of
that motivation is fueled by pundits and talking heads insisting that
"the market is still cheap based on historical earnings." Investors
should understand that while the market as a whole may be attractively
priced based on operating earnings, it's a far different picture when
looking at companies' true earnings.
The difference between true earnings and operating earnings has never
been bigger than it is right now. Standard & Poor's recently
reported that GAAP earnings per share for the 500 biggest public
companies is $7.21 per share, while operating earnings are $61.20. That
$54 gap is an all-time record.
Why does it exist? Much of it can be explained by huge write-downs in
the financial sector
in addition to a high degree of write-offs in other industries address
as more companies deal with their own impaired assets, too. Job cuts
and declining production explains more of the gap. But to be clear,
some companies appear to be abusing the notion of operating earnings,
Take the case of Alliance Data Systems, a Texas company that manages
customer loyalty programs and provides private label credit cards.
You'll notice in the subheading of its most
recent quarterly earnings release that the company highlights
"cash earnings per share" and not GAAP earnings.
How does Alliance define cash earnings? By taking GAAP earnings and
adding back certain expenses, including the cost of stock compensation
given to management and employees. It also adds back a chunk of the
premiums it pays to acquire credit card portfolios and customer lists.
While GAAP considers such premiums the cost of doing business, Alliance
considers them an intangible asset – meaning it can amortize them. And
because Alliance adds back amortization expenses to get to its touted
"cash earnings," the earnings figure the company is highlighting grows
larger - despite the fact that it is an expense that actually reduces
Alliance's "cash earnings" for the second quarter were 95 cents a
share, but GAAP earnings in the period were 51 cents a share. The gap
between the two figures was even wider in the first quarter, when
Alliance reported "cash" earnings of $1.19 a share compared with GAAP
earnings of 45 cents.
Only on Wall Street can a company take expenses, add them back to
profits, point to that number as the primary indicator of serious
business progress, and then see its shares hit a 52-week high. And
would you care to guess what the primary metric is that Alliance uses
when awarding its
executives with company stock?
Unfortunately, Alliance is not alone in emphasizing non-GAAP earnings.
Pfizer is another company with operating earnings that do not provide a
picture as clear as you might be lead to believe. Pfizer prefers to
publish "adjusted earnings" - ostensibly to ignore the impact from
acquisitions - and the Street follows unquestioningly. Pfizer acquires
firms every year, though, and even with the big hole in its pipeline
that Pharmacia seems to fill, it seems likely that it's still going to
have to acquire growth pretty consistently in the future. If part of a
business' operations is consistently acquiring other firms, shouldn't
that be treated as a regular expense?
Kodak might also be considered a serial offender, in that constant
restructurings and repeatedly closing factories over multiple years are
not truly one-time expenses. Last year Kodak also adjusted its pension
fund assumptions and, surprise, it happened to boost their
In the telecom world, QualComm historically received a hefty percentage
of its earnings from investments, as opposed to coming exclusively
from the companies' operations. Those investments had not been doing
too well early this year, highlighting yet another reason why investors
to pay attention to the quality of company's reported earnings.
Why does this distinction matter? Because, as described
eloquently here, while the market has increased by more than
the last few months, the actual aggregate GAAP earnings of companies
have declined by 6%. Given the gap between actual earnings and the
figures used by many market commentators, there could be unpleasant
surprises in store for investors who blindly buy into the market
thinking that it is cheap.
It is not, and knowing the difference is critical.
Q. On the
Accounts Overview page in my FOLIOfn account, it shows the Tarpon Folio
and also some separate cash. What is that, and is it there
for a reason?
A. That cash is there to basically serve as a
little over two years worth of fees for both FOLIOfn and IIM.
It's computed as 2% of the initial amount you invest, and I
leave it separate so that we don't have to incur any tax consequences
or reduce any potential growth in the portfolio. More
specifically, it's there so I don’t have to sell something and increase
your tax bill just so FOLIOfn and I would get paid every quarter,
and/or so we can let the invested portion of the portfolio grow as much
as possible without having to trim anything back just to pay fees.
Ideally, every other dime in your account is invested in the market, it
grows over time, there are minimal changes to the portfolio
and those fees just come out of that cash for the next two years.
If things become screaming cheap in the market again, there
may be a time when I reduce that 2% to as low as 0.5% just to put every
dime possible to work and forget about the tax impact, but we're not
there these days. Having that cash is also different than a mutual
fund, which doesn't keep the cash separate but instead charges you
literally every day so the mutual fund company is sure to get it's take.
If you've checked your account lately, you probably also noticed that
inside the Tarpon Folio itself is another 10% in cash. That's a result
of selling some companies, as per the discussion earlier in this
letter, and I'm in the process of putting that to work. So that number
will be close to 1% eventually, too, in terms of cash held inside the
With a total of 3% cash in the portfolio, that leaves more than enough
for fees for a couple of years without having to sell at all - which
may be idealistic, but is a useful benchmark. And some stocks
we buy could come with a commission payable to FOLIOfn, too, to make
the trade. We don't pay any commissions to buy/sell shares in
any companies right now, but in the event we did, that's all the more
reason for a little slack cash in there.
If you have any other questions, please let me know.
The Tarpon Folio is an innovative,
investor-friendly alternative to the traditional actively managed
mutual fund. It's built on a model we call a Spoke Fund®.
It is more transparent, takes more concentrated
positions and is significantly less expensive than the vast majority of
mutual funds. The portfolio is managed for long-term growth using value
Fees are 0.90% of assets annually, assessed on a
quarterly basis. Turnover, taxes and trading are minimized in the fund,
and investors can customize their accounts in several key ways,
including tax preference. Each Tarpon Folio account is also protected
by three types of insurance for a maximum of up to $11.5 million
For more information, visit our website.
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policy, our Form
ADV and our Fiduciary
See our performance disclaimer for more. The historical performance data contained above
represent performance results as reported by the portfolio listed. The
performance results are for illustration purposes only. Historical
results are not indicative of future performance. Positive returns are
Individual results will vary depending on market
conditions and investing may cause capital loss. The S&P 500,
used for comparison purposes, is significantly less volatile than the
holdings of the funds listed. The performance data is “net of all fees”
reflecting the deduction of advisory fees, brokerage commissions and
any other client paid expenses. The performance data includes the
reinvestment of capital gains.
The publication of this performance data is in no
way a solicitation or offer to sell securities or investment advisory