Letter to Investors, December 2016

Below is my recent letter to investors in the Tarpon Folio, originally sent out on December 18th. You can sign up to receive future letters here.

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“It is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism. For it is in the essence of his behavior that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

– J.M. Keynes

Dear Investors,

From January 1 through November 30, 2016, net of all fees, the Tarpon Folio is up 91.8% compared to an increase of 9.8% in the S&P 500 over the same period.

As of the market close last Friday, December 16, Tarpon is up more than 100% year-to-date, after fees, on an unaudited basis. So I am pleased to report that it appears that you will have doubled your money in Tarpon in 2016.

Merry Christmas.

Thank you for hanging in there after a tough 2015. We are succeeding unconventionally. And we are not done yet.

We now have two ten-baggers in Tarpon. I have made no trades since August. And subsequent to that investor-only email I sent in early November, OPEC cut production, as expected, putting a floor under oil prices and formally closing out one of the most head-scratching chapters in the history of the oil market.

My expectation, in short, is that oil will continue to grind higher in 2017. Global oil flows now look to be in deficit, while elevated oil stocks will be drained further by the recent OPEC/non-OPEC production cut agreement.

I also believe the risk of sleepwalking into a supply crunch in either ’17 or ’18 remains uncomfortably high. That risk is due to several pro-cyclical idiosyncrasies of today’s oil market, the most notable of which is the inconsistent quality of global production and inventory data. IEA numbers in particular are, on occasion, confounding and irreconcilable, appearing to obscure or conflate trends in production and/or inventories which would otherwise be price-supportive for oil.

I suspected it a year ago, and now unequivocally believe it: there are some strange things in that macro oil data – whether Gulf of Mexico oil production forecasts, OECD inventory stock revisions, or the obscuring of oil-versus-condensate storage levels here in the U.S. All of which makes the forward curve even less predictive of future oil prices than it already is.

Get on it, 60 Minutes.

In any case, our companies remain resilient, and our returns in Tarpon next year should be attractive enough that I believe my primary goal as your portfolio manager is to avoid doing anything that might cut the compounding process short.

So let the record show that it’s in your best interest if I do a lot of fishing next year.

But let’s not get cocky – nor forget the role good luck played for us this year. We’ll all be better off if we ratchet down our expectations for 2017.

We found a glitch in The Matrix last year. It continues to be exploitable in a reasonably systematic way via the shares of deeply undervalued U.S. E&Ps – without using margin, derivatives or algorithms – although on occasion it does require some scotch. And we are not done taking advantage of it yet.

As a reminder:

Stock prices are not data. They are an opinion. To a value investor, they are an opinion about the future earnings power of a company. That there is a lot of data available to form an opinion about a company’s true value should not be confused with the idea that all opinions about stock prices are equally valid.

The vast majority of the time, the market values companies correctly – or, at least, an investor should start by assuming the market is correct. But every so often, the market makes a grievous error that alert and patient investors can exploit. And for Tarpon, this has been of those times.

Please understand that because of what we stand to gain the next few years, I will make no apologies for whatever short-term volatility may come as a result of continuing to hold our current Tarpon companies, at their current portfolio weights, for an indefinite period of time.

We own good assets, bought at even better prices, which produce a critical product that many in the market don’t appear to realize may temporarily be in short supply in the not-too-distant future. The primacy of price over all else in the oil market has been nearly absolute. But it is also untenable. I continue to believe this is a perfect storm of cognitive biases, incentives, ambiguity and groupthink on Wall Street that we can take advantage of.

And my job, essentially, is to not screw it up. So we are going to take every penny the market gives us in 2017.

Right now, though, there is a worrisome oversupply of eggnog in Islamorada.

And. I. Am. On. It.

I’ll have more thoughts on Tarpon, OPEC, the new U.S. administration and the shale industry’s response to higher oil prices in a few months.

In the meantime, Happy Holidays!

Peace, love and cash flow.

– Cale

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Read my original 82 page thesis on investing in U.S. E&Ps (exploration and production companies) here.


Disclaimer: This post nor any of the material linked to herein in any way constitutes investment advice. Historical performance data above represents performance results as reported by the portfolio identified. Performance results are for illustration purposes only. Historical results are not indicative of future performance. Positive returns are not guaranteed. Individual results will vary depending on market conditions and timing of initial investment. 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 and dividends. The publication of this performance data is in no way a solicitation or offer to sell securities or investment advisory services.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.

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