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In This Issue
bullet Cale's Notes: Another High This Month.
bullet Get To Know Your Company: Why we own Pacer Int'l.
bullet About the Tarpon Folio: More about our Spoke FundŽ.

Letter to Investors
For April 2011 [email protected] (305) 522-1333             

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Cale's Notes

Cale Smith

Dear Investors,

The Tarpon Folio reached another high on the last trading day of April, up 2.4% percent for the month. Since day one, then, Tarpon has increased 150.2%, or 81% more than the S&P 500.

The few days that have elapsed since the last of April have been historic in more ways than one. If you’ve been spending all your free time this week reading about U.S. Navy SEAL Team Six - God bless those guys - then you’ve been missing some real panic in the commodities markets. The stock market saw a few down days as that commodity angst spread a bit, but most of the activity this week was likely in places you normally wouldn’t notice.

There have been steep drops in the prices of just about every commodity lately, with one well known commodity index, the GSCI, dropping 10% this week alone. Silver is off 30% from recent highs, copper fell below $4 for the first time this year, oil has dropped back below $100 a barrel, coffee and cotton prices are tanking, the dollar spiked and Treasury bonds rallied. Also, the Check Engine light in your car is about to go off.

It’s a fool’s errand to try to divine any meaning from most short-term gyrations in the stock market. This week was a bit unusual though, due to the smell of pure panic emanating from the commodity pits. So, this fool will try to interpret the commodities sell-off for you.

The headlines cite a combination of factors behind the commodities rout, from increased margin requirements at commodities exchanges to a post-Bin Laden decline in oil prices to a few tepid jobs reports and some hedge fund liquidations - not to mention a delay in eventual interest rate increases by Europe’s Central Bank.

Meh. Never mind all that. Here is what is really happening:

Speculators are panicking.

This week’s volatility has nothing to do with a double-dip recession. It’s not another global financial crisis. The fundamentals are actually strengthening in the employment market. And there is no need to start stockpiling guns and butter.

The drop in commodities prices is due to a classic rush-to-liquidate that happens every so often in markets that are jam-packed with people chasing price instead of focusing on value.

So to the extent that you were even paying attention to it at all, what we were seeing is (1) the hurried unwinding of a ton of commodities trades by speculative late-comers who shouldn’t have gotten into those positions to begin with, and (2) some major second-guessing by institutional investors who had previously bought commodities like silver and oil as a hedge against a declining dollar. And some of that fear crept into the stock market.

My advice?

Ignore it. There are serious things to keep an eye on these days, but this is not one of them. You’ll recall I won’t invest our money in commodities directly - rampant speculation being a big reason why. And a little less froth in those markets will ultimately be better for all of us.

It’s always hard to gauge how long a panic might last, but based on the violence of this latest commodities sell-off, as well as the wild-eyed gusto with which lemmings typically run off a cliff, I’d say we’re almost through it. Unfortunately, I don’t expect the stock market will pull back enough to make any of my current watch lists stocks truly compelling - but one can always hope.

So, barring anything truly interesting happening in the stock market as a result of all this, my plan for the Tarpon Folio is, well, to do absolutely nothing. I trust you’ll understand.

It is probably unrealistic of me to expect you all to like hearing about turmoil in the markets, but I don’t want you to worry about it, either. Go enjoy the weekend. The poincianas are in bloom. The Heat seem to be marching their way to another NBA title. And - I swear I am not making this up - the big three U.S. car manufacturers are actually profitable.

Plus, we’ve got SEAL Team Six. And as Winston Churchill said:

"We sleep soundly in our beds because rough men stand ready in the night to visit violence on those who would do us harm."

Thanks as usual for humoring me.

- Cale

Get to Know Your Company

Why We Own Pacer International (PACR)

Famed money manager Peter Lynch used to have a tell-tale indicator of how frugal a company’s management team was:

“All else being equal, invest in the company with the fewest color photographs in the annual report.”

This being 2011, I think I’d add the corollary:

“Invest in the company with the most hideous Powerpoint slides.”

Bonus points for clip art, dissolves, spins, and that “whoosh” sound effect. Okay, maybe not the noise, but my point is this:

I want the businesses we own to be focused on operations and keeping costs low, not making pretty slideshows.

There are exceptions, to be sure, but I am nonetheless drawn to that homely corporate slideshow - the kind that looks like it was done late the night before by a drunk, jet-lagged, one-eyed engineer trying to get even with the CFO.

Which brings us to the slides of Pacer International. And I believe I’ll just leave it at that.

No, I'm kidding. Pacer’s latest slideshow actually looks great if you’re not a Powerpoint snob - appropriately frugal and unabashedly direct.

And you really shouldn’t look to me to be an arbiter of design, anyway. I painted my office walls purple.

Why Is This a Great Business?

The reality is that management at Pacer has been impressively focused, and on the right things. Consider the Pacer shares we own another special situation investment - this time in the “turnaround” category.

Pacer calls itself a leading “non-asset-based provider” of logistics services over one of the largest integrated intermodal networks in North America.

In the human tongue, that means companies that need their goods shipped over vast distances hire Pacer to handle it all for them. Pacer matches up companies with high volumes of goods to ship - like customers Costco and Proctor & Gamble - with large transportation companies like railroads, cargo ships and trucking companies. Both sides can ultimately earn much higher profits if they coordinate and combine delivery schedules, routes, and warehouses, but the huge number of variables involved in doing that well demands a highly specialized logistics quarterback. Thus, the rise of firms like Pacer.

I should also distinguish between the expedited delivery services you’re probably most familiar with and Pacer’s business. FedEx works great if you need to overnight a forgotten passport to Uncle Louie. But it’s not quite as simple if you need to ship a thousand Toyota Camry drivetrains from Tegucigalpa to Newfoundland. As cheaply as possible. To arrive next Thursday. And after swinging through Topeka for ball bearings. So, Pacer handles a much larger range of potential variables at a completely different scale of service.

Most of Pacer’s revenues come from moving freight over two or more different kinds of transportation (“intermodal”) - usually rail and truck. But the company also provides international freight forwarding services and acts as a broker for regional trucking services, too. The common thread among all of Pacer’s services is that every load it ships represents a custom solution. And to deliver all those customized services, the company taps a network of over 5,000 independent trucking companies, relies on contracts with numerous railroads and ocean shippers, and maintains a fleet of doublestack railcars, containers, and trucking chassis, too. It doesn’t own them, though. It leases them.

Being “non-asset-based” means Pacer has purposely avoided investing a ton of capital in equipment and facilities. It operates mainly by making attractive long-term deals with rail, ship, warehouse and truck owners and specialized equipment providers, too. So the company is in the enviable position of having full access to a wide range of freight terminals and facilities, while also having complete control over large fleets of specialized equipment - without actually owning any of it. And that’s a key part of why this business can be such an attractive one to own.

In most businesses, the economics of being a middleman are poor. It’s almost a business school cliche that all middlemen eventually get squeezed. Pacer and a few other third-party logistics or “3PL” firms are different, however. In fact, the economics of 3PL companies can be among the most impressive you’ll see. Strong top-line growth over decades, high profitability and 35%-plus returns on invested capital are not uncommon thanks to the network effects inherent in this business.

The more ways Pacer can ship goods between various locations, the more attractive its services become to those businesses needing to ship large volumes over vast areas. Likewise, as the number of companies Pacer provides shipping services to increases, the more truckers and railroads join Pacer’s network, in hopes of getting some of that business. Companies in this industry must also have the capacity to handle all aspects of shipping goods long-distance well before they can ever convince a new customer to try them, and that means years of considerable toil and expense before ever seeing the first dime. So the benefits of scale also provide firms like Pacer some insulation from new entrants to the industry.

The bottom line is that if Pacer gets it right, its business can have powerful competitive advantages. And yes, that’s an “if.” While a strong moat is achievable, Pacer right now has little to point to in the way of a sustainable competitive advantage. But I believe that is about to change.

Why is it Cheap?

The challenge for a value investor in finding an attractive 3PL company is that they’re rarely cheap enough to get excited about. Luckily for us, Pacer fits that bill. I bought our shares at about $4.75 each, in the middle of the market drop caused by the Japanese earthquake last month. Shares have since risen to $5.64, but I believe Pacer is worth closer to $8 a share. So the value is there, but why?

Shares are cheap because Pacer is a turnaround story. About the only positive thing you can say about the company during the recent economic downturn was that it survived. A new management team took over when things looked most bleak, however, and after first addressing several crises, including a liquidity crunch, the new team set out to do three things:

1 - Reduce overhead. Costs were way out of whack compared to competitors.

2 - Invest in a top-shelf IT system. This is absolutely critical to quarterbacking those deliveries.

3 - Build out its “retail intermodal” business by shipping right to the customer’s loading dock door.

To date, Pacer has largely accomplished those first two goals, cutting overhead by 17% last year alone, and integrating four old IT systems that management believes will save the company $20 million a year. And that third goal?

Is it Cheap for Temporary Reasons?

Pacer is significantly undervalued because the market is waiting for proof the company can grow that retail intermodal business. And, candidly, the company is still in the process of earning back the trust it lost a few years ago under the prior management team. So some skepticism is understandable. But to quote Peter Lynch again, “You can’t see the future through a rear view mirror.”

Prior to the downturn, PACR historically emphasized the “wholesale” side of its business, or serving a customer base consisting largely of other shipping intermediaries, and that meant often shipping goods only as far as another rail hub or warehouse. Current management, however, is strongly focused on growing the “retail” business. That means Pacer will provide door-to-door delivery service directly to various manufacturers, consumer product companies and major retailers. That retail service represents the best economics, the highest potential growth and the most feasible way to recover revenue Pacer lost during the downturn.

Why am I optimistic Pacer can pull it off? First, to be clear, Pacer is not completely out of the woods yet. Most turnarounds fail to really turn, and though high debt levels are no longer a threat for the company, Pacer could still face notable risks if either (1) it is unable to pass future price increases on to its customers or (2) demand for its services drops significantly for any reason.

So, real risks exist here. If they did not, shares wouldn’t be so cheap. I just believe those risks are low-probability, and that we will be well-compensated for assuming them at current prices. I also believe those risks will ultimately be outweighed by a number of fundamental positives, including:

1 - The caliber and prior experience of the company’s management team.

2 - Early success in growing its retail intermodal service in the first quarter of this year - and otherwise surprising the Street with positive results. Initial efforts are tracking well.

3 - Management anticipates being able to raise prices 3% to 5% this year. So risk #1 above seems likely to be a non-factor.

4 - Growth in industrial production and consumer demand will drive increased use of Pacer’s services. This would minimize risk #2.

5 - High diesel prices incentivize customers to ship via rail, as rail consumes only 25% of the fuel used in trucking. Rail costs are significantly cheaper than trucking over long distances.

6 - Should demand falter, asset-light businesses have more durable margins.

7 - Globalization and an increase in the outsourcing of all corporate shipping will be a considerable top-line tailwind for years.

8 - The industry is seeing a secular shift from trucking to intermodal services within the shipping sector. So new business will also come from customers who used to rely on trucks but want to move to rail.

9 - Intermodal volume across the industry has been extremely strong. The intermodal market was actually operating at 100% capacity in 2010, and, even better, most of the costs of expanding that capacity are shouldered by the railroads, not our guys.

10 - There is a high probability that one of Pacer’s large long-term railroad contracts will be renewed at higher rates in 2014.

11 - Pacer already has a significant container fleet, which will be critical to capturing emerging demand.

12 - Trucking is a tough business. Annual driver turnover exceeds 100% a year, and the industry is chronically short of drivers. The solution - raising prices and paying drivers more - makes intramodal services like Pacer’s even more attractive to customers.

13 - Plenty of room for growth exists, as intermodal services still represent less than 10% of dry long haul freight.

14 - Most large customers want to work with multiple intramodal firms. Exclusive arrangements are rare, which is good for a company attempting to build a moat based on network effects.

15 - The company’s primary competitor doubled its operating margin after making operational and strategic changes similar to those Pacer is pursuing now. This should serve as both proof and inspiration for Pacer.

16 - The company’s operating efficiency, and by extension its profitability, is improving steadily.

“Equipment turns” is a key metric when it comes to gauging the success of Pacer’s operational improvements. Those turns tell us how many times per month that a single container carries cargo (and therefore creates revenue). Using the same container twice in a month would be reflected in equipment turns equal to 2, a respectable benchmark in the industry. Pacer’s equipment turns have gone from 1.5 two years ago to 1.70 in the first quarter of this year - an increase all the more pleasing to see given some tough weather this past winter. I expect those turns to improve further over time. And should Pacer ever achieve the same 2.4 turns per month as its primary competitor, look out.

Last but not least:

17 - Warren Buffett bought a railroad company last year.

So there’s gotta be something appealing about all this rail shipping business, no?

In summary, Pacer is a formerly troubled but potentially advantaged company in mid-turnaround with a solid new management team that has been executing well to date. If operations continue to improve, the economics of the business and the dynamics of the industry will give Pacer the opportunity to earn an attractive moat around its business. Uncertainty still exists, but the actual risks to the company’s operations and finances appear to have decreased dramatically lately. Pacer has multiple levers to increase its earnings power, early signs of success are emerging, and both the top and bottom lines should should benefit markedly from multiple favorable secular trends. And as with our other companies, in Pacer we have an attractive stream of future earnings, a large margin of safety and a high probability of large gains.

All of which is another way to say: I am of the strong opinion that Pacer’s future will be considerably brighter than the market now seems to believe. It will take some time to realize, of course, but in the interim, all that’s left to do is wait and see which opinion will ultimately prove to be more accurate.

Please let me know if you have any questions.

And if you're reading this in South Florida, don't forget to mark your calendars for the first annual Islamorada Fishing Film Festival on Sunday night, May 22nd. Here is more info. Hope to see you there!

About The Tarpon Folio

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 FundŽ

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 investing principles. 

Fees are 1.25% 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 $9.0 million

For more information, visit our website.  

Here is our privacy policy, our Form ADV and our Fiduciary Oath.


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 not guaranteed.

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 services.

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