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In This Issue
bullet Cale's Notes: In the mangroves.
bullet Portfolio Summary: Going shopping.
bullet Get To Know Your Company: Everywhere, yet undiscovered.
bullet Ask the Geek: Our advertised returns.
bullet About the Tarpon Folio: More about our Spoke Fund®.

Letter to Investors
For August 2009

Contact us: (305) 522-1333             

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Cale's Notes

Cale Smith

Dear Investors,

I'll apologize in advance for the brevity of this month's letter. As described more below, I've sold the shares of two of our holdings since I last wrote. Both produced terrific gains for us, and as a result, selling them created a relatively large amount of cash for us to reinvest elsewhere. So, I am deep in the mangroves looking at other companies for us to invest in.

The process of finding new companies to invest in can take some time, particularly after a market rise like the one we've seen the last six months. There are fewer beautiful cheap businesses lying around.  Still, there are enough.  Several great businesses that I've had on eye on for a while have been declining in price over the last few weeks in spite of the market's continued rise, and I'm hopeful that trend continues. In the meantime, I'm spending time on some newer names, too, in telecom, reinsurance, banking, software, commercial real estate and education.  
A word of caution, though - if you're dabbling in the market on your own, please beware. I'm seeing a significant number of companies trading at much higher levels than they seem to deserve. Tread carefully, and please give a shout if you want a second opinion.

I will keep you posted as usual on any changes to our portfolio. 

- Your Portfolio Manager, Cale Smith
Portfolio Summary

Tarpon Folio - up 79.8% since inceptionOut of the hammock. 

Seeking More Big Fish in Skinny Water 

The Tarpon Folio increased by 3.6% during August compared to an increase of 3.4% in the S&P 500. Since inception last November, the Tarpon Folio is up 79.8% through the end of August, and is outperforming the S&P 500 over the same period by 53.1%.

Since I last wrote, I have sold all of our holdings in both Pzena Investment Management and International Game Technology. Both continued to rise strongly, with the former nearly tripling since our original purchase, and the latter more than doubling. While I continue to have great respect for CEO Rich Pzena, his company's shares had simply increased too far enough beyond what I believed them to be worth.  

IGT shares, too, rose uncomfortably beyond what I believe the company is worth today, particularly in light of continued deteriorating fundamentals. Increased operating costs and lower sales continue to crimp the company's profitability - a not unexpected trend, mind you - but when combined with the vigorous climb in share price of the past few months, I decided we'd be better off letting someone else assume the risk of any further hiccups at IGT.

I also rebalanced the weightings of many individual holdings in Tarpon during August. In general, I reallocated more money to our most undervalued securities - Paychex and Contango, specifically - and trimmed back on those companies trading nearer to their intrinsic values.

As I write, we're currently sitting on slightly more than 20% cash in Tarpon. If this current rally continues, that percentage could grow as other companies reach my fair value estimates. But not to worry. I'll be putting that cash back to work soon enough.

Get to Know Your Company
Everywhere, Yet Undiscovered 

If you’ve ever drank a glass of orange juice, eaten at a fast food restaurant, opened a can of soup, received a package from FedEx or walked onboard an airplane, you already know John Bean Technologies. Perhaps you just didn’t notice.

John Bean Technologies, or JBT, was named after an entrepreneurial orchard owner. In the 1880’s, Mr. Bean invented a high pressure spray pump for his trees, the first in a century-long string of innovations, product launches, management changes, corporate mergers and divestitures that ultimately resulted in a spin-off that left this wonderful little business trading at a surprisingly low valuation. Despite increasing more than 150% since originally buying it last November, I believe it’s still undervalued. Here’s more about our company JBT.

Why Is This a Great Business?

JBT is actually two separate businesses. The first provides food processing “solutions” (i.e. equipment and technology) including specialized freezers, protein processing machines and fruit processors, to the big conglomerates of the food processing industry. The company estimates that its equipment collectively processes 75% of the world’s production of citrus juices, freezes 50% of the world’s commercially frozen foods and sterilizes 50% of all canned foods.

JBT’s other business sells equipment and technology to the air transportation industry. It provides ground support equipment used in cargo loading, aircraft deicing, and aircraft towing; gate equipment for passenger boarding; airport facility maintenance services and automated vehicles. This business’ customers include airport authorities, passenger airlines, and air freight and ground handling companies, among others.

Why two such different businesses? While you probably wouldn’t start a company from scratch trying to compete in these two disparate lines of business, they were put together under one roof by a previous parent company that spun out JBT as a way to focus and streamline its own operations. In other words, JBT was just born that way.

But there is more in common between the two businesses than you might otherwise think. JBT has the number one or number two market-share position in every major product line across both businesses. It has 40,000 pieces of food processing technology currently installed around the world, and 30,000 pieces of airport equipment all over the world. That large installed base of equipment means JBT earns significant recurring revenue streams from both businesses, too.

More notable, however, is that JBT does not need high levels of capital to grow or sustain either of its businesses. Both produce innovative, high-quality product lines that are in the aggregate relatively inexpensive to manufacture. The company’s returns on invested capital of 18% in ’06, 20% in ’07 and 24% in ’08 underscore that the moat around JBT’s business. The company’s installed base of products provides the company with strong, long-term customer relationships which JBT uses to help develop new products. The ability to stay close to the customer and turn insights into new products while improving existing ones can be highly profitable.

JBT invests about 2% of its sales into research and development, and spends less than 1.5% of sales on warranty costs. On a standalone basis those figures aren’t particularly remarkable, but together with the company’s impressive ROIC they underscore a conclusion that management probably wouldn’t say outright but which I believe to be true nonetheless. Specifically, JBT’s new products - while in demand and of high quality - aren’t too hard to develop or manufacture.

It might be counterintuitive, but that “not too hard to make” bit is actually a good thing. JBT has an intellectual property portfolio of more than 550 patents with another 350 patents pending. So despite the relative ease with which JBT can manufacture its highly valued products, competitors still can’t copy them. And while patents don’t create moats, they can help reinforce a moat that already exists.

To be clear, I don’t mean to imply that it’s easy to create a new high-speed, double-barreled, frozen chicken nugget wrapping machine. I can barely imagine the engineering hours that went into the Elmo doll in my house that stands up all by itself. I’m simply saying that building profitable new products doesn’t consume a lot of JBT’s capital.  

Why Is it Cheap?

JBT was cheap when originally purchased in Tarpon last November because of forced selling related to the spin-off of the business, a temporary drop in new orders due to concern about the health of the airline industry, and then the massive broader market sell off at the end of ‘08. The more relevant question now, however, is, “Why is it still cheap today?”

That’s not as easy to answer. I have found only one plausible reason JBT isn’t more highly valued. Essentially, it’s still unknown.

The company’s debt is manageable and being paid down, the risk of integrating two seemingly intelligent acquisitions seems minimal, and the company’s exposure to the cyclicality of the airline industry has proven less of a risk than I think was earlier perceived. There is some currency risk to the company’s results given its overseas operations, but I assign little weight to that as I don’t foresee the dollar growing dramatically stronger anytime soon.

Another factor that may explain the company’s continued low valuation has to do with the difference between the company’s profits as reported under accounting rules and the profits as a true long-term business owner would view them. Many valuations on Wall Street rely on a company’s earnings as reported under GAAP, or generally accepted accounting principles. On a GAAP basis, JBT might look like a reasonably valued company. For instance, by applying the average market multiple (or P/E) ratio of 15 to the $1.05 in diluted earnings per share - the mid-point of the company’s expected ’09 profit range – you might come to the conclusion that the company’s current share price of $17 is at or even more than its intrinsic value.

It’s no surprise to many of you, however, that I tend to follow the advice of Warren Buffett, not Wall Street. As such I use his concept of “owner’s earnings” instead of GAAP earnings to better identify the core earnings power of a company. In the case of JBT, GAAP accounting rules dramatically understate the prodigious amounts of cash the business is producing. Owner’s earnings highlight just how much value the company is creating. More on my take in the What’s it Worth section below.

JBT seems to simply be one of those microcap value stocks that sometimes struggles for the attention and respect it deserves. Despite recording more than $1 billion in revenue last year, and increasing dramatically in share price the last nine months, JBT is still small by Wall Street’s standards, meaning many institutions won’t bother with it. There’s nothing particularly sexy about food processing and air transportation, either, which probably hurts in the popularity contest that Wall Street can be. But as I said when we bought Paychex, boring can be beautiful.

What's It Worth?

I think it’s reasonable to assume that JBT can grow at 12% per year for a five-year period once the company’s businesses have completely emerged from the global recession. That may take a few more quarters to occur, mind you, but in the meantime, we’ll at least earn a nominal 1.6% dividend on the recent share price. 

Over the last year, JBT has generated about $56 million in owner’s earnings, and using a discounted cash flow model based on that number as opposed to GAAP earnings, I believe shares of JBT are worth $24 each. They currently trade at $17. So, despite their rapid rise since being initially purchased in Tarpon, shares would increase another 40% over today’s prices if my estimates of the company’s intrinsic value are accurate. 

That means we both have things to do, investors. I will continue to monitor JBT’s progress and wait for it to reach fair value. You, however, should immediately defrost some string beans, grab some chicken nuggets, wash ‘em down with a fruit smoothie and then board that airplane for a flight to the Keys. It’s for the good of your portfolio, after all.

Ask The Geek

Q.  Do the returns I see in your Tarpon Folio ads exactly mirror the performance of all your investors' accounts?

A. Great question I've gotten lately from potential investors and other portfolio managers considering launching spoke funds of their own. 

The answer is "no."  Here's why, in several parts.  

First, for investors: rarely will your own returns match the advertised historical returns of any fund you may see. Ours are no different. (Thus, the disclaimers.) Many variables explain the difference, some of which are specific to spoke funds. More on those below if you're interested.

With regards to future performance, please understand that we will likely never see another period where the portfolio increases as much over a nine month period as it has since launching Tarpon. My goal when I launched Tarpon was for everyone to earn 15% a year. Then, in five years, we'd double our money. That remains my goal today. We have taken advantage of some truly exceptional circumstances lately, but it will likely be years before we ever see so many compelling values spread so widely across the market again. 

So, to be clear, our returns over the next few years will not look like those of the previous few months. That won't be for a lack of effort on my part, mind you. I still expect to outperform as much as is safely possible over the long term. But those are just the odds. Quality companies are simply no longer as dirt cheap as they had been, and the price we pay for them determines our ultimate returns.

The next part of this answer gets a little wonky. While it's probably geared more for other spoke fund managers, I'll include it here, too, for any investors who care to read more. 

The question brings up a couple of other important points regarding differences between investors' returns and those you see in our ads. The first, again, is that performance figures are historical snapshots, not future guarantees, as most investors realize thanks to the disclaimers in the ad and/or common sense. In the case of Tarpon, those advertised returns are also the actual, post-commissions-and-fees, pre-tax returns for a $12,000 portfolio of my own money outside of my family's other investments in Tarpon, set up specifically to report performance. Our performance is presented using a simple holding period return for now, as I believe it's the most objective during this first year. (I'll talk more about geometric averages down the road). Currently, at the end of every month, I record the value of that tracking account, divide it by the $12,000 minimum required investment we started with in the tracking account, subtract 1 and, walla, that's our return since inception as a percentage.

FOLIOfn computes performance differently, however, as you may have noticed when checking your account. FOLIOfn relies on the same method of calculating returns that mutual funds do - the "modified Dietz" formula. Tarpon's returns calculated using modified Dietz have been at times considerably higher than the returns I publish, but that's okay by me because (1) conservative numbers are a good thing and (2) I'd rather our returns reflect the logic of my calculator than the accounting logic of massive portfolios.

The other reason your returns may differ from what is advertised in the local papers and our website is because of what's called "drift." Because investors come onboard at different times, each of you are buying shares of Tarpon companies at different prices. The number of shares of each individual company that you own in your account will differ from the number of shares of each company owned in the tracking account, too. That's because I buy stocks in your account according to a percentage-based portfolio weighting that I control for Tarpon through the FOLIOfn back end. So, any differences between your account's performance and the Tarpon tracking account are most easily explained by (a) when you invest and (b) the number of shares you are initially buying of each individual company, according to a portfolio weighting formula that I determine.

To date, the "drift" or difference in performance between each account in the spoke fund and the Tarpon tracking account has not been large enough to be a concern to me. Some drift is to be expected given the huge swings in the market over the last year, which further amplify the impact of the variables above. More to the point, though - I've rebalanced Tarpon's portfolio weightings twice since launching the fund nine months ago. Those rebalances have the effect of bringing that drift close to zero for all investors. I do not currently have nor do I plan to create a rigid rebalancing schedule, but I suspect once or twice a year will probably be a reasonable average looking ahead. 

Another key point about those numbers: on the day you invest with us, you buy shares in all companies as determined by the most recent portfolio weightings I have loaded into FOLIOfn - not the current weightings of the fund itself as measured by the Tarpon tracking account. That initial "sync" will create some future drift between your results and the tracking account from that day forward, but it is intentional.  I do it because (1) that drift will be negated during the next rebalance, and (2) even then that initial drift is still still in your best interest. Otherwise, on the day you invest, you'd effectively be buying shares in those companies that have already gone up the most in price. And that's just, well, dumb. I want you buying more shares of the most undervalued companies, all things being equal.

That last point hints at yet another reason why I believe the spoke fund model is superior to the mutual fund model; because I as the portfolio manager can invest your money in accordance with the portfolio weightings that I want you to have. Mutual fund managers cannot make that first day tweak. The day you invest in a mutual fund, you are effectively buying more of the shares that have already gone up the most. Add that in with the other strikes against the mutual fund model, and it becomes even harder for your money to outperform - even at the hands of the most talented mutual fund managers in the world.

In summary, then - no, your returns will not exactly match those presented in our marketing material, particularly in volatile markets. But they should be close enough. When investing in spoke funds, also realize that a small degree of occasional "drift" is the trade-off for incrementally better long-term returns.

So take all fund performance ads with a grain of salt. They should be viewed only as a historical measure of portfolio management skill. In fact, a statistician will tell you that track records are effectively useless at predicting future performance until a fund manager has at least a 25 year history. I would say that I'll be on the beach long before then except, well, I already am. 

If you have any questions, by all means please let me know.

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 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 investing principles. 

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.  

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.

© Islamorada Investment Management. All rights reserved.

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