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In This Issue
bullet Cale's Notes: A new home for IIM.
bullet Portfolio Summary: Still doing well.
bullet Value Investing 101:  Direct from Warren.
bullet Get To Know Your Company: An opportunity in plain sight.
bullet Ask the Geek: Protection on the downside.
bullet About the Tarpon Folio: More about our Spoke Fund®.

Letter to Investors
For July 2009

Contact us: [email protected] (305) 522-1333             

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Cale's Notes

Cale Smith

Dear Investors,

It has been a busy few months since I last wrote. I'm pleased to inform you that IIM has a new global headquarters - the "Dynamite building." For you locals, it's bayside at mile marker 92 behind the Ace Hardware in Tavernier. It's part of the second-oldest building in town, having survived more hurricanes, healthcare debates and lobster mini-seasons than anyone keeps records for. It also oozes character.

The building was originally built to store pallets of dynamite used for construction and canals in the Keys - and, presumably, to celebrate the 4th of July back when men were men. It's secure, quiet and gritty, kind of like our funds, I'd like to think. It's also got a loading dock for - as one of you put it - shoveling all the money we've made out of there lately. If that comment doesn't jinx us, nothing will.

I'm still in the process of fixing up a few things, but I hope to officially open the doors soon so you can stop by Dynamite for a visit. And a special thanks to Tom Chasteen.

If you would like an IIM T-shirt, and haven't already requested one, please email me with your preferred size.  To see what the shirt looks like, here's a video from a rather interesting gentleman wearing one.  Send in your own pics or vids in your IIM shirt and I'll do my best to make you internet-famous.

One last administrative issue - by now you all should have received your quarterly performance statements and summary of fees. Any questions, please email. Any complaints, please call. Any urges to strip naked and sprint joyously into the ocean...please wait until the investor meeting in January.

Heady days for us lately, but the economy still appears to face some serious headwinds. Foreclosures and unemployment will likely continue unabated for some time. And while I'm concerned about the commercial real estate market, any significant healthcare legislation will have a much bigger longer-term impact on the economy.

So if The Terminator knocked on my door tonight, I'd immediately ask two questions:

1 - Didn't you hear that Sarah Connor moved?
2 - What happens to the health insurance companies in 2009?

More on our sole healthcare company Alcon in the below, plus some words of wisdom from the Oracle of Omaha. 

But first, about that performance...

- Cale Smith, Portfolio Manager
Portfolio Summary

Tarpon Folio - up 73.5% since inceptionNo offense, little red stub. 

The Green Bar Gets Bigger.

I last wrote about our performance through the end of May. The Tarpon Folio  increased by 1.6% during June and notched another 7.8% increase in July. Since inception last November, the Tarpon Folio is up 73.5% through the end of July, and is outperforming the S&P 500 over the same period by 50.9%.

I made no changes to our portfolio in June or July. Two of our fifteen companies were approaching my estimate of their intrinsic values at the end of July, however, and should their shares continue to increase at a rapid rate, I may have to roll out of the hammock, put down the margarita, and make some changes. 

I don't intend to do that lightly, however. Our portfolio as a whole is still significantly undervalued over the long-term despite its recent rise. Should I make any changes, they would be bittersweet. We own some terrific companies whose strengths are still under-appreciated, and though I'd be sorry to see any of them go, you don't pay me to be a sentimentalist, either.  

I confess I find myself in a somewhat odd position as I write this month's letter. I am typically a skeptical contrarian when it comes to the market. Lately, however, that has meant I've found myself more positive than the consensus, which on Wall Street seems to be that the market is in the mother of all bear market rallies. I can't swing a dead cat these days without finding some commentator I've never heard of explain why the market's next leg will be down.  

But I can't find anything that dims my enthusiam for our companies' long-term prospects. If the prices of our companies do decline significantly in the months ahead, I will create some cash and buy more of them. More specifically, here is why I find myself optimistic about our companies even after the recent market rise:

1 -  Valuations are still attractive;
2 -  Earnings have yet to recover from recessionary levels;
3 -  Competitive advantages are increasing in a difficult environment; and/or
4 -  Historical abilities to earn high returns on invested capital.

Our companies continue to perform relatively well in spite of the macroeconomic headwinds. They're showing earnings that exceed most of Wall Street's short-term expectations, despite a lack of growth in sales. So, I believe we still have a significant amount of upside left in our portfolio as it is currently invested. And should I feel the need to make any changes, there are still some appealing values to be found.

To be clear, I have no idea what will happen in the stock market the next three months. But - and I hope this doesn't sound too flippant - I don't particularly care, either. Not because it's unimportant, mind you, but because it's so difficult to predict. The beauty of value investing is that you don't have to try. Our companies should be able to increase their earnings over time in spite of whatever macroeconomic challenges may impact their revenues because of the economics of each business. To date, they're succeeding.

And in case it is not yet obvious, a value investing strategy is exactly where you want to be during and following a recession. But don't take my word for it. One of your CEOs, Rich Pzena, made the same case more eloquently in his own letter here.

So in many respects we've repeatedly been in the right place at the right time the last few months. We've benefitted from a broad rise in the market that appears more driven by the collective relief of avoiding a depression than any meaningful fundamental economic improvements. You will likely continue to hear well-reasoned arguments from both bulls and bears alike about why the market will either rise or fall further over the next few months. My advice is to ignore them both. 

There are at least three certainties to be aware of when investing. The first is that the media exists to sell ads, which on Wall Street leads to an inherent bias towards columns, shows, guests and/or topics with strong opinions. Those opinions may have nothing to with reason, logic or accuracy. The second truth in investing is that the general consensus is usually wrong. The third is that at some point in the future, share prices will be driven by earnings, not emotion or macroeconomic predictions.

In the case of our companies, that, too, should be a very good thing.

Value Investing 101

Circle of Competence

Warren Buffett, the world's most successful investor has often stated his belief in the importance of staying within a circle of competence when investing. At its core, that means focusing on companies in the market where you can know significantly more than the average investor.

Everyone's circle of competence varies. In the case of the Tarpon Folio, my desire to stick with what I know means we'll be biased towards companies in media, telecom, investment management, certain technologies, retail and a few industrials. We'll likely stay away from investment banks, alternative energy companies and healthcare businesses. That's not to say I don't spend a decent amount of time learning about new companies in an attempt to expand my circle...just that it takes a lot of time.

What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”. You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital. 

— Warren Buffett

I also believe there are certain economic truths that apply to all companies, regardless of industry. The importance of being the low-cost leader in any commodity industry, for instance, is evident in our holdings in both Contango and Cogent. The network effects present in a technology company like Google can be present in an air cargo business, too, making a company like Forward Air much more appealing than you might first think.

This month I wanted you to hear directly from Warren on the importance of staying within that circle of competence and investing in businesses you can understand. Few can say it better. 

So here's a clip from a speech Buffett gave to MBA students at the University of Florida in 1998.  The circle of competence discussion starts at the 1:55 mark.  

And here's a link to the rest of the clips from the speech, too.

Get to Know Your Company
An Opportunity in Plain Sight

Before I get in to why we own eye care company Alcon (NYSE: ACL), I'd like to make an admission: most healthcare businesses are outside my circle of competence.

The business of healthcare baffles me. The industry's well-known inefficiencies offend my sensibilities as a businessman. That caregivers - doctors and nurses - ever came to be viewed as "part of the problem" probably speaks more to the industry's dysfunction to me than any other factor. And the irony that one of the most successful pharmaceutical drugs in recent history, Viagra, was discovered by Pfizer by accident - researchers were trying to treat hypertension - makes me question the long-term predictability of all pharmaceutical companies' earnings.  

The health insurers' business model clearly faces significant regulatory risk - if not now, then certainly at some other point over the next decade. Most biotechnology companies appear to be little more than off-balance sheet R&D departments for the big pharmaceutical companies. While generic drug makers, diagnostic testing businesses and medical device companies can have appealing economics, their revenues, too, face a cloudy future these days.

In short, many healthcare companies have moats created by federal regulation, and a tremendous number of those regulatory-based moats appear under threat. While I have no doubt that there are good healthcare businesses whose shares are currently oversold, I lack the expertise needed to confidently invest our money in those companies. So we probably won't own too many healthcare companies in our portfolio.

All of which, however, begs an obvious question:

"Why, then, Mr. Smartypants, do we already own shares of a healthcare company!?!?!"

I thought you'd never ask.

Welcome to Alcon - and the world of special situation investing.

Why Is This a Great Business?

By all measures Alcon is a wonderful business. It's the world's largest eye care company, with sales in 2008 of $6.3 billion and profits of $2 billion. It has the broadest portfolio of eye care products in three key categories: surgical, pharmaceutical and consumer eye care. If you've ever had contact lenses and reached for the Opti-Free, you're already familiar with one of Alcon's products. Based in Switzerland but originally founded in Texas back in 1945, the company now does business in 180 countries.

Alcon has a leadership position in the cataract market, helping to prevent blindness and restore sight among those patients that make up the 25 million people affected by cataracts each year. The firm's Infiniti system, used to remove the eye lens during surgery, represents a big upfront investment and requires loads of training, making hospitals and surgeons reluctant to switch. Similar advantages exist in Alcon's intraocular lens business, and its large opthalmic drug portfolio targets only a handful of diseases, so the same salespeople can sell each drug. That saves the company a bundle. 

Since going public in 2002, Alcon has averaged returns on invested capital of greater than 40% a year. So it clearly benefits from the high switching costs of its products as well as the efficiencies of cross-selling. While its revenues are susceptible to cuts in government health-care spending, that should be at least partially mitigated due to a dramatic expected increase in eye-related diseases as baby boomers age and new emerging markets get better access to health care.

Here's the thing about Alcon, though: none of the above really matters to us the next few years. The buiness described above really just provides us with a margin of safety in the event I'm wrong about certain future events that will enable us to profit further from owning Alcon shares.  But I like our odds very much.

What Makes This Situation Special?

I probably couldn't tell a ophthalmic viscosurgical device from a toric intraocular lens if either one fell into my conch chowder. So why would I so brashly ignore that earlier "stay in your circle" advice we got from the world's greatest investor?  Because Alcon is an example of what is called "special situation investing" - and, yes, Buffett used to be quite active in these opportunities, too, some time ago.  

Special situation investing involves taking a position in a company based primarily on certain advantageous circumstances, as opposed to relying exclusively on fundamental research. You probably didn't realize it, but the Tarpon Folio contains several special situation investments, including - please excuse the jargon - a spin-off, a broken IPO, and a disguised recapitalization. Alcon came public as a "carve-out", another kind of special situation, but now it is of interest as a likely merger arbitrage case. I'll explain each term more in future letters. For now, here is what makes the Alcon opportunity so compelling.

Public shareholders like you and I hold about 23% of Alcon's shares. Currently, 52% of Alcon is owned by Nestle. In April of last year, the company Novartis bought a 25% stake in Alcon from Nestle in exchange for $11 billion and an option to buy out all the rest of Nestle's Alcon shares beginning in 2010.

Then, last fall, the credit crisis happened and Alcon's shares plummeted even further after missing an earnings forecast. This represented a tremendous opportunity for anyone who had been paying attention while, say, pounding caffeine as he studied various companies to include in a new fund to be named after a fish.

Despite being a great business, I was most excited about Alcon last fall - and still am today - because of the terms of Nestle's deal with Novartis. In short, starting on January 1, 2010 and for a period of 19 months, the rest of Alcon shares are likely to be sold to Novartis in one of two ways:

1 - Novartis may either exercise a call option to buy Nestle's remaining stake in Alcon for $181 a share; or

2 - Nestle may exercise a put option to sell its Alcon shares to Novartis at the lower of $181 a share or a premium of 20.5% over the market price.

In either case, large amounts of Alcon shares are likely to change hands at prices that will either be $181 a share, or if lower, still 20.5% above whatever price the shares trade at the week before Nestle may decide to "put" its shares to Novartis.  Here's the SEC filing that announces the transaction.

This brings up two questions:

1 - If two savvy billion-dollar institutions with decades of experience in this industry mutually agree that the true value of Alcon shares is really $181 each - might that not be a reasonable assessment of the intrinsic value of those shares?

2 - If you owned 77% of something but couldn't guarantee you'd completely maximize the benefit you derived from it, wouldn't you just buy the rest of it, too?

I think the answer to both questions is a big ol' "yes." As a result, I believe the odds are high that investors in Alcon shares at prices similar to today's (around $130 a share) will make at a minimum a 20% return on their investment over the next few years - and likely sooner rather than later.

What Are The Odds Of Success?

I believe we have a 75% probability of seeing at least a 20% return on our Alcon shares within the next two years due to this transaction. Importantly, that return would be regardless of whatever the broader stock market does. 

If Alcon shares rise from their current $130 level to $181, we'll make more than that 20% without a transaction. If the transaction falls through, we still own shares in a great company that appears significantly undervalued. And should changes in U.S. healthcare policy spark consolidation in the industry, it seems likely that Alcon might make an attractive candidate for another eventual suitor.

Both Nestle and Novartis have recently expressed their intent to honor the terms of the existing agreement. Ironically, the higher Alcon's share price climbs in the interim, the higher the probability the transaction will be completed. That's because the only potential sticking point in the deal would appear to be the price. With Novartis paying $143 per share for its Alcon stake last April, the closer shares trade to that level, the less grounds Novartis should have to renegotiate in any case. 

The acquisition of Alcon also looks to be a strategic necessity for Novartis, which presumably wants to reduce its reliance on its biggest-selling drugs, the hypertension treatment Diovan and the cancer drug Gleevec, since they will be losing patent protection in the next few years. 

In addition, Nestle clearly holds the position of strength in this deal, as the returns it is earning on its stake in Alcon are significantly higher than the low interest it would earn on the cash it received from selling Alcon. Nestle appears in no rush to unload its shares, while Novartis is constrained a bit in its own operations by this agreement because it must retain enough cash on hand to buy Nestle's Alcon stake on little notice after January 1st, when Nestle could exercise its put option and force the sale. That's why I think the sale will happen earlier in the year - it's handcuffing Novartis a bit.

I believe that high probability above may become a near certainty, as Novartis will likely be inclined to simply buy out the remaining public shareholders as part of the Nestle transaction. Why? I'll spare you a discussion of consolidated accounting methods, but think of it like this:

The economic value of Alcon to Novartis is not the profit that shows up in its (sort of) combined results. The real value of Alcon to Novartis is in being able to redeploy those profits internally any way Novartis sees fit. And as long as Novartis has us pesky public shareholders hanging around, we might represent a risk of gumming up the plans for those profits. 

So, Novartis will probably eventually offer to buy us out, too. And I think we already have a pretty defensible opinion about what our shares should be worth to them, no? 

What Happens Next?

Simply put, we wait and see. As long as Alcon shares trade below $181 per share (they're near $130 today) we have little incentive to do anything else. In the meantime, we'll collect dividends of just under 3% from an undervalued company with world class products, strong competitive advantages and superior economics.

Now you know why these situations are considered special.

Ask The Geek

Q.  Do you feel the portfolio is protected against the next big drop?

A. I'm comfortable with the companies we own no matter what happens in the economy or the stock market. I try not to pay too much attention to either - again, not because it's unimportant, but because both are so difficult to accurately forecast.

While a big drop in the stock market would likely impact the prices of our companies' shares in the short-run, too, I don't necessarily view that as a negative. Should it happen, all things being equal, I'd likely free up some cash to buy more of the same great companies at even lower prices.

It's important to differentiate between what happens in the stock market versus competitive threats our companies could face. I try not to pay much attention to the former, but I do obsess about the latter. It's important to me to own enduring businesses, as opposed to viewing stocks as pieces of paper, and if I'm right in my valuations of them, we'll all be rewarded accordingly. 

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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