Sign Up Here to Receive These Letters
Islamorada Investment Management - Contact us at:

In This Issue
bullet Cale's Notes: A Good Start to Year Three.
bullet Get To Know Your Company: OSHC: A Truly Special Situation.
bullet About the Tarpon Folio: More about our Spoke Fund®.

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

To change your subscription, see link at end of email.

Cale's Notes

Cale Smith

Dear Investors,

I'm pleased to report that the Tarpon Folio hit a new high on the last day of March, 2011. As measured from the beginning of Tarpon's third year through the end of March, Tarpon is up 27.0% and is outperforming the S&P 500 by 16.5 percentage points.

Since inception, Tarpon is up 144.3% and has outperformed the benchmark S&P 500 by 79.8 percentage points.

So, as I mentioned to those who attended the IIM annual meeting in February, it would appear that some of the changes I made to Tarpon last summer seem to be paying off. Thank you for hanging in there.

Fear returned to the market this quarter as a result of the tragedies in Japan, and I added several new companies to the portfolio during the ensuing market drop. As some of you noticed, Tarpon was actually in the unusual position of holding a relatively large cash position a week prior to the earthquake. That was due to process, though, not precognition.

Some of our companies were approaching their intrinsic values after a strong run, so I had both cash and some strong opinions about where to put it when the market temporarily dipped. That helped us notch a positive return in a flat month for the market, and I'd like to think it bodes well for the future, too.

That brings up a few fundamental investing lessons as well:

1. The first is that it pays to be prepared. Constantly scouring for new ideas and maintaining a good watch list are critical. You never know when the research you did a year ago might suddenly come in very handy.

2. Also important is having a disciplined selling process.

If there is one thing I like more than the key lime pie at Ma's Fish Camp, it's having a large pile of cash on hand when other investors start to panic. Now, many value investors enjoy that feeling so much that they keep high levels of cash in their portfolios all the time. As I've mentioned before, though, I am not one of them.

We happened to have cash on hand at an opportune time this quarter as a result of my normal portfolio management processes. Sometimes those routines may mean we'll underperform for a while - like during the summer and fall of 2010. Other times, though, those same processes may lead to better short-term outcomes. March was one of those times.

3. Lastly, I will take hurricanes over earthquakes every time.

So after a pretty quiet stretch of sitting on my hands, we now have a few new names in the portfolio. I'm happy to say we added all of them (with one intentional exception) at the nadirs of their 52-week lows. We also have a higher percentage of our portfolio in “special situations” now, which is worth a word or two.

Tarpon has seen some terrific returns in special situation investments in the past, including Alcon, Discovery Communications, and John Bean Technologies. By “special situation” I mean “a company that may not have a moat, but which still has a big margin of safety and a large chance of significant gains,” usually due to an unusual temporary inefficiency in the market. So special situations have served us well in the past, and I'm adding some similar investments to the portfolio now. That's for two main reasons.

The first is that we're in the middle of what may prove to be a once in a lifetime opportunity for one particular kind of special situation investment, which I'll talk about more below. The second reason is that appears that rumors of the death of commercial real estate in this country have been exaggerated. More on that in a future letter.

A few other quick notes:

- In February, we also held the second annual IIM investor meeting here in Islamorada. Thank you again to everyone who attended. Next year - flaming hula hoops!

- IIM is now managing more than $10.0 million. So, we're continuing to grow and we're halfway to my ultimate goal when I first opened the doors a few years ago.

I realize it will be nigh-impossible to find another group of investors anywhere near as intelligent and good-looking as the current group, but should you know of anyone looking for long-term investing help - and the occasional sycophantic email - please keep me in mind. And thank you as usual for your support.

On to one of our newest holdings.

- Cale

Get to Know Your Company

Why We Own Ocean Shore Holding Company (OSHC)

Ocean Shore Holding Company (OSHC) is the holding company for Ocean City Home Bank, a relatively new federal savings bank in Ocean City, New Jersey. The bank has ten branches, all in southeastern New Jersey, and just under a billion dollars in assets. It also pays a 2% dividend.

Ocean City Home Bank has been in business since 1887. To be clear, I'm calling it “relatively new” in reference to its status as a federal savings bank, in contrast to its previous corporate structure. More on that in a bit. But the bank is quite established, to say the least. Grover Cleveland was president when the mutual was first formed. And believe it or not, some of the bank's first customers were alive when the Cubs last won the World Series! Seriously - they actually won it once! Can you believe it?!?

And just in case you read the words “New Jersey” and immediately thought of dirty turnpikes or those reality show buffoons, I suppose I should pause here and point out that New Jersey is actually one of the wealthiest states in the country. OSHC serves customers in Atlantic and Cape May counties, which, as noted here on Wikipedia, are among some of the richest counties in the U.S. So it's gotta be true.

Having spent a little time in Ocean City, I can also assure you that it's the kind of town we want to own a small bank in. The bank's financials underscore that, too. Specifically:

Asset quality has been exceptional, even throughout the Great Recession. Bad loans have been extremely rare over the entire last decade. Turns out OSHC actually required borrowers to put down 20% on their loans. Who knew?

The vast majority of the loan book is in sound, local residential loans. OSHC owns no wacky derivatives. It took no TARP money. The bank's executives have been involved in zero scandals, nor have they been asked to give any congressional testimony. So the bank has no dilution risk - or any business risk, really.

What Ocean Shore does have is a clean, immediately understandable balance sheet, which is saying something these days. If there was a knock against the company, it would be that the bank has almost too much capital.

More to the point, though, this sleepy little bank on the shore of New Jersey did what thousands of bigger, flashier and more popular banks failed spectacularly to do the last few years: it grew - safely, soundly, and without any special favors. In fact, in 2010, OSHC recorded its best annual performance since first becoming partially public six years earlier. And they did it the right way - by focusing on growing deposits instead of issuing risky loans.

So why is it cheap?

Cuz it's a second-stage mutual holding company conversion!

Er, this is where the special situation investing comes in.

Why is it Cheap?

The Dodd-Frank financial reform bill passed last year shut down the Office of Thrift Supervision. For the past two decades, OTS had regulated savings and loan associations like Ocean Shore. OTS' regulatory powers were transferred over to the Office of the Comptroller of the Currency. The OCC is used to regulating larger banks. And that has caused a great deal of teeth-gnashing among certain small banks called “mutual holding companies,” or MHCs.

Yep. If reading about bank regulators doesn't kill ya, the acronyms will.

In any case, most mutual institutions are long-established groups that were originally set up by depositors who pooled their money together to earn some interest and make local loans. These thrifts resemble community banks, except they have no shareholders and are controlled by their Boards of Directors.

Should a Board ever decide to take a mutual public, ostensibly to grow, there are three ways to do it. For the purposes of this discussion, though, just know two things, (1) OSHC finished its conversion to a publicly traded company in December 2009, and (2) because of those regulatory changes above, the benefits of being a MHC are going away. That has prompted a rush of mutual institutions to convert to publicly traded companies.

And by “rush” I mean a “last-call-before-the-hurricane-hits” kind of blitz. Because that conversion window is closing, there are dozens of thrifts going public at valuations that are not only historically low, but just silly. It's that kind of temporary inefficiency in the market that is worth watching as an investor. Still, though, you've got to be careful what you buy. Some thrifts are coming public at cheap valuations for good reason.

OSHC, sensing the writing on the wall, became a traditional public company in late 2009. For some time, then, it has been apparent that this was an exceptionally run, conservative bank in an attractive local economy trading at an obvious discount to its true value - with more capital than they knew what to do with, thanks to the money raised after fully converting to a public company.

Why have shares stayed cheap for so long? Part of that is due to size. Ocean Shore is a very small public bank, and its shares seem to trade by appointment only on most days. Analyzing banks also takes a different set of skills then most individual investors possess, and a company like OSHC is simply way too small for a large fund to take a position in. Shoot, it was hard for me to get us in.

Plus, going public when it did was poor timing in the sense that there has been a huge number of bank shares issued the past 18 months. At the risk of oversimplifying, the stock market is all about supply and demand. The supply of bank shares has been off-the-charts-high lately due to all the capital that needed to be raised in the sector. And with demand further weakened because of all the problems banks have had, the prices of shares in good banks like OSHC have drifted much lower than they otherwise would.

Is it Cheap for Temporary Reasons?

It's because I couldn't answer that specific question last year that OSHC seemed like it might be permanently stuck on the watch list. Good bank, solid management, the business seemed cheap…but it could stay cheap for a long time, too. What I was waiting for was a catalyst - a development that would help underscore the obvious value in the company.

On February 15th, it arrived. Ocean Shore announced it was buying a $135 million dollar bank near one of its existing branches in Egg Harbor, NJ. And that was enough to get me off the couch.

To understand why requires a quick crash course in Valuation 101. Actually, this is more like a pre-requisite - it's even more basic.

Here's a simple equation that captures company valuation in a nutshell:

Value = what you really know + what you think you know

The ability to accurately determine the true valuation of a company really rests on two things, ultimately; (1) things you know you can be confident in, and (2) things you think you can be confident in. As any good engineer will tell you, to get an answer you can really rely on, you want both (1) and (2) to be good data. Adding good data to bad data results in a bad answer - and we want to avoid those at all costs.

If you were to translate that equation above into something still pretty simple but tailored to a bank, it might look something like this:

Value = (tangible book value and return on equity) + speculative value

When it comes to analyzing companies, “book value” is synonymous with what you might think of as your own net worth. To figure out your own net worth, you'd first add up the value of all your assets - your home, cars, antique fly rod collection, IRA accounts, and that $17 you've got buried in the tin can in the backyard. Then after subtracting all the debt you owe on those things, you'd have a number similar to what a bank would call its book value.

(For now you'll have to take my word that book value is more useful for valuing banks that many other kinds of companies. Also for our purposes, let's just assume “tangible book value” means book value without any fluffy stuff included. It's better data, in other words.)

Now the past few years, the book value of many banks has been anything but certain, due to all the depressing headlines you know so well. For instance, it's very easy to find the book value of JPMorgan Chase, but for a number of reasons, I don't have much confidence that number reflects good data. There's just too much fluff.

OSHC is different, though, because it's book value contains no fluff. We can have a high degree of confidence that it's good data. And so it might strike you as unusual that the valuation that the market is currently putting on OSHC shares means that the company is trading for, quite literally, less than what we know it is worth. The numbers are right there, even if nobody else is noticing them, and the acquisition made the valuation gap even more obvious.

Now typically, if something is trading at less than a very solid book value, it's for two reasons. The first is because bad things have happened or are about to happen. A company might also be trading below book value because the market believes management is literally destroying value in the company.

Neither applies to OSHC, though. It's trading below book value because, well, it's a special situation.

Back to that last equation. If we're confident in the tangible book value and historical return on equity (which will actually go up at OSHC due to a favorable acquisition price and resultant cost cutting), then - and this is the best part - at a certain share price, we can completely ignore the speculative elements in our valuation. That's good, because then there will be no chance that we let any potentially bad data into the equation. And if the market price is considerably less than a conservatively-derived intrinsic value, well, we're in business.

What Are Shares Really Worth?

Let's put aside everything else associated with evaluating the company as an investment and focus on just this one point:

If OSHC's post-acquisition tangible book value does nothing more than compound at its historical rate, then in three years, basic math indicates that shares that are now trading at $12 will be worth $18.

Sometimes it's just that simple.

There are a few potential scenarios that would make shares more valuable, too. For instance, one of the reasons investing in converted thrifts has been so lucrative in the past is that (as per a study by FJ Capital Research) since 1990, 70% of all thrifts that convert are acquired within 3.7 years.

Now current regulations prohibit thrifts from selling out for at least three years after becoming fully public, so in OSHC's case, that would be in 2013 - if it even happens. But the odds say it will. And if you presume that Ocean Shore is acquired at the same multiple of tangible book value that it just used to buy the Egg Harbor bank, then OSHC shares would be worth $24 a share. We'll have doubled our money in three years…while earning a secure little dividend and sleeping well at night, too.

So, I'm enthused about Ocean Shore and believe we'll be well-rewarded in this and other recent special situation investments. I hope the above helps explain why.

Please email me if you have any questions. Otherwise - until next month!

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 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.

© Islamorada Investment Management. All rights reserved.

Sign Up Here to Receive These Letters