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In This Issue
bullet Cale's Notes: A new look for IIM.
bullet Portfolio Summary: Up 13% in May, up 59% since launch.
bullet Value Investing 101:  Competitive strategy, simplified.
bullet Get To Know Your Company: Crazy for CarMax.
bullet Ask the Geek: Big party next January in Islamorada.
bullet About the Tarpon Folio: More about our Spoke Fund®.

Letter to Investors
For May 2009

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

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Cale's Notes

Cale Smith

Dear Investors,

By now you’ve noticed a different format for this month’s letter to investors. We’ve also updated our logo and launched our new website at All were long in coming and I'm glad to be able to finally unveil them to you.

Marcus designed our new email format, overhauled our website and Milos spiffed up our logo. A special thanks also goes out to photographer and saltwater fly fishing maven Pat Ford, whose gorgeous photos you see in the header above and in the backdrop of our new site.
May was another good month for our portfolio, as I discuss more below. In this letter I'll also continue last month's discussion on how to evaluate a management team's strategic choices, and introduce you to our company CarMax. I took a little extra space in this letter to discuss CarMax given the recent GM bankruptcy and all the angst in the auto sector in general lately.

I'm also relieved to say that cooler heads prevailed in the Target proxy fight I mentioned last month. Here's a quote from yours truly about it in the Minneapolis media near Target's headquarters.

The only change I made to our portfolio in May was its name. With this release of this letter we’ve formally changed the name from Tarpon Fund to Tarpon Folio. Same goes for the Gecko Folio. I made the switch to further differentiate our spoke fund model from the legions of other financial products with “Fund” in the name. After all, mutual funds and hedge funds are soooooooo 2007.

For those of you here in the Keys, you'll soon be seeing our first ads pop up in the local papers. I'm also now writing a column called "Island Investing" in the Keys Weekly paper here in the Upper Keys. Here's my first article in case you missed it.

One final administrative note: my next letter to investors will be published at the end of July. But as always, call or email anytime in between.

Now, on to our May performance.

- Cale Smith, Portfolio Manager
Portfolio Summary

Tarpon Folio - up 58.5% since inceptionSomebody call Mensa.

A Small But Merry Band of Geniuses

The market continued to treat us well in May. The Tarpon Folio increased by 13.4% during the month, compared to an increase of 5.3% in the S&P 500. Since inception last November, Tarpon is up 58.5% through the end of May, and is outperforming the S&P 500 over the same period by 44.4%.

I believe our performance since inception makes you, my dear investors, among the brightest minds in America. If there is another fund in the country that has performed better than yours the last six months, I haven’t heard of it yet. But now is not the time to get heady. The economy is still far from out of the woods. And on my office wall I have taped these words from the good pirate Han Solo: “Great, kid. Don’t get cocky.”

I like to think that I do this job for free, but that I get paid to worry. Regarding our results so far, I’d like to be absolutely clear about one thing: this kind of outperformance simply cannot continue.
Academics and most financial advisors would probably describe our success to date in terms of risk and reward. Because our portfolio owns just 15 companies, the conventional wisdom goes, it will be more volatile than the market, and because it is more volatile, it is deemed more risky. Put another way, it is only by assuming more risk that we have been able to outperform so dramatically. To that I say, “Hogwash.”

First, defining risk as volatility in stock prices implicitly assumes that the stock market is efficient – or in other words, that a stock’s price accurately reflects the true value of the business. While that may be true most of the time, it certainly was not true last November when the Tarpon Folio launched. The last six months may very well prove to have been the most inefficient market of my lifetime.

In addition, as Warren Buffett long ago observed, risk in investing has little to do with the volatility of a stock’s price. Risk is better defined as permanently losing your money. Here’s an example, similar to one Buffett once gave, that underscores this point.
Last November we bought shares of Google for Tarpon when trading at $287 each. Shares trade at $444 today, and I believe they’re worth closer to $550. At the time we bought Google the share price was significantly more volatile than it had been historically. Defining risk as volatility means in this case you believe it was somehow riskier to buy something worth $550 for $287 than it was to buy it for $444. Only on Wall Street does that make any sense.
Statistics will also demonstrate that after purchasing six or eight stocks in different industries, the benefit of adding more stocks to a portfolio in an effort to decrease risk is small. After that point, overall market risk – the broad up and down movement in the general market – cannot be eliminated by adding more stocks to a portfolio. Owning 15 stocks in the Tarpon Folio eliminates approximately 90% of the nonmarket risk of owning just one stock. And I believe the increased long-term returns of a focused value portfolio will far outweigh the slight increase in potential share price volatility.

Not only does stock price volatility tell you nothing about the future profitability of a business, it completely misses on one of the most important questions an investor can ask: “How much could I lose?” That’s why we insist on a margin of safety - and generally ignore the conventional wisdom on Wall Street.

My point is this: there are a handful of factors in addition to solid stock-picking that explain our outperformance to date. Luck is one of them. But the idea that our large gains have come because we've assumed a large degree of risk is more than just silly, it's a fallacy. Value investing makes it possible to generate high returns with low risk.

So congrats on your prescience in investing with a value manager. I knew you people were sharp.

Value Investing 101

The Second Most Difficult Part of Investing (Continued).

Here's the first part of this two-part series on evaluating company management. You may recall I ended the previous column by noting that execution and strategic choice were two of the most important variables when evaluating management. Execution was the most visible, but strategic choice the more important for the long-term investor. 

Michael Porter of Harvard Business School is widely regarded to be the leading authority on competitive strategy. His book Competitive Strategy is considered the magnum opus of the field. Porter's Five Forces model, summarized here, is heavily relied on by analysts, operators and business school students alike. The fundamental question it asks is, "Is this industry attractive?" It's a terrific way to think about the long-term profitability potential of an industry and the competition within it.

If your goal is anything but profitability - if it's to be big, or to grow fast, or to be a technology leader - you'll hit problems. 

— Michael Porter

As a value investor, however, I am less interested in the profitability of an industry than I am in the sustainability of a single firm's advantages. Even though an industry can have below average profitability, a firm in that industry with a wide moat around its business can still generate terrific returns. So although Porter's work on generic competitive strategies seems at times overshadowed by his Five Forces model, I believe the former is more useful. 

The fundamental question Porter asks at the firm level is, "How does the firm earn sustainable superior margins?" The answer is a great way to think about the big picture choices made by any management team.

Porter's Competitive Strategy

According to Porter, there are four generic competitive strategies:

1 - Cost leadership. A cost leader strives to be the low-cost producer. A cost-based advantage can come from economies of scale, proprietary technology or preferential access to raw materials. Cogent Communications is a good example here.

2 - Differentiation. A differentiator attempts to set its products apart from its competitors on the basis of an attribute that is important to consumers. Differentiation can be based on the product's features, how it's delivered or even how it's marketed. The products of these firms have a higher price and higher profitability.  For instance, Google's superior search results enable it to earn a premium for placing ads.

Strategies 1 and 2 are practiced by firms with a broad, industry-wide focus. The next two strategies are used by firms with a narrow scope, or that target specific market segments.

3 - Cost Focus. These firms seek a competitive cost advantage in a narrow, attractive segment of an industry. Think of Contago from my last letter

4 - Differentiation Focus. Firms pursuing this strategy attempt to achieve differentiation in a narrow, attractive segment of the market. A good example is Discovery Communications' exclusive emphasis on nonfiction programming.

There's an important thing to note here that might not be obvious: the profit margins of cost leaders and differentiators can be equally high. Here's another graphic that illustrates this point:

Profit Margin Comparison

A firm with the industry's lowest costs can be just a profitable as a firm that charges premium prices. The chart above shows why it pays to look for investments in even the ugliest industries.

To best evaluate management's decisions, you also should know the risks of each strategy:

Risks to Strategy 1 - Cost leadership. Failing to achieve differentiation parity. In other words, your customers perceive the qualify of your product as similar to your competitors. Risks also lie in technological change, or if too many firms attempt to be the cost leader. Cost leaders also must be wary of challenges from cost focusers (#3).

Risks to Strategy 2 - Differentiation. The biggest risk to differentiated strategies is not achieving cost parity, or keeping your cost structure similar to your competitors. Shifts in consumer taste and imitators both pose threats, as does competition from differentiation focusers (#4).

Risks to Strategies 3 and 4 - Focus. Both cost and differentiator focus strategies will fail if the target market segment ceases to be structurally attractive. Copycats also pose a threat, as do other firms that focus on an even narrower segment within that market.
Another important note: Porter defined a "stuck-in-the-middle" firm as one that tries to achieve both cost leadership and differentiation - and fails at both. These firms compete at a disadvantage to those that achieve cost leadership or differentiation, as margins get squeezed from both sides. Once in a while a firm with a particularly innovative technology can succeed while pursuing multiple strategies, but the odds of most investors correctly guessing which firm that may be are extremely low.

In summary, it's very difficult to sustain a competitive advantage over time. If you find a company that can do it, with shares trading at a low enough price, it's worth taking a meaningful position. When it comes to evaluating the strategic choices of your management team, be sure their future plans emerge from a disciplined process that is determined by a competitive strategy focused on profitability.
Get to Know Your Company
Crazy for CarMax

Let it be known that in the months before General Motors went bankrupt, investors in the Tarpon Folio were happily buying shares of a used car dealership.

Well, at least I was happy about it. You may have been questioning my sanity. Not to worry, though. Here's why we all own CarMax (NYSE:KMX).

First - a point about business models. In the end, General Motors was essentially a huge pension fund that sold automobiles as a means to make consumer loans. CarMax has an in-house financing arm that has contributed a significant portion of the company's past profits. But I view the company's loan business as a tactical opportunity, not a strategic imperative like I believe existed at GM. CarMax sells used autos, first and foremost - and nobody does it better.

Also, in a sin of omission, I missed out on an even more compelling price for us by not buying CarMax when trading under $7 last November. Instead we first bought shares at $11.13 in March. Consciously or otherwise, I stuck to my telecom roots last year and bought shares in Amdocs, only to have a change of heart this past March after things looked more predictable at CarMax due to the Fed's TALF program. Let the cursing begin.

Used cars account for about half of the automobile market, the largest retail segment of the U.S. economy. The market is highly competitive and fragmented, made of approximately 40,000 independent used car dealers and millions of private individual sellers. Those circumstances favor the entry of a well-capitalized, highly efficient operator into the industry which will have an opportunity to achieve significant competitive advantages. That company is CarMax.

Why Is This a Great Business?

CarMax was founded to create a used-car superstore chain that operated exactly the opposite the way the used car industry typically functioned. The company has no-haggle sale and trade-in prices, clearly discloses all financing terms, hires all salespeople from outside the auto industry and pays them a fixed-dollar commission regardless of the vehicle sold - and no commissions on loans. This differentiation in service is working quite well. According to the company, 93% of its customers would recommend CarMax to a friend, and the company ranks consistently among Fortune magazine's "Best 100 Companies To Work For."

There is no true competitor to CarMax currently capable of adopting a similar business model. Several years back Wal-Mart attempted to copy the CarMax model in a trial project in Texas but abandoned it. AutoNation, a network of predominantly new car dealers, also once tried the used car superstore idea, but it, too, walked away. And small newcomer Lithia Motors, which operates in rural areas, has proven to be a much less efficient business; CarMax has higher margins and earns 3.5 times the return on invested capital.

The company's advantages are found in two areas. The first is economies of scale. CarMax can simply sell more cars - around 335 cars per month, versus 46 per month sold by publicly traded new car dealers. Every superstore has four to five times the inventory of the typical used car dealer - and if a particular model is not available onsite, customers are led to kiosks at the terminal to access the 24,000 listings on Customer transfers from one store to another represent 25% of the company's sales. 

CarMax's scale allows it to price below smaller dealerships. By giving any further improvements in operating expenses back to the customer as a price decrease, as the CEO has said he would do, the company should also be able to further increase same-store sales while keeping competitors on the defensive.

CarMax also has an information advantage. Since 1993, the company has appraised almost 10 milion car and trucks and sold nearly 4 million automobiles. Combining that info with data from other sources has helped CarMax build a sophisticated inventory and pricing system that allows the company to buy trade-ins lower and sell them higher than the competition.

I also should mention that used cars are actually more profitable than new cars. Because every used car is unique, CarMax can earn better margins on these differentiated products than a new car dealer can when selling identical products. It's simply not as easy for customers to call around and make apples-to-apples comparisons on used cars.

With only 100 superstores in 46 markets, CarMax is also still early in its growth cycle. It operates in a huge and underpenetrated market. Despite being the largest retailer of used cars in the U.S., CarMax commands just 2% of the 19 million unit/$275 billion market for 1-6 year old cars. More amazing is that it has attained this share with just 100 of the more than 65,000 dealerships in the country. Furthermore, within markets that it serves, CarMax estimates its share at 8% to 10%. Clearly it business model has legs. Plus, the company's long-term goal is for 65% of the population to have access to a CarMax store. Right now that figure lies at 45%. That difference translates into hundreds and hundreds more stores, which the company should be able to easily self-finance through the profits it produces.

I agree with the analyst who believes CarMax is to used car dealers in 2009 what Home Depot was to hardware stores in the 1980s.

Why Is It Cheap?

Forced selling last winter by large institutions to meet investor redemptions. Soft demand for cars due to the recession. Inventory management woes caused by consumer reaction to the spike and then plummet in gasoline prices last year. Most notable, however, was the turmoil in the credit markets, which last fall left the financing division of the company - CarMax Auto Finance or CAF - temporarily dysfunctional.

CAF historically relied on securitization to sell the loans the company made to its customers. It would bundle all loans up, sell them to big investors, and report income using what's called "gain on sale" accounting. In addition to those securitization gains, CAF also made money on servicing fees and interest income.

Now we're getting to the crux of why we didn't buy KMX shares last year. 

The company uses an off-balance sheet special-purpose entity to "warehouse" the auto loans it makes before it packages them up and sells them. (If the phrase "off-balance sheet special-purpose entity" reminds you of Enron, you can relax - it's all disclosed at CarMax.) 

Using what's called a "warehouse facility," or a special line of credit, CarMax borrows money on a short-term, revolving basis to make loans to its customers, and then pays back the borrowed funds once the bundle of auto loans is sold.

Until the credit bubble burst, that model worked well. Buyers could get access to credit and CarMax earned a profit. However, when the credit crisis hit last fall, CarMax was effectively unable to sell off its loans. Investors stopped buying securitized loans of any stripe. In fact, the amount of all securitized consumer loans in the US dropped from $1 trillion a year at its peak to $8 billion in the last three months of '08. 

Without buyers of CarMax's old loans, my concern last fall (shared by others) was that the capacity to make new loans could disappear as an increasing amount of unsalable loans consumed the company's extra borrowing capacity. That would mean the company would eventually be unable to extend more credit to its customers...and that would most certainly not be good for the company's sales.

This spring, the Fed and Treasury eventually launched the TALF (Term Asset Backed Securities Loan Facility) to jumpstart the market for securitized lending. It came at the right time for CarMax, which had just $185 million left to loan out of its $1.4 billion borrowing capacity. In early April, the company announced a securitization that will effectively clear out its warehouse facility by half. Next, CarMax needs to refinance the warehouse facility itself, and I suspect TALF will be the best option to do so, too.

So, I think we're done with the drama at CarMax. Management still has miles to go before they can sleep, mind you, but the business is back to being reasonably predictable in the long-term.

In case you want to know more about TALF, here's a good summary by The Wall Street Journal which contained this graphic:

TALF overview

And to be clear - the quality of the loans CarMax originated is not a huge concern to me. Loans that qualify for TALF must meet strict criteria, and the vast majority of CarMax loans are eligible.

Is It Cheap For Temporary Reasons?

Yes. While it clearly will take some time for CAF to begin functioning normally again, the company's earnings power will eventually return. Fewer cars sold in the country today means more pent-up demand later. In the meantime, CarMax is making right moves to address the headwinds...suspending store growth, slashing inventory, reducing headcount and completing a securitization using TALF. Also of note is that in spite of those headwinds, the company was able to increase its gross margin in the most recent quarter as it gained modest market share and generated its first free cash flow in some time due to inventory liquidation and reduced capital spending.

CarMax is a high fixed-cost business. When business suffers, profitability quickly does, too.  However, when the economy turns, CarMax will benefit from two levers in its business - sales growth and, because of the operating leverage in the business, higher net margins. In other words, once we're over the hump, profits should increase quicker than sales.

In addition, another key growth driver is that more than half of CarMax stores are less than five years old. Consumers historically buy cars every three to five years. So my hunch is that same-store sales will increase, too, once formerly delighted customers start to come back.

Hundreds of new and used car dealers are likely to go out of business by year's end. CarMax will also likely pick up market share as a result. Another potential catalyst is the pending "Cash for Clunkers" legislation making its way through D.C. Leaving aside the political debate about the program, it's hard to argue that CarMax would stand to benefit greatly if used cars are included. If not, that's still okay. I'm happy to wait for the economy to recover, and with it the used car market, too.

What Is It Worth?

I believe CarMax is worth $22 a share, though it could take a few years for industry conditions to normalize enough to approximate my valuation assumptions. Longer-term, CarMax could be worth much more.

I did not attempt to value the company's auction business, which though small in terms of revenue could be another growth engine for the company. It's the third largest wholesale auction provider in North America and that scale adds value to the rest of CarMax's operations, too, by reinforcing that information edge mentioned above and CarMax's auction business is probably underappreciated in the market.

I should also note that in the third quarter of 2007, the GEICO subsidiary of Warren Buffett's Berkshire Hathaway conglomerate purchased shares of CarMax at prices between $21 and $25 per share. And if you presume that Lou Simpson at GEICO also likes to invest with a big margin of safety, he likely believes shares were worth significantly more than my $22 estimate.  And who am I to argue?

Ask The Geek

Q.  You mentioned in your last letter that you didn't want to invest in complex businesses that were too dependent on a visionary CEO, but doesn't that describe Ken Peak of Contango?

A. Peak is the ultimate owner-operator and has done an amazing job with Contango. But the business itself is pretty straightforward. You'll recall he outsources the truly complex part - determining where to drill for natural gas. My comments were intended more towards CEOs like Steve Jobs at Apple. I have no doubt that heir-apparent Tim Cook is a fantastic operator, but history shows that Apple previously floundered without Jobs there. It's a huge business with a lot of moving parts - the success of which has had an inordinate amount to do with Jobs. I love Apple's products, from my MacBook to my iPhone, but history has also shown that in the long-run, all electronic devices are basically toasters. Apple is great at constantly pushing back that "toaster line," but I suspect it's due more to what's in Jobs' head than any sort of systematic process of innovation at Apple. I could be wrong, but I don't intend to risk any of our money waiting to find out.

That's also why we don't own shares in Berkshire Hathaway, by the way. There is no bigger fan of Warren Buffett's investment philosophy than yours truly, but his business will unequivocally be impacted by his eventual departure. Just how much is an uncertainty I don't want us to bear. 

Q.  Along those same lines - what about IIM? You are effectively the whole business.  What happens to our investments in the Tarpon Folio if you are suddenly out of the picture?

You'll remember that during sign-up you received full contact info for our custodian, FolioFN. (You can also find it by clicking the "Client Login" link on our new website and then the "Contact" link in the upper right of the next page).  Should I meet an untimely demise, you can always contact Folio and arrange to transfer your assets elsewhere. Otherwise, our firm has an agreement with another independent fee-only advisory to assist you in moving your assets elsewhere. Also, I would expect you all to spoil my girls rotten.

Q. Will there be an IIM "Annual Report"...or will the newsletter and blog take care of that?

A. Yes, and please mark your calendars now, people. The first annual meeting of IIM investors will be held here in Islamorada on Saturday, January 30, 2010. More details will come out later, but it will be a Keys-ey kind of affair. We'll wear flip flops, drink margaritas and stand around counting our money. Stay tuned for more.

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.

Privacy Policy Statement

Investment advisers, like all providers of personal financial services, are required by law to inform their clients of their policies regarding privacy of client information. Investment advisers have been and continue to be bound by professional standards of confidentiality that are even more stringent than those required by law. Therefore, we have always protected your right to privacy.

Types of nonpublic personal information we collect

We collect nonpublic personal information about you that is either provided to us by you or obtained by us with your authorization.

Parties to whom we disclose information

For current and former clients, we do not disclose any nonpublic personal information obtained in the course of our practice except as required or permitted by law. Permitted disclosures include, for instance, providing information to our employees and, in limited situations, to unrelated third parties who need to know that information to assist us in providing services to you. In all such situations, we stress the confidential nature of information being shared.

Protecting the confidentiality and security of current and former client's information

We retain records relating to professional services that we provide so that we are better able to assist you with your professional needs and in some cases, to comply with professional guidelines. In order to guard your nonpublic personal information, we maintain physical, electronic, and procedural safeguards that comply with our professional standards.


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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