|Dear Investors, |
The Tarpon Folio has increased by 11.1% from June 30 through the market close on Friday. Since the beginning of its fourth year last November through last Friday, Tarpon has increased by 41.9% compared to an increase in the benchmark S&P 500 of 17.5% over the same period. On a calendar year basis, Tarpon has increased by 25.4% through yesterday, compared to an increase of 13.6% in the S&P 500.
So we’re having a good year, although I suspect some of you, like me, may have contracted a mild case of Vicarious Uncertainty Fatigue. I’m not sure what else to call it – I have simply grown tired of watching traders exhaust themselves every day. It’s as if the market has become a room full of pre-schoolers with yummy espresso and dozens of free puppies.
Uncertainty abounds, whether about the November elections, the fiscal cliff, Europe, China, or the unintended consequences of QE3 - and traders apparently continue to believe they can stay ahead of it all. Fortunately, the principles of value investing haven’t changed in decades. Now there are certainly risks worth keeping an eye on, but to attempt to trade around them, like so much of the market seems to do these days, strikes me as way too emotional and ultimately futile. Plus, in this particular day and age, when 70% of daily market volume is generated by machines, if you are a trader, and you are not a computer, then you, my friend, are an idiot.
So, let them trade. We’re going to stick to buying well-managed, growing companies when they are cheap, and then waiting for the gap between market price and real value to close.
That said, it’s probably best to prepare yourself for another few choppy months in the market ahead. But let’s keep it in perspective, too. Here is how I’m thinking about a number of headline issues these days.
On Politics and Volatility
One way or the other, the uncertainty surrounding the upcoming elections will disappear in about three weeks. Unless, you know, hanging chads and what-not. Dealing with the fiscal cliff, however, means we’re going to have to endure yet another loud, chaotic, mud-slinging political fracas, and it may or may not be done in a way that immediately addresses our long-term fiscal challenges. The odds seem highest that we’ll see another set of stop-gap measures ushered in right after the election that will delay more permanent policy changes until 2013. But we’re going to have to wait and see.
In the meantime, start stockpiling that rum, but keep in mind that as dysfunctional as politics can be, neither party wants to be blamed for so blatantly forcing another recession upon us. My expectation is that disaster related to the fiscal cliff will ultimately be avoided. Alas, we’re going to have to endure some sophomoric theatrics first.
You may have questions about the impact of fiscal policies related to the cliff and/or a change in administrations on your investments here. Unfortunately, attempting any sort of routine year-end tax planning in 2012 is going to be extremely challenging. From the possible expiration of some or all of the President Bush-era tax cuts to the imposition of new Medicare taxes on investments and wages, it is no easy task to get familiar with either expiring or new tax incentives in 2012, let alone try to figure out what may replace them next year. But if you’re wondering whether or not to accelerate some income or defer any deductions before year-end, I’d strongly encourage you to talk to your accountant soon, or let me know if you need help finding a good one.
So uncertainty looms on many fronts, and because most of the associated risks stem from politics, they can be particularly difficult to quantify…which may make already high-strung traders jumpy again. And that may bring up the same question some of you have asked during other volatile periods over the last few years – namely, if the market is going to get volatile, why don’t we move some or all of our money to cash and wait it out?
First, I could be completely wrong about expected volatility. The market could go smoothly up and to the right for the rest of the year. After all, the fiscal cliff shouldn’t be a surprise to anyone in the markets at this point in the year. Otherwise, though, my answers to that question now are the same as they have been before - in no uncertain terms, volatility is part of long-term investing, and if you can’t tolerate it, you shouldn’t be in the market at all. Nobody can time peaks or troughs perfectly. And most importantly - our companies are still very attractive and cheap.
Please don’t confuse volatility with risk, either. The seeds of our outperformance this year were sown in the historically volatile summer of 2011, and while it may be too much to ask you to truly welcome that kind of volatility, I hope the benefits of grinding it out are a little more apparent now in retrospect. And for the record, I don’t expect the next few months to be anywhere near as volatile as last summer, either. More on this below.
Also, many investors out there still believe that bonds are “low risk” investments. I am of the strong opinion, though, that at today’s prices, long-term bonds are a smoldering pile of dynamite. Similarly, many of you may still believe that low-growth, high-yield stocks are among the least risky stocks you can own, and again I would disagree. Because many of those stocks – utilities and big old telecom companies among them – have been bid up so much by investors the last few years, I actually think of them as among the most risky stocks right now. Again, let’s not confuse real risk – permanently losing your money - with the market going up and down a bit.
Here are three other reasons I intend to stay the course in Tarpon in spite of the potential headwinds.
I do not believe the market quite yet grasps the significance of the latest round of quantitative easing. Unlike previous versions, which were focused on buying Treasury debt, QE3 is focused on purchases of mortgage-backed securities (MBS). This is an important distinction. Here is why.
Because the issuance of new MBS has been so anemic of late, the Fed will need to buy these securities “on the secondary market” – which in this case means directly from banks, which have stuffed themselves with MBS over the last few years (since most MBS are very safe and pay more interest than Treasuries).
By buying these securities from banks, the Fed will both free up the balance sheets of the banks and – this is where it gets interesting – incentivize them to actually start lending money again. The banks will return to lending, that is, because (1) they’ll earn more lending than by continuing to buy MBS, and (2) the cash they will bring in from selling their mortgage-backed securities to the Fed will ease the considerable pressure they are under to maintain high capital ratios.
The Federal Reserve has pledged to buy $40 billion in MBS every month, as long as it needs to. After a year and a half of this scale of buying, though, the Fed will have effectively created the same amount of new bank capital as it did with TARP a few years ago. And this is underappreciated good news for the economy…both because of that huge capital injection into the lending system, and because it doesn’t change the amount of money in the economy - so additional inflation risks from QE3 in and of itself won’t arise.
To be clear, there are real risks associated with quantitative easing, particularly when interest rates begin to rise. And all this certainly would seem to mean there’s likely going to be another bubble in something, somewhere, soon. We shouldn’t count on our Treasuries being a safe haven for the rest of the world forever either, nor should we take for granted the benefits of the U.S. dollar being the global reserve currency. But like it or not, those are worries we will deal with later, after we solve the unemployment crisis in this country. At least, so sayeth the Fed. In the meantime, the economy should improve at a faster rate. Why do I say that?
Well, the spread, or difference, between the average mortgage rate consumers are offered and the benchmark rate on mortgage bonds recently hit a record high. In other words, never has it been more profitable for a bank to lend money for mortgages than it is right now. And remember, because the Fed will soon be buying up MBS, those prices have risen, offering uninspiring returns to the banks who up until now had been buying them hand over fist. So that means banks will now be truly incentivized to return to good old fashioned lending in this country. Finally. And with more refinancings comes more freed-up household cash…which will lead to more positive momentum in the economy.
So although the economy is not out of the woods, QE3 has made it very appealing for homeowners to borrow and banks to lend – and this is key – at the same time. Incentives matter in economics, and I believe the Fed may finally have gotten them aligned properly in QE3. This is a good thing. For now.
When it comes to Tarpon, QE3 provides strong reassurance that it will make good sense to buy and/or average down on any dips in the market the next few months.
2. We are sitting on large gains in a number of holdings that are still undervalued.
The gap between what I believe the companies we own in Tarpon are really worth and their current prices is still quite attractive to me. I am hesitant to sell any of them even after a rally like the one we’ve seen in the third quarter – because doing so will negate the magical benefits of future compounding off a low cost basis.
You should know that my reluctance to sell could impact our performance negatively in the short-term, since a small decrease in the price of an overweight holding in Tarpon will impact the total value of our portfolio more than a similar sized decrease in a smaller holding. The argument for hanging on to shares even though they have increased in value quite a bit can probably best be demonstrated by a real example.
In May of this year we bought a full position in shares of a new company, Walter Investment Corp (WAC). Great management, demonstrably cheap, and has both sector and secular tailwinds behinds it. Our cost basis in Walter is $20.77 a share. As of last Friday’s close, shares were priced at $40.31. For investors who bought at that same price on Friday, an increase in the share price of, say, $0.25 on Monday would represent a 0.62% gain. For we fortunate few who own our shares at a cost basis of $20.77, however, that same twenty-five cent increase in share price on Monday would represent a 1.20% gain. Not bad, right? It’s like safe, free-range, all organic leverage.
Now consider that Walter should be able to earn at least $4.00 in earnings per share next year, and if you were to make the reasonable assumption that they should be valued at the same earnings multiple as their closest competitor, Walter shares will be worth $60.00 by the end of 2013. And that doesn’t even consider how much those earnings will grow if Walter manages to outmaneuver our old pal Warren Buffett and Berkshire Hathaway at a bankruptcy auction on October 23 and win a ton of new mortgage servicing rights…and, knock on wood, right now it appears Walter’s team has the advantage.
Were we to sell our shares in Walter now, say out of fear about the fiscal cliff, and attempt to buy them back after a dip at, say, $35.00 each, then should those shares be priced at $60.00 next year, we would have earned a 72% return. If we hold tight to those $20.77 shares we now own, though, and see shares hit $60 next year, then we’ll have earned a 189% return. And you would absolutely be able to tell the difference in your monthly statements.
Ain’t compounding great?
My point is that even though WAC shares have doubled this year, they’re still worth considerably more. Despite whatever the market may throw at us the next few months, we’re going to sit tight on those Walter shares, because we’ve got the wind at our backs in terms of the magic of compounding.
Course, it goes other way, too. A drop in Walter’s share price would sting us disproportionately more than it would the newer investor, but I feel pretty strongly that it will be worth hanging on for the long-term in any case.
On a related note, Clearwire shares have just come off a tremendous week, too, rising 71% on Thursday alone. It appears the value of that spectrum may finally be getting the respect it deserves. More to come there in the weeks ahead.
In case you’re wondering, our cost basis in Clearwire is $1.17 a share. And I have no intentions of letting go of that kind of cost basis anytime soon.
3. The superior math of value investing.
If you can bear with a little more basic investing math, I’d like to underscore the final reason I intend to sit tight in the fourth quarter, using another current Tarpon holding as an example.
Our cost basis in the Dell shares we own is $12.18. We’re actually underwater in Dell right now, as shares currently trade at $9.69, but I’m not too worried about it, primarily because I have a high degree of confidence that shares are worth much closer to $24 each. Dell is selling at a big discount to its intrinsic value in large part because people mistakenly assume most of Dell’s business is in selling PCs to consumers, which is incorrect and worthy of another discussion.
For now, though, I want to highlight that we’ve bought shares in Dell for 50% of their intrinsic value. It is reasonable to expect the intrinsic value of the business to grow by 12% per year for the next three years – if it does nothing more than retain its own earnings. Even if it takes four years for the market price of Dell shares to reflect the company’s true worth – which is twice the current share price – then when that gaps closes, our investment will have compounded at a rate of 30% per year.
Mathematically, two thirds of that return comes from the gap between market price and intrinsic value closing. Only one third comes from the business value growing. So as long as the businesses we own are improving - and they clearly don’t have to grow like weeds if we buy them at the right price - then I’m less concerned with whether the stock price follows my estimate of intrinsic value on a monthly basis.
Dell is also a good example of a current Tarpon holding that we might average down in – meaning we would buy more shares at a lower cost – in the fourth quarter. Now I hope you might better understand why.
Finally, since we’re on a roll with the basic investing math, here’s a good bar trick:
To find the square of a two-digit number ending in 5, take the first digit, multiply by itself plus one, and then put "25" after it.
So to find 252, multiply 2 by 3, take the answer 6 and then add 25 to the end. So "625" is the answer.
Works every time. I should caution you, though, to use this trick sparingly. I think little math shortcuts like this are the height of coolness, but I’m told that in high school I was also a bit of a nerd.
Finally – a quick note on next year’s annual investor meeting. Islamorada has been so bustling with tourists the last few winters that most local investors have been too busy to attend the annual meeting. I’d like to try to correct that in 2013 by pushing the meeting back into April or May. So, more details on the meeting after the end of this year.
In the meantime, I plan to continue to look hard for investments that may lead to significant gains for us. And don’t be surprised if you see me doing some buying on any dips over the next few months.
As usual, call or email anytime with questions. Thank you.