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It's Official: Tarpon Folio Returns 91% in First Year 

bullet Cale's Notes: Meeting at Holiday Isle.
bullet Portfolio Summary: An amazing year.
bullet About the Tarpon Folio: More about our Spoke Fund®.

Letter to Investors
Special Edition:
One Year Anniversary (305) 522-1333             

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Cale's Notes

Cale Smith

Dear Investors,

This is a particularly enjoyable update to write. Last Friday was the one year anniversary of the launch of the Tarpon Folio. I'm thrilled to be able to report that in its first year, Tarpon returned 90.6% and outperformed the S&P 500 by 55.2%.

Thank you all for your support this year. And to those who are reading this but haven't invested yet - fees are going up on January 1st, so let your inner cheapskate loose and sign up here.

Before I get into my expectations for next year, here's an update on the annual meeting.  On Saturday, January 30th, 2010, we'll be taking over the tiki huts at Holiday Isle here in Islamorada. The Isle is the home of the world famous Tiki Bar and where the first Rum Runner drink was originally concocted. You may also be interested to know that the resort's owner, Starwood Capital, has also decided to pour a million dollars into giving the resort a facelift prior to our meeting. Coincidence, my tuckus.

In case the thought of listening to both yours truly and Contango Oil & Gas CEO Ken Peak wasn't scintillating enough, perhaps you can be swayed by dinner and - I really hope I don't regret this - an open bar. Call or email me for hotel suggestions, and please feel free to bring your spin-offs, too. We'll have some on-site babysitting help during the meeting. I'll soon pass on some suggestions for other things you can do in Islamorada that weekend also. Please RSVP by January 9th if you plan to attend. 

I'll provide the usual monthly update on Tarpon at the end of November, and will write more about why we own Leap Wireless then, too.  What follows in this anniversary letter are my thoughts about the upcoming year for Tarpon.

Thank you again. Margaritas on me in January.

- Your Portfolio Manager, Cale Smith
Portfolio Summary

Tarpon Folio - up 92.3% since inceptionOne year down, fifty to go. 

Thinking Hard About Retiring

The Tarpon Folio increased by 90.6% in its first year compared to an increase of 35.4% in the S&P 500. Over that same period the portfolio outperformed the S&P 500 by 55.2%. 

Over the next few decades as a portfolio manager, I may never have another year like this one. So, I'm thinking hard about walking away at the top of my game and starting up a frozen yogurt stand. 

Kidding, people. With our first year now in the books, though, it does seem like a good time to step back and examine where we are. While I'm thrilled the portfolio has done so well this first year, I am also very aware of the market's tendency to punish the overconfident.

Where We Are Today

For most people, investing serves one of two purposes; you're either attempting to grow your wealth or you're trying to preserve it. When it comes to preserving wealth, broad global diversification, asset allocation and working with a team of experts often makes the most sense. It's my opinion that applying that same approach when you are trying to grow your wealth, however, will drive you insane long before you're ever able to retire. 

I view a portfolio as a collection of assets built to maximize the long-term earnings of its owner. I also believe this kind of investing - growing wealth as opposed to preserving it - is best done by a single unbiased person having as few distractions as possible. That person doesn't have to literally be on an island, like I am, but he should be on an island in the metaphorical sense. In investing, he who thinks the clearest wins. 

I have considerable faith in the processes I use to grow our portfolio's value, in everything from finding attractive companies to analyzing them to accumulating positions. It is a systematic approach driven by a long-term business owner's mindset, and I'd like to think it pretty clearly showed its worth this year. I hope you share some of my faith in those processes now, too.

I also want to remind everyone of a simple truth about value investing:

It works best over years, not months.

Some of our newest investors have seen lackluster returns in Tarpon the past few months. Hang in there with me. Those returns are also consistent with how the process typically works. While I have no idea what will happen in the market in the next few months, I have recently been taking new positions in some impressive businesses the market is overlooking. I have also effectively staked my own net worth on the expectation that their intrinsic value will eventually be recognized. There is no telling when that will happen - it could be within months, like we saw in 2009, or it could be years - but in either case it's important to have faith in the process.

Despite this year's returns, the performance of our portfolio in some ways was less than ideal. During the year I sold some holdings that I would have preferred to hold forever, all things being equal, because their share prices went too far beyond what I estimated them to be worth. I also cost us even better performance by selling American Express in March. I am comfortable that the process I went through prior to selling those shares was sound, and given the same circumstances, I would have sold again, but the reality is that those shares have quadrupled since that decision. I imagine the feeling is similar to the record producer who decided not to sign the Beatles.

That said, you should know that I don't intend to change a single part of my approach based on our recent success, economic predictions, the market's trajectory, federal deficits, the phase of the moon or any other reason. That's why it's a system, after all - to produce consistently superior results over time. If the process is sound, and I believe mine is, and if it's followed methodically, which sometimes takes a lot of caffeine, then the results will eventually take care of themselves - whether you're training for the Olympics or managing a portfolio.

So, the state of the Tarpon is strong. Now about the year ahead.

My Expectations for Tarpon in 2010

Expectation #1: Outperformance.

The spoke fund model is not subject to the same limitations that box in mutual fund managers. As such I believe it is reasonable to anticipate outperforming the market again. In an absolute sense, the return I shoot for every year is 15% and my goal in 2010 is no different. It's also important to understand that I am willing to tolerate volatility and short-term underperformance in exchange for long-term outperformance. I'll take a lumpy 15% annual return over a smooth 11% return every time.

Expectation #2: Slightly less correlated returns.

I expect that Tarpon's performance over this coming year will better answer the question that I sense may still lurk in the back of some people's minds:

"Is he good, or he is lucky?"

I think I know the answer, but I suppose I should be objective about that sort of thing. So, into the numbers I dove.

In September I did a statistical comparison between the monthly returns of Tarpon and our benchmark, the S&P 500, from November through August. I found the correlation between Tarpon and S&P 500 returns over that period was 0.943. For you less geeky readers, that means the returns of Tarpon were strongly positively correlated with the returns of the overall market.

I admit my ego was hoping to see a lower correlation. I feel our companies are truly wonderful businesses, and I'd like to think the performance of their share prices would be more independent of a broader market which contains a lot of lower quality companies.

A regression analysis indicated that this correlation might be a bit unreliable, though. (More specifically, the data had a high standard error, indicating that it is uncertain how useful the regression is predicting future correlation.) Also, the analysis (R squared, for the stat geeks) indicated that about 89% of the variation in Tarpon returns could be attributed to the change in S&P 500 returns. The remaining 11% of the variation could be attributable to "other factors" - like knowing what the heck I'm doing.

So the results seemed to point to this conclusion:

While luck in the form of the timing of the fund's launch last year clearly played a large role in Tarpon's performance, so did the skill of its portfolio manager. Moreover, that little bit of skill added a very significant amount of excess return to the portfolio.

Now back to the point in bold above. The Tarpon Folio now is more concentrated than it has been at any time during the last year. Our top two holdings - Paychex and Contango - represent 20% of the portfolio. As a result, Tarpon's returns this year will be correlated closer to the stock prices of those two companies in particular than the more equally-weighted portfolio we held earlier in 2009. So while next year's correlation probably won't differ much from that of this year, that 11% number above shows that it doesn't necessarily have to be, either, in order to significantly outperform the market.

Some of you may have noticed this already. Tarpon's returns are now slightly less sensitive to the overall market's returns than they were a few months ago. And to be clear, that is an intentional result of recent changes I have made in the portfolio.

While our returns will no doubt continue to be influenced strongly by the direction of the broader market, I believe they will be slightly less correlated than in the past. I view that as a good thing, particularly if we are trying to outperform a market that is no longer undervalued.

Expectation #3: Inflation will return.

I am not attempting to divine the future inflation rate here, but I am underscoring the need to ensure that we are protected from inflation however strong or weak it may be. High inflation is an invisible tax that can cripple businesses. For long-term investors, inflation's impact on a portfolio should be considered at all times, however, and not just when the pundits start getting nervous.

As I have written previously, while I don't intend to ever seek direct exposure to gold or commodities through ETFs, derivatives, or other managed funds, we do own companies that would be beneficiaries of increasing commodity prices caused by inflation, like Contango and Compass Minerals. We own them because they are good businesses with moats, however, not because they produce commodities.

I believe we are relatively well-protected from inflation both through owning companies like those above, as well as those with pricing power and/or which would benefit from increased interest rates. (The Fed will increase interest rates to combat inflation.) Paychex is a prime example of the latter, because it will earn more interest on its float - cash balances resulting from the lag between when it receives payroll-related funds and when it pays them out - when interest rates rise. And owning good companies that have pricing power is important because if their costs rise due to inflation, they can then pass those higher costs on to their customers and avoid crimping margins.

The threat of inflation really underscores the value of owning companies that set prices in their industries rather than react to them. In other words, moats always matter.

Expectation #4: An increase in the probability that the market will make me look dumb at some point this year.

The share price of each of our companies in 2009 went up significantly, with a handful of doubles and several even tripling in price. That's not how value investing normally works, however. We will probably buy shares this year that will go down in price after we purchase them - in some cases dropping significantly. That's okay, though, assuming the investment case is still strong, because I'm confident in the reasons we own each of our companies. I will most likely buy more shares on those dips.

That said, I concede that watching me buy more shares of a company you aren't familiar with as it drops in price could be pretty nerve-wracking. If it really bugs you, just pick up the phone and we'll discuss my rationale. If nothing else, though, I'd ask you to remember that it's my net worth at stake, too.

When there are fewer truly great, seriously undervalued businesses we can buy shares in, I have two options as your portfolio manager:

1 - Leave a lot of cash in Tarpon.

To me, leaving a high percentage of cash in our portfolio for an extended time is lazy. There is always value somewhere in the market, and if you're not finding it, it's because you're not looking hard enough. While billion dollar funds may at times hold cash because they can't take a meaningful position in any suitable companies, we don't have that problem. If you invest in Tarpon, I interpret that to mean that you're paying me to find good companies, not to be a savings account.

2 - Find the next-best companies I can.

At a very high level, there are just two criteria for the companies we invest in. Each must have a competitive advantage, or moat, and each has to be cheap.

I will not invest in any company that is not cheap - or more specifically, that does not have a large margin of safety. That means during times like we're in now, when the market appears fully valued, our pool of potential investment candidates will expand to include companies with smaller moats, but never any companies that appear overvalued.  Only one of those two key criteria can vary.

The share prices of companies with narrower moats are in general more volatile than those with wide moats. So in 2010, the prices of our narrow-moat companies could fluctuate quite a bit, and as a result, I very well may look dumb at some point. 

I'd like to think that should it occur, however, it won't be a chronic condition.

Expectation #5: We will continue to benefit from unexpected events.

As I write, there is still a tremendous amount of uncertainty about the outlook for the economy. The market hates that uncertainty, which is one reason why you can't step off your front porch without hearing another Wall Street expert predict everything from a market correction to a double dip recession to the beginning of a new bull market. History has shown repeatedly that in most cases, though, it's all just noise.

I don't spend much time trying to guess the direction of the market. To paraphrase Warren Buffett, the key to investing is not trying to predict the future but to determine the long-term durability of a company's competitive advantage.

By definition, the only time good businesses are cheap is when the market has low expectations for them. If I'm right in my analysis, then the businesses we own will eventually show some unexpected positive developments, and we will be rewarded accordingly.

Five Other Things To Keep In Mind

As you think about your own financial future next year, I'd also ask you to remember these things:

1. Wall Street destroyed our economy.

Why people continue to lend any credibility to the banks, analysts, rating agencies, and mainstream financial media baffles me. And don't confuse free markets with Wall Street.

2. The economy is cyclical.

While it doesn't feel like it today, the economy will improve eventually.

3. History shows it is a mistake to bet against America and its best businesses in the long-term.

We had a scare a year ago, but capitalism will survive. See Warren Buffett's recent acquisition of the Burlington Northern railroad company.

4. Beware of anyone saying, "This time it's different."

There is always an ulterior motive.

5. Incentives matter.

The financial incentives and motivations of those entrusted to manage money make a difference. Without exception, the best portfolio managers I know work at independent firms. Be a steward of your own wealth, not a consumer of financial products.

A Final Note

Lastly, I couldn't be more biased when I write this, but so be it:

The mutual fund model has failed investors. It was a good idea that has run its course. Its many faults are being overshadowed these days, however, by the moral bankruptcy of Wall Street. Nonetheless, all investors need viable alternatives to mutual funds. I think spoke funds should be one of those options. I hope you do now, too.

Thank you again for all the support this past year. On to the next one.

- Cale

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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