Letter to Investors

Q3 2013

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In the 4th century B.C., an unusual philosophical movement began in Greece. An offshoot of Socratic teaching, its early practitioners adopted unusual attitudes and unconventional behaviors that they believed offered a short-cut in the pursuit of happiness and freedom from suffering.

Though the movement had no codified principles, included among the group’s core beliefs were a cult of indifference towards conventional values, a rejection of material wealth, and the elevation of shamelessness over modesty as a virtue. The group appointed itself the watchdog of humanity, and through antagonistic confrontations on street corners and the caustic use of satire, followers strove to uncover and expose all the pretensions they saw rife in the society of their day.

This group came to be know as the Cynics, and their informal philosophy was called Cynicism.

During the tremendous uncertainty in the ages that followed, Cynicism grew in popularity and eventually spun off mini-philosophies of its own. In more modern times academics often link the same Cynical suspicion of others to the philosophical works of Marx and Nietzsche. Ultimately, however, Cynicism as a philosophy has a fatal flaw: to be a true Cynic, you must hold in complete disbelief the sincerity and goodness of any and all human motives and actions. And I imagine that sort of thing can make it hard to find a date.

I have little interest in politics. I do, however, have pretty strong opinions about leadership, teamwork, and management in general. And if you were not baffled by the last few weeks of political theatrics in D.C., it’s probably because you weren’t paying close enough attention. It was a perplexing brew with consequences of uncertain scope. In the end, unfortunately and yet again, we have all paid an unclear price to only buy more time.

I will leave it to others to make predictions about the repercussions of all that angst on the economy, the dollar, the Fed, and the next round of elections. But keep in mind that uncertainty is an ally when it comes to finding bargains in the stock market. And because we’re going to have to endure yet another round of political drama all too soon, the intro above is really a roundabout way to make this request of you:

Do not become a cynic.

I get it. It’s hard not to be upset these days. Too many politicians in both parties of late seem to follow an ancient Greek character arc - the bright-eyed idealist who, through disappointment or frustration or fear, eventually succumbs to the most cynical of attitudes. Solutions for the country’s most pressing problems languish, and the cynicism in D.C. becomes more contagious than a yawn after Thanksgiving dinner.

But let’s keep things in perspective, too. American politics may be dysfunctional, but our businesses are still the best in the world. Hands down. So when it comes to investing, let’s stay stoic. I’ll keep plugging away on this portfolio, and we’ll all agree that it’s okay to have a little faith in our businesses and the market. A stock market that, you know, is being recklessly manipulated by the algorithms of a secret cabal of disgruntled ex-nuclear physicists holed up at Goldman Sachs.

It’s not cynicism if it’s true, people!

Now, on to Tarpon.

Since the beginning of its fifth year through past Friday, the Tarpon Folio is up 34.0% compared to an increase in the S&P 500 benchmark of 28.2% over the same period. Since inception, Tarpon is up 190% compared to 126% in the benchmark over the same time.

That said, I cost us some outperformance in Tarpon the last few months. I sold out of two companies Whose Names Shall Still Not Be Mentioned after the management teams of both made unexpected announcements that caused me to seriously question their credibility and my sanity. So we got dinged in both of those positions, and then had a relatively high percentage of cash in the portfolio as the broader market crept higher.

Then - and perhaps this is the best way to say this - my level of defensiveness in Tarpon became inversely correlated with the volume of rational thought coming out of our nation’s capital. So I trimmed back on a few other positions, hedged the market a bit using an inverse ETF, and then waited until something - anything - resembling reason began to emerge from Washington. In the end, the market saw right through the political bluster while we held extra cash and I then got cautious, so Tarpon has lagged its benchmark since late June.

Though it’s taking more effort to find good values out there lately, there are still bargains to be had. Witness the following:

1 - We initiated a new position in Sears Holdings in the quarter, which increased almost 50% in the weeks after we bought it. And as I write there are reports of a possible buyout of our long-term holding Chesapeake Energy, too. Our positions have otherwise roughly mirrored the rise in the broader market this quarter. So there is still some value out there, and I’m not too concerned with our ability to resume beating the benchmark again over time in Tarpon.

2 - In its first quarter, the Frigate Folio, IIM's new international capital appreciation portfolio managed by Lauretta “Retz” Reeves, was up 9.5%. Retz is off to a great start in Frigate and is hard at work launching her second Spoke Fund, the Treasure Harbor Folio, which will focus on international dividend-paying stocks. You’ll hear more about both soon.

Incidentally, somewhere in here is probably a good joke about the relative excellence with which the Europeans have governed themselves lately...but it’s just too soon.

3 - Others are recognizing the value in Tarpon companies, too.

To set the stage a little:

For a value investor, watching the market constantly grind higher can be a bit boring. In my spare time this summer, after catching up on company filings and honing my watch list, I ended up entering several contests. These were “investment idea” contests, mind you, not the how-many-hot-dogs-can-you-eat-on-Coney-Island kind of thing. Though I could totally take Joey Chestnut.

Earlier this summer I won the top prize in the Open Professional Division of a competition held by Origami Capital, a private equity firm in Chicago. My idea was a lucrative and compelling strategy for investing in a particular kind of private company. Alas, that particular idea is also going to remain secret for at least a little bit longer - except for the truly curious among you, for whom I have an excellent deal...

Origami awarded me $10,000 for my idea. Let’s call that its market price. I believe the intrinsic value of the idea is many times the size of that award, but, good guy that I am, I am willing to sell you a PDF of the exact same write-up for the current market price of $10,000.

You’re welcome. Paypal accepted.

Otherwise, if and when I ever go public with that Origami investment idea, you all will be the first to hear. In the interim, just know that my brain is constantly scanning for opportunistic investments in all kinds of unexpected places.

Then, in August, yours truly was named a finalist in the 2013 Value Investing Challenge. Of more than 200 entries submitted, my write-up of Tarpon Folio holding Markel (MKL) was deemed to be in the top 20 by an independent panel of value investing heavyweights. Here’s a link to the article announcing the contest results on the Wall Street Journal site. I’m also including the first few pages of my analysis on Markel below for you to read.

Finally, just last week, I was invited to present another investment idea, this time on stage at the inaugural “Battle of the Buyside” event at Columbia University in New York City on November 12th. I’ll post the video on the IIM website afterwards if I can get my hands on it. And if you’re reading this in NYC and would like to talk Tarpon in person that week, please drop me a line. Billionaires accepted.

To summarize, the country has gone through yet another dramatic chapter in these historically histrionic times, but we’re doing just fine in Tarpon this year. I’ll keep working hard to turn that short-term “just fine” into long-term “amazing” - and please try to stay stoic about politics in the coming months.

Please let me know if you have any questions. You’ll find that write-up on Markel below.

- Cale

Why We Own Markel (MKL)

The common stock of Markel Corp. (MKL) represents an extremely attractive long-term investment. The recent acquisition of Bermuda reinsurer Alterra (ALTE) has created structural alpha at Markel that will result in long-term economic returns superior to those of the legacy company without a proportional increase in risk.

Markel’s relatively small capital base had previously constrained the dollar returns of its investment portfolio, as CIO Tom Gayner was limited in the proportion of shareholders’ equity deployable in common stocks. By acquiring Alterra, however, the $5.1B market cap Markel increased its supply of low-cost float by 66% to $8.9B – in spite of a soft market and without compromising on underwriting standards – and can now begin to optimize capital allocation across the enterprise. More specifically, Gayner can invest an increased percentage of significantly more float in higher-return securities. The ALTE acquisition will also dramatically increase annual gross premiums written by Markel’s insurance operations.

Assuming continued excellence in underwriting at Markel, expanded investment operations and increased premium volume will increase the company’s return on equity (ROE), leading to increased growth in book value per share and the rate at which intrinsic value will compound - with little incremental increase in risk. Value drivers in the company are (1) investment returns, (2) the cost of float and (3) the degree to which assets are funded by liabilities, including float, as opposed to equity.

The intrinsic value of Markel can be estimated via numerous methods and averages at approximately $1,300 per share, compared to the recent trading price of $531. That gap should close due to both increased ROE and multiple expansion. Catalysts in addition to float growth and increased premiums include a rise in interest rates, meaningful growth in Markel Ventures, new acquisitions and equity investments, share repurchases and/or upward revisions by credit rating agencies. In addition, Markel now has a leadership position in the emerging alternative reinsurance market and stands to benefit considerably as reinsurance becomes a viable asset class among institutional investors.

A margin of safety exists in the talent, integrity and risk aversion of management - as evidenced by the company’s conservative investment philosophy and loss reserving practices. The risk of significant and permanent capital loss is remote.

It is a peculiar conceit of our age that in spite of the tens of billions in personal wealth created from scratch by Warren Buffett at Berkshire Hathaway, so few have attempted to replicate it. After all, the blueprints for the Most Successful Wealth Generation Machine of all time are free to download, easy to read and even include witty, voluminous notes from the architect himself. Nonetheless, to date, more than 500 million people have attempted to digitally sling fat cartoon birds into snickering pigs, and very few have even bothered to try to build a Berkshire Hathaway of their own.

Perhaps Huxley was right.

In any case, among the discerning few is the management team of Markel, a diverse financial holding company that underwrites a variety of specialty insurance products for niche markets. While Markel has certainly customized those original Berkshire blueprints, management’s intentions are clearly derivative and admirable.

Markel’s recent acquisition of Bermuda reinsurer Alterra is analogous to Berkshire Hathaway’s 1998 acquisition of General Re in the following sense: with a significantly increased capital base, management now has considerable flexibility to invest both the premiums paid by insurance policyholders (float) and the regulatory capital (shareholders’ equity) that underpins the insurance operation’s promise to repay policyholders. The ALTE deal affirms that Markel is now an investment business financed by an insurance company. The company will over time employ a tremendous amount of free Other People’s Money into excellent businesses both public and private.

While somewhat constrained in terms of allocation across its portfolio, Markel has historically invested exceptionally well. On a weighted annual tax equivalent basis, over the last ten years CIO Tom Gayner has averaged 9.2% returns on Markel’s equity investments – an achievement that would put him in the top ten of large cap domestic equity mutual fund managers over the same time period. Over the same period, Gayner returned an average of 5.3% a year in the fixed income portion of Markel’s investments, for a total annual portfolio return over the last ten years of 6.2%.

So, you know, we want to keep feeding that guy the ball all night long.

Not to be overlooked is Markel’s insurance business. It is, in short, highly disciplined and deeply respected, emphasizing long-term financial strength over short-term profits. For the past five years, Markel’s combined ratios have averaged 98% per annum, underscoring the company’s ability to consistently underwrite at a profit in even the dreariest of markets. By way of contrast, its peers lost money in underwriting over the same period, averaging a combined ratio of 103% over the same period of time.

Markel, like Berkshire, is a rare company – both by corporate culture and results. The combination of excellent investment returns and disciplined underwriting at Markel have led to a 20-year compound annual growth rate in book value per share of 17%. And near the end of 2012, Markel announced a transformative acquisition, the significance of which still seems vastly unappreciated by the market.

To better frame what is transpiring at Markel, some context is in order.

Insurance companies like Berkshire and Markel make money two ways; writing insurance policies to collect premiums, and investing the float - money that the insurance company holds after accepting premium payments but before paying out claims. For a typical insurer, the premiums it brings in do not cover the losses and expenses it must pay. That leaves it running an “underwriting loss” – the cost of float – which is functionally equivalent to interest on conventional debt. If, however, the insurance company can underwrite profitably and consistently, that float essentially becomes free to hold, forever, like an interest free loan that never has to be paid back. And then the float can be invested in long-term securities, like stocks, to really compound.

Because nothing ever goes perfectly, however, regulators, credit rating agencies and disciplined Chief Investment Officers require minimum levels of equity capital in insurance companies to support given amounts of reserves. A detailed discussion of reserving at insurance companies involves actuaries, models and state insurance regulators, but in the abstract, the key point is that, all things being equal, more capital means more reserves means more flexibility when it comes to investing – and that means better investment returns.

Prior to the ALTE deal, Markel’s largest source of investment funds was loss reserves, typically invested in fixed income of various durations to be able to provide funds to meet insurance claims. The next biggest source of funds for Tom Gayner was shareholders’ equity, which can be invested with an infinite time horizon. And typically a portion of that equity would also be invested conservatively in fixed income - primarily to provide a margin of safety with regards to insurance claims obligations. But by boosting shareholders’ equity by $2.6B in the acquisition of Alterra, Markel has given itself considerably more discretion in its future investments.

To continue the previous investment firm analogy, prior to the Alterra deal, Markel had historically invested its own equity in other equities and its float in long-only fixed income - similar to, say, a near-year target date mutual fund. Post acquisition, however, Markel is more akin to a judiciously leveraged long-only hedge fund. Only it keeps all the fees to itself. And its investors love this.

Multiline insurance enterprises are complex businesses in constant competition. Nonetheless, under the right circumstances, the reinvestment dynamics of a well-run insurance company inside a holding company like Markel can be incredibly attractive.

Property and casualty insurance in general can be a good business for several reasons. Profits can be generated several ways, whether from investments or insurance operations, and capital requirements are usually minimal, with few outlays required for fixed assets or working capital such as inventory. As a result, the business can scale easily and have significant operating leverage.

In addition, the best insurers and reinsurers essentially self-generate permanent capital to invest by issuing policies for premiums and investing those premiums (net of operating expenses) until claims are paid. As long as a (re)insurer continues to operate, new premiums will replace reserves as claims are paid out, and to the extent that shareholders’ equity is growing, it can support ever increasing reserves - if the underwriting opportunities are available. And that availability is tied to (re)insurance events, rather than asset values or lender issues.

With regards to Markel specifically – despite its complexity, because the company has a history of underwriting at a profit and earning excess investment returns, we can fairly easily catch a glimpse of the kind of business it could be. By calculating its investment leverage ratio (total invested assets divided by shareholders equity), we can determine it currently has 2.6 dollars in its investment portfolio for every dollar of book value. This number is currently low, incidentally, as the ten-year average is 3.1x. Even given that depressed 2.6x level, though, achieving a 6.0% annual after-tax return on the investment portfolio would result in a 15.6% increase in book value per share. And if you include underwriting profits in that figure, then Markel’s returns could approach 20% fairly easily.

The acquisition of Alterra also appears to be an excellent fit. ALTE has a similar underwriting discipline and was acquired at just over 1x book value. The deal will be accretive to annual gross premiums written, book value, and return on equity. In addition, Markel’s investment portfolio went from $8.9B to $15.8B pro-forma, and the company stands to accrue significant additional value by re-allocating Alterra’s $6.7B investment portfolio. Notably, $6.3B of Alterra’s total portfolio was invested in fixed income, with the remainder allocated to alternative strategies. On a proforma basis, only 17% of the new Markel’s investment portfolio was in equities. If Tom Gayner increases the equity allocation of the combined investment portfolio from that pro-forma 17% to the historic ten-year average of 23%, then on the new $15.8B combined investment portfolio, he will have created $950M to buy equities. In other words, one of the most talented investors of will soon be looking to deploy an amount of new capital equal to 19% of his company’s current market cap.

Alterra was also among the first reinsurers to begin to exploit systematic inefficiences in the reinsurance market, specifically by expanding its capacity “on-demand” to write retrocession cover. The retrocession market – providing reinsurance to reinsurers - is highly opportunistic and can provide substantial returns. It is also indicative of an ongoing convergence between the capital markets and the reinsurance markets. While a detailed analysis of the alternative reinsurance market is beyond the scope of this report, investors can look to Alterra’s post-Japanese earthquake “sidecar” vehicle New Point as indicative of a novel way to extend additional capacity quickly to the reinsurance market and to profit handsomely from it. While still early, it appears that Alterra (and now Markel) has the relationships, infrastructure and proficiency to effectively arbitrage the reinsurance market and strategically lever third party capital to further boost returns.

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®.

Spoke Fund® is a group of separate investor accounts linked to a portfolio containing a significant portion of the net worth of the portfolio manager. Cale Smith at IIM is the creator and owner of this trademarked and proprietary approach to better transparency and integrity in investing other people’s money.

Fees for Tarpon are 1.25% of assets annually, assessed on a monthly basis. Turnover, taxes and trading are minimized in the fund, which uses a long-term value investing strategy.

For more information, visit our website.

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See our performance disclaimer for more. Any 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.