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Tarpon Folio
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In This Issue

bullet Cale's Notes: Alibaba and Other Annoyances
bullet Get To Know Your Company: Why We Own SeaChange
bullet About the Tarpon Folio: More on our flagship Spoke Fund®

For Q3 2014
Published 9/21/2014

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Cale's Notes

Dear Investors,

Through the end of August, Tarpon in its sixth year was up 9.4% net of fees, though it did begin to lag its S&P 500 benchmark this summer. We're sitting on a little cash in Tarpon that I have been slowly putting to work in spots, but that alone doesn't explain our standing still while the broader market has inched ahead.

Contrary to headlines about the market continuing to reach new highs all summer, you may find it surprising that nearly half of the stocks on the NASDAQ are actually down by 20% or more in 2014.

You might chalk that disparity up to any number of things, from naughty algorithms to a more hawkish Fed to, more recently, "the strong-dollar trade", but from my perspective, it doesn't particularly matter. That all goes into the "things we cannot control" pile. I try to keep things simple by staying focused on things we can control, like material risks, monitoring the performance of our companies and the constant search for new ideas. So despite the headlines, it's actually been a busy summer in terms of finding new companies to look into - and for a number of other exciting things going on at IIM, too, that I hope to be able to share more about soon. You may notice I'm sending out this third quarter report a few weeks early, and that's to clear the decks for some more announcements later this year. Please stay tuned.

There are still good values in the market, though quality companies are unequivocally harder to find - at least in large cap names. Small cap stocks in particular have had a rougher go of things of late compared to larger companies, and that has crimped our recent results a bit. And yes, I find that a bit annoying in the short-term, too, but that's also the price we pay in trying to outperform over the long-term.

The biggest macro risks that I continue to keep an eye on - other than ranting about high frequency trading, I mean - are with regards to interest rates and the economic slowdown in China. To be clear, the latter is of far less concern to me than the former, and though it is probably worthy of a much longer discussion at a later time, until then, just know that very few scenarios involving the Chinese economy would entail me actually making any changes in Tarpon. It's more likely that a bad scenario over there would unearth some good opportunities for us over here.

Alas, along the same lines - no, Alibaba shares trading at 18 times revenue will never show up in Tarpon. And technically, those aren't even "shares" of Alibaba that are now trading. They are actually legal contracts for what is called a Variable Interest Entity registered in the Cayman Islands that purports to provide investors here with a stake in the company's profits - if approved by the Alibaba CEO and board. So the next time someone asks you if your investment guy got you in on the Alibaba IPO, please tell them, "No, my guy is a cranky old fiduciary." But I digress.

The economy continued to slowly improve this summer, in fits and starts and still at a less-than-satisfying pace. While unemployment remains an issue in the eyes of the Fed, core rate inflation is nowhere to be found. Nonetheless, an eventual rise in interest rates should be of modest concern to all of us - though not because of the consequences of that rise on the stock market, which will likely be irritating but brief, but because the Fed is in uncharted territory here in general. A small mistake in interpreting data could in theory quickly escalate into a big mistake in macroeconomic policy. And there are plenty of ways to make small mistakes when interpreting so much data.

Nonetheless, the bond market seems to suggest that we have plenty of time, and that we, too, should let the data determine what if anything we should do about rates that will eventually rise. As per reports this past week, most economists on the Fed's Open Market Committee now see interest rates rising to 1% before the end of 2015, and then hitting 2.5% by the end of 2016. Those absolute percentages aren't nearly as informative as what they imply about monetary policy, however, which is that the Fed is well ahead of the markets in those predictions. In other words, the bond market thinks rates are going to stay low for much longer than the Fed does. And I would submit that we want the Fed to be a little more forward-leaning on rates then everyone else - to be absolutely sure we avoid the scourge of high inflation in particular.

So when it comes to macro portfolio risks, all of that is a long-winded way of saying, "Lot of watching. Not much doing. This is okay, for now." And as this summer winds down, I once again have Macro Pundit Talking Head Fatigue. Let's get back to some good old fundamental analysis, eh?

Below I am including the first page of a longer write-up on one of our newest holdings, SeaChange International. I thought it might better illustrate the kinds of good opportunities that are out there right now - if you're willing to do the digging. This particular investment thesis gets a bit techie, but I think you'll recognize some common themes for us. SeaChange is a significantly undervalued company with obscured earnings power and a modest competitive advantage going through a smart, deliberate transformation of its business.

To download the complete PDF, please click here. And if you would like a copy of my valuation model, just shoot me an email.

Please let me know if you have any questions. And thank you for investing with IIM.

- Cale

Get to Know Your Company

Why We Own SeaChange International (SEAC)


New entrants and technological change have conspired to expose weakness in the traditional business of cable television providers. Lulled into over-reliance on geographic monopolies, cable providers were slow to respond to competitive threats represented by Netflix, Tivo, YouTube, iTunes, Amazon Prime, Google Fiber, telcos and direct broadcast satellite, among others. Internally, cable providers were hampered in their response by operational inefficiencies, specifically in the fragmented IT infrastructure that resulted most visibly in poor customer service. Other external threats have come from judges, regulators, and cord-cutting millennials. The disruption of cable television, it has seemed, is all but inevitable.

A survey of recent results for global cable companies, however, casts doubt on that imminent fate. The resiliency of cable providers in retaining television customers despite the level of competition has been impressive. The impact of cord-cutting to date appears overblown. Retransmission fees continue to be significant deterrents to channel unbundling. Consolidation is not defensive but opportunistic in the pursuit of growth - in an industry where organic subscriber increases in the U.S. are otherwise effectively capped by regulation.

While it can be difficult to predict the long-term future of the cable television industry with a high degree of confidence, the bar to being truly disruptive in the space is also set much higher than most investors seem to believe. Cable companies have an enduring competitive advantage in the two-way pipes they own into more than 100 million homes in the U.S. - protected by local monopolies in most markets. In addition, cable networks allow for much faster speeds than fixed telecom networks, and in a few years, DOCSIS 3.1 technology will enable download speeds of up to 1.0 Gigabits per second. In the interim, cable companies will retain the upper hand in the competition to provide superfast broadband due to their ownership of superior assets.

Now the industry appears close to an inflection point in its capacity to respond to competitive threats. “TV Everywhere (TVE)” - or authenticated video-on-demand – allows a cable customer to access content on multiple screens, from televisions to tablets to mobile phones, as part of an existing subscription. According to McKinsey, nearly half (48%) of all the television watched today is either "time-shifted" (using DVRs or Video-on-Demand) or "device-shifted" onto laptops, tablets or mobile phone screens. And the growth of this “multiscreen” viewing over the past five years has made it clear to the cable companies that the future lies in TV Everywhere.

All major pay-TV operators have now implemented some form of TVE service. More consumers are watching on-demand content than ever before – days, weeks and even months after a program originally airs. Surveys reveal that TVE users watch 64% more television (72% for millennials), 98% of those users say TVE adds value to their pay-TV subscription, and 93% report that they’re more likely to stay with their pay-TV operator as a result of TVE. And that last point in particular is very important.

From a high level, cable television providers see TVE or “multi-screen viewing” capabilities as a means to (a) extend efforts to enhance the value of a core subscription; (b) increase average revenue per user (ARPU); (c) reduce churn; (d) create new revenue sources for viewing and advertising; and (e) hedge against the ever-increasing range of online distribution options available to consumers.

Simply put, the easiest way for a cable provider to increase profits is to reduce churn – the number of subscribers who cancel service and/or switch to another provider. And TVE helps them do just that. TV Everywhere can really be viewed as a defensive price discrimination tool intended to dissuade subscribers from disconnecting their television service - and it certainly helps that TVE has very good customer “optics” and favorable business economics.

So video content over cable networks is shifting from being delivered in a linear, traditional, centrally “programmed” way to being delivered in a much more dynamic and personalized way - driven by the viewer. That fundamental shift in the way we watch TV has dramatically increased the complexity of the technological infrastructure that cable providers use to manage, prepare, deliver and monetize content to a growing number of screens. And for many of the largest players in the industry, a core technology enabling TVE is being provided by a single company.

Which brings us, finally, to SeaChange International. The industry uncertainty mentioned earlier has impacted companies at all layers of the industry’s value chain. In the case of SeaChange (SEAC), however, that impact has created an exceptionally attractive long-term opportunity.

To read my full report on SeaChange, click here to download a PDF copy. And please let me know if you have any questions.

About Tarpon

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.

Here is our privacy policy, our Form ADV and our Fiduciary Oath.


Historical performance data above represents performance results as reported by the portfolio identified. 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 timing of initial investment. 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 and dividends.

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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