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Tarpon Folio
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In This Issue

bullet Cale's Notes: Tarpon vs. Skynet
bullet Get To Know Your Company: Why We Own First BanCorp
bullet About the Tarpon Folio: More on my Spoke Fund®

For Q4 2013
Published 1/4/2014

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Cale's Notes

Dear Investors,

In year five, which ended in late November 2013, the Tarpon Folio increased 32.9% net of all fees, compared to an increase in the benchmark S&P 500 of 31.3% over the same period.

Since inception through the end of year five, Tarpon has increased 189%, or 57 percentage points more than the 132% increase in the S&P 500 over the same period.

All of our gains in year five came in the first six months. As mentioned in my last letter, the second half of the year was largely uninspiring in terms of performance. On balance, we had a solid year and your portfolio manager is smarter now than he was a year ago. We will review the year in more detail here in Islamorada at the 2014 Investor Meeting in May. Stay tuned for more details on the meeting.

For now...on to year six.

'Tis the season for investing clickbait - that flurry of "Outlook for 2014" articles and "Best Stocks for the Coming Year" headlines. Ah, if only it were that easy. I trust you'll view those sorts of things with appropriate skepticism. And here is the headline about 2014 that I'm still waiting to see:

"Never Mind BitCoin: Stock Market Already Chock Full of Shady Algorithms"

Daily trading in the U.S. stock market has become dominated by computers. Some estimates put algorithmic or "algo" trading at close to 80% of daily volume. Assuming that's accurate, then the best indicator of the algos' impact on the market every day is the S&P 500 Index itself. In other words, the "market" has become the algos, and vice versa. So it should follow that in order to beat the index, you've got to beat the algos.

Now, if I asked you to describe the best way to compete against a thousand racks of the highest-powered servers in the world, running code written by the kind of folks who thought the large Hadron collider wasn't a challenging enough project...well, let's be honest, not many of you would say:

"Yeah, find me someone on a remote island chain. Someplace with lots of rum and rusty fish hooks lyin' around. Maybe some drag queens nearby. I want this guy to invest my money using a process that started in the 1930's. He's gotta spend most days alone, reading stuff, from inside someplace dank. You know, like an old explosives garage. But throw a dog in there with him so he doesn't go all Walter White."

Here's the thing, though: we've beaten the machines over the past five years. Not even close, actually. So I ask you - which way to invest is insane, really?

If you're competing with the algos, you need a process which gives you the best odds of coming out on top over time - because the shorter your time frame, the less likely you are to come out ahead. Besides, focusing too much on the daily noise means you risk short-circuiting the hard drive in your own head.

Because these algos can process and trade on new financial data within seconds of it being published, you should also realize the futility of attempting to beat the market by basing your investment decisions solely on things that are easily quantifiable by a computer. To win, you need to pick your spots, focus your efforts, go where the algos cannot or will not go and/or have as core to your investment thesis something that cannot be easily captured in a programmer's code.

So for us, I think the main thing to keep in mind when it comes to 2014 is this:

Myopic machines do not care about the absolutes of over- or under-valuation when it comes to a company's shares...only 'better' or 'worse' than prior expectations.

Most algos focus on changes to a company's expectations relative to just thirty seconds ago. And many high frequency trading algos appear to exist solely to flood the exchanges with fake orders in an attempt to scalp shares to the next investors who show up - as if they were desperate tourists outside Madison Square Garden.

To be blunt, I do not care for high frequency trading. Legalities aside, it's effectively a $10B-to-$20B-a-year tax being paid by unsuspecting investors - and the megaminds who collect don't even bother to come pick up the garbage on Tuesdays. That said, you're not paying me for expertise in municipal waste management.

The reality is that when it comes to the long-term performance of Tarpon, these algos aren't necessarily a bad thing. In fact, they can be very good.

More specifically, if a stock's price is driven disproportionately further below its true intrinsic value due to short-sighted algorithms (or the emotional investors they fleece), then as long as we can stomach the volatility, we should eventually realize above average returns.

That does come at a price, though - a temporary emotional one, really, which I think means it's all the more important that our investing philosophy be grounded in reason. We will "be early," or buy stocks as they are still going down. Some of the companies we own may induce nausea at first glance. Others may be small - too small for algos to trade in. All of those are just part of the deal in Tarpon.

The presence of a "catalyst" - a positive future event that a programmer can't confidently model - has also become that much more important to the case for investing in a given company of late.

So let's set aside prognostications about the Fed, interest rates and inflation. When it comes to Tarpon specifically, my crystal ball for 2014 looks a lot like it did at the beginning of each of the last six years. It's a bit fuzzy, but I foresee lots of time in some kind of bunker. In there with me is either a very large ferret or my black lab, not clear yet. Either way, I am hunkered down and attempting to correctly anticipate significant positive revisions to the long-term expectations for the best, most undervalued companies I can we can profit accordingly over the coming years.

Manhattan Is A Fine Island...

During this past quarter I presented one of our newest Tarpon companies at a conference in New York City. I spoke about First BanCorp (FBP) at the inaugural InvestPitch event put on by SumZero and Institutional Investor magazine at Columbia University. You can see a brief video of me at the event here. I did wear a tie, but in my own defense, it had tiny pictures of fish all over it.

Below is the write-up on FBP that I prepared for the event. It explains why we own shares. And if the idea of owning a small piece of a bank in Puerto Rico leaves you a bit underwhelmed, you're clearly not alone. But my investing thesis for FBP originated in the success we've had owning Bank of America (BAC), First Financial Northwest (FFNW) and Citizens Republic (formerly CRBC, subsequently acquired by FMER) in Tarpon over the past five years. So our investment in FBP was the result of a specific, repeatable strategy that while highlighted by yours truly is also independent of me, if that makes sense. It is also gloriously free of fads, trends and FaceBook.

Here's a quick wonky overview of what's going on in the financial statements of FBP right now:

Once a bank is well past the worst of its credit risk and is comfortable enough to begin releasing reserves, a relatively simple way to describe what's happening on the balance sheet and income statement is this...

When a bank releases its reserves, the contra-asset reserve account on the balance sheet will decline, so gross loans will go up. Assuming the liability side of the balance sheet stays the same (or increases less slowly), then book value (or net worth) will increase. In addition, when loan loss provisions on the income statement decline (assuming reserves are declining at the same rate), then earnings will also get a bump, all things being equal...and that earnings boost will then filter through and increase book value on the balance sheet as well.

The point is that for distressed banks that have successfully mitigated their credit risk and have enough capital, the potential increase in book value per share coming off the bottom of the cycle can be very accelerated - thanks to boosts from both the balance sheet and income statement impacts at the same time.

This is about to happen at First BanCorp, and that is kind of a big deal. Alas, you won't find it in any of those 'Best Stocks For Next Year' articles, either. Maybe that has to do with the fact that it takes a lot of old-fashioned legwork to figure it out, and, you know, most other investors these days are robots. In any case, hey, good for us.

That expanded thesis on First BanCorp from InvestPitch can be found below. Please let me know if you have any questions.

And Happy New Year.

- Cale

Get to Know Your Company

Why We Own First BanCorp (FBP)

Executive Summary

The market systematically underestimates the speed with which the earnings power of certain distressed banks will increase after credit risk has been sufficiently mitigated. Successfully exploiting that temporary mispricing will result in excellent returns to investors with significantly less risk than high levels of loan loss provisions might otherwise imply. First BanCorp (FBP) in Puerto Rico is at such an inflection point.

The common stock of previously distressed FBP has been significantly de-risked. Management has taken decisive action to rehabilitate the loan portfolio and demonstrates good cost control. Lower provisioning expenses, funding costs, and noninterest expenses are improving the bank's net interest margin, putting FBP on the cusp of a notable increase in earnings power. Independent of earnings growth, the recapture of a deferred tax allowance (DTA) will also provide a significant increase in tangible book value per share. Value drivers in the company are (1) mitigation of the remaining credit risk in the loan portfolio, (2) growth in tangible book value and (3) margin expansion. The bank is well-capitalized.

The intrinsic value of First BanCorp can be determined via several methods that estimate shares are currently worth between $7.85 to $9.00 per share, depending on certain key assumptions, compared to the recent trading price of $5.69. That gap should close due to both increased ROA and multiple expansion. Catalysts include a stabilization of the island government's fiscal woes, a continual decline in loan loss provisions, DTA recapture, the lifting of an FDIC consent order, the U.S. government exiting its stake, and/or further consolidation in the overbanked Puerto Rico market. A margin of safety exists in the company's current discount to pro-forma tangible book value. The risk of significant and permanent capital loss is low.

Background on First BanCorp (FBP)

The Commonwealth of Puerto Rico (PR) is an island the size of Connecticut with the population of the city of Los Angeles and GDP close to that of Las Vegas. Approximately 175 Fortune 500 companies have facilities on the island. PR possesses 270 miles of beachfront, and almost as many tourists visit the island every year 3.6 million as live there. Puerto Rico is the fifth largest biopharmaceutical manufacturing hub in the world, and in 2009 produced 16 of the top 20-selling pharmaceuticals on the mainland U.S. The island's capital of San Juan is home to the fourth largest port in the Western Hemisphere.

Puerto Rico is serviced by 8 banks with approximately 420 branches and $52B in total deposits. First BanCorp (FBP) is the second largest commercial bank by assets ($9.9B) in Puerto Rico, with 47 branches and employingapproximately 2,500 people. The bank was chartered in 1948 with capital of $200,000 and went public in 1987. FBP is also the largest bank in the Virgin Islands (11 branches, $820M in deposits), and has 14 branches in central and south Florida, where it operates a full-line commercial bank and has recently been hiring. Included among its whollyowned subsidiaries is a residential mortgage loan origination company with 37 offices on the island. FBP also offers insurance products for personal lines on an agency basis, and brokerage services in its branches through a strategic alliance.

Banking in Puerto Rico is highly competitive. Tax incentives and the tropical climate make it a desirable locale for corporations and the wealthy. On average there are approximately 8 bank branches every square mile on the island. Strong mortgage banking growth on the island in the early 2000s was driven by low rates and housing shortages due to population growth. By 2006, however, cracks began to showing in the island's banking sector, just as Congress ended a corporate tax incentive ("Section 936") that made profits from goods manufactured in PR exempt from taxation. A six-year recession began, from which Puerto Rico has only recently and barely emerged.

To read the full report on First BanCorp, please 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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