Zeke Ashton's Centaur Total Return Fund 2015 Annual Letter: Bargain Hunting in High Yield BondsVW Staff
Zeke Ashton’s Centaur Total Return Fund annual letter to shareholders for the year ended October 31, 2015.
Dear Centaur Total Return Fund Investors:
The Centaur Total Return Fund produced a return of ?0.87% for the year ending October 31, 2015. Our primary benchmark, the Dow Jones U.S. Select Dividend Total Return Index, experienced a gain of 2.03% for the same period, while the S&P 500® Total Return Index returned 5.20%.
For the trailing 5?year period ending October 31, 2015, the Fund has produced an annualized return of 7.92% versus the primary benchmark’s return of 14.11% annualized over the same period. The S&P 500® Total Return Index has returned 14.33% annualized for the five years.
For the trailing 10?year period ending October 31, 2015, the Fund has produced an annualized return of 9.00% versus the primary benchmark’s return of 6.73% annualized over the same period. The S&P 500® Total Return Index has returned 7.85% annualized for the ten years.
Since the Fund’s inception on March 16, 2005, the Fund has produced an annualized return of 8.77% versus the primary benchmark’s return of 6.72% annualized over the same period. The S&P 500® Total Return Index has returned 7.63% annualized for the ten years.
(For the Fund’s most up?to?date performance information, please see our web site at www.centaurmutualfunds.com.)
Centaur Total Return Fund – Thoughts on a Difficult Year
The Centaur Total Return Fund’s performance for the fiscal year 2015 was disappointing to us, though we believe that our investing process remains sound and that the decisions we made over the twelve months were on balance both reasonable and consistent with the Fund’s risk?conscious strategy. While we would like to have done better, our performance as a concentrated, value?oriented Fund in any given year will be highly dependent upon the performance of a handful of investments. In addition, while we believe our approach to value investing allows for considerable flexibility in its execution, we are and likely forever will be heavily influenced by the biases we hold as investors. These biases have been shaped by long experience over a wide range of market conditions and represent the sum total of the many lessons we have learned. In addition, our mental filters have been shaped by the study of various other well?known investors of all styles and their experiences over time. Unfortunately, our value?oriented style tends to be unhelpful in certain market conditions, and we believe that the market conditions since late 2013 have been especially unfriendly to an approach weighted heavily on assessments of company valuation and business risk rather than on factors such as revenue growth, stock price momentum, and the excitement of the narrative or “story” surrounding individual securities.
We have also learned that in the world of investing, experience is not always the advantage it would seem to be. Knowledge of how things generally turn out in the longer term based a study of history and personal experience can be highly detrimental to keeping up with a crowd in the shorter term that is not encumbered with any bias other than being fully invested and focused on what is working now.
Of course, it is also true that the future does not have to play out as it has in the past. As Warren Buffett once said, “If past history was all there was to the game, the richest people would be librarians.” Formerly great businesses can decline suddenly due to new technology or changing industry conditions. New businesses or entirely new industries can burst onto the scene with unpredictable speed, disrupting formerly entrenched players. Every few years it seems we encounter conditions that neither experience nor historical study could fully prepare us for. We witnessed the unprecedented technology bubble of the late 1990’s, the financial crisis of 2008?2009, and more recently, zero and even negative interest rates on government?issued debt accompanied by a widespread effort on the part of central bankers around the world to influence asset prices. Finally, it is simply the nature of the market to occasionally behave in ways that are not entirely rational, and this behavior can often last much longer than one might think. Markets are prone to bubbles, busts, fads, trends, and the occasional bout of random weirdness. One of the key lessons we’ve taken from our experience as investors is that one can never really know what kind of market you may encounter next. We accept that our value investing style isn’t likely to be the best approach for any given scenario, but we believe that a framework that allows for reasonable returns with acceptable risk over the widest possible variety of scenarios is preferable to an approach that relies on correctly forecasting what is coming around the corner.
So, what exactly do our investing biases look like? Below is a short sampling of the most important:
- As value investors, we believe that the price one pays for a security in relation to the underlying asset value, future cash flow profits, or value to a knowledgeable all?cash acquirer is critical to future returns. Consistently paying low prices relative to economic value shifts the odds in one’s favor and reduces risk over time. Buying securities with no regard for value may work at times, but offers little margin for error.
- We prefer slow?growth businesses with a history of consistent profitability to those that are showing rapid recent sales growth without demonstrated profitability.
- We prefer companies that maintain strong balance sheets, with excess cash and debt levels that can be easily repaid with a few years of cash flow to companies that make aggressive use of debt in an effort to grow profits rapidly. It has been our experience that excessive debt (almost always taken on during periods of optimism) is the single most common cause of permanent capital loss for investors.
- We generally prefer conservative, low?key management teams that have managed well over the long term and communicate candidly with shareholders to highly promotional management that appears unduly concerned about near term stock prices.
- We prefer management teams that are owner / operators and who own a considerable amount of stock to hired agents that are largely compensated with stock options.
- Our valuation methods are heavily focused on free cash flow (which we define as cash that can be returned to investors or reinvested in the business) to reported accounting earnings or other often?used proxies for profitability (such as Earnings Before Interest, Taxes, Depreciation and Amortization EBITDA).
- We prefer companies that demonstrate a consistent and rational approach to capital allocation (sustainable dividends, intelligent share repurchases, and prudent acquisitions done with cash) rather than companies that attempt to maintain unsustainably high dividends, buy back stock aggressively at elevated prices, and which utilize debt to fund acquisitions or buybacks in a manner that reduces future flexibility or increases risk to shareholders.
- We favor a relatively concentrated portfolio of 20?30 securities, with our top ten ideas routinely comprising 40?50% of the portfolio’s value.
- We favor companies that pay meaningful dividends so long as they meet our other criteria.
- We look to sell covered calls on certain Fund holdings when we believe the prices received offer good value and where our valuation aligns well with the all?in stock price plus premium we would receive if the stock were called away from us (please see the Fund’s prospectus for a more complete discussion of selling covered call options).
- We prioritize the avoidance of catastrophic loss first and foremost and focus on potential gains second.
The above list of our investment preferences is certainly not complete. Many successful value investors we have studied would likely produce a similar, though not identical, list of investment preferences if asked. Unfortunately, value investing in any form doesn’t work better than other methods all the time. There have been long periods during which value investing falls out of favor and those who practice it are maligned and marginalized as “oldfashioned” and stodgy. We believe today’s environment is one such period, and we certainly feel old?fashioned and stodgy as we read about the many profitless venture capital “unicorns” with billion?dollar valuations and observe institutional fixed income investors buying European government bonds priced at negative yields. Obviously, in a world as complex as ours, investment results cannot be guaranteed or predicted, but we believe investors have a choice of frameworks. We think our approach makes logical sense, and is likely to help protect us from the temptations that lead to excess risk taking and performance chasing that will inevitably be heavily penalized at some point.
Of course, we still need to execute our strategy well in order to produce acceptable returns. Every year we review our decisions in an effort to learn lessons from our analytical mistakes or errors in judgment in an effort to improve as investors, and we hope as always that this year’s lessons will lead to improved performance in future years. Most of our recent lessons have served to reinforce to us the importance of being able to predict how management teams will react to various conditions (either good or bad) and ensure that we are not overly generous in our assessments of management quality when evaluating potential investments. On the flipside, we continue to gain appreciation that truly outstanding management is actually quite rare and deserves extra consideration when making investment decisions, particularly when it comes to the tough decisions to average down into an investment that is declining in price. As always, we will make every effort to ensure that the lessons learned in the past year will add to our future performance by improving our own judgment and adding to our accumulated knowledge.
Centaur Total Return Fund – Portfolio Update
As of October 31, 2015 the Centaur Total Return Fund was approximately 67.99% invested in equities and warrants spread across 26 holdings, offset by covered call liabilities equal to less than 0.46% of the Fund’s assets. Cash and money market funds represented approximately 29.98% of the Fund’s assets. The top ten investments represented approximately 40.11% of Fund assets.
As of October 31, 2015 our top 10 positions were as follows:
Please refer to the Schedule of Investments section of the Annual Report for a complete listing of the Fund holdings and the amount each represents of the portfolio. Holdings are subject to change without notice.
We continue to find the current environment a challenging one, given that U.S. stocks remain extremely expensive relative to historical norms and to our own internal estimates of underlying business value. At the same time, global economic growth appears challenging and we continue to see heightened risk factors and declining fundamentals across asset classes. The recent performance of market?cap weighted U.S. stock market indices is being driven by a small number of issues that is masking weakness across a large swath of securities with lower index weightings. Many of the companies that we monitor have recently reported disappointing financial results due to a combination of the strong U.S. dollar and declining global demand, and we have found ourselves revising our estimates of investment value down for the stocks on our watch list with far more frequency than we have been revising them upwards. Finally, it is our view that many publicly traded companies have already stretched to take on considerable debt levels at low interest rates in recent years to buy back stock or make acquisitions, which has helped boost stock prices but which may leave many companies vulnerable if credit conditions tighten or business performance declines. In short, we expect that the market may look quite a bit different in 2016 than it has in the last couple of years. We would not be surprised to see higher volatility and, hopefully for us, more opportunities to find great investment ideas.
As always, we would like thank our investors in the Centaur Total Return Fund.
Portfolio Manager, Centaur Total Return Fund