Zeke Ashton on the Painful Decision to Hold Cash NowVW Staff
Zeke Ashton Q2 2013 letter to shareholders below.
We have a rather simplistic investment philosophy: we like to buy assets when the prices of those assets reflect a sizable discount to what we believe them to be worth. We like to sell those assets back to the market when the market is willing to give us what we believe is a full, fair price. The catch is often that in order to buy discounted assets, there usually needs to be some fear and uncertainty reflected in securities prices. As the old saying goes, you can have cheap prices or you can have good news, but you usually can’t have both. When it appears that all is well in the world and the market is driving asset prices higher, we tend to be net sellers. That has been especially true for us over the past year, in large part because there has not been a significant market sell?off during that time that has lasted for more than a few days to allow us to make significant new investments. Our strategy greatly benefits from the occasional market break in order to re?stock our portfolio with new investments that meet our Fund’s risk?averse, income generating mandate. In a way, we need the occasional market volatility that accompanies fear and uncertainty in order to achieve our strategy’s full potential.
It is somewhat unusual for mutual funds to let un?invested cash build up in their portfolios, because it is an invitation to under?perform the markets if the market appreciates in the near term. We suspect that very few mutual funds would be willing to let more than 30% of the assets sit fallow, particularly given the historically low rates on money market funds, but in our view the willingness to do so can be a competitive advantage in the right circumstances. The reason for this is that markets tend to run in cycles driven by fear and hope; when the market is going up, it feels like it will never come back down. The reverse is also true. Our view is that the best way to exploit the occasional bouts of market fear is to have an inventory of ideas that one is ready to buy at the right price, and the cash available to carry out that buying. One without the other is useless. The willingness to radically flex our invested balance up and down with market conditions (buying heavily into fear and uncertainty, selling appropriately into happy, fully?valued market conditions) based on the availability of cheap individual securities or the absence of the same is likely to increase the chances of a good experience over time, and theoretically should reduce risk. The unfortunate reality is that following such a course can lead to uncomfortably long periods of under?performance which can test the patience of both the Fund’s manager and its investors. It is for this reason that we are satisfied with the Fund’s recent returns that essentially matched the market’s strong performance. We are willing to endure a performance drag in the short term in order to achieve our longer?term objectives, but it’s nice when we don’t have to.
On that note, it is important for our investors to understand that there are really only two ways within a mutual fund structure that one can ensure that there will be cash available at the right times to follow this discipline. One way is to have sold assets that have fully appreciated in price and allow cash to build up in the Fund. The other is to have a base of investors that are conditioned to invest more money into the Fund during significant market selloffs. Unfortunately, this latter source of potential cash is rarely available and certainly can’t be counted on. This is because it is the natural impulse for most investors to sell assets when the market is down and assets are cheap, only to buy assets when things are “safe” and prices are higher. As noted above, this is pretty much the opposite of what we try to do. The next best thing is to have a reasonable base of Fund investors that mechanically add to their investments over time, for example via an automated investment plan. This allows the manager the comfort of knowing that at least some new capital will become available to buy assets in a market downturn.
As an investor in our Fund, you can help contribute to our chances of longer term potential success if you can condition yourself to make additional investments when market declines are making front page news – or at least not to sell during such times. Usually we will be net buyers at such times, and the more capital we have available, the better. Alternatively, you can make your investments fully mechanical by establishing programs to automatically invest a certain amount on a monthly or quarterly basis.
As of April 30, 2013 the Tilson Dividend Fund was approximately 70% invested in equities spread across 30 holdings, offset by notional covered call liabilities equal to approximately 1.1% of the Fund’s assets. Cash and money market funds represented approximately 30% of the Fund’s assets. The top ten investments represented just over 44% of Fund assets.
As of April 30, 2013, our top 10 positions were as follows:
|Position||% of Fund Assets|
|1) First American Financial Corp. (FAF)||7.0%|
|2) Apple, Inc. (AAPL)||6.5%|
|3) Coinstar, Inc. (CSTR)||4.8%|
|4) EMC Corp. (EMC)||4.4%|
|5) Coach, Inc. (COH)||4.4%|
|6) Kohl's Corp. (KSS)||4.1%|
|7) Blucora, Inc. (BCOR)||4.0%|
|8) Tetra Tech, Inc. (TTEK)||3.1%|
|9) OM Group, Inc. (OMG)||3.0%|
|10) American International Group, Inc. (AIG)||2.8%|
One area that we believe still offers some value in the market is in high quality, large?cap technology stocks that may be momentarily out?of?favor as they transition from rapid growth to slower growth. In particular, we become interested when that transition is also accompanied by a change in capital allocation policies designed to return more cash to shareholders in the form of dividends and share repurchases. We believe that Apple and EMC are two of the absolute highest quality technology businesses in the world and both have recently announced very material, shareholder? friendly changes to how they will allocate capital.
Apple is a business everyone knows and likely has an opinion about; the stock price reflects an opinion that Apple’s best days are behind the company and that Apple is in for a protracted period of decline. We believe that this negative outlook is unwarranted, and at recent prices net of its cash balance, Apple is priced at a mid?single digit multiple to the cash flow generated by the business. Even better, Apple recently increased its dividend (the stock yields just under 3%) and also announced that it would repurchase roughly $60 billion worth of shares between now and the end of 2015. This would reduce the share count by approximately 15% at current prices. Our view is that Apple likely enjoyed a “peak year” in 2012, and that intensifying competition is likely to reduce Apple’s amazingly high profit margins in the future. However, even accounting for that, we believe the recent stock price discounts too pessimistic a view of how Apple’s business will perform over the next several years. In our estimation Apple remains an extraordinarily well?run business with terrific products in expanding product categories and will remain a relevant and uniquely valuable business for many years into the future.
EMC is the leader in data storage and cloud computing technology and has, in our view, one of the best management teams in the IT industry. EMC was able to lead the trend towards server virtualization through its majority?owned subsidiary VMware, and it has historically been a leader in data storage, which is a huge and growing market as more and more businesses look to store and utilize customer and business data. The company has also staked out an early presence in the nascent trend of network virtualization through its acquisition of a company called Nicira. Like Apple, EMC carries a significant amount of excess cash on the balance sheet and generates enormous amounts of cash flow from its business every year, some of which is used to invest into new technologies via acquisitions and internal research and development. But there is plenty of cash left over, and in June 2013 EMC announced a much more aggressive share buyback program (similar in scope to Apple’s announcement) and also initiated a dividend for the first time. EMC, like Apple, is valued by the market at a single?digit multiple to cash flow net of cash on the balance sheet.
Importantly, while technology businesses are inherently difficult to predict due to rapid changes in product cycles, stock price can be an important risk mitigation element if they are low enough that one doesn’t need to project significant growth in the future to justify today’s stock price. In the case of both Apple and EMC, the stock prices are low enough to offer us a reasonable margin of safety should both companies suffer near?term set?backs as each is priced as if a meaningful and lasting decline in business profitability is an inevitable outcome. Importantly, these aren’t businesses that have been left behind in terms of technology trends and need to invest heavily to catch up; these are both leaders in technology with track records of getting out in front of the pack and creating new product categories.
The Chimera Called Risk
Risk is an interesting concept when discussed in the context of investing. It is impossible to measure, and while the financial industry has a lot of ratios that purport to “risk adjust” returns, it is our view that while some of them are interesting none of them are definitive. There are also an infinite number of risks that an investment portfolio is exposed to; including the risk of being under?exposed. Further, risk means different things to different people. Our primary view of risk when it comes to investing in our Funds is the risk of a significant and permanent capital loss across our portfolio – one that cannot reasonably be recovered within a short period of time by the resumption of normally functioning capital markets. But others may define it differently. Finally, every single investor in our Fund likely has a unique and personal risk threshold; some people get nervous if their account is down relative to where it was yesterday, or last week, or last month. Others will have a very high tolerance for short?term volatility, particularly if they are confident that they are invested in a vehicle appropriate for their particular goals and risk profile. We make every effort to be risk?conscious in our investing decisions for the Fund, and we like to think of our ideal investor as one who wishes to have the opportunity for equity?type returns over a multi?year horizon but is willing to sacrifice some positive return if necessary in order to enjoy a lower risk profile than a typical equity portfolio. We believe an important “litmus test” for risk is how defensive a Fund is during very significant market declines, and we believe that the Fund scored well on this test during the market downturn of 2008?2009. Of course, we also think that our Fund is a good fit for those who are looking for equity?type returns with a meaningful income profile.
Over longer time horizons, we have been pleased to discover that by being focused on reducing risk, we have actually not been required to sacrifice returns. We cannot guarantee that this will be the case going forward, but we would like to think that we will generate satisfactory returns at a risk profile that most people can handle, even if those returns don’t always keep up with the broad stock market indices or our benchmark. On the other hand, our number one priority is to avoid permanent capital loss and it is this guideline that drives our activities at the margin.
Let’s bring this discussion back to the here and now. The current environment feels very much on the risky side to us; the market is going up, and has gone up for what seems like a long time now. The securities in classic yield and dividend?bearing categories are extremely expensive, particularly REITS, MLPs, and utility stocks. We see some stocks in these categories that we believe are worth much less than the current stock price, but investors are buying them because the stated (and in our view, unsustainable) dividend yield seems acceptable. For those companies that can legitimately earn and pay their stated pay?outs, yields are very low by historical standards. In adjacent capital markets, such as high yield and convertible corporate bonds, yields are also quite unappealing. In our view, the prevailing low interest rates (which we believe are also unsustainable for much longer) have caused a dramatic yield compression across the capital markets and force many investors to take on significant risks to achieve a given yield profile.
Outside of the traditional categories for income investors, prices are somewhat more reasonable, and we have been able to use covered call selling in spots to create investments that can justify the deployment of capital. As we’ve noted in past letters, we believe the flexibility our strategy offers to use the option markets to generate income can be a big advantage, and we believe this is one of those times. Even so, we’ve not been able to find enough ideas to maintain a fully invested portfolio, and we aren’t willing to bend our standards for safety to be more fully invested. We will remain patient for as long as necessary to find compelling opportunities.
As always, we wish to thank all of our investors for your continued trust and confidence in the Tilson Dividend Fund.
Portfolio Manager, Tilson Dividend Fund