End of 2015 Letter


Uncertainty was the word of the year for 2015. Pervasive skepticism exists that the market can sustain the strong upward trend it has been in since 2009. This is generally a good sign for the stock market, as a widely used saying by Sir John Templeton goes, “Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria.” The stock market is well within the historical range of fair valuation. The S&P 500 (“S&P”) ended the year at 2,044 and began at 2,059, relatively flat overall with, as always in the stock market, a lot of fluctuation in between.
Through December the market moved lower and the trend continued for nearly all of January, although a casual observer of the press would assume a much greater than 10% by the terminology (i.e. tanked, crashed, plummeted) used by the press. I recently read an interesting article in Barron’s, between 1950 and 2014, half of all annual periods saw a correction of 10% or worse, we have experienced two 10% corrections in the last six months. It is important to not be overly enthused during the good times, or overly depressed in the bad times.

Late in the year, the market in general declined due to uncertainty of the fed raising rates, US GDP growth, weakening demand from China, 2016 earning and margin expectations for US companies, and select tax loss selling. When a stock has declined substantially over a year investors will sell the stock towards the end of the year to realize tax losses, and often times buy them back in the beginning of the year. To realize the losses the stock cannot be repurchased for 30 days after the sell. This creates selling pressure in November and December, and often increases buying pressure in January. Since we like to buy stocks that have become cheap in price, this tax loss selling effect was somewhat anticipated, however the January bounce back did not occur.

It is not all negative, the future positives I believe possible are – an increase in residential housing construction and household formation, government reduced taxes on repatriation of overseas capital held by corporations, reduced corporate income tax rate, rising wages in a tight labor market and lower energy prices increasing consumer spending. These are all very positive indicators that are likely outcomes of current monetary policy and the state of the economy.
Evaluation or prediction of the overall market is not foremost in my mind as outcomes in this area are always uncertain. Identifying undervalued securities is my primary focus, and market declines provides opportunities in this area.

My continuing goal, with your funds, is to achieve a long-term performance record superior to that of the S&P including dividends, measured over a period of not less than three years, while minimizing the risk of permanent loss of capital. We had a strong start in the first half of 2015, and our results fell in sympathy with the broader market over the second half. Those placing funds with me in the middle and second half will lag the full year performance of the model portfolio. I have some work to do this year to meet my three year performance goal, but like our chances with the current portfolio.

I track the results of a model portfolio as a measure of our performance. The model portfolio is based on the first client account I began managing. Your results may differ slightly, or may differ materially in the event that you placed money in the fund during the year, but over time your results should match closely the results of the model portfolio. All accounts are invested similarly to the model portfolio. The results of the model portfolio are as follows:


*The model portfolio returns are after a subtraction of a 1.25% management fee. The S&P 500 Total Returns have no fees subtracted from them, management costs for an S&P index fund are typically 0.17 to 0.50%.

Over the last several years growth stocks with expensive valuations have been more in vogue than value stocks. To illustrate, FANG – Facebook, Amazon, Netflix and Google – were the rage this year, and had spectacular 2015 returns of 34%, 178%, 145%, and 49% respectively with price to earnings (P/E) ratios of 100, 900, 300 and 35 respectively. Buying the “glamour” stocks at these P/E ratios is very speculative, an activity we abstain from, and only succeed if the next speculator (“sucker”) will pay you more than you paid. It may be a while before the speculators turn to “suckers” and the preference for “glamour” stocks over value stocks could continue producing headwinds for value investors like myself.

The market value of five of our core holdings, on January 1, 2013, was about $19.5 billion and earned $700 million in the trailing twelve months (ttm), this is the equivalent of a P/E ratio of 28. Today the market value of these five companies is about $10 billion with ttm earnings of $1.265 billion, for a P/E ratio of less than 8, in total they currently have $1.5 billion in cash and $190 million in debt. We purchased positions in these five holdings over the last year, as you can see they have a lot of cash, little debt, and are leaders in their respective industries. The current valuation of these five companies is almost half of what they were two years ago, and the earnings have increased by 80%. Several of these companies are valued as cheaply as they have ever been my multiple measures. The intrinsic value of these five holdings is somewhere in between the 2013 values and the present values, but substantially higher than present valuations. It is important to note, the value of a stock is not what the market will pay today (price), but rather the true value is based on characteristics of the business such as earnings and growth, free cash flow, private market values, and asset values. So whenever I mention value, I am not referring to the price of a stock. In time the market prices will oscillate around the intrinsic value of the business, sometimes irrationally high and other times irrationally low. The irrational swings of the market are the friend of the patient.

It is my intent to own 5 – 20 securities that I know well, and generally most of the portfolio will be invested in 5 – 10 stocks. Most generally positions in particular stocks will be sized at 5 – 15% of your total portfolio. However on occasions in which I have a “high-probability insight” of a potential outcome, accompanied by a good margin of safety, we will take a sizeable position. Over the last year I established a 30% position in a particular issue, see enclosed article about First Internet Bank. Developments in the company’s financial results have been positive and the position has grown.

I choose to invest in undervalued securities that sometimes become more undervalued after our purchase. This does not trouble me, unless developments occur that affect the underlying value of the company. If they do get more undervalued and you see it on your monthly statements, if it gives you any comfort my assets are invested in exactly the same investments as yours. Oftentimes we will invest more funds in an issue as it becomes more undervalued. My time horizon for a stock to get back to full value is three years when I purchase, oftentimes the process is much shorter. My concern is the performance of the portfolio over a three to five year period, not the performance of an individual stock over a period of six months. This year has had its challenges, we can’t control the market, but the value in our portfolio is substantial, and potential opportunities are more available than they have been at any time in the last two years.

If you haven’t funded your Roth IRA for 2015, you can fund up to $5,500 (or $6,500 if you are over the age of 50) for your 2015 contribution through April 15th, 2016. If you haven’t started a Roth IRA I would strongly encourage it. If you earn less than $183,000 you are eligible. Roth IRA’s are funded with after tax contributions and allow your funds to grow tax-free, and unlike the traditional IRA are tax-free upon withdrawal after the age of 62. Funding a Roth IRA should be the biggest priority in your retirement strategy.

I am fortunate to spend the great majority of my time researching opportunities to protect and grow the hard earned capital that you have entrusted to me, therefore marketing/sales receives little or no attention. I appreciate the referrals several of you sent me over the last year, I will continue my efforts in the research department to generate performance worthy of referral. In the meantime, if you have any questions regarding this letter or otherwise I am always available and happy to hear from you.


Randall S. Herion,
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