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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The Stock Market In 2014

The stock market has had an amazing run over the last six years uninterrupted in any meaningful way. It
is common place for all types of prognosticators in the media to tout that market the market is terribly
overvalued and a crash is inevitable over the next few months, and others say money is going to flood
into the stock market from investors who are tired of receiving very low returns from the bonds they
own, bond yields, or interest, are at historic lows.

Currently the stock market as a whole is priced towards the upper end of a reasonable historical range of
valuations. A couple of measures I like as a general measure of the stock market valuation are the total
value of the United States stock market divided by United States Gross National Product (30 year
average = 82%, currently = 122%, currently overvalued by this measure), and the earnings yield of the
S&P 500 – 10 year US Treasury Bond (30 year average = -1.09%, currently = 2.02%, currently
undervalued by this measure). So it is undervalued by one measure and overvalued by the other
measure. While these prognosticators may take one measure and predict with gusto and conviction the
future movements of the market, the truth is there are many variables that affect the value of the market
and no one can predict the market, least of all me.

The best way to be wrong is to try to predict the unpredictable. I try to not be wrong all the time but
especially when there is nothing to gain from being right, so I will continue the practice of abstinence as
it relates to forecasting the behavior of the general stock market. While it is prudent to understand
where you are in the business cycle, it is foolish to predict how the economy will rectify any deviation
between price and value. I will continue my efforts doing what I know and love, finding undervalued
securities. Prices may be affected by movements of the general stock market but the underlying intrinsic
values of the businesses we own will not be affected.

Result of 2014
My continuing goal in managing our funds is to achieve a long-term performance record superior to that
of the S&P 500 return with dividends, while minimizing the risk of permanent loss of capital. Unless
we achieve this goal and continue to do so when measured over a period of not less than three years then
we should be investing in a low cost S&P 500 index. The only exception I would make to the previous
sentence would be a three year period of an explosive speculative bull market, such as occurred in the
internet bubble of 1998 – 2000. During this period markets became irrational and the prices of securities
lost all relation to the underlying value. We will be a fish out of water in markets like this, for us to own
securities we demand prices that are at a discount to value and not the other way around.

I track the results of a model portfolio as a measure of our performance. The model portfolio is made up
of my personal account. Your results may differ, especially 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.
The results of the model portfolio for 2014 are as follows:


I consider the performance of the last year to be a relatively good performance, given market conditions
that were not exactly ideal for the management style of yours truly. When the market is fully valued as I
believe it to be at the present time, it becomes more difficult to find businesses priced at a discount to
value. Difficulty will not deter our search for these businesses though.

Portfolio Developments
As I have stated it is my intent to own 10 – 20 securities that I know well. You all know the securities
held currently in your portfolios from the statements and/or by online account access. I will always limit
my comments to the positions that we have exited, explaining the rationale for entering the position and
exiting the position.

American Public Education – APEI – In late September/early October the valuations of this provider of
online secondary education became very attractive. There were headwinds for the education industry in
general, rising cost, government scrutiny to student loans, etc. However they were a leading provider at
lower cost with a solid balance sheet and no debt, and stable revenues/earnings. We purchased our
position in early October and added to that in early November. Much to our satisfaction the stock
quickly moved up and reached what we deemed as full valuation and we exited the position in the
second week of January at a 25% gain.

Teradata Corporation – TDC – This analytic data solutions company was at attractive valuations for the
majority of 2014. I felt a lot of data moving to the cloud would prove to be tailwind for this company.
Again strong balance sheet, little debt, buying back shares of the company and stable rising earnings.
We purchased in early November, however on their earnings release and conference call of February 5tt I
gathered that 2015 was going to be a tough year and I felt the valuations weren’t as attractive with the
reduced guidance as compared to 2014 and our funds would be better utilized in other opportunites. We
exited that position the following week at a 9% gain.

Teradata is an example of the importance of ensuring that you have a wide margin of safety when
investing. Although the investment didn’t develop as we thought, we still exited the investment in three
months with a 9% gain, I presume in the future investments that do not develop as planned will not be as
pleasant as this one. However the wide margin of safety will limit the pain.

I look forward to talking to you again after the second quarter of 2015. In the event you have any
questions regarding this letter or otherwise I am always happy to hear from you.
Randall S. Herion, 2/15/2015

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