Auxier Report: Summer 2010

Jun 30, 2010

Download Summer 2010 Letter (PDF)

Market Commentary

Auxier Focus Fund ended second quarter 2010 with a -9.04% return, outperforming the -11.43% return for Standard & Poor’s 500 Index (S&P) by 2.39 percentage points. Year-to-date the Fund is down -3.99% versus a -6.65% decline for the S&P. The Fund has outperformed the market (S&P) by 87 percentage points cumulatively since inception in 1999.

A Formula for Going Nowhere Fast

Velocity trading has followed in the footsteps of velocity banking[1] as the latest easy shortcut to the arduous fundamentals of capital allocation.  Like the parabolic rise of derivatives that enhance returns through leverage, commodity Exchange Traded Funds (ETFs) have grown fifty fold from $50 billion ten years ago to $277 billion (Bloomberg). These vehicles generate no cash flow and therefore are speculations. Many buyers apparently overlooked the unanticipated “contango” effect[2] (the inability to deliver on the futures contract) and experienced losses when there should have been gains.

In addition, two-thirds of stock exchange volume has recently been tied to so-called algorithmic trading formulas. Computer models abound that can fail to factor in periodic bouts of emotional folly. This means a greater likelihood of material misappraisals and plum pickings for flexible bargain shoppers. There are no shortcuts to investing.  The economy is too dynamic and competitive. It is time to get back to the basics of investing—the craft of the specific.  That’s knowing more about what you own than the market; showing conviction to buy more at compelling price points; quantifying true risk to invest when odds are highly favorable.  Just as velocity banking failed, speculation that is not grounded in cash flow and fundamental analysis could in time fail as well.

Beware of Politicians Bearing Bonds

Two great Warren Buffett sayings apply today. “If money is easy, grab your wallet and run the other way” and “most men would rather die than think; many do.”  Like the heady, high-tech bubble that peaked in 2000, followed by comparable manias for real estate and private equity, the investing herd is stampeding into bond funds like never before.  In the past 18 months, some $580 billion has been channeled into US taxable bond funds and $500 billion into municipal bonds at the highest prices in history (Dow Jones News).  Never mind that estimates of off-balance sheet liabilities at the federal level run seven times our gross domestic product (GDP). Governments at all levels have made entitlement promises that are unsustainable and, if unchecked, would lead to bankruptcy. Good money continues to be allocated to Fannie Mae and Freddie Mac, a disreputable duo that has already cost taxpayers $300-$500 billion.  Illinois and California face a solvency crisis. Worse, the failed leadership and policies of both states have now been transferred to Washington DC. Once deficits reach a certain point, the risk of a failed bond auction becomes closer to reality.  Remember, in eight centuries only a handful of countries have honored their debts.  James Grant (Grant’s Interest Rate Observer) recently noted how Illinois, back in the railroad boom of 1842, was forced to pay 42.75% interest on its municipal bonds. More recently, yields on two-year notes in Greece climbed from less than 4% to over 20% in a very short period.  If policymakers don’t make adjustments the market will.  Unfortunately, unlike Japan, the US does not have the savings to absorb the shortfall.  I would bet that we could see a similar panic in government bonds, especially if current spending policies are not corrected.  In the early 1980s, the biggest municipal bond default in history occurred when Washington Public Power Supply System (WPPSS), aptly nicknamed “whoops”, failed to pay on a number of partially constructed nuclear plants. We were able to profit from the gloom by buying senior secured notes yielding 16% tax free.  The bonds had originally been rated AAA[3] and paid puny interest. Examining the entire capital structure is so important when investing in stocks and bonds.  It is difficult to survive over the long term with a weak balance sheet. As Jim Grant says, there is no such thing as a bad bond, just a bad price.

New Zealand’s Lesson for US Housing Subsidies

Back in 1985, New Zealand abolished all farm subsidies. Farmers’ income initially plunged as land and stock prices slumped. However, productivity soon recovered dramatically, boosting farming’s share of GDP from 14% to 16.6%. Farm products now comprise over 50% of all exports, and the rural population has grown.  The move created a much more vibrant industry commanding a greater share of the overall economy.  American policymakers should study this model to help reform Fannie Mae, Freddie Mac and our failed approach to housing subsidies.

Gateways to Emerging Market Middle Class

The US consumer and government face painful restructuring periods ahead. But many emerging economies learned their lessons the hard way back in 1998, and today have much better balance sheets. Global population is expected to grow from 6.8 billion to 9.2 billion by 2050.  Chinese consumption of skin-care products, cosmetics and fragrances has quadrupled to $13 billion the last decade (Business Week). We like low-ticket necessity products that have a steady demand.  Global austerity tends to favor our high-quality, self-funding businesses.  Prime examples are multinational corporations, with powerful global distributions. Many of these stocks have sold off to price points where there is very little premium for the emerging market gateway these companies provide.  Their high free-cash flow provides the needed flexibility to profit in times of distress.

Election Day 1994 Revisited?

The current US stock market feels like the early 1990s.  Hillary Clinton was trying to socialize medicine. The country had endured one of the worst banking crises since the Great Depression. The 1994 midterm elections led to the biggest Republican sweep in fifty years, overtaking both the House and Senate. This catalyst helped fan favorable tailwinds in the market.  Over the following six years, surviving small and midsized banks appreciated 400-800%.  Healthcare stocks in general enjoyed meaningful upward valuations in price/earnings ratios[4].  Large blue chips had three consecutive years of above-average returns. It is rare to have the chance to buy high-quality businesses at ten times earnings. Currently, 13 of the top 25 S&P 500 stocks sell for 10-11 times estimated 2011 earnings.  Neon Liberty Capital recently (July 2010) analyzed market performances after a decade in which the economy was in recession 25% or more of the time, as has our past decade. Guess what? Returns in comparable decades ending in 1955, 1958, 1975 and 1982 were well above average.  The subsequent average gains over three, five and ten years were all above 14% annually.

Why Our Approach Can Win Over Time

We will always have to face crisis situations.  Our approach is to work hard to anticipate potential areas of harm and irrational behavior. Then take advantage of the resulting bargains.  Our edge? Managing through challenging environments back to 1983 demands rational, tenacious daily research effort that focuses on minimizing the downside.  Seeking to identify durable investments is critical to outpace devaluations that result from the “easy path” politicians consistently follow.  We are in times when you can’t depend on a rising market for returns.

We rely instead on our dedication to spot exceptional individual opportunities and moving when we believe the price is right.

Your trust and support is appreciated.

Jeff Auxier

  

As of 06/30/2010, the Fund held those securities mentioned in the letter as follows:  Washington Public Power Supply System (WPPSS) 0%;  The Federal National Mortgage Association  0%; Federal Home Loan Mortgage Corp 0%.

 There can be no guarantee of success with any technique, strategy, or investment.  All investing involves risk, including the loss of principal.  The S&P 500 Index is a broad-based, unmanaged measurement of changes in stock market conditions based on 500 widely held common stocks.  One cannot invest directly in an index.

 The views in this shareholder letter were those of the Fund Manager as of the letter’s publication date and may not reflect his views on the date this letter is first distributed or anytime thereafter.  These views are intended to assist readers in understanding the Fund’s investment methodology and do not constitute investment advice.

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[1] A term used to describe the rate at which money is exchanged from one transaction to another.

[2] When the futures price is above the expected future spot price. Consequently, the price will decline to the spot price before the delivery date.

[3] The highest rating given on bonds by bond rating agencies.

[4] Price/earnings ratio is the value of a company’s stock price relative to company earnings.

 

Auxier Report: Spring 2010

Mar 31, 2010

Download Spring 2010 Letter (PDF)

Market Commentary

Auxier Focus Fund ended first quarter 2010 with a 5.55% return, versus 5.39% for Standard & Poor’s 500 stock index. The equity component of the fund appreciated over 6.5%. What’s more, Auxier Focus Fund has outperformed the market by 93 percentage points cumulatively since inception in 1999.

Rapid expansion in the US government’s balance sheet (from $850 billion to $2.3 trillion), coupled with the Federal Reserve’s (“the Fed”) policy of zero interest rates, has helped stimulate the economy and recapitalize banks. At year-end 2009, over $8.2 trillion in federal loans and guarantees backstopped the economy (Grants Interest Rate Observer). Recovery appears to be broadening. Inventories are being rebuilt; equipment spending is rising, and non-financial firms are sitting on roughly $2.8 trillion in cash, or 15.7% of total assets. That’s the highest level in over 20 years (Kiplingers.com 31 Mar. 2010). As credit trends improve, some $1 trillion sitting in bank reserves (source: the Fed) could further boost the octane of rocket fuel provided by the government. There tends to be a twelve month lag from the time of policy changes to when effects are felt on Main Street. Witness China, where government’s $1.4 trillion in aggressive lending over the past year has ignited a growth rate exceeding 12%.

Food Chain Fast Lane

Severe price deflation in the past year has created opportunities to profit along the food chain. Massive herd liquidations in pork, chicken and beef led to “mouth watering” opportunities in both the debt and equities of such meat producers as Smithfield Foods and Tyson. Cattle inventories by year-end were back to 1959 levels, contributing to the greatest price appreciation for beef (so far in 2010) in over 50 years. Shares of grocers Wal-Mart, Kroger, Supervalu and Tesco corrected on both food and fuel price declines last year. These companies offer consistent value to the customer and, due to high inventory turns, can perform well during periods of high inflation. In the 1970s for example, grocers proved to be one of the best performing groups as inflation exceeded 10%. More expensive food often tracks growing middle- class populations in emerging countries, whose obstructionist socialist policies can mean more bottlenecks in supply as demand swells. Younger populations in emerging countries are also attracted to western brands, benefiting those companies with strong international distribution (Tesco, Wal-Mart, Unilever, Nestle). The United States is a global leader in high-quality food products. In 1940 one US farm produced food and fiber for 15 people. Today one farm feeds 155. We will need to feed another 2 billion over the next forty years.

Dr Pepper Pops

One of our larger investments in the past year is Dr Pepper Snapple Group (DPS). At the time of our purchase, many skeptical investors assumed (incorrectly) that DPS suffered from poor trends in the domestic soft-drink business. The stock drifted down to nine times earnings. However, after being spun off from Cadbury (in November 2008), CEO Larry Young and his management team successfully focused on re-energizing a strong stable of brands. As a result, the company has enjoyed an upward revaluation, expanding its earnings multiple over 60% to 15. Outstanding management can add enormous value. This is the benefit of our practice of studying and judging the character and diligence of managements. We want the business to generate our returns, not the market.

Mispriced Government Bonds

Early last year, corporate bonds were discounting a so-called loss probability approaching 50%. That’s the worst since the 1930s, when the worst-case reality was 5%. This led to a tremendous double-play return, generating high cash interest with above-average appreciation. Conversely, government bonds now appear to be mispriced in the other direction—too little return for the risk.

There is currently no such thing as a safe government. I can’t remember a time in my career when there was so little return for the risk of owning local, state and federal government securities. Local and state governments collectively have amassed over $3.3 trillion in pension and health benefits that need to be paid out over the next thirty years (The Pew Center on the States). To further compound the problem, state pensions were major players in funding the private equity bubble during the 2005-2008 period. As we have seen, borrowed money secured with inflated assets is a lethal combo. It can take years to dig out of losses resulting from extreme leverage. Ironically, in the face of such deteriorating fundamentals, more money flowed into municipal bonds in 2009 ($78 billion) than in the prior ten years combined. Investors have continued to trust rating agencies, which again are behind the curve. California seems to be emulating the failed policies of countries like Greece and Argentina, where uncontrolled government spending leads to insolvency (and in the case of Argentina, 3000% inflation in 1989).

Growth in the US federal deficit, both on and off balance sheet, is dangerous and worth monitoring. Pew Research Center polls recently found that trust in government is at a “historic low” of only 22%. Leadership at the federal level seems out of touch with voters, a disparity that hopefully, is a catalyst for change.

The Number One Cause of Business Failure

I had a recent discussion with David Coffman, author of a number of books on factors leading into bankruptcy. What is the number one reason for business failure I asked Coffman. He countered without hesitation: “Three letters, EGO.” Lack of humility and decisions based on emotions, not facts, can sink the ship. We are seeing the dangers of unchecked egos in Washington, DC.

Final Thoughts

The powerful fiscal and monetary stimulus orchestrated by the Fed has worked to bring “animal spirits” back to the markets. A zero interest rate policy has rewarded speculators (to the detriment of savers) as the highest risk categories have shown dramatic outperformance. Ironically, many of the more stable, higher quality stocks have lagged. But they now represent better relative value and could prove to be the best place to endure once the proverbial punch bowl is removed. Prognostications can be expensive when wrong, of course. So our approach is to seek the right business with tenacious, high-integrity managements more than equal to the most daunting challenges.

Your trust and support is appreciated.

Jeff Auxier

As of 03/31/2010, the Fund held those securities mentioned in the letter as follows: Smithfield Foods (1.2%); Tyson Foods, Inc. (1.0%); Wal-Mart Stores (2.6%); Kroger Co. (1.6%); Supervalu (1.5%); Tesco PLC ADR (1.3%); Unilever NV (1.3%); Nestle (0.1%); Cadbury (0%); Dr Pepper Snapple Group (4.0%).

There can be no guarantee of success with any technique, strategy, or investment. All investing involves risk, including the loss of principal. The S&P 500 Index is a broad-based, unmanaged measurement of changes in stock market conditions based on 500 widely held common stocks. The Nasdaq Composite Index is a market-value weighted index of all common stocks listed on Nasdaq. One cannot invest directly in an index.

The views in this shareholder letter were those of the Fund Manager as of the letter’s publication date and may not reflect his views on the date this letter is first distributed or anytime thereafter. These views are intended to assist readers in understanding the Fund’s investment methodology and do not constitute investment advice.

Auxier Report: Year End 2009

Dec 31, 2009

Download Year End 2009 (PDF)

Market Commentary

Auxier Focus Fund (Fund) ended the fourth quarter 2009 with a return of 4.53%, versus 6.04 % for the Standard and Poor’s 500 Index (S&P). For the full year the Fund returned 24.76%, versus 26.46% for the S&P. The Fund’s stock market exposure for the year averaged between 70-75%, with the balance in corporate bonds and cash. The equity component of the Fund was up over 28%. Long term, the Fund outperformed the S&P by 87 percentage points since our 1999 launch. The Fund’s Morningstar ratings and rankings are as follows:

Morningstar awards us its Morningstar Overall Rating of five stars in the Large Value category as of 12/31/09. The Fund received 5 stars in the 3, 5 and 10 year periods and was rated among 1104, 912 and 459 funds, respectively. The Overall Rating is derived from a weighted average of the risk adjusted performance figure associated with its 3, 5 and 10 year Morningstar Rating metrics.

The Fund beat over 98% of its peers over the past three years. As of 12/31/09, the Fund’s 10, 5, 3 and 1 year Morningstar rankings are, respectively, 15 out of 459 funds; 46 out of 912 funds; 19 out of 1104 funds; and, 509 out of 1272 funds. Morningstar rankings are based on a fund’s total return performance. Past performance is not an indicator of future results.

Our goal is to materially outperform in down markets and match up markets. We are mindful that a 50% decline requires a 100% recovery to break even. A 90% decline requires a 1000% recovery. We strive to adhere to a disciplined, systematic, low-risk approach based on highly favorable odds. We also believe investors need to be well-compensated for the risk taken.

In 2009, massive U.S. government stimulus (four times greater than in all post-war recessions combined) led to rapid narrowing of credit spreads. As we commented in the last letter, the liquidity crisis presented us with unprecedented bargains in corporate debt—especially in the higher risk names. That play is largely over, as spreads on the highest risk bonds narrowed from a high of 21% to under 7% recently. That’s the benefit of being a business analyst and studying the entire capital structure of enterprises. Our years of dedicated research and cumulative balance sheet knowledge provide huge advantages in times of distress because we are prepared for bargains as they unfold. It is necessary to stick with a game plan to enjoy the fruits of compounding. We have found that investors need a proven, understandable approach to stay the course during challenging markets. To win, you must first finish.

Profiting on Fears of Nationalizations

Recall how in early 2009 stock markets were hitting lows in the face of shrinking liquidity and rising fears of bank nationalizations. Free markets detest government takeovers of private industry. The threat of nationalized healthcare further added to the gloom. Back in 1994, when Hillary Clinton proposed government-run healthcare, we loaded up on the industry’s stocks as they got pummeled in anticipation of the worst-case scenario. Those bargains provided us with material outperformance for the following three years. Similarly, this past year we were able to buy both the stocks and bonds of health insurers below the cost of liquidation. We like to invest when prices are discounting “horrible.” The move to just a “bad” outlook can be extremely rewarding. Buying when the outlook is “good” and hoping for “great” is usually too expensive. Ironically, prices resulting from hopelessness can be safer than those from euphoria, which can be deadly. The Nasdaq Composite Index over the past ten years is down 45% starting from the point of extreme elation. Optimistic price levels also contributed to the worst ten-year returns for the Standard and Poor’s 500 in over 200 years. Price and value do matter more than people think.

Time-Honored Observations and Lessons

It is good to look back over the past 18 months and revisit some investing basics:

• One decision investing—buy and forget—can be costly. Investing is never easy. Autopilot does not work.
• This time is not different; we have seen it before. Human nature does not change. There are no new eras. All bubbles end the same way: in disaster.
• Over the long run, businesses that are nurtured return the favor. One dollar invested in stocks in 1871 is now worth over $10,000, thanks to reinvestment of dividends (adjusted for inflation).
• Borrowing short term to fund long term asset purchases can be fatal in a credit crunch.
• Every class of investment needs to be aggressively monitored as to fundamentals and price. This is even more important in a competitive global economy.
• Compounding is the priority. Imploding bubbles act to torpedo the portfolio. Popularity must be pruned.
• Larger funds are not safer, because they are less nimble in down markets. In fact, index funds give the greatest weighting to the most popular (and typically overpriced) companies.
• There are no easy shortcuts or formulas. Day-to-day homework is critical as is the ability to think and reason independently. A skeptical contrarian nature is needed.
• Understanding history and psychology is critical in navigating emotional auction markets.
• A free market system works; socialism does not. Contrasting Brazil with Venezuela, one sees the benefits of a free market vs. a socialistic leadership. Venezuela, which has nationalized industries such as oil, steel and cement, is looking at 45% inflation for 2010.

Perception vs. Reality on Debt Defaults

Investors generally view government and municipal bonds as low risk. Many, until recently, also thought houses only went up in value. The reality? Solvency of government entities is threatened by growth in government unions and excessive borrowings in the face of lower income, property and sales taxes. Indeed, sovereign debt default is extremely common in world history; only a handful of countries have consistently honored their obligations. Greece is currently making such headlines, which are hardly new. From 1800 until well after World War II, Greece found itself in continual default (This Time is Different: Eight Centuries of Financial Folly). Given the current free-spending leadership in Congress and the White House (only 7% of Obama’s cabinet has worked in the private sector), the United States could easily find itself facing credit downgrades if not careful. The result would be much higher financing costs.

Uncle Sam’s Exposure to Housing

The U.S. government has shifted the sub-prime mortgage problem from the banking sector to the Federal Housing Authority (FHA), where 3.5% down payments are still allowed. No skin in the game is a recipe for disaster. Over 85% of home loans originated over the past seven months have been FHA loans. The agency is allowed to have an absurdly low capital level—less than 2% of assets—that pales only in comparison with the 80-to-1 leverage ratios at Fannie Mae and Freddie Mac. Such leverage has distorted the housing market while materially inflating Federal debt loads and bad assets. Fannie Mae’s balance sheet is exploding because it now must add back off-balance sheet loans. There’s still a shadow inventory of 1.7 million homes in some stage of foreclosure—45% more than the official 3.75 million burden with which banks are wrestling (American Banker). Government involvement has gummed up the clearing mechanism needed to start the recovery process.

Looking back over the past century, adjusted for inflation, it becomes apparent how the easy financing craze contributed to house appreciation. Between 1996 and 2006, the cumulative real price increase in housing was 92%—more than three times the 27% comparable real return from 1890 to 1996 (This Time is Different: Eight Centuries of Financial Folly).

Aggressive Credit Growth in China

China’s economic revolution is well known and popular. But their $586 billion stimulus program may be the shaky foundation for another crisis down the road. Financial panics and collapses are usually preceded by acceleration in borrowed money. Debt fueled booms can provide false short-term confirmation of a government’s policies. In 2009, the Chinese government mandated over $1.4 trillion in bank lending, up 30%, and is looking at a further increase of 18% in 2010 (Wall Street Journal). One has to question the quality of loans at that frenetic pace. Can there be that many attractively priced opportunities to absorb such volume? This aggressive lending has driven up Chinese real estate as home prices are trading between 10-20 times the average annual household income. Another troubling development: Chinese banks have also discovered the wonders of “off balance sheet financing” to lever up further.

Perils of Overproduction

According to Trim Tabs1, $256 billion flowed into commodities in 2009. Commodities have historically traded close to the cost of production. Today’s market is very confusing and risky. Oil, priced at $75-$80 a barrel, trades at double the cost of production. Yet wheat recently dropped in price to 200-year lows adjusted for inflation (Progressive Farmer). With technological advances, the risk in these areas is massive overproduction. Strong pricing is so rare that when times are good, forces of supply build much faster than in the past. Again, extremely easy money is distorting reality and can ultimately lead to sloppy capital allocation. Another example: just as interest rates dropped to the lowest levels in 40 years (highest bond prices), $421 billion flowed into bonds while $35 billion was withdrawn from domestic stocks.

Favorite Out of Favor Areas

Despite the recent rally, there are industries that are still unloved and represent potential rewarding investments.

• Many topnotch online education stocks are trading at their lowest valuations in a decade. Fears of government regulation and financing issues have hampered the group. Yet there is an increasing need for specialized education and retraining. Industries are constantly restructuring in today’s competitive, knowledge-based global economy. The fundamentals for online education continue to be strong.
• The S&P Health Care Index is trading at a 19% discount to the market, again, in fear of a government takeover. Over time, the sector has traded at a premium. We think it will again.
• Many grocery chains have underperformed this past year. Wal-Mart is one of the worst performing stocks off the March 2009 lows. Deflation in food and gasoline negatively impacted the sector. Yet strong international franchises sell necessities into the growing global middle class. So there is unrecognized value in powerful distribution models that can reach the masses.
• About $1.5 trillion of commercial real estate loans come due over the next 24 months at appraised values far lower than the original purchase price (American Banker). The uncertainty could lead, over the next year, to some compelling price points among downtrodden regional and community banks.
• Refiners have been pummeled by sluggish demand for gasoline and diesel plus increased global capacity. The near-term outlook is bleak, with prices below the marginal cost of production. The stocks sell at steep discounts to book value. Industry leader Valero has declined from a high of $78 to a recent low near $15. Forces are at work to reduce excess capacity, at the same time the economy is starting to show increased strength.
• Bonds of natural gas producers have been cheap because new shale discoveries are promising but expensive. Yet these bonds have potential for upgrades as equity investors and major oil companies are attracted to the industry.

Instead of trying to predict markets, we strive to identify businesses with the managerial ethics and drive to endure seemingly insurmountable economic conditions. We like managements that nurture business instead of rob it. From an investment standpoint, it is hard to beat a well-run business, purchased at a compelling bargain price, with the potential of exceptional long-term results. Even though markets have rallied, U.S. stocks had declined 57% off their 2007 highs. So a 50% increase off that base still means the market is down 35%. This is a good backdrop to deploy capital astutely, always vigilant to avoid euphoric bubble conditions.

Your trust and support is appreciated.

Jeff Auxier

1 Trim Tabs is an independent institutional research firm focused on equity market liquidity.

As of 12/31/2009, the Fund held those securities mentioned in the letter as follows: Wal-Mart (2.6%); Valero (0.4%).

There can be no guarantee of success with any technique, strategy, or investment. All investing involves risk, including the loss of principal. The S&P 500 Index is a broad-based, unmanaged measurement of changes in stock market conditions based on 500 widely held common stocks. The Nasdaq Composite Index is a market-value weighted index of all common stocks listed on Nasdaq. One cannot invest directly in an index.

The views in this shareholder letter were those of the Fund Manager as of the letter’s publication date and may not reflect his views on the date this letter is first distributed or anytime thereafter. These views are intended to assist readers in understanding the Fund’s investment methodology and do not constitute investment advice.

For the period ended 12/31/2009, the Fund’s Overall Morningstar Rating was 5 stars. For each fund with at least a three-year history, Morningstar calculates a Morningstar Rating based on a Morningstar Risk- Adjusted Return measure that accounts for variation in a fund’s monthly performance (including the effects of sales charges, loads, and redemption fees), placing more emphasis on downward variations and rewarding consistent performance. The top 10% of funds in each category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars and the bottom 10% receive 1 star. (Each share class is counted as a fraction of one fund within this scale and rated separately, which may cause slight variations in the distribution percentages.) Past performance is no guarantee of future results.

©2009 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this.

Auxier Report: Fall 2009

Nov 1, 2009

Download Fall 2009 Letter (PDF)

Market Commentary

As of September 30, 2009, Auxier Focus Fund returned 12.58%, versus 15.61% for Standard and Poor’s 500 Index (S&P) for the third quarter of 2009. Year-to-date, with approximately 70% stock exposure, the fund gained 19.35%, beating the S&P’s 19.26%. For the 12 months the fund earned 1.87% vs. -6.91% for the market (S&P). Since inception (7/9/99) the fund has returned 75.71% vs. a negative 9.72% for the S&P (an 85.43 percentage point cumulative outperformance).

Over the past nine months, the fund profited by scooping up high-yielding corporate bonds. Forced liquidations by institutional holders of such bonds led to drastic misappraisals and historic bargain prices. By carefully monitoring company capital structures, and being flexible, corporate bond bargains can occasionally achieve equity type returns with far less risk. Higher yield corporate bonds have actually far outperformed domestic stock indexes this year. We try to understand each business and its capital structure to determine its cash generating potential. It is rare when you can buy senior debt securities sporting double-digit returns like we have seen the past year.

Stocks stellar rally since March is a reminder of how costly it can be to focus on unknowables such as the market, interest rates and the economy instead of specific investment opportunities with mouth-watering odds. The window of opportunity is often very brief. So being prepared in advance is critical to have the conviction to act. Having a database built over a number of years helps to decipher facts from fiction in the height of a crisis.

This past quarter, ironically, our high-quality companies lagged riskier stocks (those most dependent on the capital markets and crushed in the market decline). One reason: the aggressive fiscal and monetary action by the Federal Reserve tightened credit spreads dramatically over a short period of time. Just goes to show that outperformance is possible for any asset class when starting from a point of severe undervaluation. Everything has a price.

A Solid Investment Approach

We have endured one of the longest recessions (22 months as of June), the third worst stock market decline since 1900 (a 57% drop to the March 9 lows) and one of the poorest 10-year periods for stocks since 1871. As we have seen, markets tend to be harsh to those who don’t follow a sound investment approach. To win the race you must first finish, focus on the balance sheet and understand risk factors that can lead to permanent capital loss. Supply and demand must be monitored closely. The misperception of risk and odds continues to take many investors out of the game.

Economic Recovery May Surprise

A current worry is that we will have structurally high unemployment for years—that we will have a “jobless” recovery. Historically, companies coming out of recession operate lean to insure survival. Caution is evidenced by corporate cash levels now near 40-year highs, according to the Wall Street Journal.

As Jim Grant, editor of Grant’s Interest Rate Observer has recently commented, “Currently, 25% of American workers are employed in jobs that the Census Bureau didn’t even list as occupations in 1967. We underestimate the resiliency and capacity of market economies to reinvent the nature of work.” Contrary to the current consensus, Grant adds, the key determinant to the strength of an economic upturn was the severity of the downturn that preceded it. There were no exceptions to this rule. The recent downturn ranks as the worst since World War II.

Master the Game -10 year minimum

Geoff Colvin’s Talent Is Overrated studies high performance in a number of fields. Colvin cites highly specific “deliberate practice” over a 10-year period as a key to extraordinary achievement in any field. The most important is solitary practice, and the advantage is cumulative. More total practice is powerfully associated with better performance. Anders Ericsson’s “The Role of Deliberate Practice in the Acquisition of Expert Performance” noticed a theme that emerged in research on top-level performers. No matter who they were, or what explanation of their performance was being advanced, it always took them many years to become excellent. If a person achieves elite status only after many years of toil, assigning the principal role in that success to innate gifts becomes problematic. The phenomenon seems nearly universal whether in math, science, chess, musical composition, swimming or tennis. No one, not even the most “talented” performers, became great without at least 10 years of hard preparation. Many scientists and authors produce their greatest work only after twenty or more years of devoted effort. The “deliberate practice” made all the difference. Colvin says, “The difference between expert performers and normal adults reflect a lifelong period of deliberate effort to improve performance in a specific domain.”

Final Thoughts: The Search for Drive and Passion

We are constantly on the lookout for corporate managers who have integrity and a passion for the business. They also have a focused obsession to navigate through the most challenging of economic conditions. USA Today published a list in April of 2007 of the top 25 US stocks over a 25 year period starting in the 1982 recession. You see returns ranging from 17,808% to 64,224%. And you can see why the goal is to be a diligent business analyst, not a stock market prognosticator.

Thank you for your continued trust.

Jeff Auxier

There can be no guarantee of success with any technique, strategy, or investment. All investing involves risk, including the loss of principal. The S&P 500 Index is a broad-based, unmanaged measurement of changes in stock market conditions based on 500 widely held common stocks. One can not invest directly in an index.

The views in this shareholder letter were those of the Fund Manager as of the letter’s publication date and may not reflect his views on the date this letter is first distributed or anytime thereafter. These views are intended to assist readers in understanding the Fund’s investment methodology and do not constitute investment advice.

Auxier Report: Summer 2009

Jun 30, 2009

Download Summer 2009 Letter (PDF)

Market Commentary

On July 9, Auxier Focus Fund celebrated its 10th birthday—and a major milestone. Over the 10 years to June 30, 2009, the most recent period for which data were available, the Fund delivered a cumulative 56% return, versus a corresponding -21.9% loss for the Standard & Poor’s 500-stock index. So, we not only made money during a bear- mauled decade; we also beat the market by 78 percentage points.

The Fund also excelled in the six months to June 30, returning 6.02% versus 3.16% for the S&P 500. For the second quarter of 2009, the Fund returned 13.12% against 15.93% for the S&P 500 Index.

After falling 57% from the 2007 peak through the March 2009 low, the S&P rebounded sharply in response to aggressive fiscal and monetary steps taken by the United States government. The U.S. stimulus so far authorized in this downturn is ten times greater than the average amount spent in recessions over this past century. It amounts to roughly 30% of Gross Domestic Product (GDP)—twelve times greater than the pump priming during the Great Depression. Back then, the cumulative decline in GDP was 27%. (Source: Grants) Today, we are nowhere near that level of economic decline, perhaps because total government payments now comprise over 25% of the economy. By contrast, there were virtually no safety nets such as social security in the early 1930s.

China also has been aggressively stimulating its economy to help increase domestic consumption and to offset weak exports. These actions, together with a more private market approach (versus nationalization) to treating U.S. banking ills, helped to loosen credit, stabilize industry and encourage risk taking.

Buy Cash Flow Cheap

In an environment where it could take years to deleverage the accumulated mountain of debt, our focus has been to buy predictable cash flows when they are cheap. The capital structure of each individual business needs to be scrutinized, as there are times when it makes sense to be a creditor as opposed to a common shareholder. Too much emphasis has been put on asset appreciation and not on dependable underlying cash flows. Government policies that aim to help banks earn their way back to solvency could lead to a long period of low interest rates. So at the end of 2008 when corporate bond spreads widened dramatically (from 2.5 to 21 percentage points), we took advantage of the bargains. Corporate bonds were discounting a potential default factor of 50% when the absolute worst previous period—the 1930s—saw only 5% defaults. We bought shorter to intermediate-term senior debt securities with the goal of achieving equity type returns with less risk. Also targeted were common stocks with high free cash flow yields, strong balance sheets and above-average dividend yields. The goal is to make exceptional buys in entities that can throw off cash, rather than counting solely on a rising market for returns.

Know What You Own

The investment industry has continued to come up with new innovations that take investors farther away from understanding what they own. Investing is the craft where cumulative years of intense study can add value in determining the odds of when to invest. Exchange traded funds (ETFs), derivatives, and hedge funds, to name a few, are promotions of short-term speculation in which leverage is often easy to disguise. Investors have continued to drift from long-term stock ownership to short-term speculation. When a financial genius is commonly characterized as one who uses “leverage in an up market,” you know the pendulum has swung too far.

Furthermore, the average 401k statement shows all kinds of funds that make it extremely difficult to quantify risk/reward. When it is time to invest, when prices are low and potential risk-adjusted returns are attractive, the average investor has no clue on the odds…and therefore no conviction to allocate when the time is right. In the current environment, it is hard to determine crucial variables such as the winning “drive” and asset allocation skill of management, balance sheet strength, etc. Without a strong balance sheet, a company can’t endure downturns. I have owned or followed many investments we have in the Fund, both domestic and foreign, for over 25 years. As the “chief risk officer,” that cumulative knowledge is critically important to differentiate between those businesses that can provide superior returns.

Reflecting on Our First 10 Years

We believe it is helpful to look back at some of the basic operating principles that may have contributed to the Fund beating the market by 78 percentage points.

• Pledging that the manager has a big personal stake locked in the Fund—now over 153,000 shares—and a top priority of persistent daily research.
• Having lots of humility. Understanding that anything can and will happen in the markets is vital to enduring tough times.
• Being wary of the dangers of “animal spirits,” controlling one’s emotions. Thinking critically and rationally are key to beating the market over time.
• Running smaller sums of money, which is a huge advantage when combined with a flexible mandate to exploit misappraisals over a broad range of asset classes.
• Sticking to the Benjamin Graham approach, which encourages a manager to wait for compelling bargains without the pressure to be fully invested all the time.
• Appreciating the power of compounding and the potential downside of each investment. To enjoy the fruits of compounding, it is important to avoid the blow-ups. A drop of 50% requires a gain of 100% just to break even. A plunge of 90% requires a corresponding, and nearly impossible, 1000% gain. To mitigate risk it is important to understand the basic laws of supply-demand, as well as the dangers of “bubble valuations” stemming from periods of easy money.

It is worth noting that fewer than 17% of all mutual funds have had a single manager over a ten year period. That very few managers have a meaningful stake in the funds they manage. This may explain why over 80% of stock funds underperformed the market last year, when the S&P 500 lost over 38%. I strongly believe executives in a stewardship position should have their money locked up for their tenure of leadership, as I have. This forces managers to focus on the downside, as opposed to having a free ride to speculate with investors’ hard earned money.

Another expensive misperception is that bigger is better in the investment field. There are over 34,000 publicly traded stocks globally, but large funds are unable to invest in 90% of them. Additionally, in bad markets the larger funds are inflexible and unable to protect principal. They can be locked into positions, unable to sell stocks without depressing prices. Yet, investors blindly pile into megafunds or companies whose size is definitely an anchor to performance. Too much attention is placed on getting bigger—not better.

Reasons for Optimism

The S&P 500 Index was conceived 82 years ago. As of January 2009, we had witnessed the worst 10-year period in the index history—an average annual loss of 5.1%. The good news? When looking back, other poor 10-year periods (the 1970s and 1930s) were followed by 9-15% average annual gains in the decade following. In addition, the total stock market value as a percentage of Gross Domestic Product (GDP) dropped to 75% in January, down from 190% in March of 2000 at the peak of the tech mania.

Final Thoughts

A serious long-term investor seeks opportunity when volatility and emotion engulf a quality investment; when the lines between perception and reality are blurred. The result can be a compellingly cheap double-play opportunity. You don’t need to go from good to great to enjoy above-average gains. Horrific to bad can serve the same purpose. It all depends on price.

Thank you for your continued trust.

Jeff Auxier

There can be no guarantee of success with any technique, strategy, or investment. All investing involves risk, including the loss of principal. The S&P 500 Index is a broad-based, unmanaged measurement of changes in stock market conditions based on 500 widely held common stocks. One can not invest directly in an index.

The views in this shareholder letter were those of the Fund Manager as of the letter’s publication date and may not reflect his views on the date this letter is first distributed or anytime thereafter. These views are intended to assist readers in understanding the Fund’s investment methodology and do not constitute investment advice.