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Auxier Report: Fall 2010

Sep 30, 2010

Download Fall 2010 Report (PDF)

Market Commentary 

Auxier Focus Fund ended third quarter 2010 with an 8.9% return, versus 11.29% for Standard & Poor’s 500 stock index (S&P).  Year-to-date the Fund is up 4.55% versus 3.89% for the S&P.  Since inception in 1999, the Fund has outperformed the market by over 92 percentage points, cumulatively.

Quality At An Attractive Price

Looking across the investment spectrum, the current climate has created opportunities to buy high-quality businesses at prices below what such exceptional companies historically command.  For example, their earnings yield compared with government bond yields recently reached record spreads. The Fund is well positioned in global franchises with powerful distribution networks reaching an “aspiring emerging middle class” numbering over two billion. Rapidly advancing communications fuel greater desire to improve one’s life, starting with necessities. Healthcare is an underpenetrated segment for many of these potential customers as well. We especially like producers of low-ticket consumable goods.  These stocks are a partial hedge against fallout in China from “local government funding vehicles” (LGFVs), which are similar to our structured investment vehicles (SIVs). These Chinese creations have contributed to aggressive lending and overall fixed investment approaching 50%. 

Houses, Bonds and Businesses Compared

With a change in political winds, much needed government austerity measures should be implemented in the U.S. in the same way they are globally. This would increase the attractiveness of so-called “self-funding” businesses with low mandatory capital requirements. Americans are waking up to the fact that real estate “eats” a lot of mortgage interest, taxes, insurance, maintenance, etc. Many may be better served with bargain purchases of businesses that sell a quality product or service, earn high rates of return on capital and generate excess cash. With recent regulation, the popularity of financial engineered returns is diminishing.  Remember the definition of a financial genius—leverage in an up market. Bonds look overvalued in the face of deteriorating fundamentals and a Federal Reserve (“the Fed”) apparently eager to fire up the printing press to solve the country’s problems.

Back in 1972, top-quality companies dubbed the “Nifty Fifty” were thought to be “one-decision stocks.”  All a person had to do was buy and hold, regardless of price. This craze led to price-earnings ratios that soared to over eighty times, only to crash to under 10 in 1974. Similar premiums were common in the late 1990s. Today, I am finding comparable quality under 12-13 times, often with double-digit free cash flow yields. Historically, over 70% of stocks’ return is attributable to reinvestment of dividends. Therefore, businesses that can grow cash payouts at a consistent pace look attractive.  Here are a couple of lessons from the “Nifty Fifty” period. There is no such thing as a “one decision” approach in investing. Aggressive research and monitoring are a must. One also needs to sell into bubble valuations, or risk torpedoing the portfolio.

 The Benefits of Cumulative Research 

This is a uniquely favorable time for an independent minded business analyst.  Since 1982, I have amassed more than 30,000 hours of investment research, including three major recessions, numerous crashes, and interest rate swings from 18% to 1%. This database is helpful in sensing danger and identifying securities that will endure through the most difficult economic challenges. A diligent research effort is cumulative. It’s also a competitive advantage, assuming the approach is fundamentally sound, the ego is kept in check, and the work ethic is maintained (fortunately, I am a lousy golfer). Daily dedication to uncovering facts and fundamentals is crucial, as you can never tell when emotional panic will engulf markets.

For example, Fed policies have led to distortions in capital allocation with far greater speculation, mathematical trading and quantitative modeling. The longer the Fed adheres to a policy of artificially low interest rates, the greater the likelihood of investment mistakes that ignore underlying cash flows. This in turn leads to momentum and ultimately manias. Surviving the past 11 years (the period the Fund has been in business) requires you to be on “bubble alert.” Recall such recent disasters as zero-down mortgages, zero-down auto loans and 5% down derivative contracts.

The mistaken belief that there is no cost to capital is problematic. A pension funding crisis is brewing at all government levels—federal, state and local, just like the corporate bond bust 18 months ago. California and Illinois already face dangerous debt levels abetted partly by government subsidized Build America Bonds. Ironically, Build America Bonds may prove to be the final straw that breaks the backs of those states’ fiscal burdens. When the bond herd stampedes in the opposite direction, we hope to be well prepared to take advantage of bargains created by the crisis.

Why Buying Low Rules

With the threat of higher tax rates next year, it is worth revisiting a Jim Grant (Grant’s Interest Rate Observer) study of the 1951 market.  Harry Truman, champion of the Revenue Act of 1951, lifted top marginal tax rates from 84.4% to 91%.  Despite this onerous move, the decade from 1951 to 1961 was one of the best for investors in the twentieth century. In fact, the Dow Jones appreciated 50% in 1954. Why?  The starting point was cheap, with quality stocks trading close to 10 times earnings.  

The price you pay is a huge component of the return you will achieve.  So is inflation, now a distant memory for many investors. The purchasing power of $1 million drops to $680,000 over ten years with a 4% inflation. We are in an environment where investors need to work extremely hard to find double-play returns, providing both a margin of safety and a hedge against the hidden loss of purchasing power.

Final Note

Auxier Focus Fund was recently recognized by Standard & Poor’s Equity Research in its first ever U.S. Mutual Fund Excellence Awards Program.  To learn more, please visit www.spfundawards.com.  We greatly appreciate our shareholder trust and support!

Sincerely,

Jeff Auxier

This Internet site is not an offer to sell or a solicitation of an offer to buy shares of the Fund to any person in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. Foreside Fund Services, LLC. Distributor (www.foreside.com) | Hosted by clnw.com