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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.


[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.

 

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