In a letter to shareholders for April 2014, Vltava Fund’s Daniel Gladis announces that the European value fund has sold preferred stocks of Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) after 300% return and has bought Russian stocks. You can find the letter below.

Fannie Mae Freddie Mac FHFA Federal National Mortgage Assctn Fnni Me (FNMA)

Vltava Fund Sells Fannie, Freddie Preferreds

Dear shareholders,

In the first quarter of 2014, the Fund’s NAV grew by 7.3 %.

Form follows function

Once upon a time long ago (in fact, more than a quarter century ago), I entered the Faculty of Civil Engineering at the Brno University of Technology. That was still in the times of Communism, when essentially neither finance as a field of endeavour nor financial markets yet existed in our country. By the time I had completed my studies a year and a half after the Velvet Revolution, the world here had suddenly and completely changed. I left my five years of studies behind and set out into the fascinating world of finance.

It might appear as if my degree in civil engineering means nothing to me, because it was clear that I would not use it to earn my living. But all education has value in its own right, and even fields appearing to be completely unrelated can have a great deal in common. That may be true even of civil engineering and investing. Or, to put it more precisely, of architecture and investing.

At the close of the 19th century, the face of a great city had been taking shape in Chicago. While skyscrapers are typical for New York, it was Chicago which determined the direction in which they would develop. And so it was in Chicago at that time that the phrase “form follows function” originated and came into use. In architecture, it means that a given building’s shape and structure should be determined by the function which the building is to perform. This was the fundamental idea from which the architectural style of functionalism would later evolve. Although the idea was fundamental, it perhaps was not wholly original, as similar reflections had been recorded already in the times of ancient Rome when Vitruvius had written that every building should be robust, useful and beautiful.

And what has all this to do with investing? The parallels ought to be clear. Every portfolio should take such form as properly corresponds to its function or its investment objective.

In order to achieve such a state, our first step must be to define the function that we want the portfolio to perform. In our case, the function can be stated, for example, as follows:

The portfolio’s function is to deliver long-term, substantially positive real appreciation accompanied by minimal probability for permanent loss of capital.

Creating the form

This definition in fact encompasses three crucial functions of the portfolio:

  1. Long-term orientation. Our objectives are unambiguously long term in nature. It can be said that we have no short-term objectives whatsoever, and, if we were to have such goals, we admit that we would not even know how to achieve them. In our approach, long-term orientation means at least several years.
  2. Positive real appreciation. The investor’s greatest enemy and at the same time his or her motivation is inflation. Day after day, it steals from the value of money. A function of the portfolio, therefore, must be to produce real returns, namely returns net of inflation.
  3. Minimal probability for permanent loss of capital. This depends on more than just price but also on how an investment’s value develops. It is precisely by choosing investments whose values grow over the long term (and acquiring these at low prices) that the probability for permanent loss of capital will be diminished.

Regarding individual classes of assets, the data clearly show that over the long term as well as over most medium-length periods equities are the assets which bring the greatest returns. If we define risk as the probability for permanent loss of capital (in real terms), then equities are also less risky.

Most people think exactly the opposite. People mostly associate risk with volatility, whether knowingly or unknowingly. So for them, equities appear to be risky and holding cash appears to be safe. Holding cash, however, brings the certainty of a permanent real loss of capital. We want to steer clear of this problem, and so we create a portfolio the great majority of which is composed of equities.

Three portfolio levels

We segment our portfolio internally into three levels.

The conservative core (robustness). There exists only a small group of companies in the entire world which are wholly unique and practically cannot be replicated. All of these have some permanent, sustainable competitive advantage, and their businesses are so robust that they can thrive under almost any conditions. There are not many of these, and when there is a possibility to buy stock in one at a good price, that is cause for celebration. We own stock in four such companies comprising one-fifth of the entire portfolio. Their attractiveness derives mainly from their combination of expected returns and very, very low risk. We would sell the shares in these companies only under the most extreme conditions, such as if their prices were to rise so much as to become outrageously expensive. Another case might occur if a dramatic slump were to hit the entire equity market. In such instance, the share prices for our conservative core companies would probably decline by much smaller increments and thereby become a very rich source of cash from which to acquire other, momentarily much more attractive investments.

The value majority (usefulness). The majority of our portfolio is composed of shares in very high-quality, financially strong companies. The value of these companies grows solidly over time, and they are managed for the benefit of shareholders. By their quality these companies do not attain the uniqueness of those companies in the conservative core (of which there are truly only a few), but they generally stand just a bit below them. Their somewhat higher risk is balanced by their appreciably higher expected returns. The majority of the returns to our portfolio are generated by these very companies. We measure the anticipated holding period for these shares in years.
The opportunistic. From time to time, there appear in the market attractive investment opportunities in companies which, for reasons of their type and character, we would not want to hold over the long term. It would be a real waste, however, to ignore these opportunities, and so the smallest part of the portfolio is made up of just these cases.

Sometimes there are more of these, sometimes scarcely any at all. It is not possible to plan this in advance, as it depends upon these opportunities arising and, above all, upon how successful we are in finding them. These positions have the greatest turnover, and indeed some of them remain in our portfolio for only a couple of months. The return, however, can be excellent.

Are you still missing the beauty in our portfolio of which Vitruvius wrote? We think it is there. We do not see beauty in a great multitude of transactions or in titles

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