Broad Run Investment Management’s separate account client letter for the quarter ended 2014.

In addition to describing how they react to volatile markets, the portfolio managers of Broad Run Investment Management in their new quarterly letter describe why they recently “swapped” out of T. Rowe Price and into Brookfield Asset Management.

For the quarter, the Focus Equity Composite returned -1.9% net of fees1 compared to 0.0% for the Russell 3000 Index. Year to date, the Composite returned 0.5% net of fees compared to 6.9% for the Russell 3000 Index. The returns for your individual account will differ somewhat from the Composite due to variations in account holdings and other client-specific circumstances. Your account’s actual performance is presented in an attachment. We remind you that your portfolio’s composition is significantly different from the broad market indices, so your performance will inevitably deviate from these indices, especially over shorter time periods. We manage your portfolio for long-term results, and we encourage you to evaluate its performance over a multi-year time frame. Long-term Composite returns are presented at the end of this letter.

Volatility has returned to the market after a long hiatus. The S&P 500 declined about 10% from its all-time high in September, only to recover nearly all of its lost ground more recently. One moment the market appeared concerned about plummeting German exports, falling commodity prices, and a tumbling ten-year Treasury yield. The next moment the focus had shifted to the potential for an expansion of quantitative easing in Europe, a delay to the Fed’s first interest rate hike, and strong corporate earnings.

Broad Run Investment Management: How to react to various macroeconomic concerns

All investors face the challenge of how to react to various macroeconomic concerns that emerge on a fairly regular basis. Most often these concerns prove irrelevant with the passage of time, but occasionally they manifest in damage to the real economy and corporate profits. Our general viewpoint is that it is extraordinarily difficult to make money by placing bets on macroeconomic events. The world is too complex with too many moving parts to have this be a consistently profitable exercise. Experience has taught us that we are most effective when building your portfolio one security at a time.

As long-term investors, we fully expect that your portfolio will face turbulent economic times at various points during our investment horizon. So we prepare for this eventuality, not by selling all your stocks at the first signs of trouble, nor by rotating your portfolio into more conservative sectors, but rather by owning companies with a wide “margin of safety.” By this we mean companies with the business model and balance sheet to survive and thrive in many economic environments, owned at attractive valuations so that we are well protected from both company specific and macroeconomic risks.

We think your portfolio is constructed with a good margin of safety. In fact, we think that many of your holdings are well positioned to grow cash earning per share at a mid-teens rate or better over the next several years regardless of the overall U.S. economic growth rate. These companies have their own profit drivers that are largely independent of the overall economy, i.e. American Tower Corp (NYSE:AMT) is driven by the adoption of data intensive smartphones and O’Reilly Automotive Inc (NASDAQ:ORLY) is driven by a unique distribution model that should allow for continued share gains in the largely non-discretionary market for aftermarket auto parts.

Broad Run Investment Management: Notable Portfolio Changes

Bally Technologies Inc. (NYSE:BYI) – On August 1st, Bally Technologies announced that it entered into an agreement to be acquired by Scientific Games Corp (NASDAQ:SGMS) for $83.30 per share in cash, about a 38% premium over its prior day closing price and a modest premium to the stock’s all-time high set in January.

The gaming equipment supply industry (Bally, IGT, GTECH, Multimedia Games and others) has been undergoing a wave of consolidation over the last year, and rumors involving Bally circulated in June and July, but we were nonetheless a bit surprised that this particular transaction came to fruition. The rationale for the deal makes sense to us – there are significant synergies to be realized by merging the second and third largest gaming equipment manufacturers – but the combined entity will have significant financial leverage and integration risk. Post deal, Scientific Games will be leveraged about 7x Debt/EBITDA. In addition, Scientific Games just acquired WMS in October of 2013, and Bally just acquired Shuffle Master in November of 2013. Now, effectively, all four of these formerly independent public companies are going to be consolidated into one entity. We have a great deal of respect for Scientific Games CEO, Gavin Issacs (a Bally alum), but he has a challenging task ahead of him.

Broad Run Investment Management Broad Run

See full Broad Run Investment Q3 in PDF here.