This is one of our favorite funds – Eric Khrom just kills it again and again while maintaining a high level of cash – too early to proclaim the next Seth Klarman? Who knows – but watch this guy.

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Khrom Capital letter to investors for the first half ended June 30, 2015.

Dear Limited Partners:

In the first half of 2015, our Partnership returned 18.2% net of fees and expenses. On average, we held 10% of our assets in cash throughout this period. For the past five years, the fund has had an average cash balance of 26%.

Khrom Capital

Our returns in the first half of this year were generated about equally among six investments (with an average market capitalization greater than one billion dollars, hopefully answering the question of whether our strategy is scalable). Our investments consist of businesses that we underwrote to hold forever. This does not imply that we will never sell them. It means that our investment theses do not depend on a sale.

We assume a buyer for our shares will never come along. That way, we are forced to evaluate the total earnings a business will produce over its lifetime, as opposed to speculating on what others will pay us for it in a given year.

Of course, this implies that our Partnership’s reported return so far this year does not matter much. The stock prices-what others are willing to pay for the businesses we own-will continue to fluctuate (sometimes wildly) so long as we own them. We must-and so should you as our Limited Partners-ignore thoughts on where a company’s share price may go. Our focus must remain on determining the earnings we think a business can produce over its lifespan. Then the only remaining actions are to buy shares when the price undervalues-and sell when the price overvalues*-the company’s lifetime earnings. Sticking to this methodology-assuming we can never sell a business once we buy it-is how we hope to avoid becoming stock price addicts.

Khrom Capital - Investment approach

We recently made a new investment based on taking this lifetime view of a business. This company is disrupting a large industry; it has only a 0.3% share of a growing market, a clear and increasing competitive advantage, an astute and well incentivized board of directors, and is run by an extraordinarily intelligent CEO who has a clear strategic vision and has created an outstanding corporate culture.

However, if our investment strategy focused on trying to estimate what the stock price could be in a year—or even five years—from now, we might have passed on this investment. There are many reasons that the stock price could decline in the near-term. Competition will likely increase since the opportunity that this company is pursuing is large and lucrative. The company’s current profitability is depressed, and its CEO will likely continue to suppress it further in pursuit of significant advantages of scale. The U.S. economy may enter another recession, and since this business hasn’t previously proven itself through an economic contraction, there may be panicked sellers of the stock. These and other factors may make for a “messy” stock price over the next few years.

However, by encouraging ourselves (and structuring our Partnership to allow us) to think as permanent owners of the business, we focused our attention not on the share price this company could trade for in a few years, but on the profits this business is likely to produce over the next few decades. Ironically, the farther out we look, the easier it becomes for us to approximately predict things.

Khrom Capital - Focus on long-term profitability

For example, take the risk of competition. We think that this company has obvious and growing competitive advantages that should help solidify it as the dominant player in its space. (Think how the number of search engine startups dried up once Google solidified its dominant position.) We think it is ideal that this management is willing to reduce short-term profitability to invest in growing the company’s competitive advantage, increasing the quality of its long-term profitability. (Think how Amazon.com has barely shown any profits for over a decade, but the value of its business has grown significantly every year.) We think that a recession could benefit this company, since their cash-rich balance sheet, economies of scale and prudent management team would enable them to grow stronger as weaker competitors die off. (Think how Wells Fargo is earning more money today than before the Great Recession.)

In short, since we do not need to concern ourselves with where the stock price will be in the next few years (since you have allowed us to follow an investment strategy that focuses on the fundamentals of a business), we are able to look beyond all the short-term noise. That is how we attempt to generate our excess returns. By taking the profits that people cannot take (and hopefully avoiding the losses that they incur) because they want to rent a stock.

* * *

We remain excited about the investment returns we think we can deliver to our Partners over the long-term. Virtually all of my family’s and my entire net worth remains invested in the Partnership, as we aim to compound our wealth alongside yours. As always, if there is anything you wish to discuss, please feel free to call me. I look forward to writing to you again after year-end.

Sincerely,

Eric E. Khrom

Managing Partner

Khrom Capital Management, LLC

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