Value Investing

Murray Stahl 2015 Shareholder Letter: New Positions

Murray Stahl Letter to shareholders dated August 14, 2015.

 

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Dear Fellow Shareholders,

The past year was a year of harvesting. As noted in the 2014 Shareholder Letter, we have been gradually disposing of our closed end fund investments that have been primarily oriented towards bonds. It might be recalled that these were purchased during the aftermath of the 2008 bond market crisis when the bond market essentially ceased to function. Closed end funds were not only priced at very significant discounts to net asset value, but most bonds, apart from U.S. Treasury Securities, sold at substantial discounts to par value. Years of ultra-accommodative monetary policy have certainly changed this circumstance. We concluded that the after tax returns from this point forward are likely to be at best in the low single digits and these returns are not at all proportional to the risk of continued investment. Hence, we have been sellers of these funds for the past year.

Nevertheless, we have also planted some new seedlings in the past year. None of the seedling practice is a departure from the past. However, continuous seedling investment is gradually transforming the company. Our shareholders’ equity has now surpassed $102 million. Our cash and cash equivalents balance now comfortably exceeds $44 million. We have more financial resources than at any time in the company’s history. We can operate upon a far more ambitious scale should opportunities present themselves. We are a more diversified and balanced company than at any time in our corporate history.

In our discussion of business affairs we will more or less follow the FRMO segmentation that we introduced with the 2014 Shareholder Letter. However, we will take this opportunity to introduce some new investments as well as provide some strategic commentary that we did not supply in the 2014 letter. The format will be as follows:

  1. Investment in Horizon Kinetics LLC
  2. Horizon Kinetics LLC Revenue Share
  3. Bermuda Stock Exchange
  4. Investment Securities divided as follows:
    a. South LaSalle Partners LP: the Minneapolis Grain Exchange
    b. Investments in Horizon Kinetics Funds
    c. Marketable Bonds & Equities
  5. Winland Electronics
  6. New Venture – One Chicago
  7. Securities Sold Short
  8. Cash and Equivalents
  9. Strategic Commentary

Murray Stahl - Horizon Kinetics LLC

Since much of what Horizon Kinetics does in the investment management realm is in the public domain, it has probably not escaped shareholder notice that funds under management have not been increasing. As of the most recent reckoning, assets under management (AUM) is approximately $9.1 billion. We have most assuredly not been immune to the trend of investors to give preference to indexation strategies. Perhaps more importantly, we have resisted the temptation to move into the various currently popular “momentum” strategies.

The popularity of momentum strategies has had a modestly negative impact upon our own index business, which was discussed for the first time last year. For example, in August of last year our classical index assets amounted to about $200 million of AUM dominated by approximately $130 million in the Virtus Wealth Masters Fund. Although this fund has about $154 million of AUM as of this writing, our classical index assets now amount to roughly $170 million of AUM. Historically, index funds, or passive management, was marketed upon a diversification premise.

The recent trend is to create even less diversified indexes that can exhibit extraordinary performance, at least for a time. Intensive and largely successful efforts are then made to gather assets on the basis of short-term performance.

We have no intention of joining these efforts. Of course, it is rather easy to create an index comprised of companies that back test very well. Unfortunately, there is only a limited supply of raw material for such purposes. Hence, the equities of firms involved in Biotechnology, Cyber Security, Cloud Computing, Chinese “A” shares, and many other groups exhibit, in our humble and perhaps incorrect view, signs of over evaluation. In any case, if newly created indexes are to be marketed upon short-term performance criteria, the effort is contrary to the basic underlying idea of indexation, which is that performance is a random walk. Once the index business is dominated by short-term performance considerations and imaginative and expensive advertising, it is simply no longer indexation.

Just as we have no intention of competing in indexation upon short-term performance considerations, we have no intention of doing likewise in the field of active management. Companies that are very exciting but nearly devoid of earnings are taking their places among the top 100 market capitalizations of the S&P 500, among other indexes. We remain value oriented investors. We will readily confess that this appears more than a trifle passé at the current time. However, the so-called new concepts do not appear very new to us. Readers of these pages who are intrigued with the history might wish to consult The Go-Go Years by John Brooks or perhaps The Rise and Fall of the Conglomerate Kings by Robert Sobel. One will discover eerie similarities and echoes of the current era in the history of the stock market in the late 1960s and early 1970s. We do not wish to leave readers with the impression that the new technologies will not transform human life for the better. The issue is simply that in any investment sense, a participant in these industries is subject to considerable valuation risk that we do not wish to accept. We much prefer the “time risk” of a dormant asset such as land that is to be developed, or unused frequency spectrum that generates no cash but is likely to be needed by the grand technologies currently being deployed. It is the old story of the need for patience which, as always, is a commodity in short supply. In other words, as in La Fontaine’s fable of the ant and the grasshopper, we prefer to play the role of the ant.

In any case, FRMO was founded by us as a company where patient investing can be practiced without the pressures of the need to continually raise outside capital. It is for this reason that FRMO has a gradually expanding list of activities, so that we will never be reliant upon the cash flow of any single activity for success. It is also the reason that this letter seems to become longer with each passing year.

Murray Stahl - Horizon Kinetics Revenue Share

The remarks in the aforementioned section are intended to apply to the revenue share as well with one salient exception. It should be observed that the revenue share income declined by about one third. This is because the fiscal year 2015 includes essentially no performance fees as opposed to the prior fiscal year. The performance fees, of course, come from our investment partnerships. The irony with regard to the partnerships is that the indexation movement which, of necessity, ignores contrarian out-of-favor securities that do not manifest first order liquidity, leave the long-only value oriented investors with no alternative apart from patient investing. This is not necessarily true with regard to the partnerships, since these have the flexibility to be short, use options in various ways, and to arbitrage indexation anomalies. Indexation is creating opportunities that are difficult to exploit in the long-only format. The partnerships are in the process of making use of their various faculties in interesting ways.

In addition, we as a corporation are invested in the partnerships. Consequently, performance sufficiently good to generate performance fees will also be reflected in increased values of the partnerships. Thus, if and when we receive our share of the performance fee, we will also experience a robust increase in the value of the partnerships. As readers can observe in Note 4 of the 2015 fiscal year financial statements, the value of the partnerships at fiscal year-end exceed $25 million. The size of those investments in relation to our assets plus the periodic performance fees make it likely that our results will be episodic in this regard. However, the performance aspect, when earned, can have a very dramatic positive impact upon shareholders’ equity. In fact, in order to achieve such an impact, a large amount of assets under management is not necessary. Indeed, it might even be an advantage not to raise large sums, since we enjoy great liberty of action with smaller sums. In any case the lesson that we ultimately learned is that in the realm of asset management, smaller is better.

Murray Stahl - Bermuda Stock Exchange

In February 2015, we increased our investment in the Bermuda Stock Exchange (BSX) to 40.8%. The investment is performing rather well. One of the exciting aspects of the exchange is the growth of the Insurance Linked Securities market. These are essentially investment grade bonds with coupons of perhaps 7.5% to 8.0% with 4-year maturities. In order to earn this unusually robust rate of return, investors must accept the risk that if certain insurance related catastrophe events such as hurricanes were to occur, the bond could forfeit most or even all of its value. There might be a 2% to 3% chance that this would happen; however, those events would be unrelated to global economic activity or the credit cycle. Inclusive of catastrophe events, these bonds have yields similar to high yield bonds. However, these Insurance Linked Securities do not exhibit spread widening or narrowing as a group, as is the case with conventional high yield bonds. In the bond world, Insurance Linked Securities are a diversifier.

The BSX has become a leader in this asset class. According to the BSX new release dated July 7, 2015 (http://www.bsx.com/News.asp), the BSX now lists Insurance Linked Securities with an aggregate value of $17.5 billion, which represents a 67% market share. According to an article published by Artemis, the leading research firm in the Insurance Linked Securities field, the BSX had attained an Insurance Linked Securities listing level of $15.9 billion on December 31, 2014. The Insurance Linked Securities asset class is really in its infancy at this stage. Artemis calculates the total Insurance Linked Securities market at roughly $24.7 billion worldwide. This sum is minor in relation to the size of the global high yield market. Bond investors wish to diversify away from the fixed income credit and interest rate cycle. Insurance companies wish to diversify their underwriting risk and retain less risk on their own balance sheets. It is for this reason that the Insurance Linked Securities market is expanding rapidly.

From the FRMO standpoint, we ourselves diversify into a different asset class with significant positive optionality. We define optionality as the ability to earn substantial sums without investing substantial sums in relation to shareholders’ equity.

Murray Stahl

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