Fernbank Partners up 22.45% in 2011, Detail Bullish Case for MBIA Inc.

Fernbank Partners up 22.45% in 2011, Detail Bullish Case for MBIA Inc.
By MBIA (Aus MBIA-PDF) [Public domain], via Wikimedia Commons

Fernbank Partners up 22.45% in 2011, Detail Bullish Case for MBIA Inc.

Fernbank Partners LLC

1200 North Garfield Street Suite 913

This Credit And Equity Fund Saw Sizable Contributions From Its Stocks In Q3

Arena Investors Chilton Capital Management Schonfeld Strategic Advisors Robert Atchinson Phillip Gross favorite hedge fundsThe DG Value Funds were up 2.7% for the third quarter, with individual fund classes ranging from 2.54% to 2.84%. The HFRI Distressed/ Restructuring Index was up 0.21%, while the HFRI Event-Driven Index declined 0.21%. The Credit Suisse High-Yield Index returned 0.91%, and the Russell 2000 fell 4.36%, while the S&P 500 returned 0.58% for Read More

Arlington, Virginia 22201

 2011 Annual Letter

April 12, 2012

Dear Fernbank Investor-Partners,

 * Fernbank Partners earned 22.45% in 2011, despite holding on average over 30% of its net assets in cash throughout the year. We are pleased with these results, but not overjoyed (we’re saving our excitement for 2012).

 * For the three months ended March 31, 2012, the Fund earned 6.57%.

 * Since inception on September 1, 2010, the Fund has earned 46.27% despite holding on average over 30% of its net assets in cash for the period ended March 31, 2012.

 The table below shows these performance figures.

Fernbank Partners up 22.45% in 2011, Detail Bullish Case for MBIA Inc.

Your individual results to date will vary depending on the timing of your investment. Neither leverage nor short selling was a significant factor in the returns displayed above.

Significant Investments (as of Dec 31, 2011)

We discuss MBIA Inc. (NYSE:MBI) , Inc. at length further below, however we would like to briefly introduce one of our other holdings, Newmarket Corporation, about which you probably know very little. Newmarket, headquartered in Richmond, Virginia, is a specialty chemicals manufacturer with a great business and a very strong, durable competitive position in the lubricant additives industry. This industry is controlled by only a handful of long established incumbents-none of which can supply the entire market, each operating within their own unique sub-industry niche.

 About a decade ago the lubricant industry began a shift as technological and industrial specifications placed new demands on lubricant properties and performance. For instance, as little as ten years ago, it was quite common to have your car’s transmission fluid changed every few years, however most new car owners today will never have their transmission fluid changed. As lubricant performance demand shifted, so too did the industry’s economics and we believe this shift is here to stay. Scale advantages coupled with captive customers affords Newmarket significant pricing power. Strict regulatory hurdles, high start up costs, high customer switching costs makes entry into this market extremely difficult, in fact, uneconomical for potential entrants. We really like Newmarket’s business (as well as the current price) and unless the price increases substantially, we will be adding to this position going forward.

The Fernbank Approach

 We measure our success by the annual rate at which our investors’ account balances increase over five year periods. If, over this time, we are unable to outperform your next best alternative on a risk adjusted basis, we have no business earning a living managing your money, and you should fire us on the spot.

 Investment success requires a lot more than being able to identify the difference between good and bad investments which is, incidentally, far more difficult than it sounds. With only so much time in the day, it is critically important to avoid wasted efforts. Knowing where the most attractive opportunities are likely to arise before starting a search for mispricings gives us a huge edge. That said, it is irrational for us to expect to be able to find attractive opportunities every day. In fact, several months may pass before we identify something new of interest. Our job is not only to decide what to invest in, but when to invest. We are not talking about market timing, but rather standing by conservative principles of value, from which we refuse to deviate. Furthermore, our decision to buy or sell an investment will never be influenced by the opinions of other market participants, but rather upon our own measure of the business in which we have an interest. Our responsibility as money managers is to keep our heads when others have lost theirs.

We intentionally built Fernbank to be a long-term partnership for a small group of investor-partners. There is a good reason for this. The magnitude of our success will depend, to a varying degree, on two key items: (i) our ability to generate more investment successes than failures and (ii) your ability as investor-partners to recognize the difference between stated investment results and economic (actual) investment results. Having a small group of investors that understand our approach is extremely important to us because the latter item will never be understood by the typical investor. Focused, disciplined, rational investing will only appeal to a select group of rational like-minded people who have sound emotional temperament, patience and courage to follow through with their decisions despite the crowd’s opposing views; these are prerequisites to understanding item (ii).

 This letter is intended to provide you with meaningful updates about the fund’s activities during the preceding year; information that will help you determine how well (or poorly) we have done. Although this sounds easy enough, understanding investment results, especially over short periods of time, can be very difficult. A large portion of this letter seeks to address this problem, however, it may be instructive to first bring a few industry issues to the forefront that are rarely, if ever, openly discussed by the general investment community.1

1 One notable exception among journalists is Jason Zweig of the Wall Street Journal. Anyone interested in first class journalism specific to investing, will want to check out Jason’s “Intelligent Investor” column which appears in the WSJ each Saturday.

Client Obfuscation

 The world is horribly confused and terribly misguided by Wall Street. Much of this confusion stems partly from a lack of basic investment knowledge among most investors and partly from a flood of misleading information (provided by Wall Street) about the way the investment world works. Incidentally, the investment industry benefits from client ignorance. Client obfuscation is beneficial to most of the investment industry because confusion and uncertainty are the reason individuals outsource their investment decisions in the first place. To make matters worse, these individual investors make decisions based upon information provided by institutional “experts” who make a living by advising others to do what is best for them. Additionally, these experts do not measure success by the long term rate of increase in the value of client accounts, but rather by client retention rates and the magnitude of new money they attract. It is hard to see how a rational person could, on the one hand, understand how the traditional money management industry operates, yet on the other hand, continue to allow their money to be managed by them.2 A system focused on retaining or increasing clients is naturally focused on market trends and the fear of short-term underperformance and since the vast majority of assets are held by relatively few institutions, the result is enforced mediocrity.3 That is, there is a huge incentive for these institutions to get big, and not much incentive to deviate from the indexes, more or less, because money managers that do about average tend to keep their clients. Unfortunately, the general public does not spend enough time learning to understand the industry and, consequently, end up paying huge management fees to “investment experts” that generate the kind of results otherwise achievable by dart throwing monkeys. If we assume investors can distinguish a monkey from a money manager, it must be that there is a problem specific to the measurement of investment results.4

 Not everything that counts can be counted, and not everything that can be counted counts. -A sign in Albert Einstein’s Stanford University office

The Measurement Problem

One might reason (incorrectly) that individual annual investment performance figures represent whether or not an investor or investment manager is competent. The mistake lies in the assumption that annual investment results provide relevant feedback about investment success or failure. Consider the standard process of calculating investment performance, customarily done by periodically measuring individual annual investment results against a standard benchmark5 such as the S&P 500. These periodically reported results are calculated with precision over fixed periods of time, which makes comparing results a relatively painless process. With such a convenient measuring tool, investors easily observe performance records and make judgments about how well their investments did for that period (e.g. a 10% return for the year might make you feel pretty good about your investment when the S&P 500 returns 5%, but not when it returns 30%). However, this method of measurement has a serious drawback: reported returns generally measure changes in market prices, which are, in effect, merely opinions about future expectations. This provides a very precise measure, but also provides terribly inaccurate and irrelevant feedback over short periods of time.

2 Traditional Money Management includes: Stock Brokers, Private Wealth Managers (basically stock brokers under the disguise of another title), Financial Advisors, and anyone else that “manages” the money of individuals, but outsources the heavy lifting. We include most mutual funds in this group since they are almost entirely “closet” index funds.

3 At the end of 2010, mutual funds managed roughly $13 trillion, an amount roughly equal to 46% of all US Household Financial Assets. At the beginning of 2011, the largest 25 mutual funds managed 74% ($9.62 trillion) of the industry’s assets. In aggregate, these funds can’t possibly produce better than average market returns, because they are the market.

4 Of course, this requires us to assume that people want more money than they already have, all else equal.

5 A benchmark is a tool to compare the results of an investment against available alternatives. Generally, the S&P500 is used as a benchmark because it is supposed to represent the general business experience of investors in American businesses, however it does not always do this.

Feedback provided by single year changes in market prices rarely reflect changes in underlying business values. Furthermore, investors that pay attention to market price changes without regard to changes in business value are destined for failure, because they are measuring the wrong information. Perhaps an example will be useful. Let’s say you make a bet that the Washington Wizards will win in a basketball game against the Los Angeles Lakers. Would you pay up if the Lakers were leading at the end of the first quarter? You might pay up if you were unaware that the game had more than one quarter, but you would be a little short of silly to do so otherwise. Although the score at the end of the first quarter may provide you with some information about the progress of the game at that moment, it tells you nothing about the game’s final outcome. The only relevant information is the final score, everything else is just noise-and most of Wall Street’s focus is on noise.6 Using annual performance figures to draw conclusions about the quality of investment decisions is akin to observing the score at the end of the first quarter and drawing conclusions about the final score. At best you have an illusion of an outcome and a completely flawed method of measurement. Unfortunately, this is the way almost all people measure investment performance.

 Let’s see how this discussion relates to Fernbank. The first table below shows our largest holdings as of December 31, 2011. This is the same table that appears on page one with an additional column listing closing market prices for the period. Focus your attention on the market price column in the first table. Now look at the same column in second table, which shows the same information, but for the period ended March 31, 2012.

Notice that in almost every case the market prices changed substantially. In the three months ended March 31, 2012, Bank of America Corp (NYSE:BAC)’s stock price increased 72% from $5.56 to $9.57, Newmarket Corp’s stock price decreased 5.23% from $198.11 to $187.74, American International Group, Inc. (NYSE:AIG)’s stock price increased 32.88% from $23.20 to $30.83, and MBIA Inc. (NYSE:MBI) ’s stock price decreased 13.89% from $11.59 to $9.98. You’re probably wondering what changed. Absolutely nothing changed in any material way for Bank of America Corp (NYSE:BAC), Newmarket, or American International Group, Inc. (NYSE:AIG) With respect to MBIA Inc.(NYSE:MBI), if anything, they are in a better position at the end of March than they were at the beginning of the year.7

6 For an example of “noise” just watch a few minutes of CNBC’s “Fast Money”, “Squawk Box”, or “Mad Money”. 7 Alison Frankel, a Reporter for Thomson Reuters, has done a first class job covering MBIA Inc. (NYSE:MBI)’s litigation. See “Alison Frankel’s On The Case” for top notch coverage of MBIA’s ongoing court cases.

Market price changes are based upon the expectation and emotions of market participants. However, these changes almost never reflect the current progress of underlying business results. The more people are interested in a given investment, the higher the price the seller will generally require, but true economic value (“intrinsic value”) necessarily changes at a much slower pace.

 Unfortunately, there is no benchmark that will distinguish between positive short-term investment returns and justifiably positive short-term investment returns. Human nature dictates that people prefer an incorrect model over an incomplete model and as such, many are forced to compare short-term results to the S&P 500 (or any other market benchmark), but we urge you to make a conscious effort to recognize that these results may be inaccurate and misleading. Since annual investment results often do not provide reliable information, we recommend our investors adjust their measure of investment performance.

Reducing Noise: An Improved Approximation

 Single year observation periods do not generally measure investment outcomes. This can be partially resolved by simply extending the time interval between observation periods. For instance, extending the time between performance measurements from one year to ten years will generally provide a more accurate account of investment success (or failure), because ten years is sufficient to cover several iterations of investment decisions and corresponding outcomes. However, this does not do much for you today. We cannot expect our investors to wait ten years before making decisions about whether we have succeeded or failed. You need to be able to make some judgments along the way. If one year observation periods are too short and ten year observation periods are too long, how much time must pass between observations of investment results before they begin to provide a meaningful measure of investment competency? If you are only looking at performance figures, we are of the impression that three years is the minimum amount of time required to ensure that investment outcomes materialize. The shorter the time between observations, the more likely you are measuring opinions (current prices) not facts (ultimate outcomes). By extending the observation period from one to three years, you get a more accurate measure, because irrelevant noise is, for the most part, eliminated. This of course is not a perfect science, but rather an improved approximation. As previously stated, “Investors that pay attention to market price changes without regard to changes in business value are destined for failure, because they are measuring the wrong information.” Let’s add a corollary to this point: they are also destined to make systematic errors in their judgments about the competency of their investment manager.

Measuring What Matters: Decision Quality

 When attempting to measure any investment manager, you should set out to measure decision quality, not necessarily investment results. This is, of course, counter-intuitive, but it is the right way to think. A sound decision process requires knowledge, from the outset, of all relevant facts as they relate to the set of possible outcomes. A profitable investment alone, does not validate a good investment decision. In our book, a good investment decision is one that is profitable for clearly identifiable and measurable reasons established before capital is committed. In fact, there are few things more dangerous than a favorable outcome from a bad decision. When you fail to recognize error, you are certain to make repeated mistakes on a larger and larger scale. This defect is extremely common in investing. It is also particularly dangerous. For instance, on the flip of a coin, we all know the probability of getting heads is just as likely as tails, but it is not terribly uncommon to get several consecutive tails before a single heads. With each consecutive tails in a series of flips, the probability of getting heads on the next flip increases substantially. Drawing the conclusion that the outcome is attributed to coin flipping skill, when it is merely a series of random events, will destroy a Vegas-bound coin flipper. (You are in big trouble if you think you are playing a game of skill, when it is actually a game of chance.) This dysfunctional phenomenon is exacerbated in the investment business, because massive amounts of capital flow to investment managers that are literally engaged in coin flipping-like behavior. Of course, investors don’t realize they are gambling any more than their investment managers, and as with every series of gambles, they eventually lose. They might not lose on the next flip, but they will lose eventually, and lose big. After all, it’s never the gambler with a billion dollar house, it’s always the “house” with a billion dollar casino. (For a recent account of a Vegas-bound coin flipper, take a look at Jon Corzine of MF Global.)

 Good investment decisions are never based on opinions, unfounded beliefs, “gut” feelings, or superstitions. All investment decisions must be supported by facts and sound logic. Part of the investment process is knowing what to buy and determining how much it is worth. If you properly understand these two items, you will have a much easier time identifying what most influences expected outcomes. Equally important, you will also acquire insights about the items that most influence unexpected outcomes. But you must identify all possible outcomes. Unexpected, unforeseeable outcomes (“black swan” events) must also be accounted for in some manner-sensible investors typically resolve this uncertainty by requiring a large discount to ultimate expected value (a “margin of safety”). Furthermore, profitable investments that result from unexpected outcomes never constitute quality investment decisions. When evaluating our investment decisions, the critical factor we look to determine is how closely outcomes correspond to our understanding and expectations of the situation at the initial time of purchase.

 As stated above, you can gain some idea about what will effectuate a favorable or unfavorable outcome by clearly understanding what you are buying and by knowing what it’s worth. This information also helps you to identify what will need to continue or change for your expected outcome to become an actual outcome. Understanding why the opportunity exists gives important information about future outcomes. Namely, what must take place for the investment to be successful and what will cause expected outcomes to ultimately be realized (“catalysts”). A reasonable timeline may be established in the presence of a clear catalyst, which allows you to monitor the progress of the situation over time.

Outcome Timetables: Clearly Defined or Ongoing

 We call investment decisions with clearly defined outcomes, “one-off” situations, because these situations depend on the outcome of a known event, have identifiable timelines and end with clearly favorable or unfavorable results. Generally, “one-off” investments arise out of some corporate event, such as a liquidation, spin-off, merger, reorganization, or litigation. “One-off” investments often take at least one year to develop, but may take as many as three or more.

Ongoing investments are generally ideal investment situations and consist of investments in businesses we believe will do quite well over a long period of time. The investment outcome is based on the long-term ongoing success of the business’s underlying operations.

 It is important to consistently monitor progress over the course of any investment. With the discovery of relevant new facts, conclusions must be updated accordingly. To assess the investment you must be able to observe how the situation is playing out. Ultimately, an investment is a success only when outcomes correspond with initial expectations that are supported by empirical evidence.

 Overall, notice that this is vastly different from placing money on “number seven”, closing your eyes and hoping for a decent result. We know our approach is sound because it is systematically repeatable for well understood, identifiable reasons, and also greatly reduces our chances of making big mistakes.

Process into Practice: An Illustrative Situation

 “It is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his weight.” -Benjamin Graham

 Let’s walk through our largest holding, MBIA Inc. (NYSE:MBI). Although, ensconced in apparent uncertainty, any rational person willing to seriously look into MBIA will find that it is worth significantly more than its current market price. When purchased cheaply, good companies with one time huge, but clearly solvable, problems are almost always superb investments. Such opportunities are quite rare since, by definition, good companies generally avoid huge problems. MBIA is such an opportunity and throughout 2011, we acquired large quantities of shares at dirt cheap prices. The table below shows the disparity between MBIA’s price and value.

 MBIA’s Price Versus Value (as of Dec 31, 2011)

What is the Opportunity and Why is it Available?

 MBIA Inc. (NYSE:MBI) is a monoline insurance company with two insurers, Municipal Bond Insurance (“Public Finance”) and Mortgage Bond Insurance (“Structured Finance”). After a thirty-four year run without a meaningful loss, MBIA’s Structured Finance business began experiencing losses mainly tied to misrepresented financial guarantees of investments involving securitization of real estate guarantees. Faced with largely unknown loss exposure from these financial guarantees, MBIA’s credit rating was called into question. Due to the then corporate structure of MBIA, this uncertainty spilled over to MBIA’s Public Finance operation, preventing the underwriting of new municipal debt issues.

With the approval of the New York State Insurance Department (NYSID), MBIA legally separated the Structured Finance subsidiary from the Public Finance subsidiary (the “Transformation”). The thought at the time was that, if the Public Finance division became a legal separate entity, then MBIA could continue to underwrite municipal bond insurance at a time when municipalities appeared to need it more than ever. NYSID’s Superintendent (the “Superintendent”), made the determination that both of MBIA’s subsidiaries would be able to meet their future claims and that both were solvent. This is key. The Superintendent’s job, before anything else, is to protect policyholders by closely monitoring insurers for insolvency. However, Structured Finance policyholders, primarily a group of eighteen domestic and international financial institutions (the “Banks”), did not like the idea of separating assets into two separate companies and filed a legal complaint against MBIA arguing that the Transformation moved capital to the Public Finance subsidiary at the expense of Structured Finance policyholders.9 MBIA in turn, sued the Banks for contractual misrepresentations (primarily guarantees from

8 Municipal bond insurance provides Municipalities with a higher credit rating than they would receive without insurance. The higher the credit rating, the lower the interest rate. In effect, the Municipality gets the credit rating of the bond insurer, because the bond insurer guarantees timely payment of principal and interest. There is however one requirement, the bond must be insured by an insurance company with a solid balance sheet. Two complaints were filed by the Banks, Article 78 Proceeding and Plenary Action. The Article 78 claim seeks to reverse the Superintendent’s approval and the Plenary Action is an attempt to recover damages for, as the “Banks” claim, the fraudulent conveyance of assets from Structured Finance to Public Finance.

securitizations originated by Countrywide Home Loans) to recover several billion (almost $6 billion to date) in structured finance claims payments to the Banks.

 In short, the Banks are suing MBIA for the Transformation and MBIA is suing the Banks for contract misrepresentations (the “Put-Back Litigation”10). Although these are separate legal proceedings, they are very much related. Of the original eighteen Banks that filed claims against MBIA, only three remain. Each of the fifteen Banks no longer involved in litigation against MBIA, settled their Put-Back Litigation claims and simultaneously dropped their transformation litigation claims. You can also see how these cases are related by assuming that the Banks succeed in reversing the Transformation, in which case Public Finance’s assets would again be available to pay for losses stemming from structured finance guarantees, thereby recapitalizing Structured Finance. However, if MBIA successfully recovers claims paid on misrepresented contracts from the banks, its Structured Finance unit will have significantly reduced its exposure while recapitalizing its balance sheet. Meaning, successfully recovering claims payments destroys the Bank’s Transformation litigation argument.

 From our perspective, if MBIA wins the Transformation litigation, the Put-Back Litigation is  largely irrelevant. The Banks have to prove that the Superintendent either committed fraud or was professionally negligent, which makes reversing the Transformation highly unlikely.11


What We Bought

Our decision to buy MBIA was centered around our appraisal of Public Finance’s runoff value.12 In effect, we bought MBIA at a 50 percent discount to the runoff value of Public Finance alone, which we believe is worth roughly $3.2 billion, net of parent company (MBIA Inc.) debt. If Public Finance exits runoff mode and resumes writing new business, we believe it would command a going concern value of roughly twice runoff or approximately $6 billion. We should also point out that our appraisal of MBIA does not (and did not) attribute any value to Structured Finance. However, this does not mean that Structured Finance is worthless. A recapitalized Structured Finance unit, primarily from Put-Backs and rescission’s13, and significantly less exposure, primarily from commutations14, could very well add additional value to MBIA. In effect, Structured Finance adds free optionality to our purchase of MBIA. In the event that there is residual value in Structured Finance, we will gladly take it, but we did not pay anything for it.


Our Expectations

We are highly confident that the Transformation will be upheld. This can happen in one of two ways, either the Banks will drop their Transformation litigation claims or the dispute will be resolved in court. As evidenced by each of the fifteen Banks that have already dropped out of litigation against MBIA, the more likely outcome at this juncture is that the Banks will drop the Transformation litigation

10 Suits based on alleged mortgage contract breaches of representations and warranties are known as “Put-Back” claims.

11 The legal standard for the Superintendent’s actions is that it must be above that of “arbitrary and capricious” acts. In other words the Superintendent’s actions would be reversible only if he acted randomly for no reasonable cause.

12 Public Finance agreed not to guarantee new municipal bond issues until they resolve the Article 78 and Plenary Action. This means that Public Finance is currently operating in runoff mode. (An insurer enters runoff mode when they stop writing new business and continue operations only to see through existing guarantees.) However, as policies expire, the unearned premium reserve converts into equity-so long as the insurer underwrites at a profit. Moreover, the insurer earns additional income from interest earned and realized gains on their investments until the final policy expires and all claims paid.

13 A “rescission” is the cancellation of an insurance policy back to its effective date resulting in a return of all premium charged.

14 In the monoline industry, an insurance policy is “commuted” when the policy is cancelled in exchange for a cash payment or some other consideration from the insurer.

claims (scheduled to begin trial in May) as part of a comprehensive settlement package related to the Put-Back Litigation.

 Furthermore, as part of the Put-Back Litigation which is scheduled to go to trial this spring, MBIA has acquired through legal discovery a massive amount of mortgage fraud evidence against Bank of America Corp (NYSE:BAC)’s subsidiary Countrywide Home Loans.15 If Bank of America Corp (NYSE:BAC) decides to go through with the trial, the evidence accumulated by MBIA will most likely become publicly available. The very last thing the “Banks” (with emphasis on Bank of America Corp (NYSE:BAC)) should want is additional exposure to a massive number of new legal liabilities, but we believe that is exactly what they will get if they decide to defend themselves in court against MBIA’s Put-Back Litigation claims.

 Ultimately, as long as the Transformation litigation ends favorably for MBIA (a high probability event), the Put-Back Litigation is completely irrelevant. If the Put-Back Litigation ends in settlement (as we expect it will) so ends the Transformation litigation. We are of the impression that the only way we lose a dime is if each of the following three events occur: (i) The Banks win both the Put-Back Litigation (very small probability event) and the Transformation litigation (even smaller probability event); (ii) mortgage backed securities default at an increasing rate, and (iii) otherwise financially sound municipalities decide to default almost simultaneously. We put the combination of these three events in the category of “guns and milk” because most of us will be gathering guns and basic food as we prepare for anarchy.)


 There is nothing more rewarding, humbling or motivating than having the opportunity and responsibility to generate an extraordinary amount of wealth for a small group of deserving investors. We wake up every morning excited about the day ahead and for this we are grateful.

 Our idea of a good time is working exhaustively to find wonderful opportunities to invest in that others neglect, dislike, overlook, or ignore. We will consider Fernbank a success only if we earn our investors vastly superior returns with very minimal risk over the next twenty or more years. (We truly take a long-term perspective!) This is why we concentrate on avoiding irrecoverable losses before we think about outsized gains. Only when both items are present will we make an investment.

We, as managing partners, will always have our entire liquid net worth invested in Fernbank, right along side yours. Additionally, many members of our extended families also have significant amounts of their liquid net worth invested in Fernbank. How could it be otherwise? Many of you have invested a large percentage of your liquid net worth in Fernbank and several of you have gone all in. We strongly encourage each of you to concentrate your money in a handful of investments that you believe offer you the greatest opportunity of a long run of outsized risk adjusted returns. If you have more attractive opportunities than Fernbank, it is in your best interest to concentrate on those opportunities. If Fernbank is your best opportunity, then you should seriously consider placing a meaningful amount of your net worth in Fernbank. Our reasoning behind this urgency is not without merit. We believe MBIA’s catalyst, a comprehensive settlement package, is rapidly approaching. There is a very good chance a settlement will come by or before mid-year. Such an outcome should have a significant impact on each of your Fernbank account balances. To put this into context, if MBIA settles sometime this year, we expect, (but do not guarantee) Fernbank to report year end returns for 2012 ranging from 30 to 60 percent just from MBIA alone. (No that was not a typo!)

 As always, please do not hesitate to contact us with any lingering questions or concerns.

15 Countrywide Home Loans was by far the largest originator of mortgage related securities guaranteed by MBIA Inc. (NYSE:MBI)


Very truly yours,

Fernbank Partners LLC

Supplemental Information

 We often hear otherwise intelligent individuals compare the stock market to a casino. The implication here is that investing in public markets is in all cases, considered the same thing, as gambling. Interestingly, such comparisons are commonly made by owners of private business. This is particularly odd since, the only real difference between a public and a private business is liquidity. Apparently they fail to recognize that markets do not make decisions, people make decisions and if people decide to treat markets like a casino, markets will look and feel just like a casino. Also, buying an interest in a private business does not preclude gambling behavior. In fact, if you fail to recognize the similarities (and differences) between public and private markets, chances are you are playing dice, whether or not you realize it. Rational investors understand that the function of markets is not to facilitate gambling, but to facilitate the exchange of different kinds of assets for money.

 Once you get beyond the noise constantly being churned out by Wall Street, it’s quite easy to see that the fundamental nature of investing is fairly straightforward. When you allocate money you are either investing or you are speculating. (A major source of confusion among market participants stems from a lack of understanding this distinction.) In either case you have the option to purchase either debt or equity by means of public markets or private markets. Public markets are far more liquid than private markets, otherwise these two markets are, in essence, identical.

Investment & Speculation Are Two Very Different Things

 There is a clear difference between an investment activity and a speculative activity. An investment occurs when money is exchanged for an income producing asset that the buyer believes is worth more than the price paid. The focus is on how much the asset is worth, both now and in the future. The risk of an investment pertains to the durability of the assets income producing characteristics and to the investors ability to appraise underlying value. That is, investment risk occurs when an asset does not produce sufficient income to justify the price. Conversely, speculation occurs anytime return of capital is expected from the resale of an asset instead of the income produced. The risk to a speculator depends not on the value of the asset, but rather on the price at which the asset can be resold.16 Thinking you are investing when you are speculating is just as detrimental as confusing a lucky flip of a coin for coin flipping “skill”.

Debt & Equity

 An investor generally has the option to buy two things; debt and equity–everything else is just Wall Street spin. Debt is an extension of credit to a borrower. The borrower guarantees to pay the creditor a fixed amount of interest over the term of the loan and to repay principal upon maturity. Creditors have priority status over the borrower if the interest or principal is unpaid. That is, creditors have a legal claim on the asset and can seize the asset from the borrower and liquidate the asset as a return of capital. Equity is ownership. Owners have a claim on the earning power of the asset in excess of any fixed income or senior priority obligations.

16 Our definition of investing and speculation are not as rigid as they might first appear. Arbitrage, for example, depends on price movements, but is well within the boundaries of any sensible investment operation. Arbitrage consists of the simultaneous purchase and sale of an asset at a profit yielding price spread and is made possible by the existence of two or more markets, which trade the same asset or by two separate assets exchangeable for one another. The simultaneity of arbitrage necessarily eliminates the investors downside risk which the speculator necessarily assumes. Arbitrage is not considered a speculative activity because the the risk of loss is removed almost entirely from the transaction, leaving only the possibility, but not the guarantee, of a profit. Additionally, the purchase of operating assets, at depressed prices, would also constitute an investment, even though it may at first appear to fit our definition of speculation. The process of purchasing assets at a discount to their true worth in a fire-sale, affords the parsimonious buyer the advantage of leisurely winding down the business piecemeal. The profit depends, not on the price movement, but rather on the value that a well informed private business owner will pay in a negotiated transaction.


Two Markets

 Investors have, in essence, two markets from which to choose; public and private. Public and private markets share nearly identical legal and economic rights. The most significant difference between public and private markets is liquidity. The liquidity of an investment is defined by the speed with which an investment is exchangeable into cash. Most public companies are very liquid because they are easily accessible and actively traded. An unhappy silent partner with minority ownership in a publicly traded business can quickly dispose of his or her ownership by selling their shares at prevailing market prices. Conversely, private interests rarely change hands, meaning, the silent partner in a private business is not afforded the luxury of liquidity.



 Investment: Is one where you look to the asset itself to determine your decision to put down money now to get more money sometime in the future. The focus is on how much the asset is worth, both now and in the future.

 Speculation: Any time return of capital is expected from the resale of an asset instead of the income produced, with the speculator’s risk dependent on the price at which the asset can be resold and not based on the income producing value of the asset. (Also known as looking for a “greater fool”.)

 Gambling: A subset of speculation for which there is no legitimate purpose in society, such as Russian roulette, slot machines, certain derivative contracts, speculative IPO participation, etc. Some gamblers wear tank tops and sit in front of slot machines all day and some wear fancy suits and work on Wall Street. These individuals are at greatest risk when they fail to recognize their activities as gambling; it is Russian roulette with a twist; instead of one bullet they are playing with one empty chamber. Of course, many money managers use your money to play a game of heads they win, tails you lose.

 Risk: The probability and amount of permanent loss of capital. Wall Street often define risk as “Beta”, which is a measure of market price volatility. Beta measurements are worthless and misleading. Anyone using Beta calculations should never be taken seriously for financial matters of any sort.

Permanent Loss of Capital: An unrecoverable loss.

 Risk Control: Risk is controlled by avoiding activities that subject one to permanent loss of capital. An investment operation does not control risk by means of a special department, rather, risk is controlled by employing an investment process centered around conservative principles of value and by exercising the discipline to only acquire assets at prices that provide an adequate margin of safety.

 Diversification: Having investments spread across an appropriate number of assets to protect against unforeseen and unpredictable catastrophic events (e.g. “black swan events”). Diversification can be accomplished by investing among different industries or to a lesser extent among different companies in the same industry. Diversification is often taken to an extreme. Most of the financial industry engages in over-diversification, such as holding a portfolio of 50, 100, or more securities. A portfolio can be appropriately diversified with roughly six to twelve holdings.

Investment Observation Period: A minimum of several years, at the very least three years, more correctly five to ten years plus. A calendar year of three-hundred-sixty- five days (plus or minus a few for leap years) is the period of time that it takes the Earth to orbit the Sun. A good measure for age, but

a completely arbitrary period of time to measure investment performance. The longer the time period for measurement, the better the chances that the results reliably reflect economic reality.

 “Asset Allocation”: A red flag. Be skeptical of anyone who uses this term, or discriminates between various asset classes, generalizes the characteristics or performance of an asset class broadly, speaks of “tactical asset allocation”, or anything similar. The use of the term asset allocation indicates market timing, macro-economic forecasts and other unknowable assumptions about the future.

 Value Investing: An industry classification typically used by institutional investors to group funds into “Style-Box’s”. The term “value investing” is a redundancy. If you are not investing in terms of price versus value, you are not investing, but instead speculating. Red flag: use of the terms “Growth Fund” or “Value fund”. Growth is merely a component of value.

 Investment Success: Actions with corresponding systematically repeatable outcomes (empirically provable) under any broad array of economic environments.

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