Bank Of America Corp (BAC) Helps Fernbank Trump Market (Again)
June 9, 2014
Dear Partners:
In 2013, the Fund earned a 43% gross and 36% net return. In comparison, the S&P 500 delivered approximately 32% (dividends included) during the same period. Under stable domestic economic conditions, the S&P 500 will not generate long-term percentage gains commensurate with those experienced in 2013. Similarly, we do not expect to earn our partners such high returns each year, however we believe that we will be able to consistently generate returns in excess of most people’s next best alternative over three or more year periods.
2013 Highlights:
Realized Gains
• MBIA. Our largest holding, MBIA Inc. (NYSE:MBI) settled its longstanding litigation resulting in a significant gain for Fernbank (more details below).
• AIG. We bought American International Group Inc (NYSE:AIG) at a significant discount to what we conservatively calculated to be approximate book value. We closed the position around approximate book value. This resulted in significant gain for Fernbank.
• Bank of America Corp (NYSE:BAC). We bought BAC well below our adjusted book value and closed the position around this approximate book value, which yielded a return in excess of 100%.
Current Holdings
We became the largest shareholder of a company that we anticipate will provide Fernbank with considerable returns in the future, particularly in the medium to long term. Our intention is to continue to increase our position in this company. In fact, we welcome additional capital to Fernbank in order to seize this unique opportunity. It would be sinful to not maximize on this opportunity. Whatever happens with the economy, markets or interest rates, this is an excellent opportunity to allocate money to today at its current price.
MBIA Revisited:
We bought MBIA Inc. (NYSE:MBI) believing that it was selling for a significant discount to our estimate of underlying value and that MBIA would unlock this value following a multibillion dollar settlement with Countrywide/Bank of America. Ultimately this is exactly what happened.
MBIA Inc. (NYSE:MBI) entered into a comprehensive settlement agreement with Bank of America consisting of over a billion dollars and other concessions in May 2013, which fell within our range of expected outcomes detailed in our 2011 and 2012 annual letters. This resulted in significant gains for Fernbank. To further demonstrate the comparison between our analysis and the outcomes, here are some highlights from those letters:
EXPECTATION: “We are highly confident that the Transformation [litigation over the splitting of MBIA’s subsidiaries] will be upheld.” – 2011 Annual Letter
OUTCOME: In a court ruling, the Transformation was upheld in favor of MBIA.
EXPECTATION: “If Bank of America decides to go through… the evidence accumulated by MBIA will most likely become publicly available.” – 2011 Annual Letter
OUTCOME: The court ordered Bank of America Corp (NYSE:BAC) to publicly release tens of thousands of pages of internal documents relating to its Countrywide acquisition. This order provided to MBIA Inc. (NYSE:MBI) considerable evidence in support of its Put-Back litigation for contractual misrepresentations.
EXPECTATION: “The very last thing the ‘Banks’ (with emphasis on Bank of America) 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 Inc. (NYSE:MBI)’s Put-Back litigation claims.” -2011 Annual Letter
OUTCOME: Bank of America continued pursuing litigation, but recognized the value of settling in light of damaging evidence being disseminated in a public forum, additional lawsuits brought forth by the government and the need to shift its focus to its core banking business. Accordingly, Bank of America Corp (NYSE:BAC) settled with MBIA Inc. (NYSE:MBI).
EXPECTATION: “We believe MBIA’s catalyst, a comprehensive settlement package, is rapidly approaching.” – 2011 Annual Letter
OUTCOME: The parties settled in May 2013.
EXPECTATION: “…we expect Fernbank to report returns for 2012 ranging from 30%- 60% just from MBIA alone.” – 2011 Annual Letter
OUTCOME: In 2013 we achieved those returns on MBIA alone.
EXPECTATION: “You will see how developments in both cases lead to a reasonable expectation of a comprehensive settlement in 2013, or ultimately a trial decision by 2014. Either way, MBIA is holding a winning hand.” – 2012 Annual Letter
OUTCOME: MBIA had a winning hand.
After resolution of this longstanding litigation, MBIA’s price increased substantially. We sold out of MBIA at a significant profit to allocate our capital to more attractive investments-discussed in the following section.
2014 Activity:
Our portfolio currently consists of a number of companies that we believe will do quite well over the long-term through all economic environments. In addition, we continue to hold significant amounts of cash to deploy as opportunities arise. Fernbank has a significant advantage over fund’s that manage several billion dollars of assets, in part because we have a larger investment universe from which to choose. For instance, a 10 billion dollar fund will not benefit very much from a 10 million dollar investment even if that investment quickly doubles in price. We, on the other hand, are happy to take advantage of such situations that are unavailable to our competitors. We continue to find a number of gems even in the face of a much less bargain friendly environment than we have seen over the last several years.
Of the handful of gems referenced in the foregoing, two are of particular interest and made up most of the funds purchase activity in 2013 and early 2014. These two companies operate very profitably, can reinvest back in their businesses at high rates of return, are run by capable managers, and are, in essence, unknown to the investment world. While many people prefer to see the price of their investments go immediately up, this is not a happy result when you intend to continue buying interests in a company. Therefore, to avoid unwelcomed price increases from the presence of additional buyers wishing to ride Fernbank’s coat tail, we will continue in the same fashion as last year and to refer to them as companies Y and X.
Company Y is an absolutely incredible opportunity. The economics are as good as they come; in fact we’ve never seen better. Additionally, the company’s management team has recently implemented strategic programs to ensure future growth. We have met with management on multiple occasions to discuss ideas, and are pleased to report they are receptive and open to advice. We will continue to purchase shares in the open market as the company currently sells for a good discount to what we believe the company is conservatively worth. This is particularly exciting given the company’s outstanding economics and incredible prospects.
In a lifetime, you only get a handful of opportunities to buy, at a reasonable price, a company of this character. Fortunately, we have acquired a significant amount of the company’s shares in the open market and are now the largest shareholder. If our assessment about this company is correct, this investment will provide significantly returns to Fernbank investors for many years to come. We will increase our ownership interest in this wonderful company as our capital base increases. Therefore we welcome additional capital so we can comfortably increase our position in Company Y without decreasing our cash below a comfortable threshold. Accordingly, this is a time sensitive opportunity as the price is currently cheap, but will increase as the company grows and investors take note.
Company X has very desirable economics. It earns a considerable amount of income on required capital, which is being reinvested back into the company in attempt to generate increases to sales and income. Customer retention rates are only marginally below 100%, a clear indicator that the company’s products are very well received. Due to its talented management team and robust product offerings, profits continue to grow at a meaningful pace. Moreover, management astutely allocates capital, which we believe will benefit future profitability. The company’s CEO and founder has a significant personal investment in the
company and therefore his incentives are significantly aligned with shareholders like us. Also to our delight, the CEO’s frugality regarding corporate expenses and ability to generate profits compared to the competition is highly respected and recognized within both its industry and the company’s own work force. This is our type of CEO! We look forward to sharing this great company with you in the future. But before we spill the beans, we would like to acquire a larger stake of this company at favorable prices.
We continue to search for other similar investments into which to deploy capital. Alternatively, we search for one-off investments and special situations. In the absence of those opportunities, we will hold cash, which we discuss below.
Many market participants discuss macroeconomic conditions and attempt to set forth a short-term (6-12 month) “outlook”. Such predictions provide little useful information. To our knowledge there is no systematic approach to fortunetelling. An individual with consistently accurate macroeconomic insights would make several billion dollars, in very short order, investing strictly in the options market. Not surprisingly, this sort of thing does not happen on any consistent nor reliable basis as a result of their predictions.
Rather than speculate on macroeconomic changes, we prefer to make investment decisions based on our understanding of the economics of specific businesses or otherwise by investing in specific situations. To that end, markets do not appear to us to be particularly inexpensive and while problematic for much larger investment funds, we continue to find a modest number of “gems” that we are confident will do well in any economic environment.
We like to hold relatively large amounts of cash despite yielding nearly nothing. Cash provides us the flexibility to identify and purchase opportunities when financial markets panic. Significant fluctuations in market prices will always exist, however it is impossible to know exactly when the irrationalities of the market will provide us with great buying opportunities. The amount of cash we hold relative to total capital is simply a function of the number of attractive opportunities available to us. When an overwhelming number of wonderful investment opportunities exist, we will hold less cash and when attractive opportunities are few, we will hold more cash. In general, amount of cash most of the time.
Notes on Retirement Funds: Several partners have asked us about retirement funds. You should all know that Fernbank is permitted to accept your retirement funds if they are set up for a self-directed account. Fernbank is limited in the amount of the funds we receive from retirement accounts so we may not be able to accommodate all requests. Currently, we believe we have room to accommodate most of these types of requests. When it comes to retirement funds, it is critical to follow the correct procedures to ensure you maintain the preferential tax treatment for these dollars. We have worked with a retirement fund trust administrator that can help you do just that and can refer you to them to set up an account. Just let us know and we’ll help point you in the right direction. Ask your IRA administrator or company’s HR department if they offer selfdirected 401k’s.
Low Turnover: Investment partnerships and investment managers get the partners that they deserve. In our case, we have an excellent and crème-de-le-crème partnership group. Our partnership group is intelligent, disciplined and patient. Most other funds don’t have partners of your quality and for this we are fortunate. We have virtually no turnover and most of you continue to make additional capital contributions to the partnership. You make our jobs as managers easy, which allows us to focus as much as possible on generating the best returns for Fernbank. We look forward to the joyful work of growing your net worth!
Concluding Remarks: While the vast majority of Wall Street (“market forecasters”, market participants, and “financial advisors”) preach investment advice, very few actually eat their own cooking. We have committed a significant amount of our own personal and family money to Fernbank alongside each of you. Our interests are directly aligned-we will feel the pain of Fernbank’s losses and will share in its successes.
We believe the best way to succeed is to fairly and earnestly deserve it through hard work, discipline, patience and pragmatism and this is what we will continue to do. At the most recent Berkshire Hathaway meeting, we observed Warren Buffett ask Charlie Munger why more people don’t copy Berkshire’s investment method. Munger responded that their method requires too much patience and isn’t glamorous enough for most everyone. Human nature being what it is, suggests that this mentality is unlikely to change, which is great news because it means our competition will be limited.
Respectfully submitted,
Fernbank Partners LLC
2013 Fernbank Annual Letter (1)