Milkwood Fund half yearly letter to partners for the period ended June 30, 2015.

To our partners in the Milkwood Fund

The Milkwood Fund is up 15.5% for the first half of 30 June 2015.

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Milkwood Fund

The purpose of our letters is to communicate, as honestly as possible, thoughts on our investment approach and process. Not performance. Performance is a product of our investment process. Returns can be fleeting if we alter what we do, what we know works. At times we will be lucky, and at times unlucky, especially when measured over the short term. The longer you are invested in the fund, the lower the influence of luck will be, and the greater the influence of the manager’s (my) skill will be. To decide if the role of luck will diminish, analyze our investment process.

In this letter I will take you through two examples of our investment process. Firstly, an investment that has so far turned out to be successful (lucky?), and secondly, an investment which has cost us 1% of our fund. Painful!

Before that, a warning.

Milkwood Fund - A few thoughts on what won’t work…

The majority of fund managers today are espousing the formula for investment success to equal;

“Good quality companies”

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“Great / trustworthy management teams”

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“Fair value”.

Notice how all three are subjective.

Barrons recently asked a fund manager, “What kind of companies do you look for?”

His reply, “I want to find some of the world’s best businesses (hardly unique!) that can compound at high rates over long periods of time, identify them when they’re trading at a reasonable valuation, and then just marry them. Our goal is to find businesses we can own for five to ten years”.

I have nothing against the fund manager, but if we break this down a little, you will soon realize that it cannot possibly live up to the bill of being the answer to investment success.

The attributes such as good/great quality is something that doesn’t spring up overnight. It takes years or decades of performance to decide if a company is “good quality”. What about “trustworthy management”? Does a company create trust overnight? Like “quality”, it takes years to create trust.

The point is – companies that possess these attractive attributes were around last year, or the year before, or the decade before that. There is very little “new” out there that hasn’t been uncovered in the quality basket – especially with so many are chasing after so few.

If markets are to move higher, and if the “good quality gang” is to be the driving force behind these markets, two things need to happen. Both hold out danger signs.

  1. Clustering– the same stocks that have the “right attributes” get driven to outstandingly high valuations
  2. Investor perception becomes cloudy making an increasing number of companies appear sexy, when in fact they are pretty ordinary.

Today, we see signs of both 1 and 2 occurring. In the case of 1, it takes just one large activist fund manager to publicize his bullish views to have more than 12 apostles chasing after his latest investment idea. Unfortunately, the higher these stocks rise in price, the lower the future returns will be.

What about 2? A former “not-so-hunky” male acquaintance (let’s call him Shrek) used to have a tried-and-tested method to increase his “strike rate” with the ladies at nightclubs. Instead of arriving at 11pm when the senses of his would-be admirers are at their peak, he made of a point of arriving well after 2am. By then, the Vodka, G&T etc. had done the trick. Now appearing fresh-faced and alert, Shrek turned himself into Brad Pitt - at least to the women still dancing in the club.

In investing terms, what happened to Shrek is pretty similar to the pursuit of the current buzzwords for investment success - “quality”, “trustworthy management”, “fair valuation”. When everyone is chasing after the same thing, the longer the party continues the duller the senses become.

Many fund managers today are chasing opportunities that do not justify the valuations they are paying. The 2am Brad Pitts will turn out to be 9am Shreks.

Our approach is a little different and more flexible. Obviously, if we can find truly great companies at fair prices we will take the opportunity to invest. But our examples below illustrate the different sources of our ideas and different reasons for making the investment. To generate attractive long-term returns, and for our fund to continue to outperform, 6 factors are important to maintain:

  1. Milkwood is small which provides us with more opportunities to invest in compared to larger funds.
  2. Our fees are low (very!). You receive the benefit.
  3. We are passionate about investing. If I had a choice of what to do during the day, finding a great investment idea surpasses everything else I’d rather be doing (note – I said “during the day”!).
  4. Milkwood has a global remit. There should always be countries, regions, sectors that offer interesting ideas
  5. We have a concentrated portfolio – Menzies, our largest position - is 15% of the fund
  6. Luck

Below, follows two examples of what we do all day.

Milkwood Fund - United Insurance Holdings (UIHC)

We were lucky enough to meet the head underwriter at Lloyds last year, and he was clearly despondent about the prospects for reinsurance. This got us thinking about the repercussions of cheap capital and “alternative reinsurance” on the insurance sector. 4 It seemed to us that the winners in this sad tale of capital misallocation are likely to be direct insurers who can maintain pricing power through great client relationships or other means, but who also reinsure heavily and are active where reinsurance competition is strongest.

Nothing jumped out at us from the initial screens we did.

On a recent trip to the US, we noticed a large-scale direct advertising effort from an insurer called UIHC. A few weeks later while attending the Berkshire Hathaway AGM, co-incidentally Warren Buffett spoke about the risks of Re-insurers when he said “Reinsurers have taken a turn for the worse”. This piqued our interest, so we set about doing more work on the topic and looking again at beneficiaries of this – the direct writers – one of those being UIHC.

That’s how ideas come to us. By having inquisitive minds, we are constantly trying to find investments that are attractive. We don’t have one model that fits all.

Milkwood Fund

Milkwood Fund

See full letter below.