The stock market sputtered and stalled in the first half of 2015. Standard & Poor’s 500 index of large U.S. companies rose a scant 0.28% in the second quarter and 1.23% over the six months ended June 30. Auxier Focus Fund trailed the index, declining 0.97% for the quarter and 0.29% for the first half of 2015. One reason is that the Fund is only 70% invested in American companies (the S&P 500 is 100%). The remainder: 17% in foreign stocks, 6% in cash and 7% in so-called work-outs such as corporate spinoffs. What’s more, our lower-risk allocation has handily beaten the benchmark over time. Since inception in 1999, with an average 75%-95% equity exposure, a $10,000 investment in the Fund grew to $30,760 as of June 30, vs. $19,880 for the S&P 500.
Why was the market basically flat in the first half of 2015? One problem was increasingly negative headlines out of Greece, a country with 11 million residents, approximately $335 billion in debt and a GDP about the size of Wisconsin. These captivated the financial press and contributed to heightened market volatility. Another was rising concerns about China’s liberalization of stock ownership and margin accounts. These policies exposed a new generation of investors en masse to the cycles of fear, greed and ultimately folly as Chinese stocks went parabolic, then dropped sharply. Margin debt more than doubled in six months to 2.27 trillion yuan in June. More worrisome: between 2008 and 2013 China’s bank balance sheets grew by $15 trillion to $24 trillion. That growth exceeded the size of the entire U.S. banking system. Japan saw a similar debt growth trajectory in the 1990s. Such velocity in borrowings robs future growth and tends to lead to economic slowdowns.
Auxier Focus Fund - Correction Protection in Practice
Since 1927, the S&P 500 has averaged a correction of at least 5% every 71 trading days, or once every four months. Since 1900, the Dow Jones Industrial Average has experienced a correction of 20% or more every 42 to 48 months. A long overdue return to higher, more normalized interest rates should lead to greater stock volatility. During such squalls an investor’s “stomach” will become a bigger factor in order to “gut out” difficult times necessary to achieve higher returns. It is so important to understand what you own, why you own it and what you will do when it drops. At Berkshire Hathaway’s recent annual meeting, Warren Buffett commented that Berkshire stock had declined by 50% three times over the past 50 years. When Peter Lynch was running Fidelity’s famed Magellan Fund, he used to share the story about his largest holding in the late 1970s—Taco Bell. He started buying the stock at $14; stuck with it as Taco Bell collapsed to $1 in the energy crisis; and triumphed when it was gobbled up by Pepsi for $39.
Our strategy is to seek out “high return” businesses and buy them at a price compelling enough to earn double to triple play returns over time, minimizing trading costs and taxes. We focus more on “free cash flow yields” than dividend yields. Many of our best ideas don’t work out until year three and four (an eternity in today’s hyperkinetic trading environment). Reason: fixable problems that lead to bargain stock prices often take longer to fix than planned. Health insurers UnitedHealth and Anthem are examples that were so despised and depressed that their free cash flow yields exceeded 20% when we bought them a few years ago. Comparable yields for health insurers now average around 4%. Today these two are extremely popular with investors, and merger activity is heating up after 160% moves. We are more comfortable taking risks involving time rather than price. We prize businesses that are able to earn consistently high rates of return on capital, without high mandatory capital spending, and that can execute through all kinds of economic environments. This provides greater financial flexibility in times when liquidity suddenly vanishes. Managerial execution takes on a much greater importance in today’s higher markets. Those teams that execute can garner huge premiums in valuation.
Auxier Focus Fund - Portfolio Trends
The portfolio continues to benefit from managerial events like spinoffs. Drugmaker Baxter spun off Baxalta, which is being pursued by hopeful acquirer Shire at a substantial premium. Activists like Nelson Peltz have added value to our Pepsico and Bank of New York holdings. Citigroup’s management is executing well, yet its stock is among the cheapest banks in the country. Bank net interest margins are at 40- year lows and have room for material improvement if interest rates rise. ConAgra is divesting private label Ralcorp, which helped increase value by over 30%. We see cable-TV pioneer John Malone consolidating content companies like Discovery. Kroger has done a phenomenal job in an extremely competitive grocery environment. We see meaningful upside potential in Tesco if the Britain-based supermarket can apply the superior Kroger model to the U.K. and Europe. Delivery giant UPS has twin tailwinds of lower fuel costs combined with increased traffic through shipping enticements like Amazon Prime.
Auxier Focus Fund - Lower Energy Costs Compounded
The U.S., Saudi Arabia and Iraq have increased their collective oil output by two million barrels a day. Iran, which at one point was second only to Saudi Arabia in production, could be a new added factor in supply. Robert Dudley, CEO of BP (formerly British Petroleum) said on a recent earnings call, “I do think the industry needs to prepare for lower for longer.” Historically, these types of price declines have led to rapid industry consolidation. BP seems to be a very likely acquisition candidate as their legal issues are being resolved. Having personally invested during the oil price crashes of 1986 and 1998, I have seen firsthand how lower energy prices are extremely beneficial to the kinds of businesses we own and the economy in general. There typically is an 18 to 20 month delay before the full benefits are felt. The initial cutback on energy related capital spending is painful, but the impact of lower inputs should more than compensate. In 1986 the Saudis flooded the market for crude, fueling a 67% plunge that came close to $10 a barrel. In 1987, the U.S. economy picked up and lending accelerated, driving longer term interest rates up from roughly 7% to 10% into September. Yet the stock market climbed as well—over 40% to a rich price-to-earnings ratio of 22—before succumbing to this 38% rise in interest rates. In 1998, oil again dropped close to $10 a barrel, contributing to a Russian government bond default and a powerful move by investors into the high return business franchises we favor. In both cases the dollar was strong. But robust economic activity overcame the drag on trade of a higher currency. And today’s lower energy prices set the stage for another potential stimulant: a gas tax to fund our badly deteriorating infrastructure. The American Society of Civil Engineers estimates we need to spend $3.6 trillion by 2020.
Auxier Focus Fund - The Dilemma of Fixed Dollar Investments
Warren Buffett recently stated, “I would stay away from fixed dollar investments.” Former Federal Reserve chairman Alan