Trapeze Asset Management 3Q16 Commentary – Bizarro World

Trapeze Asset Management 3Q16 Commentary – Bizarro World

Trapeze Asset Management commentary for the third quarter ended September 30, 2016; titled, “Bizarro World.”

Q3 2016 Hedge Fund Letters

Everything feels a little backwards. President Trump getting more unsavoury in his behaviour yet managing nonetheless to win the election, despite polls to the complete contrary. The Chicago Cubs winning too. U.S. stock markets hitting all-time highs and, though fully valued, active investing being completely shunned in favour of passive. Many bonds carrying negative yields. Relative debt levels surpassing those prior to the Great Recession yet the volatility index, a measure of fear, near its lows.

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Trapeze Asset Management

And in the financial world, the most bizarre occurrence recently has been the rally in the stock markets post election. The market suffered 9 consecutive down days through early November as it dealt with rising interest rates and the uncertainty around the election results. Why the run-up post election when so many forecast a rout? Likely, for a number of reasons. What financial markets despise more than just about anything is uncertainty. With the outcome known, the markets readjusted. Furthermore, Trump’s initial comments were somewhat conciliatory, tempering nervousness. But the primary driver of the market boost came from rising interest rates—a result of foreigners selling U.S. government bonds and rising inflationary expectations. The rate of 10-year U.S. Treasuries rose from a multi-year low of around 1.3% in July to 1.8% pre-election and then post-election have jumped further to 2.4%. This is a boon to financial service companies whose earnings are dependent on higher rates on their float. So most financial stocks rocketed ahead, as did health care stocks that had previously fallen in anticipation of a Clinton win. The contribution of these 2 sectors set the tone for the overall market where gains have been relatively widespread. The spectre of lower corporate tax rates has helped too, especially for small caps—mostly domestic companies—where the Russell 2000 recently completed a 15-day consecutive winning streak.

At the same time, growth in the world economy seems to be accelerating again. Even in the Eurozone. China is in faster growth mode too.

In the U.S., new orders for manufactured goods improved recently as did consumer confidence, housing and retail sales, and importantly, unemployment continues to decline, now at 4.6%, a 9-year low, and wages generally have been rising though they declined unexpectedly in November. In light of this, and the bullishness post election, with promises of stimulus from large tax cuts and infrastructure spending (not to mention rising interest rates), the U.S. dollar has risen to a 13-year high. The stimulus should bolster growth and raise inflation but bring an accompanying rise in the deficits—the trade deficit from rising imports and declining exports as a direct result of a high dollar, and the budget deficit from rising government spending and declining tax receipts.

A rate hike this month by the Fed appears to be a mere formality—market driven rates having moved well in advance of administered rates. And more hikes thereafter are likely. Rising interest rates may be good for banks, but not necessarily for the overall economy. Mortgage rates are rising, and so are house prices, making affordability more difficult.

And as this bull market has risen since ’09, one of the longest cycles, it is no longer a bargain, trading in line with our estimate of fair market value. Bonds could once again create competition for stocks, although money has recently been pulled out of Government bonds at a record pace, and into stocks. Rates have likely moved too far too fast. So it wouldn’t surprise us to see rates actually fall temporarily, though Trump’s plans, once implemented, will likely increase the federal debt from an already extended $20 trillion, ultimately causing inflation and interest rates to rise more rapidly.

O Canada

In Canada, however, progress is slow; consumer confidence has declined and unemployment stuck at 6.8%. The Canadian dollar is down, likely a result of the wide negative spread between Canadian and U.S. interest rates. Though the lower Loonie should ultimately stimulate Canadian exports. Indeed, Q3 growth was up an annualized 3.5% from improved exports. And now that energy prices are rising, we should see some further improvement. With Canada’s total government debts now in excess of 110% of GDP (versus 90% in ’07) this could weigh on the exchange rate.

A falling CAD is positive for Canadian resource companies whose costs are in CAD but whose prices are in USD. We continue to prefer our domestic resource companies for this reason, especially since our proprietary work is calling for higher commodity prices and a still lower exchange rate. If inflation picks up and global economic growth accelerates, then Canadian stocks could outperform.

Trapeze Asset Management – Still A Bull Market

While many countries around the world continue a policy of monetary easing, the monetary aggregates in the U.S. have begun to shrink. While this is an indicator that the economic growth will ultimately be reigned in, that’s still not the case today.

Our own Economic Composite (TEC™), designed to alert us to recessions in various regions around the world, is not forecasting a peak in the business cycle. Though equities have lifted to all-time highs, and are trading at fair value in our work, bear markets rarely occur without a recession. Our TRIM™ stock market indicators, which warned earlier in the year, are back on buy in most regions. Though, after the recent market run-up, we are on the lookout for a market correction, which in a bull market has averaged about 6%. While a correction could start at any time, we continue to scour for bargains. Our own screens, where we look for stocks trading for 85 cents-on-the-dollar or less, are providing the least number of potential investment opportunities in some time—another reason a correction could be close. Meanwhile, with an earnings yield of 6%, even with 10-year Treasuries up to 2.4%, stocks are relatively more attractive than bonds. Albeit, should rates rise much above 3%, without a meaningful boost in corporate earnings, the relative attractiveness of stocks would dissipate. While a stock market correction could occur at any time, we still believe any decline in the near term will likely be modest and that growth and equity prices should continue higher, although likely at a below average pace.

Our Strategy

As value investors we look for bargains, and in the large cap arena they have become scarcer. There are some unpopular sectors, such as precious metals, but one has to have a positive forecast for the underlying commodity—which we do. We remain bullish on oil too which recently jumped on planned production cuts by OPEC. Natural gas prices have been stronger and look to move higher. Many commodities, such as copper, are at their best levels since the crash. With the recent rise in interest rates, a rotation toward financial services and away from other sectors is creating potential investment opportunities.

We continue to buy shares that pass our due diligence process when we can find them at a wide enough discount from our estimate of their fair market value (FMV) and assuming our earnings outlooks are favourable. Our objective is to continue to add more large cap positions to our All Cap portfolios as we find compelling ideas and as our current smaller cap positions are sold when they rise close to our FMVs.

The price of gold has fallen back to a floor in our work. And with inflationary expectations escalating and an ever-improving supply/demand outlook, we remain bullish on gold. Its recent setback is mostly attributable to rising interest rates (the opportunity cost of holding gold rising), a strong U.S. dollar—normally inversely correlated with bullion—and a risk-on market where participants don’t feel a need to embrace gold’s protective qualities. The supply/demand fundamentals for oil are supportive of higher prices too, though restrained by a U.S. inventory overhang which has taken longer than anticipated to work through. Most importantly, both gold and oil are below their normal premium over the cost of industry production. Normally, these commodities trade at roughly 30-40% premiums to the industries’ average all-in costs. We expect this typical premium to return in the months ahead.

Our All Cap portfolios continue to hold resource companies that are substantially below our FMVs and the further recovery in these commodity prices we anticipate should also help grow the companies’ valuations.

Our Portfolios

The following descriptions of the significant holdings in our managed accounts are intended only to explain the reasons that we have made, and continue to hold, these investments in the accounts we manage for you and are not intended as advice or recommendations with respect to purchasing, selling or holding the securities described.

Our All Cap Portfolios – Key Holdings

Our All Cap portfolios combine selections from our large cap strategy (Global Insight) with our best small and medium cap ideas. We generally prefer large cap companies for their superior liquidity and lower volatility. Importantly, they tend to recover back to their fair values much faster than smaller stocks, so they can be traded more frequently for enhanced returns. However, our small cap positions are cheaper, trading far below our fair value estimates; therefore, our All Cap portfolios currently hold a meaningful position in small caps.

Most of our small cap company holdings trade well below our estimate of their respective FMVs. Although these smaller, less liquid holdings are potentially more volatile, the risk of permanent impairment appears minimal while upside potential remains high. We elaborate on these key holdings below.

Specialty Foods Group, a shareholding in a private company held in our taxable accounts, has been preparing to liquidate its assets through a wind-down. The company has placed $55 million (of its more than $60 million cash) in trust, earmarked to be distributed to stakeholders. Its remaining business line is at near record year profitability. The approval of the wind-down plan, including the distribution of cash held in trust and the sale of the remaining business and distribution of its proceeds, requires Board approval (which we expect shortly) allowing the complicated corporate organization structure to be unwound. We expect a partial return of capital from the existing cash early in the next year with further distributions thereafter, though the timing and amounts of these payouts still remain uncertain. Our carrying value has further potential upside, mostly dependent on the sale value of the remaining business.

Orca Exploration is seeing improvement on most fronts except its share price. The situation in Tanzania having improved, the company is now positioned to resume its growth trajectory. After the company successfully worked-over 3 major wells and drilled one new one, as well as adding to its infrastructure, Orca’s production capabilities now exceed 185 mmcf/d. The country’s new pipeline needs to be filled and Orca continues to provide nearly all of the natural gas to the country. Hydroelectricity is unlikely to be a competing source of power since the country endures droughts and agricultural requirements for water are high. We anticipate new power plants coming online, powered by natural gas, which will require long-term contracts with Orca.

We see little downside for Orca since it trades essentially in line with its net cash and receivables. The World Bank continues to work with the country to help ensure TANESCO, the national power utility and Orca’s primary customer, continues to meet its obligations to Orca, including the substantial arrears. The government is expected to work faster to bring Orca’s needed gas to market. We have waited for all of these pieces to all fall into place. The wide gap between the share price and the company’s underlying value should finally begin to narrow spurred either by a resumption of growth or a monetization of its assets. The company’s estimated reserves are valued at over $11 per share, and the combined value of its TANESCO receivable and Orca’s cash, net of payables and debt, is about 4 times the share price.

ProShares Short S&P 500 is about a 6% weighting in most 100% Growth mandate accounts. This is a long position in an ETF which mirrors the inverse performance of the S&P 500 (i.e., if the market declines the value of this position increases) on a daily basis. With the market at record highs, in line with its FMV and at a ceiling in our TRAC™ work, it remains a simple way of hedging a correction in the U.S. market. Though, in our view, we remain in a bull market; therefore, we would look to eliminate this position in the next correction. We prefer to only short when our macro tools suggest overall market risks are elevated.

Kirkland Lake Gold, was sold down considerably when it ran up close to our FMV estimate. And, we wrote covered calls (for our options authorized accounts) against our position to collect premium between now and January 20, further reducing risk. The calls give others the right to buy our shares at $13 while we collected nearly $1 per share of premium. It appears likely that the stock price will not exceed $13 by the January expiration date allowing us to keep our shares and the nearly $1 of premium already collected.

More importantly, we have been able to reestablish a meaningful 5% position in the shares. In October, the company announced a merger with Newmarket Gold which recently closed. Kirkland represents 57% of the new company and Newmarket 43%. After trading at a very narrow spread based on the respective shares each company was to receive, the Newmarket spread widened significantly when Kirkland announced that it itself was the subject of a proposal to be taken over by Goldfields/Silver Standard. Because market participants thought that the Newmarket merger might not proceed, we were able to acquire shares in Newmarket (which we were fully prepared to own as a stand alone company), which allowed us to ultimately receive Kirkland shares more cheaply, now that the deal has closed, rather than by buying Kirkland directly.

After announcing the Newmarket acquisition, whilst gold bullion was also falling, the Kirkland share price sold off. At the current Canadian dollar gold price, we expect the combined company to deliver free cash flow of over $130 million. Kirkland is once again sufficiently undervalued in our view and has upside potential from a rise in the gold price along with a potential for an improvement in grades and exploration success. The merged company is a 500,000 ounce producer and stands out relative to its peers because it operates in excellent jurisdictions (Canada and Australia), has a balance sheet with over $200 million net cash, enormous land packages, high grades and a below peer-group valuation. Our estimate of FMV is about 50% higher than the share price.

Manitok’s share price should finally begin to narrow the significant gap from its FMV. The company’s production has hit record levels (now above 7,000 boepd), the IRRs on new wells are displaying outstanding economics, and debt levels have been materially reduced. Drilling monobore wells, rather than conventional multi-frac horizontal wells, has lowered drilling costs substantially while the drilling results have been much higher than the type curve. Firmer commodity prices and debt reduction from cash flow and share issuances have enabled the company to embark on a renewed drilling program. With a reserve life of 13 years and over 300 drilling locations, Manitok has the potential for years of growth.

The company’s proved reserve value is $110 million (net of all debt) or $0.42 per fully diluted share, about 3x the share price. The proved and probable reserves are estimated at over $200 million or $0.75 per share, over 5x the share price. The fact that the company doesn’t even trade for its proved producing value of over $0.30 per share is an oddity. We attribute this to concerns of an overly levered balance sheet, an unsupportive banking relationship, ongoing dilution and, production glitches, all of which are dissipating. The company has high quality assets trading at an unusually low valuation.

Our top holdings in our All Cap portfolios also include large caps Fiat Chrysler Automobile, Magna International, Eastman Chemical, Berkshire Hathaway and 21st Century Fox, which are discussed below in our Global Insight portfolio review.

Our All Cap Portfolios – Portfolio Changes

In the last few months, we have bought and still hold several new large cap positions including PulteGroup, Hanesbrands, Husky Energy, Apple and Naspers—summarized in our Global Insight portfolio review below. We bought, then sold, Alaska Air Group after it ran up to our FMV estimate and sold Bank of Nova Scotia, Alphabet, HP, NCR, Harman International Industries (an acquisition target of Samsung), Bank of Montreal, and Robert Half International after each ran up to their respective TRAC™ ceilings, in line with our FMV estimates, and sold KBR and KKR & Co. as both triggered sell signals falling below their respective TRAC™ floors.

American Eagle Outfitters, the specialty retailer, fell after announcing a disappointing Q4 outlook. Aeropostale, a competitor in the teen space, has been aggressively liquidating inventory since filing for bankruptcy protection. This has pressured apparel selling prices, masking the turnaround efforts underway at American Eagle. Jay Schottenstein, who oversaw American Eagle’s tremendous growth between 1981 and 2002, has returned to lead the company. Gross margins have been expanding. Product innovation has created several breakthrough products such as the “Amazingly Soft Shirts” line. Aerie, American Eagle’s lingerie and swimwear brand, is posting 20%+ comps. Our FMV estimate is $23.

Global Insight (Large Cap) Portfolios – Key Holdings

Global Insight represents our large cap model where portfolios are managed Long/Short or Long only. A complete description of the Global Insight Model is available on our website. Our target for our large cap positions is more than a 20% return per year over a 2-year period, though many may rise toward our FMV estimates sooner should the market react to more quickly narrow their undervaluations. Or some may be eliminated if they decline and breach TRAC™ floors.

At about 77 cents-on-the-dollar versus our FMV estimates, our Global Insight holdings appear to be much cheaper, in aggregate, than the overall market. Because of the run up in stocks, and the fact the overall markets are fairly valued, we are finding fewer investment opportunities and therefore are holding much more cash than usual. ProShares Short S&P 500, given our negative near-term outlook, is about a 7% weighting in most 100% Global Insight accounts. This is a long position in an ETF which mirrors the inverse performance of the S&P 500 (i.e., if the market declines the value of this position increases) on a daily basis. With the market at record highs, in line with its FMV and at a ceiling in our TRAC™ work, it remains a simple way of hedging a correction in the U.S. market. Though, in our view, we remain in a bull market; therefore, we would look to eliminate this position in the next correction. We prefer to only short when our macro tools suggest overall market risks are elevated.

Berkshire Hathaway, like most financial shares, has rallied with the increase in interest rates but still remains only halfway up to its next ceiling and below our growing FMV estimate of over $175 per Class B share. The company’s value should continue to build from its diversified mix of first-class businesses, which are run via their own top-notch management teams. Book value per share growth at about 11% per year in the last 4 years is remarkable for such a large enterprise.

Meanwhile, Berkshire keeps adding to its substantial cash hoard which could act to fuel additional growth while providing downside protection.

Fiat Chrysler Automobiles shares have perked up. With our FMV estimate over $10, Fiat had been one of the most undervalued stocks in our large cap universe. The company is just starting to realize synergies from Chrysler. CEO Sergio Marchionne is pursuing several other value-creating initiatives. Its auto parts supplier, Magneti Marelli, could be sold. And, Marchionne continues to champion an outright sale or merger with another major auto manufacturer to boost economies of scale. In the meantime, the company trades at a low multiple of earnings, particularly based on the targets management has set for the next couple of years.

Rebounding commodity prices have sent shares of Japanese conglomerate Sumitomo up substantially from its summer lows. Q2 results exceeded analyst expectations. Sumitomo’s Ambatovy mine—a joint venture with Sherritt and Kores—has seen markedly improved profitability on higher nickel prices. Tubular products and transportation and construction systems are still facing difficult market environments. We see earnings per share growth of 9% through ’19. Our sum-of-the-parts valuation estimate has lifted to ¥1,600.

After being stuck in neutral for the past year, shares of General Motors have ascended to their upper breakpoint and close to our $42 FMV estimate. We will likely part with the shares shortly. Automakers are facing numerous headwinds including a peaking market cycle that will see aggressive price reductions and overleveraged customers.

As mentioned above, we believe automakers are facing numerous headwinds. Auto suppliers such as Magna International will no doubt see business impacted should car volumes stall at present production numbers. Magna itself recently trimmed its own expectations for ’17 vehicle production. However, at 7x ’17 earnings, we believe that shares have overshot to the downside. And, we still see EPS growth of 8% per year over the next three years driven by a ramp-up at Steyr, improvements at its European operations, and continued strong demand from Asia. Our FMV estimate is $75.

Eastman Chemical has been the beneficiary of rebounding oil prices. Shares have ascended close to our $84 estimate of FMV. Our investment thesis in a nutshell was that the market was so focused on its struggling Fibers business it was ignoring the stellar performance of Advanced Materials, the company’s future growth engine. Strong Q3 earnings and an increase in full-year guidance was a testament to our view. We will likely part with shares soon and redeploy funds into a more undervalued company.

Liberty Media (Sirius XM) is a tracking stock for Sirius XM. While Sirius trades at around a 10% discount to our estimate of its FMV, Liberty (LSXMK—the tracking stock) trades for a 20% discount to its holdings of Sirius, implying an estimated FMV of about $42 per LSXMK share. Since it’s the only asset behind the tracking stock, that Liberty owns 65% of Sirius, that Liberty’s position keeps increasing as Sirius repurchases shares, and that the wide discount is a source of aggravation for Liberty management, we don’t believe the disconnect in price should last long. Meanwhile, Sirius continues to grow in all facets, including, most importantly, the number of installed vehicles, average price per unit and free cash flow.

21st Century Fox has displayed nice growth recently in both cable and filmed entertainment. Despite being restrained by the strong dollar, earnings grew by 17% in the most recent quarter. The company has a good combination of original programming (e.g., Modern Family, Homeland and various film titles) and exclusive rights (e.g., NFL, College Football, MLB), while Fox News remains the number one news channel. Its cable networks and pay TV channels should continue to benefit from the still underpenetrated foreign market versus the U.S. Our sum-of-the-parts provides us with an estimated FMV of $35.

The premise behind our Walt Disney investment is simple: investors are overly focused on ESPN subscriber losses. At more than 40% of operating income, cable is a critical asset for Walt Disney. However, while ESPN stagnates, Disney’s other segments—Parks & Resorts, Studio Entertainment, and Consumer Products—are firing on all cylinders. Even with ESPN’s woes we see high single-digit EPS growth over the next 4 years. This projected growth rate is substantially higher than the market’s expected growth rate yet Disney trades at a market multiple rather than its usual premium. Our FMV estimate is $115.

Global Insight (Large Cap) Portfolios – Portfolio Changes

In the last few months we have bought and still hold several new large cap positions including PulteGroup, Hanesbrands, Husky Energy, Apple and Naspers summarized below. We bought, then sold, Alaska Air Group after it ran up to our FMV estimate and sold Bank of Nova Scotia, Alphabet, HP, NCR, Baker Hughes, Priceline Group, Harman International Industries (an acquisition target of Samsung), Bank of Montreal and Robert Half International as each lifted to a TRAC™ ceiling close to our FMV estimates and sold KBR and KKR & Co. as both triggered sell signals falling below their respective TRAC™ floors.

Husky Energy, an integrated energy company, has faced numerous challenges over the past year including a large oil spill in Saskatchewan, dividend suspension, a major fire at its oilsands project, and a dispute with its partner CNOOC over gas pricing from its offshore Chinese energy project. These challenges, combined with falling oil prices, led to a significant drop in Husky’s shares since July ’14. We see opportunity now that Husky trades at a significant discount to its peer group and our own estimate of its risked net asset value at over $20. Sunrise production is ramping back up, averaging 36,000 b/d during the third quarter. A better than expected agreement was reached with CNOOC that only saw a 13% decrease in gas pricing and oil prices have firmed which could spur another potential catalyst, the reinstatement of the dividend.

PulteGroup, repurchased in October, after we sold it in August when it ran up to our FMV estimate, is benefiting because its communities segment is experiencing significant growth after years of investing in land development. We see a favourable demand backdrop, even as interest rates start to rise off of historically low levels. Nearly half of sales come from the move-up category. The company has conducted intense research on the millennial buyer—the biggest demographic segment—to gain first-time buyer market share. Low cost debt and steady cash flow are allowing for an aggressive share buyback plan—nearly 3% of shares outstanding were repurchased in the third quarter. Our FMV is $23, or 12x ’17 estimated earnings per share. As a purely domestic company, PulteGroup stands to benefit from the proposed Trump administration corporate tax cuts.

We have grown accustomed to how quickly market sentiment shifts for Apple. Despite its continued dominance of high-end smart phones, envious margins, and incredible successes achieved in new markets (its 1½ year-old watch business is now the second-largest watch brand in the world, behind only Rolex), investors once again aren’t paying the business the respect we feel it deserves. Its lowly 10x forward earnings multiple, excluding net cash, reflects this as does its discount to our $135 FMV estimate. A potential tax hiatus may allow a repatriation of a large portion of the company’s overall cash balances—now over 25% of the company’s market cap. With a large percentage of users still using the iPhone 5 and 6, we see huge pent-up demand for the iPhone 8 which we expect to be a totally new design in ’17.

Hanesbrands is an apparel manufacturer and marketer whose portfolio includes, among others, Hanes, Champion, DIM, Maidenform, and Playtex. The company is a quintessential large moat business, with a globally owned supply chain, strong brands, and economies of scale. This well-oiled machine turns out nearly 2 billion units annually. Companies that outsource manufacturing have been under pressure since Donald Trump’s election victory. Tariffs of 25% to 45% on products produced abroad would severely impact margins. We do not see such tariffs materializing as it would have an enormous impact on clothing affordability and would break international accords. Our FMV estimate is $33.

Naspers is the largest company in Africa. Listed in Johannesburg, South Africa, the company has made a number of shrewd cable and internet based investments over many years. But none compares to the single investment made in Tencent—one of China’s leading internet companies—back in 2001. A $32 million investment has grown to over $90 billion. Tencent has over 800 million loyal users. Its broadly based social networking platform includes a 50% market share in China’s online games market. The company’s primary brand, WeChat, continues to grow dramatically. Overall company revenue grew by more than 50% in the latest quarter, though profit margins were below expectations as the company increased its spending to drive future growth. This has dropped Tencent back to a floor in our work, about 83 cents-on-the-dollar based on our FMV estimate. When we apply Tencent’s value to Naspers, which owns just over one-third of Tencent, even after accounting for full capital gains taxes, Naspers trades at about a 35% discount to our Naspers’ FMV estimate. Should Tencent lift by 30%, to our projected FMV looking out 12 months, Naspers could nearly double that if it reaches its FMV.

Income Holdings

The 10-year U.S. government bond yield is 2.4%. The Canadian equivalent is 1.7%. While still likely to rise from relatively low levels, the recent rise could have come too far too quickly. After rising to about 10% earlier in the year, high-yield corporate bond yields have now settled in around 6.2%. Because we believe rates are likely to rise over time, and yields in general are low, we have been finding fewer attractive opportunities than usual for our income accounts. Accordingly, we have been holding a larger than usual portion of the accounts in cash while we await more favourable investment opportunities.

That said, we did buy 2 new positions recently. We purchased the Manitok 10.5% 11/15/21 Collateralized Notes on issuance (for which Trapeze Capital Corp. was included in the investment banking syndicate). At purchase, newly issued at par ($100), these senior secured notes yielded 10.5% and we also received 5-year warrants (exercisable at $0.18, well below the company’s proved reserve value) which could provide a material capital gain should the share price rise back

toward our estimate of its FMV. And, we bought Care Capital Properties REIT when this U.S. provider of skilled nursing services, owning over 340 locations under triple-net leases, fell back to where it provided a dividend yield of 10%, while it’s paying out only 75% of its normalized funds from operations, and was trading at about a 20% discount to our FMV estimate.

We also sold Morguard REIT after it gave a sell signal in our TRAC™ work.

We continue to hold a number of undervalued income positions and collect outsized interest income on these positions due to the depressed prices. Our income holdings have an average current annual yield (income we receive as a percent of current market value of income securities held) of nearly 8%.

Of note, regarding our top holdings in our income accounts: Specialty Foods, now an equity holding of a private company, is planning to return capital to us (see the reference under All Cap holdings above); JAKKS Pacific’s convertible bonds may benefit from the possibility of a buyout; Advantex Marketing debentures maturity was revised to December, from September, but it remains well secured by the company’s asset base; Manitok collateralized notes are well covered by its reserve base; Ruby Tuesday’s bonds are well covered by underlying real estate; Enerdynamic Hybrid Technologies’ interest payments remain in arrears but the asset value is above the outstanding secured debt; Care Capital Properties REIT’s income stream is non-cyclical and growing; Northwest International Healthcare Properties REIT’s units and bonds are underpinned by a stable income stream; Gran Colombia convertible debentures should benefit from higher gold bullion; and, Calfrac bonds where the recovery in oil price should bolster earnings.

Not Bizarre At All

More than ever, we are pleased with our investment process. Buying stocks at a discount to our FMV estimates, when they’re at floors in our work, and waiting for them to rise to those FMVs is a recipe for success. Sometimes we’ll misjudge a business and take a loss (hopefully a small one) as we admit a mistake. Other times the market might merely decide to be even more negative and depress a share price even further—hopefully our TRAC™ tool triggers a stop loss allowing us to mitigate damage in those instances. In some periods most stocks might fall as markets correct. But we have a road map to be applied in each circumstance. As such, it’s not bizarre at all that our proprietary tools, along with their continued refinements, provide us with a process which allows us to invest in a wide array of companies, while believing that our results will be successful.

President Trump’s plans for tax cuts, infrastructure spending and, potentially welcoming U.S. corporations to repatriate $2.5 trillion parked overseas should stimulate growth. And growth should cause corporate earnings, capital spending and consumer demand to rise—a virtuous cycle. But as we have said, this trend may be offset by higher interest rates and wage costs and greater foreign competition for a high U.S. dollar. The market giveth and the market taketh away.

It’s always a time to invest cautiously. Just more so now that opportunities are scarcer. We will continue to diligently seek out bargains. Looking for individual opportunities in which to invest. And holding cash if sufficient opportunities aren’t present. Should risks heighten and our tools alert us to macro risks, we won’t be shy about attempting to diminish or, where we are authorized, hedge off risks.

Herbert Abramson and Randall Abramson

December 12, 2016

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