Broyhill Asset Management letter for the year ended December 31, 2016.

2016 Hedge Fund Letters

For the year ending December 31, 2016, Broyhill generated low-to-mid-single digit returns across the majority of our separately managed accounts. Detailed quarterly reports, including portfolio allocations, individual account and benchmark performance, portfolio holdings, and transaction history, have been posted to our investor portal.1

Few investors truly understand what their managers do or how they do it. We write these letters to provide that context. We share our thinking. We highlight our concerns. We explore our mistakes and review our decision making process. Education is important as it helps all parties make informed decisions and plays a key role in allowing us to think rationally. More on this after addressing the elephant in the room.

It’s Business Time

If you haven’t read Ayn Rand lately, it might be a good idea to dust some of her work off your bookshelf to put today’s political mindset in perspective. We’d also suggest George Orwell’s 1984, but last we checked it was sold out on Amazon’s best seller list.2

There has been plenty of ink spilled on the ideological shift which has occurred since last November. So we’ll resist the urge to add our two cents. Instead, we’ll offer the following perspective from a recent Barron’s cover story:

“Judging by the stock market’s reaction, the Trump administration so far has been a grab bag of policy proposals, some good for the economy, some bad, some potentially disastrous. Our future depends on the president’s ability to champion the good ones and his willingness to back off the disastrous ones.”

Kicking and screaming like a toddler who was just told he can’t wear his Spider-Man costume to dinner will not make Spider-Man a more acceptable dinner guest.3 Rather than kick and scream about how the world should be, our job as investors is to see the world as it is and position accordingly. Stephen Dubner, co-author of Freakonomics, demonstrates how one’s moral compass can impact decision making:

“If you try to approach every problem with your moral compass . . . you’re going to make a lot of mistakes. You’re going to exclude a lot of possible good solutions. You’re going to assume you know a lot of things, when in fact, you don’t, and you’re not going to be a good partner in reaching a solution with other people who don’t happen to see the world the way you do.”

Successful investing requires an open mind to approach complex problems. Investors are a confident bunch, but it’s dangerous to assume you know a lot of things. Flexibility and humility allow us to admit what we don’t know, and accept that there is little to gain from investing as it should be.

A strong moral compass will do many things for you in life, but it will not help you navigate capital markets. Seeing the world as it is rather than as you wish, will. Today, investors are seeing the world as they wish. They’ve watched stocks climb to new all-time highs and have concluded that the president’s policy proposals must be good for the economy and for the markets. They have decided that perilously high valuations can be ignored and rising uncertainty is of no concern.

The consensus views the current backdrop analogous to Ronald Regan’s shift to the right. There are a number of similarities which make it easy to reach this conclusion. But all analogies are imperfect. In this particular case, starting points matter.

Broyhill Asset Management

Markets are applauding early efforts to stimulate domestic manufacturing and return traditional blue collar work to the US. Yet, few seem to be thinking through the dangerous implications of increasing protectionism and decreasing globalization.

Free trade has not been all rainbows and unicorns in this part of the country. But that doesn’t mean unwinding free trade will bring them back. We’ve tried this before. It didn’t work out so well last time.
The Smoot–Hawley Tariff, signed into law in 1930, raised U.S. tariffs on over 20,000 imported goods. The tariffs “successfully” cut American imports in half, but retaliation by our trading partners ensured that US exports fell the most. Made in America has a nice ring to it. But with personal consumption still making up nearly 70% of GDP, that ring may sound more like an alarm when our returning blue collar work force has to shell out $75,000 for a Chevy Malibu.

Bottom Line: Investors are chasing momentum and buying more of what has gone up the most. The fear of missing out on the climb to new highs has blinded investors to the risk of falling back to reality. Valuations don’t matter as long as there is a greater fool to buy your shares at a still higher price. There are always plenty of fools around to play this game. They just aren’t around very long. They’d be wise to consider that the end of every two-term presidential cycle has been greeted by a recession within twelve months. But then, I suppose, they wouldn’t be called fools.

Broyhill Asset Management – Benchmark Envy

Now that we’ve addressed the elephant in the room, let’s talk about the gorilla.

We underperformed the major equity indices last year. In fact, along with most active managers in the industry, we’ve underperformed the major averages for the past few years. But unlike most of our peers, we don’t worry much about market returns.

Our goal is to construct portfolios capable of generating as high a return as possible, without subjecting your wealth to significant loss. Our priority at Broyhill is protecting your capital.

In any given year, you should assume that someone or some index will do better. This can be torturous. Nothing clouds judgment more than watching your neighbor get rich. But you don’t get rich by taking risk at the end of the cycle. You get rich by buying cheap assets. You stay rich by being patient. Our goal is to keep you rich. It is far more important than outperforming the herd in the short term.

We report index returns to investors as a basis for comparison, but warn that short-term index envy is inconsistent with long term capital preservation. In a rising market, our results may be inferior to market indices. But this says more about the timing of results than the ultimate outcome.

We have no control over the timing of our results or those of market indices. We can, however, exercise control over the quality of our research process and our investment decisions.

Only a focus on the inputs can determine the long run success of the outputs.

The discussion below attempts to provide you with additional perspective on the inputs and outputs of previous investment decisions. Our investment in Time Warner (TWX) was our largest contributor to performance for the year and a good illustration of the difficulty in predicting near term outcomes. SeaWorld, our largest detractor, demonstrates the importance of focusing on process rather than outcome.

As usual, we’ll begin by examining a mistake before discussing a more positive outcome.

Orcas and Drunken Sailors

Time travel is impossible (that is of course, unless Elon Musk knows something we do not). Yet, traveling back in time is necessary to effectively evaluate past decisions.

We must replace the

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