Martin Capital Management commentary for the year ended December 31, 2016.

2016 Hedge Fund Letters

“Public opinion is a permeating influence, and it exacts obedience to itself; it requires us to drink other men’s thoughts, to speak other men’s words, to follow other men’s habits … Being without an opinion is so painful to human nature that most people will leap to a hasty opinion rather than undergo [its absence].” — Walter Bagehot, 19th-century British journalist, businessman, and essayist

“In science you need to understand the world, in business you need others to misunderstand it.” — Nassim Nicholas Taleb

“More money has been lost because of four words than at the point of a gun. Those words are ‘This time is different.’” — Regina M. Reinhart and Kenneth Rogoff, This Time Is Different: Eight Centuries of Financial Folly (2009)

This evokes an equally pertinent earlier quote:

“More money has been lost reaching for yield than at the point of a gun.” — Raymond DeVoe Jr., Wall Street analyst and author of “The DeVoe Report” (1995)

“During bubbles, it seems that the psychological ambience is rather one of public inattention to the thought that prices could fall, rather than firm belief that they can never fall. The new era stories are not new strongly held convictions—they are merely ideas foremost in people’s minds that serve as justification both for the actions of others and of themselves.” — Robert J. Shiller, Nobel laureate

Martin Capital Management

Dear Client,

From our vantage point, 2016 provided more evidence of an aging bull market in complacency, during which the apprehensions of absolute-return value investors like ourselves were again elevated because of the generalized absence of fear itself. Not surprisingly, little attention was paid to valuation and tail risks, known as “Black Swans,” in an economic, financial, and geopolitical environment that might be characterized as the triumph of hope over experience.

We feel fortunate that the unpopular equity wallflowers in which we invested have begun to bloom, but we suffer under no illusions that finding similar equities will be any easier until a repricing of risk assets to more rational levels occurs. Stocks are priced for a future tinted by rose-colored glasses, so rooting out unloved, overlooked, and rejected companies and committing capital to their equity is arduous and devoid of anything approaching instant gratification. To develop sufficient confidence that the general disdain for a company is more than discounted in its stock price, we have to dig deeply into each investment. Opportunity of this sort is often overlooked because “it is dressed in overalls and looks like work,” so said Thomas Edison, the man who knew firsthand how opportunity was frequently disguised as misfortune or temporary defeat.

Moreover, we need assurance that the issues leading to undervaluation are not irreversible or fatal, but are instead temporary afflictions from which the company will recover. Such is the curse of being a value investor in late-stage bull markets. The conundrum is why we value practitioners are so small in number. The most difficult aspect of executing the simple adage “Buy low, sell high” is that one must invariably act counter to the natural instinct to buy on good news and sell on bad. A successful value investor must do the opposite. We have never witnessed a stock that’s cheap when its narrative is getting rave reviews.

A few bargains got our attention in the oil & gas industry. Industry conditions and outlook were both darker then than they are today. Over the arbitrarily selected post-2000 timeframe, the price of crude oil has averaged $70 per barrel, ranging from a high of $145 in 2008 to an improbable low of $26 early in 2016. We intuitively believed that the odds of this essential feedstock falling materially farther were considerably less than the likelihood that it would move back toward the average. Within the overall bull market, there clearly was a bear market in oil-related equities. That spelled both opportunity in specific companies and generalized opportunity in the industry when the force of headwinds abated.

The above segues into the constraints imposed by prudent diversification. Empirical studies have shown that up to 95% of random risk—that an investment unexpectedly produces an irreversible, goose-egg return—can be mitigated with a portfolio of 12–15 investments. That means an average position would theoretically be between 6.7% and 8.3%. However, these investments must also be prudently diversified in multiple dimensions, including among different industries. As convinced as we were that select companies in the oil and gas industry would be repriced at other than Armageddon levels in the future, we are ever mindful of other probabilities, particularly downside ones common for such cyclical industries.

Most investors instinctively imagine the future as a continuation of the present. Therefore, during a bear market, most industries and many companies within them trade at low prices reflective of the present mood instead of future opportunity. The inverse applies to bull markets, like the one we see today. Given that dynamic, complying with diversification constraints is a no-brainer in a mature bear market. While we will always carry enough cash to quickly seize unexpected opportunities, when we have more bargainpriced ideas than we have money, our reserve will shrink considerably.

Beyond being unable to find enough truly diversified investment ideas to put all our cash to work in this very expensive market, the excess liquidity serves another more subtle purpose. It is our belief that investors may well face wealth-threatening uncertainties today for which a normal frequency distribution—the proverbial bell curve—is beguiling in its simplicity but dangerously inadequate. Broad diversification practiced by institutions (including domestic and international equity and debt, foreigncurrency exposure, real estate, and private equity, to name just a few) can be effective in normal times. But we do not consider these to be normal times. Simply put, if one is going to use the bell curve as the measure risk, it should have pretty fat tails; i.e., the probability of extreme events should be presumed greater than what a normal frequency distribution would suggest.

When Black Swans unexpectedly appear, the scramble for liquidity tends to be an equal-opportunity scrum. Asset classes that under normal conditions tend to be inversely correlated (as one goes down, the other goes up) find themselves moving in the same downward direction under persistent and often panicky selling. During crises like 2008–09, the asset that no one wants to hold—cash—becomes the only safe haven in the sea of chaos. A universal currency in times of high uncertainty, cash holds its value and thus its purchasing power in the critical short run. Thus, though holding cash and sacrificing yield are spurned by virtually everyone, it could prove to be the most potent asset in our portfolio if the winds of popular sentiment unexpectedly change direction.

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In terms of the particulars to which our principles were put to the test, 2016 began with an uneasy calm in spite of the Fed’s December 16, 2015, rate hike, the first since 2008. After all, the onset of the credittightening cycle has long been expected, its origins dating back to May 2013 when the so-called “taper tantrum” reverberated throughout global financial markets. The tranquility, though, was short-lived, as one of the

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