Auxier Report: Fall 2011

Sep 30, 2011

Download Fall 2011 Report (PDF)

Fund Performance

Third quarter 2011 was tough for Auxier Focus Fund, which declined in value 10.40%. But our investors weathered the market sell-off far better than Standard & Poor’s 500 stock index (down 13.87%) or U.S. stock funds as a group (down 16.70%, according to Lipper). The Fund retreated 2.83% over the first nine months of 2011, again handily beating the S&P 500 (down 8.68%) and U.S. stock funds (down 12.20%) for that time frame. This lopsided advantage underscores our primary goal as the Fund’s steward to protect against permanent capital loss. It requires dedicated, daily research for compelling buys in terms of risk vs. reward. We will wait as long as it takes for the right price before committing your money.

Market Commentary

Stock markets around the globe have slumped on fears that Greece would default on its debt and trigger a financial contagion.  The proliferation of short-term trading vehicles like leveraged ETF’s (Exchange Traded Funds) has further stoked volatility and uncertainty.  Instead of trying to divine the outcome of a crisis, we have found it better to focus on the credit analysis of individual securities. We concentrate on businesses and managements that can survive the most challenging of economic circumstances. Today, it is especially important to be positioned in investments that can thrive through a potentially long and painful period of deleveraging. The process of restructuring debt-laden companies can result in exciting undervalued situations for serious, long-term investors. This is a favorable backdrop in which to buy first-rate companies at price levels that can eventually lead to double or triple-play returns. Given the extraordinary levels of government debt in many developed countries, investors can’t rely on a rebounding economy to bail them out of poor investment selections.  Eighteen months ago, for example, we were able to buy an extremely undervalued Weight Watchers stock at 26, a mere nine times earnings, on perceptions that profit growth faced several lean years ahead. Management, led by David Kirchhoff, proved the skeptics were wrong, and the stock tripled to 79 this past quarter.  Investing is fundamentally the craft of the specific.  Too few truly understand what they own, why they own it or what it is worth.

What Our Top Holdings Have in Common

I have owned or followed many of our top holdings for over 20 years. Most are trading at steep discounts to their average valuations over the past ten years. We particularly like far reaching distribution arms that tap into aspiring populations in emerging markets. We seek energetic management that is on a mission to create a great product or service, as opposed to using financial engineering to generate returns. Most of our businesses are self-funding. They typically have high free cash flow yields, high returns on invested capital, strong balance sheets and the ability to grow dividends.  Despite all these strengths, opportunities for material misappraisals still abound in these times of crisis when the future is unclear and the consensus is, “this is no time to invest.”

Unilever

Netherlands–based Unilever (UN) provides many of the investment attributes that we like to buy in market panics. Some bullet points:

• Founded in 1930. Roots go back 140 years. Strong, enduring franchise. UN is an appropriate investment in a slow growing economy facing austerity and deleveraging headwinds.

• Powerful distribution into 180 countries and a global population approaching seven billion. Another billion expected over the next 15 years.

• 2010 sales of $59 billion, with 55% in faster growing emerging markets. Cash flow is 8% of sales. EBIT margin is 13%-14%.

• Leading global supplier of branded, low-ticket necessities in hygiene, personal care, and nutrition.

• Food is 51% of sales and 53% of operating profits in 2010…Dressings, savory spreads, ice cream and beverages. Brands include Lipton, Ben & Jerry’s, Breyer’s, Hellmann’s, Popsicle, Klondike.

• Home and personal care are 49% of sales and 47% of operating profits in 2010. Brands: Vaseline, Noxzema, Lux, Dove, Ponds, Suave, Snuggle, Lifebuoy and Alberto Culver.

• Leader in laundry products in developing and emerging markets.

• Some 400 operating companies provide opportunities for spinoffs that could enhance shareholder value.

• Solid leadership under Paul Polman, who had successful stints at both Procter & Gamble and Nestle. Polman has the focus and energy to build brands while aiming to increase operating margins from the 13-14% lately to 16% over the next few years. He typifies the Peter Lynch example of an inspired manager in an uninspiring business. Dull and steady win the compounding game.

• For the first half of 2011, high commodity inputs contributed to a 2.3 percentage point hit to gross margins. Commodity cost pressures should abate helping margins over the next couple years as global economies slow in response to monetary tightening (especially in China and India).

• Second quarter sales were up 7.1%; volume up 1.9%; and prices up 5.1%. Emerging economies of Africa, Eastern Europe and Asia showed gains of 9.2% in sales, 3.3% in volume and 5.7% in prices. For the first half, double-digit growth was achieved in Argentina, Mexico, India, China, Indonesia, Turkey and South Africa.

• Both Unilever and Nestle enjoyed similar pricing power this past quarter.

• Low-ticket, necessity products do well in an economic slowdown. There is a trend toward eating better while eating at home. Powerful brands help during inflationary times as well.  The business has a free cash flow yield in excess of 6%, a dividend of $1.27 or over 4%, and a strong balance sheet, with debt only 33% of capital.

• Earnings should grow from $2.10 in 2011 to $2.34 in 2012. Operating earnings were up 10% in the first half of 2011.

• Buy limit of $29, with a target 17 P/E ratio over the next 18 months, equates to a potential return of 37% (including the dividend).  In the steep 2002 market correction, UN managed to trade over 25 times earnings. The stock has rarely traded below 13 times earnings over the past 10 years. Management is materially better today. The business is far more innovative, streamlined and competitive. In time, it should command a higher valuation as execution is rewarded.

• Europe’s financial crisis provides an opportunity to invest in Euro-based companies that derive most of their revenues outside the region, yet are undervalued due to the negative macro news surrounding the EU’s debt crisis.

Conclusion

Here’s our time-tested recipe for earning above-average returns in all kinds of economic climates. First, the price you pay is a major determinant in the long-term return you can expect from an asset.  Second, bargains must also be high-quality investments that generate growing cash flows and are managed by inspired, ethical leaders. When considering an investment in the Fund, think about comparing it not only to the S&P 500, but also to historic outperformers like Warren Buffett’s Berkshire Hathaway (BRK-A), especially during stressful market conditions. We never lose sight of the stewardship aspect of our job and how important it is to keep compounding with a constant eye on the downside.

Your trust and support is appreciated.

Jeff Auxier

Auxier Report: Summer 2011

Jun 30, 2011

Download Summer 2011 Report (PDF)

Market Commentary

Auxier Focus Fund returned 1.79% in the second quarter 2011, while Standard & Poor’s 500 stock Index (S&P) gained 0.10%.  For the first six months the Fund was up 8.44%, briskly outpacing the S&P’s 6.02%. The Fund also has outperformed the market by 102 percentage points cumulatively since inception in July 1999. We strive to match good markets and to excel materially in challenging, declining periods.

Negative macroeconomic headlines continue to overshadow positive underlying corporate performance. The financial media’s and public’s obsession with the “unknowable” has created opportunities to buy high-quality international franchises at attractive prices.

Many contributors to the Fund’s second quarter performance were businesses that improved from the “hopelessly out of favor” to merely unpopular. The Fund benefited from gains in downtrodden health insurers like WellPoint and UnitedHealth; education companies Apollo and ITT Educational; medical device companies Johnson & Johnson, Medtronic, and Zimmer, plus credit card processors Visa and MasterCard. These were a few industries in which proposed excessive regulation drove down price points to compelling levels a year ago.  As the worst case failed to materialize and political compromise was reached, these stocks were revalued meaningfully higher. Others showing strong operational performance include Precision Castparts, McDonald’s, Weight Watchers, Nike and Phillip Morris. It is so important in today’s environment of austerity to search harder for exceptional buys. Going forward, an investor can’t depend on government stimulus or rising markets to bail out poor investment selections. We are putting added emphasis on businesses with high free cash flow and low or no mandatory capital spending.

Balance Sheet versus Inventory Slowdowns

Downturns resulting from extreme levels of borrowed money can be classified as “balance sheet” recessions, as contrasted with those driven by inventory adjustments.  Recoveries following a balance sheet crisis like the one starting in 2008 tend to be choppy and shorter in duration (2-3 years) versus 5-7 years with an inventory recession. Easy money policies have stalled the traditional engines of recovery—housing and autos.  As a result, the Fund has been more heavily weighted in companies that sell lower ticket necessity items and are thus less vulnerable to a slowdown. Advancing global austerity increases the appeal of powerful branded franchises that can self-finance expansion in new emerging markets. Greg Page, the CEO of Cargill, recently commented, “No matter where we do business in 66 countries we see per capita incomes rising and consumers electing to spend more on meat, milk, eggs and confection.”

“Facts are facts even in the height of emotion” — Bernard Baruch

Gloom, fear and uncertainty are friends of fundamental, long-term investors. Remember, Carlos Slim, arguably the most successful investor on the planet today, made his mark buying good businesses in Mexico AFTER Mexico’s debt default in 1982. Recent negative news and partisan debate are obscuring some positives. Among them: growth in free markets, transparency and the peace dividend from winding down the Iraq and Afghanistan conflicts.  In monitoring hundreds of stocks, we are amazed how customer-focused companies like McDonald’s deftly adapt to face challenges, innovate and continue to build value for shareholders, employees and communities. Many investors think a government bond issued at rock-bottom interest rates is safer than an exceptionally well-run business with a rock solid balance sheet. But that perception may prove to be very expensive in terms of lower purchasing power over the next several years…

Beware of Commodities’ Long Bull Run

The commodity boom now exceeds both the housing and tech bubbles in duration (114 and 113 months) and looks vulnerable as China and other emerging markets raise interest rates to combat inflation. The rapid build-up of credit in China between 2009 and 2010 exceeded the credit expansions that preceded the most recent housing bubble in the United States and the Japanese property bubble in the late 1980’s.  Historically, quality stocks have bottomed as commodities speculation has reached fever levels. Another trend that looks very toppy is so-called high frequency exchange trading tied to mathematical formulas. Over the long run, when markets are free to function, they tend to be virtuous and eventually punish bad behavior. You can violate the laws of economics for only so long before paying the price of permanent capital loss.

Why Risk Management Matters

I was saddened when Borders recently declared bankruptcy. Talk about ironic: our knowledge-based economy is liquidating the second largest bookstore chain. Who would have thought traditional newspapers would be risky. Or Eastman Kodak? Such are the casualties of the Digital Age. This underscores the need for meticulous research and capital allocation rooted in fact-finding, fundamentals, price and value.  In today’s competitive global economy, appraising and pricing risk correctly has never been more important. We saw the devastating results in the misperceptions of “safe” housing investments.  Government bonds and commodities may not be as safe as portrayed. The lesson: any class of investment, when flooded with supply, can become risky. To enjoy the long-term fruits of compounding, the importance of a diligent chief risk officer can’t be underestimated. As Warren Buffett commented at his annual meeting, “My role as chief risk officer is too important to be left to a committee.”

Your trust and support is appreciated.

Jeff Auxier

As of 06/30/2011, the Fund held those securities mentioned in the letter as follows: WellPoint, Inc., 1.3%; UnitedHealth Group, Inc.,1.0%; Apollo Group, 1.4%; ITT Educational Services, 0.7%; Johnson & Johnson, 1.7%; Medtronic, Inc., 1.9%; Zimmer Holdings, 1.2%; Visa, 0.5%; MasterCard, Inc., 1.4%; Precision Castparts Corp., 0.6%; McDonald’s Corp, 0.8%; Weight Watchers Int’l Inc., 1.0%;  Nike Inc. Class B, 0.3%; Phillip Morris International, 2.4%; Borders, 0%; Eastman Kodak, 0%, Cargill, 0%.

There can be no guarantee of success with any technique, strategy, or investment.  All investing involves risk, including the loss of principal.  The S&P 500 Index is a broad-based, unmanaged measurement of changes in stock market conditions based on 500 widely held common stocks.  One cannot invest directly in an index.

The views in this shareholder letter were those of the Fund Manager as of the letter’s publication date and may not reflect his views on the date this letter is first distributed or anytime thereafter.  These views are intended to assist readers in understanding the Fund’s investment methodology and do not constitute investment advice.

Auxier Report: Spring 2011

Mar 31, 2011

Download Spring 2011 Report (PDF)

Market Commentary

Auxier Focus Fund returned 6.53% in the first quarter of 2011, versus 5.92% for Standard & Poor’s 500 Stock Index (S&P). The Fund had a 74% exposure to stocks in the first quarter.  Since inception on July 9, 1999, the Fund has outperformed the S&P by 98 percentage points, cumulatively.  For the 10 years ending March 31, 2011, a hypothetical $10,000 investment in the Fund would have grown to $19,979, while $10,000 in the S&P would have grown to $13,828. Since inception that $10,000 investment in the Fund would have grown to $21,542, versus only $11,667 in the S&P.

The first quarter was filled with dramatic news events worldwide.  Among them: uprisings in the Middle East, a tragic Japanese earthquake with a subsequent tsunami and nuclear plant crisis, and continued sovereign debt meltdowns in Europe. Despite the barrage of bad news, the fundamental earnings and cash flows for most businesses in the S&P have been strong. The moral:  positive growing cash flows should weigh heavier than headlines when allocating capital. There will always be uncertainty and obstacles. It is better to spend the time identifying the businesses and managements that can build value even in the most challenging economic times.

The Aspiring Middle Class Overseas

The powerful secular trend of rising living standards in emerging markets continues to benefit multinational corporations, not just in the U.S. but worldwide. Declining telecommunications costs are adding transparency, stimulating ambition and fueling one of the most potent human emotions—envy. The war to promote liberty and democracy in Iraq cost the United States nearly $1 trillion. One could argue that the combination of mass telecommunications, social sites like Facebook—and envy—are doing more for the spread of democratic ideals throughout the world at a much cheaper cost. Immoral dictators are finding it difficult to keep the public in the dark, and this sharing of information is igniting desires to move up the economic ladder.

Recently, top executives of Brazilian oil giant Petroleo Brasileiro S.A (Petrobras) visited our office.  Although oil was obviously a timely issue, the bigger topics were the surprising growth of the Brazilian middle class and the strong desire for fiscal responsibility.  Petrobras is having trouble just keeping up with Brazilian oil demand, as some 25-30 million people have been lifted out of poverty over the past decade. Much of the prosperity is due to a strong export market, especially into China.

U.S. trade with China has led to a 450% increase in exports into China over that period as well. Twenty to thirty percent of those are food-related. The food chain, starting from U.S. production, is enjoying strong tailwinds.  China has been moving to a more consumption-based, urbanized economy benefiting multinational corporations that can provide superior products and services.  The mass migration from rural to urban areas is accelerating consumption, as over 3.4 billion people worldwide now live in cities.  By 2050 it is projected that 70% will live in cities.  Fifty-four percent of the world’s GDP growth is in 645 cities with populations over 750,000 (Forbes). The global population is projected to grow by 1 billion over the next 12 years (Source: University of California, Berkeley). Western brands that can reach these customers stand to benefit. The first step is the diet and consumer items that help people weather their mostly mundane day at work. Once a country hits $3000 per capita GDP, you can expect a trend toward improving diet. The Fund is well positioned in companies that have the quality brands and distribution to serve these exciting growth markets. 

Strong international economic demand is offsetting a domestic hangover from the U.S. housing market, which has been slow to clear excess supply. Housing demand remains at historic lows while foreclosures continue to flood the market, hurting new construction. Foreclosure starts for March were up 33% (Source: Lender Processing Services, Inc.). Low prices should eventually clear the market. But heavy government intervention has delayed the cleansing process.

Fighting Flab on the Cheap

The Fund benefitted greatly in the first quarter from our holdings of Weight Watchers, which gained 70% during the period thanks to the growing epidemic of obesity. It is estimated by the Centers for Disease Control (CDC) that medical expenses attributable to people being overweight exceed $75 billion a year.  Two out of three adults and one out of three children are either overweight or obese. Yet Weight Watchers (WTW) was priced for very little growth, selling for a historic low, 9 times earnings.  When we invested in WTW, the market saw no anticipated growth in sales for the next three years.  As Charlie Munger of Berkshire Hathaway likes to say, the key to a successful marriage is low expectations. The same can be said for the timing of stock purchases—when they are priced with little enthusiasm. We gravitate to quality names when they are “hopelessly out of favor.”  This was a company that had previously been valued over 15 times earnings for ten consecutive years. We become interested when the reversion to the mean is substantially higher than the price we are paying.

The Elixir of Low Interest Rates

The yield curve of the bond market is generally a good indicator of future economic activity and profits.  A steep curve can signify growth, while an inverted curve (when short-term rates are higher than long-term rates) is often a precursor to recession.  The good news: today’s spread between the 2-year and 10-year Treasuries is 2.71 percentage points, versus the 1.12 percentage point average since 1990. This spread helps banks generate enough earnings to overcome the sins of the past. In a further sign of fundamental improvement, 129 companies in the S&P raised dividends during the first quarter. Buybacks of company stock were up over 67% to $95 billion. Low rates have stimulated the merger and acquisition market as well.

The Search for Businesses with Heart and Soul

The problem with stock indexes is they don’t measure the vision, drive, ethics and heart of management. Take Sam Walton, founder of Wal-Mart. During his years of leadership, Wal-Mart stock appreciated over 80,000%.  Under Costco founder Jim Sinegal, a $1600 investment in the stock in 1985 is now worth over $750,000. Look also at the contributions of Apple’s Steve Jobs. Despite this, trillions of dollars are tied up in nameless, faceless, heartless investment vehicles that make it difficult, perhaps impossible to determine the long-term odds of success.  We see tremendous opportunity for our flexible mandate to create portfolios of the most compelling values regardless of investment pigeon holes like style and size.

Inflation: The Flip Side of Low Rates

Inflation is worsening, especially in Asia and Latin America.  As money supply growth around the world exceeds productive uses, it leads to areas of investment speculation.  According to a recent study in Jim Grant’s Interest Rate Observer, inflation over the past quarter currently is running over 6% in the U.S., 5% in China and 9% in India. In the first quarter at least 17 countries raised interest rates. So-called negative real interest rates, when inflation exceeds nominal rates, are fueling a boom in commodities and contributing to sharp dollar weakness. The Federal Reserve’s zero interest rate policy runs the risk of material misallocation of capital and increasing speculation. Most U.S. government bonds fail to compensate investors for the risk at this time. A 2-year Treasury yields only 0.6%. By comparison, investors demand 24% to hold deadbeat Greece’s 2-year paper. We favor instead stocks with growing cash flows and dividend payouts, which help to maintain purchasing power as inflation accelerates. Ideal candidates are undervalued businesses with strong franchises, passionate management, high levels of free cash flow and low mandatory capital spending. They appear to be a much better bet at the present time compared to any domestic fixed income vehicle.    

Your trust and support is appreciated.

 Jeff Auxier

As of 03/31/2011, the Fund held those securities mentioned in the letter as follows: Apple, Inc., 0%; Berkshire Hathaway Inc. Cl-B, 0.9%; Costco Wholesale Corp., 0.1%; Petroleo Brasileiro, SA, 0.3%; Wal-Mart Stores, Inc., 2.0%; Weight Watchers Intl, Inc., 1.8%.

There can be no guarantee of success with any technique, strategy, or investment.  All investing involves risk, including the loss of principal.  The S&P 500 Index is a broad-based, unmanaged measurement of changes in stock market conditions based on 500 widely held common stocks.  One cannot invest directly in an index.

The views in this shareholder letter were those of the Fund Manager as of the letter’s publication date and may not reflect his views on the date this letter is first distributed or anytime thereafter.  These views are intended to assist readers in understanding the Fund’s investment methodology and do not constitute investment advice.

Auxier Report: Year End 2010

Dec 31, 2010

Download Year End 2010 Report (PDF)

Market Commentary

Auxier Focus Fund returned 5.3% in the fourth quarter 2010, versus 10.76% for Standard & Poor’s 500 Index (S&P).  The Fund’s exposure to stocks for the quarter averaged about 74%.  The remainder, mostly senior debt securities purchased in 2009, failed to keep pace with a very strong domestic stock market.  For the year the Fund returned 10.1% compared with 15.06% for the S&P.  The average equity exposure for the year was close to 74%.  Since inception in 1999, the Fund has outperformed the market by 92 percentage points cumulatively, confirming our objective to match bull markets while dramatically outperforming bearish ones.  In the face of the Federal Reserve’s zero interest rate policy, we are concerned that sound capital allocation can be distorted by the belief that such low interest rates are normal and permanent.  We are mindful that, in general, two years of 50% returns, followed by a 50% annual decline, would trail a steady 8% return over the same three-year period. The Fund enjoys a flexible mandate to move where the bargains are most compelling.

All Aboard the QE2 Economy

During the quarter, the Fed announced a second-stage economy booster in the form of $600 billion in quantitative easing (the oft-cited QE2). In addition, decisive political election results provided a counterforce to the growing threat of socialism. The extension of low tax rates also emboldened equity markets. The current macroeconomic environment is somewhat similar to 1994, when the country was recovering from a major financial stumble (Thrift Crisis). The Clinton Administration’s strong push toward socialism and regulation was thwarted by landslide congressional mid-term victories in both Houses of Congress, moving the country back to the middle of the political spectrum.  A strong three-year performance for large-cap U.S. stocks ensued. Another material positive back then was the “peace dividend” accruing from the reversal of Gulf War spending. Continuing U.S. withdrawal from Iraq should yield some beneficial savings too.

The stimulative backdrop has helped businesses restructure and survive the worst recession since the 1930s depression, yielding surprisingly strong profits and profit margins. Also rewarded are companies focused on providing exceptional value to customers via superior products or services (as contrasted with those utilizing creative financial engineering).

 Education, oil drilling, health insurers and medical devices are among the industries burdened by proposed onerous government regulations. This had led to some bargain stock prices. Just as in 1994, a move toward the political center can mean a push back against regulation that hampers businesses and job growth. Gloomy headlines provide attractive entry points for stocks—especially when the companies are experiencing improving fundamentals and cash flows. The change in perception from “horrible” to just plain “bad” can be a very profitable trade.

Our Favorite Inflation Hedge

Buying commodities at 30-year highs does not seem to us like a great inflation hedge at this time.  Over the long term, commodities typically have traded close to their marginal cost of production as advances in technology have dramatically improved productive output. Copper currently trades at triple its cost of production.  Much of the incremental demand has come from China, which mandated over $1.6 trillion of lending into its $5 trillion economy. Such a dramatic build-up in borrowed money is troublesome. Eventually rising inputs (steel prices are projected to rise over 40% this year: Financial Times) spoil the party by leading to relaxed lending standards and deteriorating loan quality.  Over $500 billion has been channeled into commodity ETFs (Trim Tabs Investment Research). But as China tightens, that could turn around. 

Money flowed into U.S. bond funds for 99 straight weeks in response to the Fed’s zero rate policy—this in the face of a depreciating currency and deteriorating fundamentals (Trim Tabs Investment Research).  The trend has recently reversed, with December showing some of the worst bond losses in years (Standard & Poor’s). Markets will reward good behavior and also punish those that violate the laws of economics.  Holding rates at zero for over 24 months now has led to market distortions in both bonds and commodities. Over the past century commodity markets have had a tendency to peak every thirty years: 1981, 1951, and 1921. The final stages are often marked by parabolic price rises. Contrary to the current consensus, if history is any guide, commodities may be too overpriced to provide a reliable inflation hedge.

We would rather bet on the bargain purchase of a mundane business that enjoys steady demand and inspired management.  Ideally these businesses have low mandatory capital spending, rapid inventory turns, and high levels of free cash flow. Quality companies tend to go out-of-favor during periods of heightened speculation.  Commodities pay no cash and will suffer if the real return on bonds increases. Better to aim for a “double-play” investment, where a stock is purchased in times of panic or distress, then returns to a premium valuation, helping outstrip the ravages of inflation. Operational excellence is highly rewarded in today’s market.

Flip Side of Extreme Leverage

Despite over $300 billion in annual subsidies, the decline in U.S. housing prices since the 2006 peak recently exceeded the 1928-1933 bust.  As of November, Phoenix homes were down 54 percent on average from the peak, Las Vegas down 57 percent, Miami down over 48 percent (RealtyTrac). No matter what the class of investment, the level of risk increases if you add extreme amounts of borrowed money. There is a misperception that government bonds can’t default. Not so, as states are facing shortfalls approaching $1 trillion (Moody’s). All this underscores the need to aggressively monitor the balance sheets of your investments. Problems in housing remind us of the twin perils of excessive leverage plus distortions to supply and demand (where the free market is unable to clear excess inventory).

Opportunities in 2011 and Beyond

High quality stocks should benefit from increasing dividend payout ratios and low relative valuations. In time, rising risk premiums on bonds should cool speculation, aiding investors focused on fundamentals and cash flow. As markets become more expensive we tend to gravitate toward defensive positions —special situations where the return is more dependent on, for example, managerial acumen than the general supply/demand fluctuations of markets. These include work-outs, breakups, spinoffs and post-bankruptcy IPOs (initial public offerings). As governments are forced to restructure in the face of ominous debt loads, there may be a generational buying opportunity ahead in the downtrodden municipal bonds.  Bargains could abound because financial disclosure is scant and less than 20% of the $2.8 trillion muni market is rated (Moody’s).  Since the recent elections where Republicans at the state level had the biggest sweep in eighty years, there is a push for wider applications of the Chapter 9 Municipal Bankruptcy Code as a restructuring tool for states. The threat is whether California and Illinois fail to get their fiscal houses in order and need to be bailed out. Such a debacle could undermine the reserve status of the U.S. dollar and lead to a buying opportunity on par with the corporate bond fire-sale two years ago. Generally, rapid and unsustainable growth in liabilities —for any entity—leads to some form of crisis or panic. As long–term investors, we want to identify such imbalances and be prepared to act when the investment class becomes hopelessly out of favor.  Stay tuned.

Sincerely,

Jeff Auxier

There can be no guarantee of success with any technique, strategy, or investment.  All investing involves risk, including the loss of principal.  The S&P 500 Index is a broad-based, unmanaged measurement of changes in stock market conditions based on 500 widely held common stocks. One cannot invest directly in an index.

The views in this shareholder letter were those of the Fund Manager as of the letter’s publication date and may not reflect his views on the date this letter is first distributed or anytime thereafter.  These views are intended to assist readers in understanding the Fund’s investment methodology and do not constitute investment advice.

Auxier Report: Fall 2010

Sep 30, 2010

Download Fall 2010 Report (PDF)

Market Commentary 

Auxier Focus Fund ended third quarter 2010 with an 8.9% return, versus 11.29% for Standard & Poor’s 500 stock index (S&P).  Year-to-date the Fund is up 4.55% versus 3.89% for the S&P.  Since inception in 1999, the Fund has outperformed the market by over 92 percentage points, cumulatively.

Quality At An Attractive Price

Looking across the investment spectrum, the current climate has created opportunities to buy high-quality businesses at prices below what such exceptional companies historically command.  For example, their earnings yield compared with government bond yields recently reached record spreads. The Fund is well positioned in global franchises with powerful distribution networks reaching an “aspiring emerging middle class” numbering over two billion. Rapidly advancing communications fuel greater desire to improve one’s life, starting with necessities. Healthcare is an underpenetrated segment for many of these potential customers as well. We especially like producers of low-ticket consumable goods.  These stocks are a partial hedge against fallout in China from “local government funding vehicles” (LGFVs), which are similar to our structured investment vehicles (SIVs). These Chinese creations have contributed to aggressive lending and overall fixed investment approaching 50%. 

Houses, Bonds and Businesses Compared

With a change in political winds, much needed government austerity measures should be implemented in the U.S. in the same way they are globally. This would increase the attractiveness of so-called “self-funding” businesses with low mandatory capital requirements. Americans are waking up to the fact that real estate “eats” a lot of mortgage interest, taxes, insurance, maintenance, etc. Many may be better served with bargain purchases of businesses that sell a quality product or service, earn high rates of return on capital and generate excess cash. With recent regulation, the popularity of financial engineered returns is diminishing.  Remember the definition of a financial genius—leverage in an up market. Bonds look overvalued in the face of deteriorating fundamentals and a Federal Reserve (“the Fed”) apparently eager to fire up the printing press to solve the country’s problems.

Back in 1972, top-quality companies dubbed the “Nifty Fifty” were thought to be “one-decision stocks.”  All a person had to do was buy and hold, regardless of price. This craze led to price-earnings ratios that soared to over eighty times, only to crash to under 10 in 1974. Similar premiums were common in the late 1990s. Today, I am finding comparable quality under 12-13 times, often with double-digit free cash flow yields. Historically, over 70% of stocks’ return is attributable to reinvestment of dividends. Therefore, businesses that can grow cash payouts at a consistent pace look attractive.  Here are a couple of lessons from the “Nifty Fifty” period. There is no such thing as a “one decision” approach in investing. Aggressive research and monitoring are a must. One also needs to sell into bubble valuations, or risk torpedoing the portfolio.

 The Benefits of Cumulative Research 

This is a uniquely favorable time for an independent minded business analyst.  Since 1982, I have amassed more than 30,000 hours of investment research, including three major recessions, numerous crashes, and interest rate swings from 18% to 1%. This database is helpful in sensing danger and identifying securities that will endure through the most difficult economic challenges. A diligent research effort is cumulative. It’s also a competitive advantage, assuming the approach is fundamentally sound, the ego is kept in check, and the work ethic is maintained (fortunately, I am a lousy golfer). Daily dedication to uncovering facts and fundamentals is crucial, as you can never tell when emotional panic will engulf markets.

For example, Fed policies have led to distortions in capital allocation with far greater speculation, mathematical trading and quantitative modeling. The longer the Fed adheres to a policy of artificially low interest rates, the greater the likelihood of investment mistakes that ignore underlying cash flows. This in turn leads to momentum and ultimately manias. Surviving the past 11 years (the period the Fund has been in business) requires you to be on “bubble alert.” Recall such recent disasters as zero-down mortgages, zero-down auto loans and 5% down derivative contracts.

The mistaken belief that there is no cost to capital is problematic. A pension funding crisis is brewing at all government levels—federal, state and local, just like the corporate bond bust 18 months ago. California and Illinois already face dangerous debt levels abetted partly by government subsidized Build America Bonds. Ironically, Build America Bonds may prove to be the final straw that breaks the backs of those states’ fiscal burdens. When the bond herd stampedes in the opposite direction, we hope to be well prepared to take advantage of bargains created by the crisis.

Why Buying Low Rules

With the threat of higher tax rates next year, it is worth revisiting a Jim Grant (Grant’s Interest Rate Observer) study of the 1951 market.  Harry Truman, champion of the Revenue Act of 1951, lifted top marginal tax rates from 84.4% to 91%.  Despite this onerous move, the decade from 1951 to 1961 was one of the best for investors in the twentieth century. In fact, the Dow Jones appreciated 50% in 1954. Why?  The starting point was cheap, with quality stocks trading close to 10 times earnings.  

The price you pay is a huge component of the return you will achieve.  So is inflation, now a distant memory for many investors. The purchasing power of $1 million drops to $680,000 over ten years with a 4% inflation. We are in an environment where investors need to work extremely hard to find double-play returns, providing both a margin of safety and a hedge against the hidden loss of purchasing power.

Final Note

Auxier Focus Fund was recently recognized by Standard & Poor’s Equity Research in its first ever U.S. Mutual Fund Excellence Awards Program.  To learn more, please visit www.spfundawards.com.  We greatly appreciate our shareholder trust and support!

Sincerely,

Jeff Auxier