Auxier Asset Management » Quarterly Letters

Auxier Report: Fall 2011

lwidolff — Fri, 30 Sep 2011 19:10:00 +0000

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

Stock	% Assets
Philip Morris	2.3
Pepsico	2.1
Wal Mart	2.0
Medtronic	1.9
Merck	1.7
Unilever NV	1.6
Johnson & Johnson	1.6
Microsoft	1.4
Coca-Cola Company	1.4
Mastercard	1.4
Abbott Laboratories	1.3
Apollo Group	1.2
Medco Health	1.2
Bank of New York Mellon	1.2
The Travelers	1.1

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

lwidolff — Thu, 30 Jun 2011 16:48:06 +0000

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

lwidolff — Thu, 31 Mar 2011 15:31:48 +0000

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%.

Auxier Report: Year End 2010

lwidolff — Fri, 31 Dec 2010 22:44:28 +0000

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

Auxier Report: Fall 2010

lwidolff — Thu, 30 Sep 2010 22:11:38 +0000

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

Auxier Report: Summer 2010

lwidolff — Wed, 30 Jun 2010 16:45:33 +0000

Download Summer 2010 Letter (PDF)

Market Commentary

Auxier Focus Fund ended second quarter 2010 with a -9.04% return, outperforming the -11.43% return for Standard & Poor’s 500 Index (S&P) by 2.39 percentage points. Year-to-date the Fund is down -3.99% versus a -6.65% decline for the S&P. The Fund has outperformed the market (S&P) by 87 percentage points cumulatively since inception in 1999.

A Formula for Going Nowhere Fast

Velocity trading has followed in the footsteps of velocity banking[1]as the latest easy shortcut to the arduous fundamentals of capital allocation. Like the parabolic rise of derivatives that enhance returns through leverage, commodity Exchange Traded Funds (ETFs) have grown fifty fold from $50 billion ten years ago to $277 billion (Bloomberg). These vehicles generate no cash flow and therefore are speculations. Many buyers apparently overlooked the unanticipated “contango” effect[2] (the inability to deliver on the futures contract) and experienced losses when there should have been gains.

In addition, two-thirds of stock exchange volume has recently been tied to so-called algorithmic trading formulas. Computer models abound that can fail to factor in periodic bouts of emotional folly. This means a greater likelihood of material misappraisals and plum pickings for flexible bargain shoppers. There are no shortcuts to investing. The economy is too dynamic and competitive. It is time to get back to the basics of investing—the craft of the specific. That’s knowing more about what you own than the market; showing conviction to buy more at compelling price points; quantifying true risk to invest when odds are highly favorable. Just as velocity banking failed, speculation that is not grounded in cash flow and fundamental analysis could in time fail as well.

Beware of Politicians Bearing Bonds

Two great Warren Buffett sayings apply today. “If money is easy, grab your wallet and run the other way” and “most men would rather die than think; many do.” Like the heady, high-tech bubble that peaked in 2000, followed by comparable manias for real estate and private equity, the investing herd is stampeding into bond funds like never before. In the past 18 months, some $580 billion has been channeled into US taxable bond funds and $500 billion into municipal bonds at the highest prices in history (Dow Jones News). Never mind that estimates of off-balance sheet liabilities at the federal level run seven times our gross domestic product (GDP). Governments at all levels have made entitlement promises that are unsustainable and, if unchecked, would lead to bankruptcy. Good money continues to be allocated to Fannie Mae and Freddie Mac, a disreputable duo that has already cost taxpayers $300-$500 billion. Illinois and California face a solvency crisis. Worse, the failed leadership and policies of both states have now been transferred to Washington DC. Once deficits reach a certain point, the risk of a failed bond auction becomes closer to reality. Remember, in eight centuries only a handful of countries have honored their debts. James Grant (Grant’s Interest Rate Observer) recently noted how Illinois, back in the railroad boom of 1842, was forced to pay 42.75% interest on its municipal bonds. More recently, yields on two-year notes in Greece climbed from less than 4% to over 20% in a very short period. If policymakers don’t make adjustments the market will. Unfortunately, unlike Japan, the US does not have the savings to absorb the shortfall. I would bet that we could see a similar panic in government bonds, especially if current spending policies are not corrected. In the early 1980s, the biggest municipal bond default in history occurred when Washington Public Power Supply System (WPPSS), aptly nicknamed “whoops”, failed to pay on a number of partially constructed nuclear plants. We were able to profit from the gloom by buying senior secured notes yielding 16% tax free. The bonds had originally been rated AAA[3] and paid puny interest. Examining the entire capital structure is so important when investing in stocks and bonds. It is difficult to survive over the long term with a weak balance sheet. As Jim Grant says, there is no such thing as a bad bond, just a bad price.

New Zealand’s Lesson for US Housing Subsidies

Back in 1985, New Zealand abolished all farm subsidies. Farmers’ income initially plunged as land and stock prices slumped. However, productivity soon recovered dramatically, boosting farming’s share of GDP from 14% to 16.6%. Farm products now comprise over 50% of all exports, and the rural population has grown. The move created a much more vibrant industry commanding a greater share of the overall economy. American policymakers should study this model to help reform Fannie Mae, Freddie Mac and our failed approach to housing subsidies.

Gateways to Emerging Market Middle Class

The US consumer and government face painful restructuring periods ahead. But many emerging economies learned their lessons the hard way back in 1998, and today have much better balance sheets. Global population is expected to grow from 6.8 billion to 9.2 billion by 2050. Chinese consumption of skin-care products, cosmetics and fragrances has quadrupled to $13 billion the last decade (Business Week). We like low-ticket necessity products that have a steady demand. Global austerity tends to favor our high-quality, self-funding businesses. Prime examples are multinational corporations, with powerful global distributions. Many of these stocks have sold off to price points where there is very little premium for the emerging market gateway these companies provide. Their high free-cash flow provides the needed flexibility to profit in times of distress.

Election Day 1994 Revisited?

The current US stock market feels like the early 1990s. Hillary Clinton was trying to socialize medicine. The country had endured one of the worst banking crises since the Great Depression. The 1994 midterm elections led to the biggest Republican sweep in fifty years, overtaking both the House and Senate. This catalyst helped fan favorable tailwinds in the market. Over the following six years, surviving small and midsized banks appreciated 400-800%. Healthcare stocks in general enjoyed meaningful upward valuations in price/earnings ratios[4]. Large blue chips had three consecutive years of above-average returns. It is rare to have the chance to buy high-quality businesses at ten times earnings. Currently, 13 of the top 25 S&P 500 stocks sell for 10-11 times estimated 2011 earnings. Neon Liberty Capital recently (July 2010) analyzed market performances after a decade in which the economy was in recession 25% or more of the time, as has our past decade. Guess what? Returns in comparable decades ending in 1955, 1958, 1975 and 1982 were well above average. The subsequent average gains over three, five and ten years were all above 14% annually.

Why Our Approach Can Win Over Time

We will always have to face crisis situations. Our approach is to work hard to anticipate potential areas of harm and irrational behavior. Then take advantage of the resulting bargains. Our edge? Managing through challenging environments back to 1983 demands rational, tenacious daily research effort that focuses on minimizing the downside. Seeking to identify durable investments is critical to outpace devaluations that result from the “easy path” politicians consistently follow. We are in times when you can’t depend on a rising market for returns.

We rely instead on our dedication to spot exceptional individual opportunities and moving when we believe the price is right.

Your trust and support is appreciated.

Jeff Auxier

As of 06/30/2010, the Fund held those securities mentioned in the letter as follows: Washington Public Power Supply System (WPPSS) 0%; The Federal National Mortgage Association 0%; Federal Home Loan Mortgage Corp 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.

[1] A term used to describe the rate at which money is exchanged from one transaction to another.

[2] When the futures price is above the expected future spot price. Consequently, the price will decline to the spot price before the delivery date.

[3] The highest rating given on bonds by bond rating agencies.

[4] Price/earnings ratio is the value of a company’s stock price relative to company earnings.

Auxier Report: Spring 2010

lwidolff — Wed, 31 Mar 2010 16:00:27 +0000

Download Spring 2010 Letter (PDF)

Market Commentary

Auxier Focus Fund ended first quarter 2010 with a 5.55% return, versus 5.39% for Standard & Poor’s 500 stock index. The equity component of the fund appreciated over 6.5%. What’s more, Auxier Focus Fund has outperformed the market by 93 percentage points cumulatively since inception in 1999.

Rapid expansion in the US government’s balance sheet (from $850 billion to $2.3 trillion), coupled with the Federal Reserve’s (“the Fed”) policy of zero interest rates, has helped stimulate the economy and recapitalize banks. At year-end 2009, over $8.2 trillion in federal loans and guarantees backstopped the economy (Grants Interest Rate Observer). Recovery appears to be broadening. Inventories are being rebuilt; equipment spending is rising, and non-financial firms are sitting on roughly $2.8 trillion in cash, or 15.7% of total assets. That’s the highest level in over 20 years (Kiplingers.com 31 Mar. 2010). As credit trends improve, some $1 trillion sitting in bank reserves (source: the Fed) could further boost the octane of rocket fuel provided by the government. There tends to be a twelve month lag from the time of policy changes to when effects are felt on Main Street. Witness China, where government’s $1.4 trillion in aggressive lending over the past year has ignited a growth rate exceeding 12%.

Food Chain Fast Lane

Severe price deflation in the past year has created opportunities to profit along the food chain. Massive herd liquidations in pork, chicken and beef led to “mouth watering” opportunities in both the debt and equities of such meat producers as Smithfield Foods and Tyson. Cattle inventories by year-end were back to 1959 levels, contributing to the greatest price appreciation for beef (so far in 2010) in over 50 years. Shares of grocers Wal-Mart, Kroger, Supervalu and Tesco corrected on both food and fuel price declines last year. These companies offer consistent value to the customer and, due to high inventory turns, can perform well during periods of high inflation. In the 1970s for example, grocers proved to be one of the best performing groups as inflation exceeded 10%. More expensive food often tracks growing middle- class populations in emerging countries, whose obstructionist socialist policies can mean more bottlenecks in supply as demand swells. Younger populations in emerging countries are also attracted to western brands, benefiting those companies with strong international distribution (Tesco, Wal-Mart, Unilever, Nestle). The United States is a global leader in high-quality food products. In 1940 one US farm produced food and fiber for 15 people. Today one farm feeds 155. We will need to feed another 2 billion over the next forty years.

Dr Pepper Pops

One of our larger investments in the past year is Dr Pepper Snapple Group (DPS). At the time of our purchase, many skeptical investors assumed (incorrectly) that DPS suffered from poor trends in the domestic soft-drink business. The stock drifted down to nine times earnings. However, after being spun off from Cadbury (in November 2008), CEO Larry Young and his management team successfully focused on re-energizing a strong stable of brands. As a result, the company has enjoyed an upward revaluation, expanding its earnings multiple over 60% to 15. Outstanding management can add enormous value. This is the benefit of our practice of studying and judging the character and diligence of managements. We want the business to generate our returns, not the market.

Mispriced Government Bonds

Early last year, corporate bonds were discounting a so-called loss probability approaching 50%. That’s the worst since the 1930s, when the worst-case reality was 5%. This led to a tremendous double-play return, generating high cash interest with above-average appreciation. Conversely, government bonds now appear to be mispriced in the other direction—too little return for the risk.

There is currently no such thing as a safe government. I can’t remember a time in my career when there was so little return for the risk of owning local, state and federal government securities. Local and state governments collectively have amassed over $3.3 trillion in pension and health benefits that need to be paid out over the next thirty years (The Pew Center on the States). To further compound the problem, state pensions were major players in funding the private equity bubble during the 2005-2008 period. As we have seen, borrowed money secured with inflated assets is a lethal combo. It can take years to dig out of losses resulting from extreme leverage. Ironically, in the face of such deteriorating fundamentals, more money flowed into municipal bonds in 2009 ($78 billion) than in the prior ten years combined. Investors have continued to trust rating agencies, which again are behind the curve. California seems to be emulating the failed policies of countries like Greece and Argentina, where uncontrolled government spending leads to insolvency (and in the case of Argentina, 3000% inflation in 1989).

Growth in the US federal deficit, both on and off balance sheet, is dangerous and worth monitoring. Pew Research Center polls recently found that trust in government is at a “historic low” of only 22%. Leadership at the federal level seems out of touch with voters, a disparity that hopefully, is a catalyst for change.

The Number One Cause of Business Failure

I had a recent discussion with David Coffman, author of a number of books on factors leading into bankruptcy. What is the number one reason for business failure I asked Coffman. He countered without hesitation: “Three letters, EGO.” Lack of humility and decisions based on emotions, not facts, can sink the ship. We are seeing the dangers of unchecked egos in Washington, DC.

Final Thoughts

The powerful fiscal and monetary stimulus orchestrated by the Fed has worked to bring “animal spirits” back to the markets. A zero interest rate policy has rewarded speculators (to the detriment of savers) as the highest risk categories have shown dramatic outperformance. Ironically, many of the more stable, higher quality stocks have lagged. But they now represent better relative value and could prove to be the best place to endure once the proverbial punch bowl is removed. Prognostications can be expensive when wrong, of course. So our approach is to seek the right business with tenacious, high-integrity managements more than equal to the most daunting challenges.

Your trust and support is appreciated.

Jeff Auxier

As of 03/31/2010, the Fund held those securities mentioned in the letter as follows: Smithfield Foods (1.2%); Tyson Foods, Inc. (1.0%); Wal-Mart Stores (2.6%); Kroger Co. (1.6%); Supervalu (1.5%); Tesco PLC ADR (1.3%); Unilever NV (1.3%); Nestle (0.1%); Cadbury (0%); Dr Pepper Snapple Group (4.0%).

Auxier Report: Year End 2009

lwidolff — Thu, 31 Dec 2009 16:00:17 +0000

Download Year End 2009 (PDF)

Market Commentary

Auxier Focus Fund (Fund) ended the fourth quarter 2009 with a return of 4.53%, versus 6.04 % for the Standard and Poor’s 500 Index (S&P). For the full year the Fund returned 24.76%, versus 26.46% for the S&P. The Fund’s stock market exposure for the year averaged between 70-75%, with the balance in corporate bonds and cash. The equity component of the Fund was up over 28%. Long term, the Fund outperformed the S&P by 87 percentage points since our 1999 launch. The Fund’s Morningstar ratings and rankings are as follows:

Morningstar awards us its Morningstar Overall Rating of five stars in the Large Value category as of 12/31/09. The Fund received 5 stars in the 3, 5 and 10 year periods and was rated among 1104, 912 and 459 funds, respectively. The Overall Rating is derived from a weighted average of the risk adjusted performance figure associated with its 3, 5 and 10 year Morningstar Rating metrics.

The Fund beat over 98% of its peers over the past three years. As of 12/31/09, the Fund’s 10, 5, 3 and 1 year Morningstar rankings are, respectively, 15 out of 459 funds; 46 out of 912 funds; 19 out of 1104 funds; and, 509 out of 1272 funds. Morningstar rankings are based on a fund’s total return performance. Past performance is not an indicator of future results.

Our goal is to materially outperform in down markets and match up markets. We are mindful that a 50% decline requires a 100% recovery to break even. A 90% decline requires a 1000% recovery. We strive to adhere to a disciplined, systematic, low-risk approach based on highly favorable odds. We also believe investors need to be well-compensated for the risk taken.

In 2009, massive U.S. government stimulus (four times greater than in all post-war recessions combined) led to rapid narrowing of credit spreads. As we commented in the last letter, the liquidity crisis presented us with unprecedented bargains in corporate debt—especially in the higher risk names. That play is largely over, as spreads on the highest risk bonds narrowed from a high of 21% to under 7% recently. That’s the benefit of being a business analyst and studying the entire capital structure of enterprises. Our years of dedicated research and cumulative balance sheet knowledge provide huge advantages in times of distress because we are prepared for bargains as they unfold. It is necessary to stick with a game plan to enjoy the fruits of compounding. We have found that investors need a proven, understandable approach to stay the course during challenging markets. To win, you must first finish.

Profiting on Fears of Nationalizations

Recall how in early 2009 stock markets were hitting lows in the face of shrinking liquidity and rising fears of bank nationalizations. Free markets detest government takeovers of private industry. The threat of nationalized healthcare further added to the gloom. Back in 1994, when Hillary Clinton proposed government-run healthcare, we loaded up on the industry’s stocks as they got pummeled in anticipation of the worst-case scenario. Those bargains provided us with material outperformance for the following three years. Similarly, this past year we were able to buy both the stocks and bonds of health insurers below the cost of liquidation. We like to invest when prices are discounting “horrible.” The move to just a “bad” outlook can be extremely rewarding. Buying when the outlook is “good” and hoping for “great” is usually too expensive. Ironically, prices resulting from hopelessness can be safer than those from euphoria, which can be deadly. The Nasdaq Composite Index over the past ten years is down 45% starting from the point of extreme elation. Optimistic price levels also contributed to the worst ten-year returns for the Standard and Poor’s 500 in over 200 years. Price and value do matter more than people think.

Time-Honored Observations and Lessons

It is good to look back over the past 18 months and revisit some investing basics:

One decision investing—buy and forget—can be costly. Investing is never easy. Autopilot does not work.
This time is not different; we have seen it before. Human nature does not change. There are no new eras. All bubbles end the same way: in disaster.
Over the long run, businesses that are nurtured return the favor. One dollar invested in stocks in 1871 is now worth over $10,000, thanks to reinvestment of dividends (adjusted for inflation).
Borrowing short term to fund long term asset purchases can be fatal in a credit crunch.
Every class of investment needs to be aggressively monitored as to fundamentals and price. This is even more important in a competitive global economy.
Compounding is the priority. Imploding bubbles act to torpedo the portfolio. Popularity must be pruned.
Larger funds are not safer, because they are less nimble in down markets. In fact, index funds give the greatest weighting to the most popular (and typically overpriced) companies.
There are no easy shortcuts or formulas. Day-to-day homework is critical as is the ability to think and reason independently. A skeptical contrarian nature is needed.
Understanding history and psychology is critical in navigating emotional auction markets.
A free market system works; socialism does not. Contrasting Brazil with Venezuela, one sees the benefits of a free market vs. a socialistic leadership. Venezuela, which has nationalized industries such as oil, steel and cement, is looking at 45% inflation for 2010.

Perception vs. Reality on Debt Defaults

Investors generally view government and municipal bonds as low risk. Many, until recently, also thought houses only went up in value. The reality? Solvency of government entities is threatened by growth in government unions and excessive borrowings in the face of lower income, property and sales taxes. Indeed, sovereign debt default is extremely common in world history; only a handful of countries have consistently honored their obligations. Greece is currently making such headlines, which are hardly new. From 1800 until well after World War II, Greece found itself in continual default (This Time is Different: Eight Centuries of Financial Folly). Given the current free-spending leadership in Congress and the White House (only 7% of Obama’s cabinet has worked in the private sector), the United States could easily find itself facing credit downgrades if not careful. The result would be much higher financing costs.

Uncle Sam’s Exposure to Housing

The U.S. government has shifted the sub-prime mortgage problem from the banking sector to the Federal Housing Authority (FHA), where 3.5% down payments are still allowed. No skin in the game is a recipe for disaster. Over 85% of home loans originated over the past seven months have been FHA loans. The agency is allowed to have an absurdly low capital level—less than 2% of assets—that pales only in comparison with the 80-to-1 leverage ratios at Fannie Mae and Freddie Mac. Such leverage has distorted the housing market while materially inflating Federal debt loads and bad assets. Fannie Mae’s balance sheet is exploding because it now must add back off-balance sheet loans. There’s still a shadow inventory of 1.7 million homes in some stage of foreclosure—45% more than the official 3.75 million burden with which banks are wrestling (American Banker). Government involvement has gummed up the clearing mechanism needed to start the recovery process.

Looking back over the past century, adjusted for inflation, it becomes apparent how the easy financing craze contributed to house appreciation. Between 1996 and 2006, the cumulative real price increase in housing was 92%—more than three times the 27% comparable real return from 1890 to 1996 (This Time is Different: Eight Centuries of Financial Folly).

Aggressive Credit Growth in China

China’s economic revolution is well known and popular. But their $586 billion stimulus program may be the shaky foundation for another crisis down the road. Financial panics and collapses are usually preceded by acceleration in borrowed money. Debt fueled booms can provide false short-term confirmation of a government’s policies. In 2009, the Chinese government mandated over $1.4 trillion in bank lending, up 30%, and is looking at a further increase of 18% in 2010 (Wall Street Journal). One has to question the quality of loans at that frenetic pace. Can there be that many attractively priced opportunities to absorb such volume? This aggressive lending has driven up Chinese real estate as home prices are trading between 10-20 times the average annual household income. Another troubling development: Chinese banks have also discovered the wonders of “off balance sheet financing” to lever up further.

Perils of Overproduction

According to Trim Tabs1, $256 billion flowed into commodities in 2009. Commodities have historically traded close to the cost of production. Today’s market is very confusing and risky. Oil, priced at $75-$80 a barrel, trades at double the cost of production. Yet wheat recently dropped in price to 200-year lows adjusted for inflation (Progressive Farmer). With technological advances, the risk in these areas is massive overproduction. Strong pricing is so rare that when times are good, forces of supply build much faster than in the past. Again, extremely easy money is distorting reality and can ultimately lead to sloppy capital allocation. Another example: just as interest rates dropped to the lowest levels in 40 years (highest bond prices), $421 billion flowed into bonds while $35 billion was withdrawn from domestic stocks.

Favorite Out of Favor Areas

Despite the recent rally, there are industries that are still unloved and represent potential rewarding investments.

Many topnotch online education stocks are trading at their lowest valuations in a decade. Fears of government regulation and financing issues have hampered the group. Yet there is an increasing need for specialized education and retraining. Industries are constantly restructuring in today’s competitive, knowledge-based global economy. The fundamentals for online education continue to be strong.
The S&P Health Care Index is trading at a 19% discount to the market, again, in fear of a government takeover. Over time, the sector has traded at a premium. We think it will again.
Many grocery chains have underperformed this past year. Wal-Mart is one of the worst performing stocks off the March 2009 lows. Deflation in food and gasoline negatively impacted the sector. Yet strong international franchises sell necessities into the growing global middle class. So there is unrecognized value in powerful distribution models that can reach the masses.
About $1.5 trillion of commercial real estate loans come due over the next 24 months at appraised values far lower than the original purchase price (American Banker). The uncertainty could lead, over the next year, to some compelling price points among downtrodden regional and community banks.
Refiners have been pummeled by sluggish demand for gasoline and diesel plus increased global capacity. The near-term outlook is bleak, with prices below the marginal cost of production. The stocks sell at steep discounts to book value. Industry leader Valero has declined from a high of $78 to a recent low near $15. Forces are at work to reduce excess capacity, at the same time the economy is starting to show increased strength.
Bonds of natural gas producers have been cheap because new shale discoveries are promising but expensive. Yet these bonds have potential for upgrades as equity investors and major oil companies are attracted to the industry.

Instead of trying to predict markets, we strive to identify businesses with the managerial ethics and drive to endure seemingly insurmountable economic conditions. We like managements that nurture business instead of rob it. From an investment standpoint, it is hard to beat a well-run business, purchased at a compelling bargain price, with the potential of exceptional long-term results. Even though markets have rallied, U.S. stocks had declined 57% off their 2007 highs. So a 50% increase off that base still means the market is down 35%. This is a good backdrop to deploy capital astutely, always vigilant to avoid euphoric bubble conditions.

Your trust and support is appreciated.

Jeff Auxier

1 Trim Tabs is an independent institutional research firm focused on equity market liquidity.

As of 12/31/2009, the Fund held those securities mentioned in the letter as follows: Wal-Mart (2.6%); Valero (0.4%).

For the period ended 12/31/2009, the Fund’s Overall Morningstar Rating was 5 stars. For each fund with at least a three-year history, Morningstar calculates a Morningstar Rating based on a Morningstar Risk- Adjusted Return measure that accounts for variation in a fund’s monthly performance (including the effects of sales charges, loads, and redemption fees), placing more emphasis on downward variations and rewarding consistent performance. The top 10% of funds in each category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars and the bottom 10% receive 1 star. (Each share class is counted as a fraction of one fund within this scale and rated separately, which may cause slight variations in the distribution percentages.) Past performance is no guarantee of future results.

©2009 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this.

Auxier Report: Fall 2009

lwidolff — Sun, 01 Nov 2009 16:00:13 +0000

Download Fall 2009 Letter (PDF)

Market Commentary

As of September 30, 2009, Auxier Focus Fund returned 12.58%, versus 15.61% for Standard and Poor’s 500 Index (S&P) for the third quarter of 2009. Year-to-date, with approximately 70% stock exposure, the fund gained 19.35%, beating the S&P’s 19.26%. For the 12 months the fund earned 1.87% vs. -6.91% for the market (S&P). Since inception (7/9/99) the fund has returned 75.71% vs. a negative 9.72% for the S&P (an 85.43 percentage point cumulative outperformance).

Over the past nine months, the fund profited by scooping up high-yielding corporate bonds. Forced liquidations by institutional holders of such bonds led to drastic misappraisals and historic bargain prices. By carefully monitoring company capital structures, and being flexible, corporate bond bargains can occasionally achieve equity type returns with far less risk. Higher yield corporate bonds have actually far outperformed domestic stock indexes this year. We try to understand each business and its capital structure to determine its cash generating potential. It is rare when you can buy senior debt securities sporting double-digit returns like we have seen the past year.

Stocks stellar rally since March is a reminder of how costly it can be to focus on unknowables such as the market, interest rates and the economy instead of specific investment opportunities with mouth-watering odds. The window of opportunity is often very brief. So being prepared in advance is critical to have the conviction to act. Having a database built over a number of years helps to decipher facts from fiction in the height of a crisis.

This past quarter, ironically, our high-quality companies lagged riskier stocks (those most dependent on the capital markets and crushed in the market decline). One reason: the aggressive fiscal and monetary action by the Federal Reserve tightened credit spreads dramatically over a short period of time. Just goes to show that outperformance is possible for any asset class when starting from a point of severe undervaluation. Everything has a price.

A Solid Investment Approach

We have endured one of the longest recessions (22 months as of June), the third worst stock market decline since 1900 (a 57% drop to the March 9 lows) and one of the poorest 10-year periods for stocks since 1871. As we have seen, markets tend to be harsh to those who don’t follow a sound investment approach. To win the race you must first finish, focus on the balance sheet and understand risk factors that can lead to permanent capital loss. Supply and demand must be monitored closely. The misperception of risk and odds continues to take many investors out of the game.

Economic Recovery May Surprise

A current worry is that we will have structurally high unemployment for years—that we will have a “jobless” recovery. Historically, companies coming out of recession operate lean to insure survival. Caution is evidenced by corporate cash levels now near 40-year highs, according to the Wall Street Journal.

As Jim Grant, editor of Grant’s Interest Rate Observer has recently commented, “Currently, 25% of American workers are employed in jobs that the Census Bureau didn’t even list as occupations in 1967. We underestimate the resiliency and capacity of market economies to reinvent the nature of work.” Contrary to the current consensus, Grant adds, the key determinant to the strength of an economic upturn was the severity of the downturn that preceded it. There were no exceptions to this rule. The recent downturn ranks as the worst since World War II.

Master the Game -10 year minimum

Geoff Colvin’s Talent Is Overrated studies high performance in a number of fields. Colvin cites highly specific “deliberate practice” over a 10-year period as a key to extraordinary achievement in any field. The most important is solitary practice, and the advantage is cumulative. More total practice is powerfully associated with better performance. Anders Ericsson’s “The Role of Deliberate Practice in the Acquisition of Expert Performance” noticed a theme that emerged in research on top-level performers. No matter who they were, or what explanation of their performance was being advanced, it always took them many years to become excellent. If a person achieves elite status only after many years of toil, assigning the principal role in that success to innate gifts becomes problematic. The phenomenon seems nearly universal whether in math, science, chess, musical composition, swimming or tennis. No one, not even the most “talented” performers, became great without at least 10 years of hard preparation. Many scientists and authors produce their greatest work only after twenty or more years of devoted effort. The “deliberate practice” made all the difference. Colvin says, “The difference between expert performers and normal adults reflect a lifelong period of deliberate effort to improve performance in a specific domain.”

Final Thoughts: The Search for Drive and Passion

We are constantly on the lookout for corporate managers who have integrity and a passion for the business. They also have a focused obsession to navigate through the most challenging of economic conditions. USA Today published a list in April of 2007 of the top 25 US stocks over a 25 year period starting in the 1982 recession. You see returns ranging from 17,808% to 64,224%. And you can see why the goal is to be a diligent business analyst, not a stock market prognosticator.

Thank you for your continued trust.

Jeff Auxier

Auxier Report: Summer 2009

lwidolff — Tue, 30 Jun 2009 16:00:41 +0000

Download Summer 2009 Letter (PDF)

Market Commentary

On July 9, Auxier Focus Fund celebrated its 10th birthday—and a major milestone. Over the 10 years to June 30, 2009, the most recent period for which data were available, the Fund delivered a cumulative 56% return, versus a corresponding -21.9% loss for the Standard & Poor’s 500-stock index. So, we not only made money during a bear- mauled decade; we also beat the market by 78 percentage points.

The Fund also excelled in the six months to June 30, returning 6.02% versus 3.16% for the S&P 500. For the second quarter of 2009, the Fund returned 13.12% against 15.93% for the S&P 500 Index.

After falling 57% from the 2007 peak through the March 2009 low, the S&P rebounded sharply in response to aggressive fiscal and monetary steps taken by the United States government. The U.S. stimulus so far authorized in this downturn is ten times greater than the average amount spent in recessions over this past century. It amounts to roughly 30% of Gross Domestic Product (GDP)—twelve times greater than the pump priming during the Great Depression. Back then, the cumulative decline in GDP was 27%. (Source: Grants) Today, we are nowhere near that level of economic decline, perhaps because total government payments now comprise over 25% of the economy. By contrast, there were virtually no safety nets such as social security in the early 1930s.

China also has been aggressively stimulating its economy to help increase domestic consumption and to offset weak exports. These actions, together with a more private market approach (versus nationalization) to treating U.S. banking ills, helped to loosen credit, stabilize industry and encourage risk taking.

Buy Cash Flow Cheap

In an environment where it could take years to deleverage the accumulated mountain of debt, our focus has been to buy predictable cash flows when they are cheap. The capital structure of each individual business needs to be scrutinized, as there are times when it makes sense to be a creditor as opposed to a common shareholder. Too much emphasis has been put on asset appreciation and not on dependable underlying cash flows. Government policies that aim to help banks earn their way back to solvency could lead to a long period of low interest rates. So at the end of 2008 when corporate bond spreads widened dramatically (from 2.5 to 21 percentage points), we took advantage of the bargains. Corporate bonds were discounting a potential default factor of 50% when the absolute worst previous period—the 1930s—saw only 5% defaults. We bought shorter to intermediate-term senior debt securities with the goal of achieving equity type returns with less risk. Also targeted were common stocks with high free cash flow yields, strong balance sheets and above-average dividend yields. The goal is to make exceptional buys in entities that can throw off cash, rather than counting solely on a rising market for returns.

Know What You Own

The investment industry has continued to come up with new innovations that take investors farther away from understanding what they own. Investing is the craft where cumulative years of intense study can add value in determining the odds of when to invest. Exchange traded funds (ETFs), derivatives, and hedge funds, to name a few, are promotions of short-term speculation in which leverage is often easy to disguise. Investors have continued to drift from long-term stock ownership to short-term speculation. When a financial genius is commonly characterized as one who uses “leverage in an up market,” you know the pendulum has swung too far.

Furthermore, the average 401k statement shows all kinds of funds that make it extremely difficult to quantify risk/reward. When it is time to invest, when prices are low and potential risk-adjusted returns are attractive, the average investor has no clue on the odds…and therefore no conviction to allocate when the time is right. In the current environment, it is hard to determine crucial variables such as the winning “drive” and asset allocation skill of management, balance sheet strength, etc. Without a strong balance sheet, a company can’t endure downturns. I have owned or followed many investments we have in the Fund, both domestic and foreign, for over 25 years. As the “chief risk officer,” that cumulative knowledge is critically important to differentiate between those businesses that can provide superior returns.

Reflecting on Our First 10 Years

We believe it is helpful to look back at some of the basic operating principles that may have contributed to the Fund beating the market by 78 percentage points.

Pledging that the manager has a big personal stake locked in the Fund—now over 153,000 shares—and a top priority of persistent daily research.
Having lots of humility. Understanding that anything can and will happen in the markets is vital to enduring tough times.
Being wary of the dangers of “animal spirits,” controlling one’s emotions. Thinking critically and rationally are key to beating the market over time.
Running smaller sums of money, which is a huge advantage when combined with a flexible mandate to exploit misappraisals over a broad range of asset classes.
Sticking to the Benjamin Graham approach, which encourages a manager to wait for compelling bargains without the pressure to be fully invested all the time.
Appreciating the power of compounding and the potential downside of each investment. To enjoy the fruits of compounding, it is important to avoid the blow-ups. A drop of 50% requires a gain of 100% just to break even. A plunge of 90% requires a corresponding, and nearly impossible, 1000% gain. To mitigate risk it is important to understand the basic laws of supply-demand, as well as the dangers of “bubble valuations” stemming from periods of easy money.

It is worth noting that fewer than 17% of all mutual funds have had a single manager over a ten year period. That very few managers have a meaningful stake in the funds they manage. This may explain why over 80% of stock funds underperformed the market last year, when the S&P 500 lost over 38%. I strongly believe executives in a stewardship position should have their money locked up for their tenure of leadership, as I have. This forces managers to focus on the downside, as opposed to having a free ride to speculate with investors’ hard earned money.

Another expensive misperception is that bigger is better in the investment field. There are over 34,000 publicly traded stocks globally, but large funds are unable to invest in 90% of them. Additionally, in bad markets the larger funds are inflexible and unable to protect principal. They can be locked into positions, unable to sell stocks without depressing prices. Yet, investors blindly pile into megafunds or companies whose size is definitely an anchor to performance. Too much attention is placed on getting bigger—not better.

Reasons for Optimism

The S&P 500 Index was conceived 82 years ago. As of January 2009, we had witnessed the worst 10-year period in the index history—an average annual loss of 5.1%. The good news? When looking back, other poor 10-year periods (the 1970s and 1930s) were followed by 9-15% average annual gains in the decade following. In addition, the total stock market value as a percentage of Gross Domestic Product (GDP) dropped to 75% in January, down from 190% in March of 2000 at the peak of the tech mania.

Final Thoughts

A serious long-term investor seeks opportunity when volatility and emotion engulf a quality investment; when the lines between perception and reality are blurred. The result can be a compellingly cheap double-play opportunity. You don’t need to go from good to great to enjoy above-average gains. Horrific to bad can serve the same purpose. It all depends on price.

Thank you for your continued trust.

Jeff Auxier