Jeff Auxier Fall 2014 Market Commentary

We have been anticipating a market correction to wring out mounting excesses of margin debt, overpriced initial public offerings and widespread security issuance in the energy sector. Indeed, during the third quarter, many of the 1500 companies we follow each year began to correct. Smaller stocks as measured by the Russell 2000 index declined 7.36%. Larger companies fared better with the Standard and Poor’s 500-stock index up 1.13%. Auxier Focus Fund ended the quarter down 1.35% with our foreign stock holdings a drag in the face of a strong U.S. dollar. Generally, severe and prolonged market declines are preceded by periods of rising interest rates and/or recession. So far fundamentals and reported earnings don’t point to either in the near term.

Welcome Return of Market Volatility

The typical NYSE stock fluctuates 50% (peak to trough) in a given year. That hasn’t been the case the past three years. Instead, volatility has been artificially suppressed in part by powerful Federal Reserve monetary stimulus and corporations’ record stock buybacks (some $330 billion in the past year). Since 1950, market corrections of 10% or more have occurred 29 times. But there have been only 10 recessions. To achieve above-average returns going forward, investors should expect greater swings in stock prices. Unfortunately, most equate volatility with additional risk, often depriving them from enjoying the potential benefits of long-term compounding.

Good News at the Pump

U.S. crude oil prices as measured by West Texas Intermediate (WTI) dropped 13% from $105.37 to $91.16 a barrel during the third quarter. Retail gasoline prices fell 9% from their second quarter peak to $3.35 a gallon. A penny per gallon drop in gasoline prices equates to over $1 billion dollars in annual savings for consumers (as 365 million gallons of gas are consumed daily). U.S. energy production more than doubled in the past six years to eight million barrels daily, up 50% since 2010. As of August oil production was at a 28 year high. The leading domestic source is West Texas’ Permian Basin, which produced 850,000 barrels in 2007 and now gushes over 1,350,000 barrels, or 18% of the U.S. output. The domestic boom has been fueled by aggressive issuance of Master Limited Partnership (MLP) shares and so-called junk bonds sporting high yields and risk. To further add to potential supply, Mexico is privatizing a state-run oil industry that some estimate could hold 90 billion barrels in oil and gas reserves. This supply is material not only to the economy but to petropolitics. The cheapest U.S. market valuations since 1960 have coincided with a parabolic three-fold increase in oil prices in 1973-74 and 1979-80. Conversely, strong markets from 1982-89 and 1995-2000 were periods of declining energy prices. High oil prices have spawned a flurry of technological innovations. Toyota is close to introducing a hydrogen car that can travel over 300 miles per tank. Technology advances act as a resource liberating mechanism. It can make the scarce highly abundant.

Government mandates for adding corn-based ethanol to gasoline started at one billion bushels and then climbed to five billion bushels. Our farmers were able to exceed that demand by producing over 170 bushels to the acre. In response, corn has plummeted from over $9 a bushel to a recent $3.60. We currently have over five thousand times more solar energy hitting our planet’s surface than we use in a year. Solar is projected to be the number one energy source by 2050. The growing risk to any portfolio today, one that needs to be monitored closely, is that of abundance—too much supply.

Bad News for the Bad Guys

Budgeting pain becomes more acute as oil drops below $100 a barrel for petro-exporting U.S. adversaries such as Iran, Venezuela and Russia. All need oil prices materially above $100 to balance their budgets. Russia loses $2 billion a day when oil is under $100.

How Taxes Thwart Compounding

Managing money in high tax states for the past 30 years has honed our focus on “high return” businesses (high returns on equity) bought at bargain prices and held for potential doubles or triples in price. Here’s why. Morningstar recently compared stocks and bonds and the return impact with taxes. A dollar invested in stocks from 1926 to 2013 grew to $4,677. That’s a 10.1% compound annual return. If you deduct 20% a year for taxes, that $1 grew to $934 (or 8.1% compounded annually). Bonds compounded 5.5% annually over the period, growing to $109. After taxes, the return shrank to 3.4% annually, or just $18. That is why we focus on being “business analysts.” We strive to price individual securities and determine the types of business that may grow and endure for long periods while deferring the tax bite.

Don’t Overlook Execution Risk

We continue to seek out strong franchises that are run by competent management and have enjoyed high free cash flow yields. Most of our companies have generated free cash flow yields in excess of long-term bond rates. That advantage provides valuable flexibility in difficult times.

We like managements focused on gains in per share intrinsic value—not growth at any price. Spin-offs and split-offs are welcomed managerial moves. Such decentralized structures, led by highly energized small teams armed with technology, can outperform large bureaucracies. The Fund portfolio is trading close to 14 times estimated 2015 earnings per share. Execution in the delivery of superior products and services is vitally important in today’s market. Those who are executing well command premium valuations. Those that stumble get punished hard. Examples of managements that are ahead of the curve include Pepsico, Molson Coors, Kroger, Dr. Pepper, Medtronic, MasterCard, UnitedHealth and WellPoint. Among our problem areas are companies we bought cheap in hopes that their readily apparent problems were fixable. But management didn’t live up to our expectations. A prime example is Britain-based Tesco, a global grocery chain purchased at a steep discount to its underlying real estate value. Tesco’s share price has continued to swoon because management has been slow to address surmountable problems.

Money manager Ron Baron (Trades, Portfolio) recently penned an excellent piece on the “built to last” business theme. He writes: “In 1958 the lifespan of a Fortune 500 company was 61 years. Now it is 15 years. Less than half of the Nifty Fifty [large, high-growth companies] of the 1960s and 1970s remain. It is often a failure of management’s vision to create consistent values and culture that causes businesses to fail.” These so-called Nifty Fifty exemplars were touted as companies that were so good there was just one decision—buy. There was a false belief that you could simply buy, hold and forget. In thirty years of dealing with client life savings, we are more convinced than ever that risk management and survival is a function of a diligent research effort based on fact finding, fundamentals, discipline and rational behavior. We see no shortcuts.

Rule of Law, Due Process, Immigration and Cheaper Energy

Everywhere I turn these days I’m amazed at the flood of foreign capital into the U.S. Corrupt centralized government leadership, controls on capital and confiscation of private property are driving investors from Russia, China and Venezuela (to name a few), to America. The attractions are our rule of law, due process, and integrity of markets. The influx of some 1.5 million immigrants a year means the U.S. will be one of the younger developed countries over the next decade. Manufacturing continues to relocate into many southern states with declining energy and transportation inputs. Investors currently worried about deflation stateside should venture to Venezuela, where rampant inflation lately was 60%, or experience Russia’s double digit inflation.

In closing, we welcome the increased volatility that should result as the Fed withdraws stimulus. Our approach to navigating the markets has been the same since the 1980s. We see investing as the “craft of the specific.” It’s a systematic approach where we can identify risk through detailed research and price discovery. Longer term this approach has been a winner. Through the third quarter of 2014, a $10,000 investment in the Fund since inception in 1999 is now worth $29,550 versus a corresponding $18,834 from the S&P 500 index.

We continue to work to earn and maintain your trust.

Sincerely,

Jeff Auxier (Trades, Portfolio)