Ken Heebner's CGM Mutual Fund 2014 Annual Letter

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Feb 26, 2015

CGM Mutual Fund increased 5.6% during the fourth quarter of 2014 compared to the Standard and Poor’s 500 Index which grew 4.9% and the Bank of America Merrill Lynch U.S. Corporate, Government and Mortgage Bond Index which returned 1.9% over the same period. For the twelve months ended December 31, 2014, CGM Mutual Fund increased 5.3%, the S&P 500 Index returned 13.7% and the Bank of America Merrill Lynch U.S. Corporate, Government and Mortgage Bond Index rose 6.4%.

The Year in Review and Economic Outlook

After a strong finish to 2013, the economy entered the new year tentatively with some weakening of vital measures. Notable among them was the Institute of Supply Management’s (ISM) manufacturing index which fell 5.2 points in January 2014 to 51.3, the largest one month decline in the index since May 2011. New orders for durable goods also declined in January and a two month spate of severe weather over much of the country contributed to a 2.9% decline in Gross Domestic Product (GDP) in the first quarter of the year. Fortunately the meteorological situation improved by March nudging the economic recovery back on track and boosting the Conference Board’s consumer confidence index from 78.3 in February to 82.3 in March.

Economic news continued to improve in the second quarter of the year with employment numbers jumping from 192,000 new hires in March to 288,000 in April and 217,000 in May. Recessionary fears that surfaced at the beginning of the year were laid to rest and in May, existing home sales rose by 4.9% while sales of new homes jumped 18.6%. Auto sales roared ahead in May at an annual rate of 16.7 million, the highest since February of 2007. In spite of geopolitical uncertainty in the Middle East and conflict in the Ukraine which drove the price of West Texas Crude Oil up over $107 a barrel, the S&P 500 Index celebrated the strengthening economy and climbed 5.2% from April 1 through June 30, 2014. The business climate continued to improve in the third quarter of the year, particularly on the employment front and in the housing market. Housing starts rose 15.7% in July and single family home sales rose 8.3% from June. Economic recovery continued to outweigh adverse political events in Russia, the Ukraine, Syria, Iraq and Israel and the stock market, as measured by the S&P 500 Index, posted a gain of 3.8% in August, the largest monthly gain since 2000. Third quarter real GDP (released later in the year) was a whopping 5% which more than offset the weak first quarter of the year.

Auto sales and employment numbers continued to climb in the fourth quarter and in November, U.S. manufacturing output rose 1.1% to a new all-time high, handily surpassing its pre-recession peak reached in December 2007. The major story leading into the end of the year, however, was the dramatic drop in the price of oil. On June 20, oil was $107.52 per barrel. By year-end, the price was more than halved to $53.46. There seem to be a number of factors responsible for this decline, though we believe the economic slowdown in China as well as in Europe combined with increased domestic supply are large contributors. The net effect of lower gasoline and heating oil prices is extra cash to spend in American consumer pockets. Oil companies and allied businesses are expected, of necessity, to reduce capital spending, but we believe the consumer benefit will outweigh the business cutbacks.

The uncertainty surrounding the price of oil and the effects of its precipitous decline may encourage investors, particularly foreign investors, to purchase U.S. Treasury bonds in a “flight to safety” which tends to drive bond yields down. The yield on the ten-year Treasury bond was 3.03% at the beginning of 2014, declined to 2.53% in June, dropped to 2.07% earlier in December and closed the year at 2.17%. The Federal Reserve Board met in mid-December and acknowledged the improving economy over the past year, but promised patience in raising interest rates—a message that sparked a rally in the equity market to end the year.

Portfolio Strategy

The CGM Mutual Fund portfolio was positioned for a robust and growing domestic economy and rising U.S. interest rates in 2014. While the U.S. economy strengthened during the year, it was at a slower pace than we projected. Additionally, concerns about Russia’s finances, the fragile European economy, a possible slowdown in China and, as mentioned earlier, markedly lower oil prices, generated unexpected demand for U.S. Treasuries which, in turn, propelled long term U.S. interest rates lower.

Homebuilding stocks (housing and building materials), the largest concentration in the portfolio, performed well in response to strong corporate earnings growth, but appreciated less than market averages, reflecting a slower-thannormal cyclical recovery in the home construction industry.

The Fund realized significant gains in retailing, semiconductor, airline and biotechnology companies and a large loss in the direct marketing industry.

The fixed income section of the CGM Mutual Fund portfolio fluctuated between 25% and 29% of total Fund assets during the year. Throughout 2014, it was invested exclusively in short-term Treasury notes in anticipation of rising interest rates that did not materialize.

On December 31, 2014, CGM Mutual Fund was 27.1% invested in U.S. Treasury securities. The three largest industry positions in the equity portion of the portfolio were in housing and building materials, money center banks, and vehicle assembly companies. The Fund’s three largest equity holdings were D.R. Horton, Inc. (DHI, Financial) (housing and building materials), Lennar Corporation (LEN, Financial) (housing and building materials) and Morgan Stanley (money center bank).

Robert L. Kemp

President

G. Kenneth Heebner

Portfolio Manager

January 2, 2015