During the first quarter of 2014, we slightly underperformed the indices in a very up and down quarter. Still, we are pleased to report strong returns over the last year and five years. Specific information regarding your account is on your performance report that is enclosed. The following is a summary of returns for selected major indexes for the first quarter, last twelve months and last five years:
Thus far in April, the U.S. equity markets are down a few percent for the month, continuing the correction that began in March. This appears to be a correction typical of the type normally seen in the course of bull markets. It is difficult, if not impossible, to predict when bull market corrections will occur, let alone their severity and duration. In addition to the broader correction, a rotation from Growth to Value/Cyclical stocks is also taking place in anticipation of an expected acceleration in economic growth in the second quarter as well as investors finally reacting to the stretched valuations for certain companies. Broadly speaking, some investors have been selling their winners and buying the stock market laggards. The biotechnology sector and certain tech/social media names have been hit particularly hard in addition to corrections to the broader category of big winners over the last few years. Selling to raise cash to pay tax bills may have also contributed to the selloff.
Periodic readjustments in stock prices are not all bad. They can put value back into the market. They help to separate the real winning companies from those stocks that were moving higher in price unrelated to their fundamentals. We are very confident the economy is not heading into a recession. The Federal Reserve is not raising interest rates, financial conditions remain very accommodative to growth, and ISI Group’s company surveys are at 7 and ½ year highs. The earnings season that just began should help to bring some clarity as to which stocks will lead for the rest of the year. We are particularly pleased with the results in 2013 for the companies that we own in your account, and are optimistic about their 2014 outlooks. For example although these companies have all recently seen their stock prices correct, it wasn’t due to a deterioration in their expected results:
Bank of the Internet (BOFI) – BOFI continues to be the fund’s largest holding at over 20% of net assets. This is not due to recent purchases. In fact, over half of the Tower’s position has been sold in the last two years. At cost, the holdings are less than 3% of the net assets. In the last five years, earnings have increased by more than 740%. Recently, asset and income growth rates have accelerated and the agreement with H&R Block announced last week will add close to $1.00 per share in earnings in 2015 and increase return on tangible book value above 20%. BOFI has been able to do this because it can spend money on things that generate returns, whereas traditional banks are wasting money on branches. BOFI will continue to have a huge cost advantage until their competition restructures and sheds the majority of branches as well as reduces other nonproductive costs. Even then, BOFI has great management and will be a strong competitor.
Portfolio Recovery (PRAA) and Encore Capital Group (ECPG) – These two companies are the premier consumer debt collection companies in the world. They buy deeply discounted debt (primarily credit card). The vast majority of borrowers will never pay these debts because they can’t afford to. Both companies sort through massive amounts of data every day to determine who can pay as opposed to who can’t. Every day they update this analysis with new information and reprioritize who can pay versus who can’t. Those determined to be capable of paying are then contacted regarding repayment of the debt. The Consumer Financial Protection Bureau (CFPB) is using the practices of these two companies to set the standards for the industry. Most debt collection companies can’t meet their high standards and are closing, thus reducing competition to buy the debt portfolios from the original lenders. In addition, the improving economy and the higher standards for extending credit are increasing the number of people that can pay back these loans, further improving returns. Lastly, both companies have recently made significant overseas acquisitions of debt collectors. We expect that these acquisitions will help to provide years of very profitable growth. PRAA has grown earnings at 22.8% per year for the last ten years and has a trailing PE ratio of 16.76. ECPG has grown earnings at a 17.2% annual growth rate and has a trailing PE ratio of 15.45.
LKQ Corp (LKQ) – LKQ is the world’s largest independent provider of recycled, remanufactured and non OEM new parts to automotive repair shops (primarily collision and mechanical) in the United States, Canada and parts of Europe. LKQ’s size and number of distribution locations gives them a significant advantage in availability and speed of delivery versus other independent distributors and a significant pricing advantage versus the OEM’s. Even though they are 40 times the size of their next largest competitor, they still have great opportunities to grow both in the US and the rest of the world. LKQ is a 25% per year earnings grower and has a less than 20 forward PE ratio.
Ubiquiti Networks (UBNT) – Ubiquiti sells a portfolio of high quality wireless networking products to small telecom service providers and other enterprises that are building and operating wireless internet networks in locations that do not have wired service. Their customers number in the tens of thousands (if not more) and are located all over the world. UBNT has a unique business model ideally suited for this market. It keeps prices low by relying on its user community to provide technical assistance and evangelizing to generate more networks and users. Thus, the company keeps prices very low, quality high and is still very profitable. This is the fastest growing infrastructure sector with growth driven by thousands of entrepreneurs. We expect annual growth of 25% or more for a number of years. It has a forward PE of less than 20.
The companies just discussed are some of the largest investments in your account. We also own names like Google, AutoNation, Cerner, Pharmacyclics and others. It is a mix of small, medium and large market capitalization companies that are leaders in their markets where the growth potential is significantly better than overall economic growth. In general we hold them for long periods, thus we can be very tax efficient in taxable accounts.
Protecting Your Account In A Downturn In The Market – We often get asked about this, usually during market corrections. US equity markets have a long bias and positive returns most years (S&P 500 has returned average annual returns of 9.7% per year since 1900). Consequently, it is very difficult to try to time the market unless you can reliably predict changes in market direction accurately. Unfortunately, corrections like the current one are difficult to predict. Every year, the market has a number of small corrections (3-5%) that are often over before we know that it is more than a one or two day event. Sometimes, they turn into 10 or even 15 percent corrections. Again, these are difficult to predict. Thus it is easy to sell stocks at the wrong time. Consequently, we do not try to time the market during corrections like the one we just experienced, because the cost is greater than the reward.
On the other hand, recessionary downturns in the stock market are more predictable. There are certain economic conditions where the likelihood of a recession is much higher. In the future, we are committed to try to do a better job of reducing exposure in your account during future recessions. It is likely that we will sometimes predict recessions that do not occur, but probably not that often. Usually, even when that occurs the stock market does not do well until it becomes clearer that a recession is not likely. This gives us time to increase our invested position in your account prior to a big rebound in the market. In situations where a recession does occur, the stock market usually suffers a significant correction and reducing investments in your account should prove to help minimize the impact of the downturn. We will inform you if these economic conditions exist and we are taking actions to reduce positions in your account.
We look forward to updating you as the year progresses.
Edward P. Hemmelgarn