elgethuncapitalmanagement.com Page 1 To: Elgethun Capital

122 S. Phillips Ave Suite 201, Sioux Falls, SD 57104
To:
Elgethun Capital Clients & Partners
From:
John A. Barker & Adam D. Schwab
Date:
30 June 2014
Re:
2014 Semiannual Letter
Tel: (605) 367-3336 / 1-888-828-3339 | Fax: (605) 367-1118
We hope you are enjoying the summer. This memo will cover our first half performance in 2014, market/economic
commentary, and a discussion topic we feel is appropriate to prudent investment. Our discussion topic in this letter is:
Investment Traps to Avoid.
Also, starting this quarter and going forward, we will be issuing a quarterly research report on one of our investment
holdings. The report will be a condensed version of our thesis and valuation for the business. I have enclosed/attached
this report, but future quarterly research memos will be sent separately. If you wish to be added to the distribution list
please email us. The note this quarter covers one of our new investments: Madison Square Garden (NYSE:MSG).
1st Half 2014 Performance:
Equity Performance: Our individual stocks returned +7.7%, net of fees, thru June 30, 2014. Our performance was driven
broadly by many of our portfolio companies, including: Walgreen (WAG) +29%, Corning (GLW) +23%, Intel (INTC) +20%,
Fairfax Financial (FRFHF) +19%, Apple (AAPL) +16%, and Jakks Pacific (JAKKS), Chesapeake Energy (CHK), & Potash Corp
(POT) all up +15%. Our worst performing stock was Weight Watchers (WTW) -33%. New positions purchased during
the first half of the year included: Madison Square Garden (MSG, cost $55/current price $63), Weight Watchers
International ($30/$20), Unilever (UN, $40/$44), Crimson Wine Group (CWGL, $8.69/$9.45), and National Presto
Industries (NPK, $74/$73). We made significant additional purchases in a few businesses, moving from small holdings
to core holdings, including: Fairfax Financial Holdings (FRFHF), Nestle (NSRGY), BP (BP), Coca Cola Company (KO), and
Intel (INTC). We partially exited/sold smaller positions in Jakks Pacific (JAKK), Joseph A. Bank (JOSB was purchased by
The Men’s Wearhouse), AstraZeneca (AZN), and John Wiley & Sons (JW/A).
Equity Mutual Fund Performance: Our equity mutual funds returned +5.8%, net of fees, thru June 30, 2014. The funds
performed as follows: Weitz (+4.3%), Yacktman (+4.8%), Tweedy, Browne (+4.7%), Goodhaven (+6.2%), Third Avenue
(+8.2%), and Wintergreen (+7.5%). All the funds performed well, with the international funds outperforming the
domestic funds.
Fixed Income Performance: Our fixed income returned +5.3%, net of fees, thru June 30, 2014. Prices, which are inversely
related to interest rates, rose as the yield on the 10-year Treasury fell from 3.03% as of 12/31/2013 to 2.52% as of
6/30/2014. We continue to search for attractive municipal bonds in the secondary market. Nearly all of the
municipalities that we invest in are located in SD, IA, MN, NE, CO, or ND. We are not as concerned with price fluctuation
and aim to find bonds with attractive absolute yields/returns. We’re not interested in buying bonds that are only
attractive when compared to manipulated Treasury yields. We will purchase non-rated bonds from issuers that we
know, understand, and have comfort regarding financials or look for opportunities when we can buy from a forced seller.
Many of the recent bond purchases have been “kicker” bonds. An example would be a bond trading above par that’s
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callable in 5 years with a final maturity in 15 years. Our goal is to find attractive yields to the call and maturity, at least
100 basis points (1%) above comparable Treasurys (which are taxable).
Benchmark / Index Returns Compared to Elgethun Capital Composite Returns: Although our focus is on performing well
from an absolute standpoint, we list benchmark returns for passively-managed indices to add context.
Asset Class
Elgethun Capital Stocks
Elgethun Capital Mutual Funds
S&P 500
Dow Jones Industrial Average
MSCI EAFE (Europe, Australia, Far East) Stock Index
Elgethun Capital Bonds/Fixed Income
Elgethun Capital Bond Mutual Funds
Barclays U.S. Aggregate Bond Index
Other Asset Classes:
Dow Jones – UBS Commodity Index
Gold
YTD Return thru 6-30-2014 (all returns net of fees)
+7.7%
+5.8%
+7.1%
+2.7%
+4.8%
+5.1%
+5.5%
+3.9%
+7.1%
+10.0%
Note: All returns listed above include dividends and interest. Our stock and fixed income performances include all accounts that we possess
discretion to make buy/sell decisions. Some accounts contain different holdings given objectives/constraints resulting in some individual investors
experiencing returns above/below those quoted above.
This was the first year since 1993 that gold, US stocks, World stocks, commodities, and bonds all advanced in the first
six months of the year (source: Wall Street Journal). Trading volumes and volatility were lower than average. The Fed
continued to reduce monthly purchases of Mortgage-backed and Treasury securities by $10 billion – current monthly
purchases are $35 billion/month, down from $85 billion/month last year. The Fed continued its stance on keeping the
Fed target rate low thru 2015. Given the reduction in monthly purchases and no change on the Fed target rate window,
most investors expected yields on Treasury securities to advance. Instead, yields plummeted from 3.03% at the end of
last year to 2.52% as of June 30, 2014.
We, like most investors, expect to see higher rates at some point in the future but rates could remain low for years.
Japan has been in a low rate environment for 20 years. Since interest rates are used to discount future cash flows, lower
rates increase valuations for cash flow-producing entities. This effect, combined with investors’ search for yield, has
generated gains in businesses (public and private), real estate (commercial and residential), and farmland. The result
has clearly generated wealth for people that own these assets. People that don’t own these assets have missed the
low-rate boat. As investment and retirement accounts rise, people feel more confident and spend more money and
given that 70% of our economy is based on consumer spending, how consumers “feel” is quite important. People
underestimate the psychological impact peoples’ feelings have on our economy. One aspect of low rates that somehow
goes unnoticed is just how much the U.S. Government is benefitting. Over the last 20 years the average interest rate
paid by the U.S. Government, according to the CBO, was 5.7%. Today, that rate stands at 2.4% or 58% lower. I’m not
calling out a conspiracy theory, just stating there could be multiple pressures to keep rates low longer into the future
(some quite necessary). Using the 5.7% rate, our current annual interest cost would be nearly $1,000,000,000,000 –
that’s 1 trillion dollars or nearly ½ of the government’s revenue from 2012.
With that said, we are cautious in the current environment. Prices have risen and we are selling stocks that no longer
meet our price/value conditions and replacing them with more attractive businesses with better risk/return
characteristics. The cornerstone of our strategy is risk mitigation and preservation of capital, which is always relevant
but we believe it’s most relevant when prices across the board are generally high. We feel confident in the businesses
and bonds we own (and those owned by the fund managers we employ). As we have discussed, not all businesses are
created equally. Some have superior economics, participate in more attractive markets, and have more rational
ownership/management. Our goal is to find these businesses and buy them when pricing is attractive – and that is what
we will continue to do.
Now to our investment discussion…..
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Investment Traps to Avoid:
We often get this question from prospective investors: “can I make money in the stock market (or other public markets)
– isn’t the gamed rigged by Wall Street and other middleman players?” Our response: “it depends.” The question is
understandable, in fact, most investors underperform broad, passively-managed benchmarks by a sizeable margin and
make substantially less than they care to realize. Research conducted by Dalbar, Inc. shows that for the 20 years ending
2010, mutual fund investors underperformed the S&P 500 by a compounded 363%! That’s not a typo. A million dollar
investment in 1990 would have come up $3,630,000 short of the index (source: Dalbar, Inc.). We explored this topic in
our 2012 semiannual letter and as you may recall, it was the consequence of many factors, most self-inflicted. But what
about the other causes of underperformance? Not all markets, asset classes, and investment vehicles are created
equally. In our opinion some should be completely avoided. In investing, just like life, you have to know where you
have an advantage and where you don’t – and stay away from the areas you don’t! Charlie Munger, Warren Buffett’s
long-time 90-year old partner quips, “just tell me where I’m going to die so I can make sure I never go there.” There are
many areas in the capital markets that are crowded with smart, motivated, testosterone-filled players and we don’t
have to compete with everyone. In the next few pages we will explore areas to avoid. We believe understanding the
playing field, your competition, and the requisite tools before you play the game is paramount to successful investing.
Areas to avoid (an incomplete list):
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Initial Public Offerings (IPOs) – not all IPOs are bad, but in general, insiders/founders are selling for a reason. If it
wasn’t a good time to sell, they wouldn’t sell. Wall Street bankers get paid based on size and execution of the deal,
including pricing, so they are motivated to push the price up and make the deal look attractive.
Story Investments – investments in businesses/industries that are going to change the world (think .com bubble).
They aren’t valued based on fundamentals (cash flows or assets) because the future is so bright it can’t possibly be
factored into a valuation. The internet did change the world but profiting from the change proved difficult for most
investors. Remember Buffett’s quote – “The secret to successful investing in not locked up in the knowledge of how
much an industry is going to alter the way people live their lives, or even in how much it’s going to grow, but rather
in determining the competitive advantage of any one company and, above all, the durability of the advantage.
Products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors!”
This was in our last letter but it’s so important we will keep repeating it!
Johnny-on-the-Spot Investments – investment strategies or products that would have worked well in preceding
periods had they been implemented, but they weren’t. Strategists look backwards, figure out what strategies would
have worked best in the past, then package them and market them to investors eager for gain. The only problem –
the past doesn’t exactly repeat itself – variables change, markets react and adapt and timely, market beating
strategies of yesteryear often prove subsequently inept.
Complicated Wall Street Products – we’ve all been marketed an attractive investment based on a new product or
strategy. Maybe it comes with a “guarantee,” holds tremendous potential, or it’s relevant because “it’s different
this time.” Our motto is, if you can’t explain the overall strategy and fee arrangement to a 12-year old, it should be
avoided. This doesn’t mean a 12-year old can execute the strategy, it just means the logic behind it should be
rational (think open-heart surgery – not an easy operation but the objective is clear).
Investment Tips (from the media, a friend, or other outlet) – people don’t give away valuable information just like
Coca-Cola doesn’t post the secret syrup recipe on Facebook. Good ideas are hard to find – if the guy shouting on
CNBC had good ideas, trust me, he’d be implementing them with real dollars, instead he’s screaming in your TV.
The Relative Comparison – an investment that isn’t attractive on its own but when compared to another, less
attractive investment it is tolerable. An example would be a 5-year bank CD at .75% when the bank across the street
is offering a CD rate of .50%. It’s still .75%, which after inflation guarantees you a negative return. Guaranteed
negative returns are not attractive, trust me. All investments need to be able to stand alone, and offer some
compelling justification for their existence.
The Middle-man Investment – this investment may hold promise but after paying many different players, the
investor is left holding the bag (usually much lighter than before). Investors need to understand who is being paid,
why, and how much. An S&P 500 index fund shouldn’t cost you 1.50%. More importantly, if your manager is getting
paid based on investment selection, not performance, you should find a new manager.
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This list is incomplete, but it’s a good start. Each of the above is roughly right, meaning there are plenty of examples of
successful IPOs, story stocks, Johnny-on-the-spot investments, products, tips, relative comparisons, and middle-man
investments. If this weren’t the case, sooner or later, people would figure it out and avoid the subject areas completely.
It’s the occasional home-run that keeps these lousy channels of the market alive – like the lottery, if someone didn’t win
it wouldn’t be open. I have one guarantee based on this advice – you’ll miss some very exciting opportunities by avoiding
the bulleted areas above. You won’t have the home-run conversation at the cocktail party, but over the long-haul, you’ll
win. You’ll win by not losing. Each of the above will have the occasional home-run, but they’ll also have the more than
occasional “go to zero”. In the end, the “go to zeroes” trump the home-runs and that is what investors should focus on.
Investors should find entertainment in other areas of their life outside of investing.
So, you might ask, where should investors place capital? How can they avoid the traps set by Wall Street, motivated
brokers, or friendly tips? First, they should have realistic expectations for investment returns and contemplate a strategy
that can meet their goals. This means saving earlier (and often). It means delayed gratification, something very difficult
to ascertain. Investment, by definition, is putting money away today in hopes of having more in the future. In order for
this equation to work, you better make sure your investment will be around in the future. Wealth is created and
amplified by a few important factors: compound interest, time, and tax deferral/minimization. If you’re strategy doesn’t
include these variables it’s time to re-evaluate.
We believe the following categories of investments can present attractive opportunities (an incomplete list):
1. Core/Moat Businesses – businesses with high insider ownership, market leadership, barriers to entry, high profit
margins, and solid free cash flow generation. Finding these businesses on sale is difficult but it does happen.
2. Fallen Angels – businesses out of favor with current investors in areas that are less crowded, where pessimism
is high, and the short-term outlook is depressing. These factors can lead to a price that is detached from reality.
No one likes pain, even short-term pain so most investors run from issues, turnarounds, and reorganizations,
leading to less demand for these businesses, thus lower prices.
3. Asset Plays – investments selling below net asset value (or adjusted book value) that have tremendous upside
if management is willing to spin-off businesses, right-size operations, and/or cut costs.
4. Cigar Butts – assets offered in a fire sale with free upside, although the asset itself might not be attractive, the
price more than makes up for it. To paraphrase Buffett, it’s like finding a used cigar on the street corner – it’s
not pretty but it’s free.
5. Other – this would include all other types of investments, including opportunities to buy attractive share classes
not available to large investors (family shares, as we have done with Grief, Inc. “B” shares); invest in businesses
abandoned and forgotten by Wall Street (we call these private stocks – businesses that should be private but
trade on an exchange); spin-offs; small obscure holdings; and others.
Ultimately, a successful investment strategy requires you to: know what you own; know why you own it; and know what
it is worth. This will allow you to make the right decision in the most difficult times, when prices are low and everyone
is panicking.
Each of our equity holdings fits in one of the categories above. The list above outlines areas we believe we have an
advantage. Below is our process to uncover these opportunities:
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Idea Generation/Search – we have many areas that we search for investments on a daily basis. Search areas
including reading trade journals, company annual reports, publications, insider buying lists, spin-offs,
newspapers, and investment screens, among others.
Tracking Ideas – ideas that meet our criteria but the price offered isn’t attractive so we track the idea until a
better price is offered.
Research/Checklist – after we find an appealing opportunity with a compelling price, we follow a research
checklist. The checklist is a repository of important questions, thoughts, or analysis that we think are germane
to investing. We diagnose competitive threats and barriers to entry, profitability, economic/business cycle,
management competence, and the ability of the businesses to replicate success. We speak to management,
suppliers, and competitors. We spend an inordinate amount of time thinking about barriers to entry. There are
many good ideas that are highly profitable but if no barriers to entry exist, profitability will be competed away.
Think about retailers and restaurants. These spaces innovate with new themes, appealing offerings/cuisines,
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and convenient locations. Why do the aggregate businesses in these spaces lose money? Because nearly
everyone can open a retail shop or restaurant and new competition can see profitable stores/restaurants and
themes and replicate them, driving profits down until the owner is struggling to earn his cost of capital.
Value – after we value different businesses and investments through our research process, we wait until
attractive pricing is available before making an investment. This is important – you must require a margin of
safety to account for error or unexpected events. After the hard work of research and valuation is complete,
sometimes the more difficult task is patiently waiting for the price to fall – this is where the money is made.
Portfolio Management – after we decide to invest in a business, decisions around how much to invest and at
what intervals need to be determined. Contingent on different investments, we may decide to buy something
at a 2%, 3%, or 5% position in our portfolios. We also want to leave room to add more in the event the price
falls further from where we buy (which generally occurs).
Evaluation & Review – When existing holdings no longer meet our holding criteria we sell. Reasons for selling
include: price appreciation above our fair value estimate, better opportunities outside the portfolio,
fundamental changes to the business, or business evaluation error on our part.
We try to implement the above strategy flawlessly. Unfortunately, we make mistakes. We believe mistakes (our own
and those made by other managers before us) are valuable learning opportunities and we strive to mitigate these
mistakes through our research checklist. The above hunting ground list and investment process isn’t right for everyone
and there are many ways to skin a cat, but we believe it offers our investors the best opportunity to mitigate risk. After
all, our process is predicated on avoiding the many pitfalls in investing.
In closing, we want to thank you for your business. We greatly appreciate the responsibility of managing your capital.
We had a solid first half in 2014 and have positioned the portfolios defensively. Our focus on risk before return will
continue to permeate through your portfolios.
Sincerely,
/s/ John A. Barker, CFA
/s/ Adam D. Schwab, CFA, CPA
About Elgethun Capital Management, Inc.
Elgethun Capital Management is a Registered Investment Advisory (RIA) firm established in 2003. We are registered
with the Securities & Exchange Commission (SEC) and are subject to their audit reviews. As of June 30, 2014, we had
approximately $205 million dollars under management/advisement, composed of individual, retirement, and
institutional accounts. Our investments include: individual stocks, bonds, and stock and bond mutual funds. Our
Compliance Consultant is Lexington Compliance.
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This Memorandum shall not constitute an offer to sell or a solicitation of an offer to buy, nor any offer, solicitation or
sale of the interests in any jurisdiction in which such offer, solicitation or sale is not authorized or to any person to whom
it is unlawful to make any such offer, solicitation or sale. Prospective investors should not construe the contents of this
memorandum as legal, tax, or financial advice, each prospective investor should consult such prospective investor’s own
professional advisers as to the legal, tax, financial, or other considerations relevant to determining the suitability of this
investment for such prospective investor.
No person has been authorized to make any representations concerning Elgethun Capital or their interests other than
those contained in this memorandum. Prospective investors must review the memorandum solely on the basis of the
information set forth herein. Performance quoted represents past performance. Past performance is not a guarantee
or a reliable indicator of future results. Current performance may be lower or higher than performance shown.
Investment return and principal value will fluctuate, so that account value may be more or less than their original cost
when redeemed.
Performance for the Elgethun Capital individual stock/stock mutual funds composite is unaudited and a representation
of our performance measurement process which we believe is accurate to our knowledge. However, we do not guarantee
to be absolute without a certification from an audit/CPA confirmation. It should not be assumed that recommendations
made in the future will be profitable or will equal the performance of the securities in this list.
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