Idiosyncratic Portfolios

Dear Fellow Partners & Friends,

I am pleased to write you after our first full year of operation. 2017 proved to be a surprisingly fruitful year for global equities. As the cliché goes, the markets like to “climb a wall of worry” and this past year was no exception. However, in our opinion this past year’s rally has run a bit ahead of the fundamentals. As these lofty valuations have been building up, we believe markets are showing some warning signs. For one, our analysis suggests that the US equity market is approximately 15% above its intrinsic value¹, as of December 31, 2017. Secondly, from my travels around the world this past year, I saw the global economy humming along, but prospectively it appears that the recently synchronized global expansion may be coming to an end. Overvaluation, extended price to earnings and potentially slowing earnings growth are not usually a recipe for success. Without knowing if recession risks are rising as a result, it at least suggests caution, with yellow flags turning amber as we welcome 2018.

Investing versus Speculation

At Centerstone Investors, we consider ourselves investors rather than speculators. We even embedded the concept into the name of our Firm. The difference between the two relates to time horizon and fundamental analysis. Investing is typically a long-term endeavor which incorporates thoughtful analysis of the merits of an investment. In the case of equities, this study may focus on a variety of fundamental factors. For Centerstone, the outcome of the analysis is an estimate of a business’ intrinsic value, while others may focus on growth prospects or other fundamental factors. One of the traits that most investors have in common, whether value or growth-oriented, is that we will decide to ignore situations where there is no apparent fundamental backing to a case—if it cannot be analyzed, we just move on.
Speculation is on the other end of the spectrum. As opposed to investing, speculating has no room for tangible fundamental analysis and usually depends on opinions rather than facts and forecasts rather than today’s reality. A real-time example of this is Bitcoin, which needs no introduction after posting massive returns in 2017. The last major speculative bubble was the technology bubble of the 1990s, which now looks like a minnow when compared to this whale. While a dollar invested in TheStreet.com Internet Sector Index (known as the “DOT” index which was a popular index comprised of the latest internet darlings) increased to over $7 in two years from 1998–2000, that same dollar would have grown to over $30 in Bitcoin over the last two years, as illustrated below.

^{The above chart is for illustrative purposes only and is not meant to represent the Centerstone Funds. Past performance does not guarantee future results.
Source: Bloomberg}
Until the tech craze, nothing rivaled that bubble’s extravagance back then. In the late 1990s, companies would merely announce the launch of a website or other “web-based initiatives” and their stock prices would surge. Even investors in companies that would soon be displaced by the digital age, such as the owner of the Chicago Tribune newspaper (Tribune Co.), rushed into the mania and their stock price nearly doubled in 1999.
Today, almost exactly 20 years later there are parallels to that era. Recently, the Long Island Iced Tea Corporation announced a name change to Long Blockchain Corp. and the stock surged 300% on the news. Biotech firm, Bioptix, changed its name to Riot Blockchain which pushed the stock up nearly 500%. Then of course, spotting easy money to be made in what looks suspiciously like a pump-and-dump scheme, SkyPeople Fruit Juice Inc. changed its name to Future Fintech Group, with the stock price rising 400%. Finally, possibly the worst offender due to its sizable market cap, woman’s apparel maker Crypto Inc, is up 15,000% from its May 2017 listing but trading has wisely been halted in this $12 billion company that has no revenues or even costs.

One of the traits that most investors have in common, whether value or growth-oriented, is that we will decide to ignore situations where there is no apparent fundamental backing to a case—if it cannot be analyzed, we just move on.

The technology bubble exhibited all the hallmarks of a speculation, such as those noted above, but also the classic bait that always plays out according to the Greater Fool Theory²— with no fundamental markers to ground anyone, buying simply begets buying. This mindless buying reinforces the bubble until the least sophisticated players become the majority of marginal buyers and sellers. It is at that point that speculations tend to self-correct, the same process in reverse. Speculative bubbles usually deflate rapidly and sometimes over-correct. In this case, the cost of “mining” Bitcoin is around $3,000, so in theory, the price could correct about 80%. It is a speculative “currency” and I never thought I would side with the world’s Central Banks, but I will take fiat currency over Bitcoin.

Potential Benefits of Size

There are many potential benefits of starting Centerstone Investors from scratch. One relates to size and the flexibility of being market capitalization agnostic. This goes hand-in-hand with our intent to limit capacity in order to uphold the integrity of our portfolios. When investing overseas, it is particularly important to manage a smaller pool of assets. Most companies outside of the US would be considered small cap or mid cap securities falling out of range for large funds. As the universe shrinks for larger funds due to size, their opportunity set dwindles along with it. The Centerstone Investors Fund (CENTX) and the Centerstone International Fund (CINTX) both invest abroad, which is why this flexibility is crucial for us. In 2017, both Funds had two takeouts³ at premiums to our cost and two potential asset conversions, all of which were in companies with less than $3.5 billion in free float⁴, which helped drive our international equity returns.
In the US there are many excellent high quality, large-cap companies. The choices are narrower overseas and you may have to make compromises regarding corporate governance, business quality, management quality or balance sheet strength. In contrast, there are many small and mid-sized international companies which exhibit the traits of high quality large US companies, but they may operate in tiny countries or niche markets. The perception of “riskiness” of small companies outside the US, due to what academia has taught us about small caps in the US, can sometimes be a distraction.

In 2017, both Funds had two takeouts at premiums to our cost and two potential asset conversions, all of which were in companies with less than $3.5 billion in free float, which helped drive our international equity returns.

For instance, ICA Gruppen⁵ has nearly 40% market share in the Swedish grocery market and is approximately twice the size of its next largest competitor. With a free float of $3.5 billion, it has a more substantial market share of Swedish grocery retailing than Walmart has of the US. Havas, which was taken out at a premium to our cost, was a best-in-class France-based operator in the advertising agency business and only had a free float of $2 billion when we purchased it.
Netherlands-based Vopak⁶ is one of the largest fuel terminal storage companies in the world, with a free float of $3 billion. Vopak’s earnings are currently depressed due to several reasons, including a backwardated fuel oil market, which reduces demand for storage. With weak sentiment, the shares now trade at a steep discount to multiples paid for comparable storage terminal assets. Topdanmark⁷ has a strong competitive position in the highly concentrated Danish insurance market and has a free float of $2 billion. They have significant excess capital which they plan to return to shareholders in the near future. They are also a potential takeout candidate with the top shareholder having recently increased their stake to just under 50%. A positive side effect of our flexibility and larger universe is potentially benefitting from takeouts and asset conversions.

2017 Performance Review

2017 was a historic year as noted at the top of the letter. For the first time in its history, the S&P 500 posted positive returns every single month of the year. Within that environment both Centerstone Funds posted equity-like returns and did so with muted downside as compared with their respective equity benchmarks, meeting my fundamental goals for both Funds.
The Funds’ equity-only performance for both Funds amounted to 23.2% for the Centerstone Investors Fund and 30.3% for the Centerstone International Fund8. The equity sleeve in the Investors Fund was held back by our US equities, however, I believe that the reason is less about growth versus value or other factors and more about our focus on US-domiciled companies with poor sentiment. Although our research indicates that the factors which have driven sentiment to current lows may prove temporary, most others take the opposite view and therefore the stock prices of such companies have remained weak. This relative underperformance is an entirely reasonable outcome of an absolute value approach. We accept short-term uncertainties for the potential long-term reward and although the US equity sleeve has been a drag so far, returning approximately 4.4% in 2017, I do believe that it may prove worthwhile, as it has in the past.

Only time will tell, but up to this point Bitcoin has all the traditional markers of a speculative instrument and for my investors, I will stick to what I know: investing.

On the other hand, the international equity sleeve delivered exceptional returns this past year. The above-mentioned takeovers and asset conversions helped elevate our non-US performance in addition to the boost provided by many of our smaller companies. Our foreign currency exposure also had a significantly positive impact on performance as most international currencies strengthened against the US dollar.
With the Bitcoin mania as a backdrop, we continue to stick to our knitting and let the idiosyncratic aspects of our stock picking dictate our performance. As Benjamin Graham counseled, “Investing isn’t about beating others at their game. It’s about controlling yourself at your own game.” Only time will tell, but up to this point Bitcoin has all the traditional markers of a speculative instrument and for my investors, I will stick to what I know: investing.
Thank you for your continued trust and support. We wish you a happy and healthy New Year.
Sincerely,

Abhay Deshpande, CFA

Chief Investment Officer

For current Fund performance information, please visit:

https://centerstoneinv.com/strategies/centerstone-investors-fund/#performance

https://centerstoneinv.com/strategies/centerstone-international-fund/#performance