As of the end of Q2, the Fund’s actual cash invested was only about 60% of the Fund’s assets, though our market exposure is roughly 75% due to our preference to express many of our ideas in the form of long-dated call options, which we believe is one way to take advantage of today’s low volatility and low interest rate environment. Such options allow us to benefit from rising prices of our securities while limiting our losses should the prices of our stocks suffer a material decline. This strategy also frees up cash to take advantage of future opportunities and would offer us a significant advantage in the next market correction, should one ever occur.
The Fund’s portfolio investments are a collection of contrarian ideas that we believe offer some combination of value and safety. Many of the Fund’s portfolio holdings are either neglected or disliked for various reasons, which explains why they are still cheap enough for us to own. Yet the portfolio as a whole appears to us to offer decent prospects for future returns in the event that the market’s perception changes to more fairly reflect our assessment of underlying business value. In some cases, we have no idea why our portfolio stocks haven’t yet moved up along with the broad market to prices closer to our estimates of fair value. In other cases, we own the securities because we can identify a specific reason why they are out of favor or neglected and we see a high probability for a positive re-pricing once the defined risk or negative perception has resolved itself.
While we don’t often mention our portfolio holdings in these letters out of respect for the cognitive bias that can ensue once a position has been discussed publicly, we would like to offer a brief sampling of some current positions and why we own them (though please note that our opinions and the Fund’s positions can change depending on price and as we evaluate new information or develop new insights).
We own positions in long-dated, in-the-money warrants of two large banks where we paid very little time premium and have exposure to future stock price increases going out in time between four and five years. These instruments give us a bit better than 10% market exposure with a capital outlay of less than 3.5% of the Fund’s assets. In a conservative base case scenario, we believe that a 40% cumulative increase in the underlying stock prices (which we consider to be reasonably valued today) over five years will result in a 2.5X-3.5X return on our investment over the remaining life of the warrants. We believe the warrant instruments offer a far superior proposition than owning the common shares outright.
We own roughly 5% positions in each of Berkshire Hathaway and Alleghany, both of which are companies that we feel are capable of growing per-share value at a decent clip in today’s challenging economy. At the same time, both feature management teams that understand and manage risk, and both have strong balance sheets capable of taking advantage of market weakness. While Berkshire Hathaway’s stock has not kept up with the S&P 500 for the past several years, it tends to perform relatively well in periods of distress, when its ample liquidity allows it to invest its vast resources when few others may be able to do so. We believe Berkshire stock trades at the low end of a conservatively calculated fair value range, despite its superior safety profile and exemplary pro-shareholder practices. Alleghany trades at a slight discount to book value, despite a long record of value creation for shareholders and its collection of excellent businesses. Both companies came out of the 2008-2009 bear market far stronger than when they entered it, and both are built to not only withstand but to exploit tough times.
We own a large position in EMC in the form of long-dated call options. When we compare EMC to other large-cap technology companies with which it competes, we see a vastly superior business and a talented management team that has managed to stay on the leading edge of new technology trends for many cycles. We’ve owned EMC on and off for many years, but our latest holding period dates back to 2011. During that time, EMC has grown revenue by 36%, operating income by 58% and free cash flow by 60%. Despite this, the stock has gone up by only 16% in the past three years. In the last year EMC has instituted a dividend and has been an aggressive buyer of its own stock. As far as valuation, the business trades for less than 10 times annual free cash flow.
We initiated a position in Target in the immediate aftermath of the well-publicized data breach in early 2014. Our position consists of in-the-money options, most of which extend out to 2016. We believe that Target remains a well-run company and that its recent difficulties will prove to be temporary. While it is certainly true that all brick-and-mortar retailers are facing competitive pressures, we believe at the end of the day there will still be a need for the one-stop shopping destinations such as Target and Wal-Mart. Target’s shares traded in the mid-$70s in the fall of 2013 prior to the weak holiday season and data breach issues; we bought at prices in the mid-$50 range which represented a low teens multiple of earnings at our purchase price.
The rest of the portfolio consists of stocks trading within the historical range of valuations for CVF portfolio investments. We are taking extra care to avoid low quality businesses that might appear cheap purely on the metrics, and we continue to avoid investing in businesses that are heavily leveraged, another historical practice of ours that has served us well over the years.
We have limited our shorting activity so far in 2014 despite a relatively long list of potential candidates. We’ve felt that shorting aggressively is not advisable in this frothy environment, particularly without a lot of offsetting long exposure. However, to the extent that valuations become further stretched, we are likely to begin to selectively place more chips on the short side of the table.