Dear Centaur Total Return Fund Investors:
The Fund produced a return of 16.73% for the twelve months ending October 31, 2017. Our primary benchmark, the Dow Jones U.S. Select Dividend Total Return Index, experienced a gain of 16.82% for the same period, while the S&P 500® Total Return Index returned 23.63%.
For the trailing 5-year period ending October 31, 2017, the Fund has produced an annualized return of 9.72% versus the primary benchmark’s return of 14.47% annualized over the same period. The S&P 500® Total Return Index has returned 15.18% annualized for the five years.
For the trailing 10-year period ending October 31, 2017, the Fund has produced an annualized return of 8.18% versus the primary benchmark’s return of 7.63% annualized over the same period. The S&P 500® Total Return Index has returned 7.51% annualized for the ten years. These comparisons, in addition to the inception-to-date comparative figures, are shown in the table below.
In previous letters we have provided a performance table for your consideration that shows calendar year performance rather than the more conventional mutual fund performance tables. Mutual fund performance is usually presented on a trailing basis (for example, 1 year, 3 years, 5 years, etc) as compared to a benchmark index , and this presentation for our Fund appears above. Below is a slightly different presentation of the Fund’s performance by calendar year with comparisons to the S&P 500® Total Return Index (under the column “S&P500”) and to our primary benchmark, the Dow Jones U.S. Select Dividend Total Return Index (under the column “DJ US DIV”). Please note that the figures for 2005 represent the performance from the Fund’s launch date in March through year-end; the 2017 figures represent the performance for the first ten calendar months of 2017 through October 31st.
Portfolio Update
As of October 31, 2017, the Centaur Total Return Fund was approximately 41% invested in equities (common and preferred), bonds, and closed-end funds spread across 29 holdings. The Fund also owned options on various securities that comprised approximately 1.6% of Fund net assets, partially offset by covered call liabilities that comprised less than 1.50% of the Fund’s net assets. Cash and money market funds represented approximately 59% of the Fund’s net assets. The top ten investments represented approximately 29% of Fund net assets.
Annual 2017 Fund Update
For the Fund’s fiscal year running from October 31, 2016, to October 31, 2017, the Fund generated a return of +16.73%, which roughly matched (underperforming by a miniscule 9 basis points) the results from the fully invested primary benchmark, which returned +16.82%. The Fund’s secondary benchmark, the fully invested S&P500 Total Return Index, returned a strong +23.63%.
While we would rather out-perform than under-perform, we are extremely pleased with the risk-adjusted performance of the Fund in the fiscal year just ended because these returns were produced with less than half the market exposure of the fully invested benchmarks. We estimate that the average cash position of the Fund during the year was somewhere north of 55% of total available capital. Adjusting for the look-through leverage of options employed by the Fund (both as expressions of long portfolio holdings and as market hedges) we estimate that the Fund’s average net market exposure during the year was likely somewhere around 45%. This low market exposure implies that the Fund’s return on capital employed during the year was quite high, likely above 40% on an annualized cash on cash basis (calculated from the 16.73% return on an average invested capital base of roughly 42% of the Fund that was not in cash) or slightly lower when compared to the estimated average market exposure of 45%. We believe this performance indicates strong stock selection in the year just ended.
So that is the glass half full. The glass half empty remains that the U.S. stock market continues to be very expensive and, in our view, continues to offer very unattractive long term prospective returns with above-average risk of capital impairment. This has limited our willingness and ability to deploy more of the Fund’s capital. Unfortunately, our patience and discipline has been largely unrewarded over the past year, as markets continued to glide higher while exhibiting record low volatility levels. With market prices pushing ever higher, we find ourselves slowly and carefully moving the acceptability lines at the margins of our buy and sell discipline in our efforts to keep capital productively deployed, and have been willing to pay a bit higher prices for certain securities than we would have considered paying several years ago. We are doing our best to be both thoughtful and prudent about how much we are willing to compromise, and have generally done so only for the highest quality businesses or those we feel we are best equipped to analyze. In order to be consistent with the Fund’s stated investment goals, we will make reasonable efforts to maintain the Fund’s market exposure at no less than 40% of the Fund’s net asset value.
The Missing Bull Market Ingredient: Euphoria
As of this writing in late 2017 median stock valuations in the United States are in the top 10% of valuation relative to history almost regardless of which metric one chooses to use for measurement, having reached heights that have only two prior instances: the late 1920’s and the late 1990’s, and investor experience in the decade following such instances have been uniformly dismal. The question one might reasonably ask is why nobody seems worried if stocks are clearly so expensive. And if nobody else seems worried, is there any reason for us to be so concerned?
There is an argument I’ve read in many different iterations over the past year or two that investors need not worry about market valuation levels until one sees clear signs of euphoria and speculation. The implication is that “you’ll know it when you see it” and that before a market can break, there always has to be a tell-tale “blow-off” top. Those of us who were investing in the late 1990’s easily remember the crazy speculative behavior and the popular manias surrounding internet, telecom, and biotech stocks.
It was also fairly commonplace at the time to read stories in the news featuring completely sane-looking people quitting respectable jobs so they could make more money day-trading tech stocks. More recently, many of us remember the media stories about the housing boom in 2005 and 2006 when speculators would show up on the opening day of a new housing development and buy five houses on credit in order to flip them later. We’re generally not seeing that kind of obviously speculative behavior being reported in the financial media with regards to stocks today. In fact, nobody seems particularly euphoric about stocks, which is a little strange given the strong returns of the past few years. Most professional managers I talk to certainly seem cautious or at least concerned about valuations (even those that remain fully invested). Stock market sentiment amongst the general public is hard for me to gauge, but from where I sit it seems that the best description of the mood would be something close to ambivalence. The really cool people aren’t talking about the stock market at all, because they are all too busy buying crypto-currencies and investing in early stage venture capital, or maybe selling put options on volatility ETFs.
Finally, there seems to be a notion gaining currency that bear market losses aren’t really all that bad. For some reason that I don’t completely understand, the financial media appears to have unofficially designated 20% as a standard definition of a bear market. To the extent that one doesn’t think about this too deeply, it would seem that the penalty for being “long and wrong” by holding a portfolio of over-valued stocks is not terribly onerous. After all, 20% doesn’t sound like much to lose in the “worst case.”
Bear Market Math
First of all, let me say that I personally am not convinced that the lack of any overt signs of euphoria or wild speculative participation on the part of retail investors means that stocks cannot suffer either a material correction or a bear market given the current valuation levels. I view this particular bull market as being somewhat different in character than prior bull markets, driven as it has been by central bank accommodation and low interest rates. I also think that many active investors feel that they have been held hostage by a lack of options, and simply have no choice but to participate in the stock market even if they have reservations about high prices and low prospective returns. While trying to call the timing of precisely when a bear market or significant correction might strike is not likely to be tremendously productive, I do think it is prudent and helpful to be a student of economic and stock market history and to be aware of the possible ramifications of investing when prices are at historical extremes on either side of the valuation spectrum. My view is that the current market offers enough of the standard warning flags to make it more prone than average to either a significant correction or, if the right conditions were to align, a bear market. But this certainly doesn’t mean it has to happen soon.
I emphatically disagree with the assertion that bear markets are easily ridden out, either financially or emotionally. First of all, a 20% decline in stock prices from current levels wouldn’t constitute a bear market in my mind. I would consider that to be a much-needed correction, depending on how long it took for the market to recover the loss. What I have seen firsthand is that since I’ve been investing, real bear markets tend to follow what I call the 40/50/80 rule. What this means is that when a bear market comes, the best and safest investments in the asset class typically decline in price by 40% on average. The median or average investment falls by 50%. Then there’s the most risky stuff, or the investments that are closest to the epicenter of whatever it was the drove the most speculative and risk-seeking behavior of the most recent bull market. That stuff usually loses 80% on average, with the flotsam going to zero.
I’ll give you three examples of what I would call bear markets since I’ve been managing money. The first was the bear market of 2000-2002. The S&P500 fell about 40% over about two and a half years. The average stock or median stock was probably down 50% in that time. As for the stocks nearest the epicenter of the speculative excess, this would have to be the technology stocks (especially internet, telecom, and biotech) and the NASDAQ index subsequently dropped 83% from its peak. In the bear market from October 2007 to March 2009, the S&P500 actually dropped almost 50%. The median stock was easily down 50% or more. Anything leveraged or directly related to real estate or the credit markets got hit the hardest, but anything small and illiquid suffered badly too. As a group, this latter category probably fell closer to 80% on average, and a lot of vulnerable or risky stuff went to zero. The third example I’ll give is the commodity bear market that began in late 2011 and lasted roughly to January 2016. Just to make the example easier, I’ll use the precious metals market as a proxy. The highest quality securities in the precious metals mining sector probably fell 40-50% and the median stock was easily down 50% or worse. A prominent gold mining ETF, the GDX, fell by roughly 80% from late 2011 to early 2016, and a lot of junior mining stocks have gone to zero over the past several years. Now that is what happens in a bear market!
Why Preparation Is Important
One of the reasons I’m writing this letter now is that I believe most investors systematically underestimate how they will be affected when a correction or a bear market comes. Stocks have been going mostly up for nine years now, and it feels like they will never – and maybe even can never – come back down. When thinking about it in the abstract (if they think about it at all) most people naturally believe that in times of stress that they will behave rationally, and that they won’t be among those who panic and sell at the worst possible time. The reality, of course, is that most investors aren’t so rational when the time comes, because when stocks are going down they feel like they might never go back up. And I can assure you that in a real correction or bear market, the percentage losses can be steep and harrowing, even if they don’t exactly follow the 40/50/80 rule that I have described above. We also want to remind you now that the Fund’s strategy is designed to be resilient and to handle stormy weather, and it has weathered corrections and even bear markets in the past and come out the other side reasonably well intact.
Also, I’d like to remind you that to some extent ours is a strategy that needs a certain amount of volatility and the occasional market correction in order to re-stock the portfolio with bargain securities in order to produce the returns we are seeking. The really great investing opportunities are almost always found in environments of fear and doubt, and it is critical to our strategy to have strong hands (and available cash) during such times. It’s for this reason that we won’t be lulled into complacency by the market’s recent strength or the current low volatility levels.
In summary, while we’d like to have more capital productively deployed than we do today, we believe the Fund’s current positioning is appropriate relative to the opportunities available. In the meantime, our search for value goes on, and if we see a great buying opportunity tomorrow we will act on it, regardless of what we think about stock prices generally. As always, we will do our best to ensure we are getting good value for money we have invested today, knowing that tomorrow might bring an entirely different and perhaps more attractive set of choices for us to consider.
Respectfully submitted,
Zeke Ashton (Trades, Portfolio)
Portfolio Manager, Centaur Total Return Fund
