Zeke Ashton Annual Commentary Plus Two Specific Investment Ideas

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Feb 11, 2011
Tilson Dividend Fund

[This section is written by Zeke Ashton, manager of the Tilson Dividend Fund.]

The Tilson Dividend Fund produced a gain of 24.21% during the fiscal year ending October 31, 2010. Our benchmark, the Dow Jones U.S. Select Dividend Total Return Index, experienced a gain of 23.32% over the same period.

For the cumulative period since the Fund's inception on March 16, 2005 through October 31, 2010, the Tilson Dividend Fund produced an annualized return of 9.53% versus the benchmark's gain of 0.34% annualized over the same period.

We are pleased with the Fund's performance for the year ended October 31, 2010, as the Fund produced a very attractive return despite holding significant cash during the latter half of the year. While it is always nice to show a performance edge over our benchmark, as we have cautioned in the past, we don't manage the Fund to any external benchmark.

Rather, we manage the Fund in a manner that we believe is likely to produce reliable, satisfactory returns without excessive risk over time. This approach may cause us to under-perform our peers or the market indices when markets are rising and when we find stock prices to be unattractive relative to our criteria for value and safety.

The Tilson Dividend Fund portfolio does not resemble our benchmark index portfolio, as it is concentrated in far fewer securities, will often hold considerably higher levels of cash, and does not conform to any industry style box definition with regards to portfolio holdings. For this reason, we expect considerable variance in performance versus our benchmark index and to other income-oriented equity vehicles. Over any rolling three-to-five year period, however, we would hope that the Fund's performance compares favorably to alternative investment vehicles that share our income-oriented, risk-averse mandate.

Strategy Review

Given that we have many new investors in our Fund this year, we would like to take this opportunity to review the investing strategy that we employ in managing the Fund.

The Tilson Dividend Fund strategy is designed for a slow and steady approach to accumulating value through three primary sources: 1) the capital gains associated with the rise in value of our portfolio holdings over time, 2) the dividend income paid out to us by our portfolio companies, and 3) the option premiums we receive from selling out call options against a portion of our holdings when we can do so on attractive terms (Please see the Fund prospectus for a full discussion on the risks and investment merits of writing covered call options).

We attempt to manage the Fund such that the combined effect of dividends and the income from covered call options sold against a portion of the Fund's holdings are likely to generate a level of total income that compares very favorably to other income-oriented equity funds.

However, we also make every effort to balance the search for income with the potential for our portfolio holdings to produce meaningful capital appreciation over time to our investors. We view income as a way to augment the portfolio's performance rather than as the sole source of our returns.

We believe the attractiveness of the Tilson Dividend Fund's strategy lies in its all-weather nature. When the markets are strong, we expect our portfolio holdings to perform strongly and gain in price. We continue to receive dividends from our dividend paying stocks, while the call options we've sold often will likely cause us to have some portion of our holdings in those securities called away from us, hopefully at prices that reflect our estimate of fair value of those securities.

This generally results in some natural selling of securities during periods of stock market advancement.

When markets are weak, numerous studies show that high-dividend-paying stocks such as those we own in our portfolio typically outperform non-dividend paying stocks. This is because the attractive dividend yields often provide support to the stock price and, in addition, dividend-paying stocks often benefit from a "flight to quality" dynamic in which investors move from speculative securities to "safe" securities in times of uncertainty.

Even in weak markets we expect to continue to receive dividend income from our dividend paying holdings, which we can then re-deploy into those securities that we find attractive in an environment in which there are likely to be compelling values. Also in weak markets, the call options sold against our holdings generally decline significantly in value or expire worthless, thus earning income that we can then re-deploy to our favorite investment ideas.

Finally, should there be an extended period when markets exhibit neither a strong upward nor downward trend, we expect that the income from dividends and option premiums will augment our returns and generate cash that we can re-deploy into compelling new ideas as we identify them.

Portfolio Update

As of October 31, 2010, the Tilson Dividend Fund was approximately 83% invested in equities, spread across 33 holdings, offset by notional covered call liabilities equal to approximately 1.8% of the Fund's assets.

Cash and money market funds represented approximately 20.41% of the Fund's assets. In addition, the Fund owned three small put option positions to hedge against specific market risks.

As usual, our portfolio is heavily concentrated in what we believe to be well capitalized, profitable, market-leading companies that generate significant excess cash flow that can be used to pay dividends, repurchase shares, or can be used to further grow via internal investment or through acquiring other companies.

Not all of the portfolio holdings pay dividends, but those that do not tend to return significant cash to

shareholders indirectly through meaningful share buybacks.

At October 31, 2010, our top 10 positions were as follows:

Position % of Fund

1) Laboratory Corp of America (LH) 5.4%

2) Microsoft (MSFT) 5.2%

3) EMC Corp (EMC) 4.3%

4) Aspen Insurance (AHL) 4.1%

5) Cisco Systems (CSCO) 3.9%

6) Vodafone (VOD) 3.8%

7) Northrop Grumman (NOC) 3.4%

8) Oslo Bors VPS (OSLO) 3.2%

9) Blue Coat Systems (BCSI) 3.1%

10) American Eagle Outfitters (AEO) 3.1%

TOTAL 39.5%

Final Thoughts

While the future is inherently uncertain, the current environment continues to be especially challenging for investors. The economy is clearly better than it was a year ago, corporate profits are improving, and valuations are by and large still reasonable. However, the overhang of large and looming structural risks and the distortions created by recent government stimulus make it very difficult to gain longer-term conviction about what might otherwise appear to be very compelling investment opportunities.

For fundamental value investors, the difficult environment has been compounded by the recent out-performance of securities of businesses that are cyclical, capital-intensive, highly-leveraged, and that

typically produce relatively low returns on equity over a full business cycle.

On the other hand, stocks of well capitalized, non-cyclical businesses with consistently high returns on equity have lagged over the past eighteen months. We have felt some of the effects of this dynamic during the year, as the Fund portfolio is comprised of the types of high-quality, high return businesses that haven't performed well recently.

Unfortunately, we can't control the short-term dynamics of the capital markets, nor are we exempt from the big-picture macro risks that may come to define our times. We can only play the hand we're dealt as best we can.

For us, that means acknowledging the many risks, taking extra care in our research, and leaving ourselves with plenty of room for error in our valuation work. We remain confident that our value-oriented approach will continue to work for us over time if we are patient, diligent, and emphasize protecting capital before profits.

We thank you for your support and continued confidence in the Tilson Dividend Fund.


Zeke Ashton runs Dallas investment firm Centaur Capital and manages Tilson Dividend Fund (symbol TILDX). Zeke is a brilliant investor who excels at finding opportunities in stocks that others ignore, and he has built a marvelous record at Tilson Dividend. The fund, launched in 2005, returned 10.2% annualized over the past five years. That beat Standard & Poor's 500-stock index by an average of eight percentage points per year. For 2010, the fund gained 18%, six points ahead of the index (all figures are through November 5).

Beautiful Business

One of Zeke's favorite sectors today is the money-management business -- specifically, firms that specialize in stock funds. Money management is a relatively simple and highly profitable business. Revenues come primarily from fees assessed as a percentage of assets under management. Assets grow as management firms receive new deposits and as the holdings in their funds appreciate. One of the beauties of the business is that costs don't march in lock step with revenues. If a fund grows from $1 billion to $2 billion, you don't need twice as many people to manage it. You may not need any extra people. In normal times, money managers can generate eye-popping net profit margins (earnings divided by revenues) of 25% to 30%.

Of course, times have been anything but normal for stock-fund managers in recent years. Even as the market has powered ahead since March 2009, investors have shunned stock funds. While bond funds experienced net inflows of $221 billion in 2010 through September, according to Morningstar, stock funds saw net outflows of $36 billion. Why this antipathy toward stocks? "Ten years of negative returns will do that for you," says Zeke.

Not surprisingly, valuations of stock-oriented money-management firms have shrunk. Zeke has focused his research on six small and midsize asset managers. The average ratio of the companies' enterprise value (market capitalization plus debt outstanding, less cash on the balance sheet) to assets under management is just 2%. That's roughly half the historical average, he says.

Consider Calamos Asset Management (CLMS). The Naperville, Ill., firm went public at $20 a share in 2004, when it had $32 billion in assets and $150 million of net debt. Today, it has roughly the same level of assets, $246 million in net cash, and the stock goes for $12.

Zeke thinks the market's pessimism toward Calamos is unwarranted. A leader in convertible bonds, the company has steadily diversified its fund offerings so that a majority of its assets are now in stocks, which generate higher fees than bonds. Calamos stumbled badly during the financial crisis, and assets under management were cut in half in 2008. But after several rounds of cutting costs and making investments to expand its roster of foreign and global funds, the company's profit margins are returning to more-normal levels as assets once again grow. But the market hasn't recognized Calamos's revival and is undervaluing the stock. Zeke thinks Calamos is worth $17 a share today.

Another beaten-up favorite of Zeke's is Artio Global Investors (ART), which was spun off last year by Swiss investment bank Julius Baer. The New York City firm's funds, which focus on foreign stocks, have excellent long-term records but have lagged in recent years. As a result, assets have fallen from a high of $75 billion in December 2007 to about $54 billion today. But Zeke believes that Artio's managers haven't lost their mojo.

As the funds' returns improve, he thinks investors will bid up the shares or another money manager seeking to increase its international expertise will buy all of Artio. Zeke pegs the current ratio of Artio's enterprise value to its assets at 1.5%. At a more reasonable 2.5%, he estimates the stock's fair value at $22, well above today's price of $15.