Dear Centaur Total Return Fund Investors:
The Fund produced a return of 5.25% for the year ending October 31, 2016. The S&P 500® Total Return Index returned 4.51% for the same period, while the Dow Jones U.S. Select Dividend Total Return Index experienced a gain of 13.49% for the same period.
For the trailing 5-year period ending October 31, 2016, the Fund has produced an annualized return of 8.40%. For the trailing 10-year period, the Fund produced an annualized return of 7.39%. Over the same 5 and 10-year periods, the S&P 500® Total Return Index returned 13.57% and 6.70% annualized, respectively, while the Dow Jones U.S. Select Dividend Total Return Index returned 14.22% and 6.52% annualized, respectively.
From inception in early March 2005 through October 31, 2016, the Fund returned 8.46% annualized. The S&P 500® Total Return Index returned 7.36% and the Dow Jones U.S. Select Dividend Total Return Index returned 7.28%, respectively, for the same period. (For the Fund’s most up-to-date performance information, please see our web site at www.centaurmutualfunds.com.)
Thoughts on Recent Fund Performance
The Centaur Total Return Fund returned 5.25% for the year ending October 31, 2016, which was ahead of the broad U.S. equity market (as represented by the S&P500, which returned 4.51% for the same period) but trailed the Dow Jones U.S. Select Dividend Total Return Index, which turned in a stellar 13.49% return. While we are pleased to have achieved a return better than the broad market average for the period, particularly given the Fund’s relatively low market exposure, the last year was largely a continuation of what has been a challenging environment for our strategy.
The Fund’s primary strategy is to assemble a portfolio of securities that offers both reasonable safety and satisfactory return potential, based largely on our view of the valuations of the securities being attractive relative to underlying business value. We are value investors, and as such we strive to capitalize on market fluctuations to purchase bargain securities when prices reflect fear and uncertainty, and to sell securities when prices reflect full value. Unfortunately, given historically high valuations for U.S. stocks, we have experienced more than the usual difficulty in identifying bargain securities that meet our criteria for value and safety for an extended period of time dating back to late 2013. With fewer bargain securities available, we have become more reliant upon the occasional episodes of market volatility created by fear and uncertainty to help us source new investments, and such episodes have become relatively infrequent and brief during the last three years.
The market did offer us two windows of opportunity in 2016 that we did our best to take advantage of. The first and best opportunity was a double digit percentage decline in the S&P500 in January, which allowed us to identify enough actionable ideas to increase the Fund’s market exposure from an all-time low of roughly 40% at calendar year-end 2015 to approximately 70% market exposure by the end of February 2016. The second opportunity came immediately following the unexpected “Brexit” vote in the United Kingdom in June. This event sent U.S. stocks down by roughly 6% in the course of two days (with other global markets experiencing bigger moves) and was followed by a few weeks of choppy conditions before the market rallied strongly into the late summer and early fall. Though brief, the “Brexit” sell-off allowed us to put some capital to work in the face of heavy selling pressure, primarily in the shares of certain financial stocks that were hit by panic selling. In addition, volatility spiked sufficiently in the weeks following the vote to allow us to selectively utilize the covered call component of our strategy, which involves the purchase of securities and selling covered calls against some of our holdings with a goal of producing additional income for the Fund. By the end of June, the Fund was as fully invested as it would get for the year, with total long stock exposure of over 80%. From July to October, we did more selling than buying as certain of the Fund’s portfolio securities reached prices that we considered to be fully valued, with the result that the Fund ended the fiscal year with roughly 50% market exposure as of October 31, 2016.
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 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 2016 figures represent the performance for the first ten calendar months of 2016 through October 31st. As the table shows, the Fund has out-performed both of our stated benchmarks from inception to date, but the Fund has generally struggled to keep pace with the fully invested indices since 2013.
As a quick glance at the table above shows, since 2012 the Fund has produced somewhat pedestrian returns, though the returns on actual capital deployed hasn’t been far below our historical standards except for the poor showing in calendar 2015. As best we can determine, the Fund was roughly 65% or so invested on average during the twelve month period ending October 31st, with market exposures ranging from a low of approximately 40% to the mid-summer high of just over 80%. This implies that return on actual cash deployed in the first ten months of calendar 2016 was in excess of 10%. The challenge for us has been maintaining a fully invested portfolio, at least one that is consistent with our traditional discipline regarding valuations, position sizes, and the limitations of various risk factors across the portfolio. We do believe that we are getting better at taking decisive action when the market offers its “limited time only” sales, as demonstrated by our successful deployment of capital in the wake of the U.K. “Brexit” vote in mid-2016. We also continue to believe that market volatility, which has been muted for many years due to a combination of factors including accommodative central bank policies and low interest rates, is likely to revert at least partially to historical levels.
Portfolio Update
As of October 31, 2016, the Centaur Total Return Fund was approximately 50% invested in equities (common and preferred), warrants, exchange-traded and closed-end funds and purchased options spread across 24 holdings, offset by covered call liabilities equal to less than 0.48% of the Fund’s assets. Cash and money market funds represented approximately 50% of the Fund’s assets. The top ten investments represented approximately 34% of Fund assets.
Commentary on Fund Holdings
The Fund’s two largest holdings at the end of the fiscal year were Berkshire Hathaway and Alleghany, each of which we think of as “total return insurance holding companies” that we believe offer a combination of strong insurance operations with flexible and conservative capital allocation.
Berkshire Hathaway (BRK.B, Financial) is of course managed by Warren Buffett (Trades, Portfolio), who is justifiably recognized as one of the world’s most successful investors and the torch-bearer for the value investing style of capital allocation. Unlike many stocks in today’s expensive environment, Berkshire Hathaway remains very reasonably valued on historical measures relative to earnings and book value, and we believe the company’s immense balance sheet strength remains a rare competitive advantage. Alleghany (Y, Financial) remains primarily a collection of insurance businesses, though the company has reinvented itself successfully many times in the past and remains flexible and conservative in its capital allocation practices.
Cognizant Solutions (CTSH, Financial) is a leading provider of outsourced business processing and technology solutions, providing mission-critical services to a base of over 1,200 mostly large global corporate customers primarily in the areas of banking and insurance, healthcare, logistics, and manufacturing. As an indication of just how successful Cognizant has been, a quick review of the financials from 2005 to 2015 reveals a business that grew top-line revenue roughly 14-fold from $885 million to $12.4 billion. Even more impressively, cash flow profitability improved from $68 million to $1.8 billion (roughly 26-fold) during the same span as the company achieved scale and operating leverage. We initially began buying Cognizant stock following the “Brexit” vote. We added to the Fund’s position when the stock sold off further in late September after the company disclosed an internal investigation related to improper payments made by company personnel in India that could be in violation of U.S. anti-bribery laws. We made this incremental investment in the belief that this unfortunate situation is likely to be an issue that will ultimately be resolved without significant financial liability or reputational damage to Cognizant. The stock had already recovered some of its losses by the end of October.
IAC/Interactive Group (IAC, Financial) is a leading media and internet conglomerate that has a multi-decade track record of developing valuable media companies, which have in the past included Expedia, TripAdvisor, Ticketmaster, and The Home Shopping Network. Today, IAC owns a collection of businesses that includes HomeAdvisor, the leading marketplace connecting homeowners with service professionals for home improvement projects, and Vimeo, a fast-growing video platform and video-on-demand marketplace. The most valuable asset at IAC is the company’s majority ownership interest in Match Group. Match is the world’s largest online dating services provider comprising 45 different brands that IAC took public through an IPO in late 2015. IAC continues to own more than 80% interest in Match (MTCH, Financial), which we think is a unique and under-appreciated asset. We have been impressed with the company’s strong history of value creation and recent capital allocation savvy, and we believe that both Match Group and HomeAdvisor have reached a point of industry leadership following a multi-year “land grab” strategy and that both businesses are now demonstrating impressive profitability growth as the businesses mature. We think these businesses could combine continued strong revenue growth with expanding profit margins for several years, and we believed at the time of our purchase of IAC shares that the market price did not fully reflect the value creation potential inherent in these businesses as well as the company’s portfolio of other internet and media assets.
Final Thoughts
We remain concerned that U.S. stock market valuations remain elevated relative to historical standards, with a number of measures indicating that stocks have rarely been as expensive as they are today. We would not be surprised if returns for U.S. stocks prove to be far lower than many people expect when looking out over a multi-year period from year-end 2016, but we have confidence that our strategy will enable us to navigate such an environment to the extent that a low-return, higher-volatility scenario does play out over the next several years. In the meantime, we remain committed to our opportunistic, value-oriented approach and will look to take advantage of opportunities as the market offers them. We would like to thank the Fund’s investors for your continued confidence.
Respectfully submitted,
Zeke Ashton (Trades, Portfolio)
Portfolio Manager, Centaur Total Return Fund
