Quarterly Letters

Quarterly Update

Understanding Risk-Market vs. Business

In the past six months investors have watched their portfolios drop and market volatility reach levels few can recall. According to a Standard & Poor's study of price swings in the S&P 500, the US stock market is the most volatile it has been in 70 years. Daily changes of 1% or more in the S&P 500 have occurred on 28 trading days this year (as of March 20). That's 52% of the trading sessions so far, which is the highest proportion since 1938, when the S&P 500 rose or fell at least 1% during 57% of the trading days. Financials in particular have investors (and policy makers) worried and the term "credit crunch" is in everyone's lexicon these days. Why are financial stocks suddenly viewed with such trepidation? And how on earth can Bear Stearns receive a buyout offer for a mere $10/share when its stock was valued at over $150/share a short time ago?

The term "risk" must be defined. Market risk is the risk that public securities can swing widely with little relation to company fundamentals. We do not believe this risk can be quantified and that, in the end, a company's intrinsic value will ultimately determine investment success or failure. As a result, long-term investors should not be overly concerned with this risk as it pertains to their equity allocation. It is simply the "price of admission" to have access-over time-to the superior rates of return generated by investing in publicly-traded securities of corporations. Business risk, however, is solely about the trials and challenges of various business models in real economic terms. The current volatility in many financial stocks, including the near or complete loss of equity value of some, has all to do with the typical financial business model-leverage.

How can Bear Stearns be a near wipeout? How can Thornburg Mortgage, a mortgage REIT, be near declaring bankruptcy given that it holds primarily jumbo prime mortgages? In two words: leverage and funding. For most well-capitalized companies facing a challenging business climate, a declining stock price can offer a potentially attractive entry point for a patient investor if one believes the existing business stress is temporary. Levered financial companies, on the other hand, can often be in worse shape, as their stock prices decline because their lenders (depositors or wholesale lending facilities) get nervous and call in their loans; i.e., demand their money back. Thus, buying a declining financial can often truly be trying to catch a falling knife. Here's why.

Thornburg boasts 5% equity to assets ($1.8 billion of equity supports roughly $36 billion of assets). Thornburg receives funding for its assets-prime mortgages-from large wholesale lenders that agree to lend such money so long as the value of its mortgage assets remains at some agreed upon market price; i.e., loan to value, or LTV. If, however, those assets drop in market value, and the wholesaler calls in its money, Thornburg is then in a position where, more likely than not, it will be forced to quickly sell its mortgage assets at a loss even though the underlying mortgages may well be performing. The losses that stem from these forced sales typically result in a significant reduction to shareholder equity with the potential of completely wiping out common stockholders due to the degree of leverage employed. Adding insult to injury are dilutive equity raises.

For example, if you as an individual buy a $1 million house and put down $100,000, and the house subsequently drops in value by 10%, and your loan is written in such a way that the lender always requires a minimum of 90% LTV, you are wiped out. The house is sold for $900,000, the bank is paid off, and you are left with nothing. In this example, if the equity was publicly traded and an investor bought it for what he or she perceived to be a terrific deal at only 50% of book value, or $50,000, the result would still be a complete loss for the investor. Thornburg and other similarly financed mortgage REITs often do not have the discretion to hold the performing paper through market dislocations and until maturity when they are so captive to their lenders' terms. Investments in such securities are often not safe even at discounts to the stated book value.

Now we come to Bear Stearns and its rapid descent from a $170 stock to receiving a bailout offer of $10/share from JPMorgan. Leverage tells the story: Bear Stearns' equity to assets was a mere 3% ($12 billion of equity sits below a whopping $385 billion in assets). The value of its portfolio of investments (i.e., loans) was suspect and ripe with write-downs few could adequately quantify. Consequently, few institutions wanted to extend credit. Further, Bear's clients, hedge funds and other large depositors, began withdrawing. Bear's "franchise value" was no match for its liquidity problems. What we are witnessing en masse today is leverage not working-as a business model-because of poor credit underwriting (bad loans) as well as forced de-leveraging (good loans simply falling in price, which forces holders to sell because of restrictive lending agreements). For clients, refer to "Recent Sales of Financial Stocks" in the addendum to the enclosed Portfolio Holdings summary to assess how we responded to the emerging credit crisis given our own financial holdings.

Contrast the risks above with Coca Cola, KO. KO may sell fewer soft drinks because of competition and as a result may be forced to increase marketing, reduce prices, and institute other measures which could reduce or even eliminate shareholder profits. KO must manage its debt, but its model does not entail the balance sheet risk that financials do. Microsoft, MSFT, has no debt with over $25 billion in cash. Its business risk lies in the sale of its software. In neither KO nor MSFT does an investor realistically live with a potential wipeout. Investors need to know how financials make money and realistically understand the benefits and risks of the model.

Not all financials are equal. For instance, we own Franklin Resources, Inc. (home of Franklin Templeton Mutual Funds), BEN, and Legg Mason, LM. BEN possesses about $3.5 billion in net cash and earns a fee on the assets it manages. Similarly, LM, though without as strong a balance sheet as BEN, earns an asset management fee. In these models, the risk is not balance sheet-related because the models are not levered business models. The risk is assets under management (AUM)-related; i.e., if AUM goes down, so do earnings.

Roumell Asset Management has long favored companies with strong balance sheets as indicated by a low level of liabilities and leverage. We favor asset-based investments where we can easily quantify a measurable asset(s) (as opposed to opining on this year's earnings). Market risk is far easier to accept than business risk, particularly the financial risk variety. To wit, investors ought to be keenly aware of the difference between market and actual business risk(s).

As we did last quarter for our clients, we have enclosed a complete listing of our current holdings. We want our clients to see the reasoning underlying our investment decisions. Additionally, we have included some notes on the increased level of trades as a result of increased volatility and acting on new and material information. Thus, in the final pages of the enclosed holdings report we describe our reasons for exiting certain securities.

We are often asked, "What is your outlook for the market?" We have always maintained a security specific orientation as opposed to a general market one and will continue to do so because we believe quantifying a security's value (referencing real company specific economic data) is more reliable than predicting the direction of overall markets. That said, it's a fair question and we have several observations. First, the domestic outlook is poor. The 30-year median home value divided by median income ratio is 2.7x and today it stands at a historically high 4x even after recent home price depreciation. Moreover, Americans' portfolio wealth has dropped. We are paying more at the pump and at the grocery store. Unemployment is creeping upward and consumer confidence is dropping dramatically. On the other hand, the world is growing: estimated worldwide growth is 3.8% for 2008 and 4% for 2009. Perhaps Warren Buffett, from an investment perspective, said it best: "The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values." Interestingly, company buybacks and insider buying have both increased meaningfully of late.

We are cautious, but we are opportunistic as well. We believe that a market characterized by a high level of uncertainty and volatility can serve our clients well because: (1) we are willing to hold cash (currently about 25% overall), (2) we are willing to buy on market weakness and sell on market strength, and (3) we employ a deep value approach to securities analysis to underscore all of our investments and, consequently, would happily hold our investments for years if the stock market shut down.

Our Three Top Purchases

Gaylord Entertainment Co., GET. GET owns a collection of unique hotel/convention assets that creates a strong moat in the large group convention marketplace. For instance, in convention situations requiring 1,000 rooms-plus, there really is no alternative to GET in a non-Las Vegas venue under one roof. Perhaps most important as it pertains to a hotel company is the stability of the model: roughly 60% of occupancy and 70% of revenue is on the books on January 1 given the nature of large convention planning (80% of GET's business is group and 20% is leisure). Feedback from convention planners is positive, with high marks for GET management. The company is well-capitalized and recently opened its fourth property, Gaylord National in Washington, DC, at the beginning of April of this year.

Gaylord's valuation is compelling on a replacement cost basis and attractive on a current multiple basis, with what appears to be a positive long-term outlook. In our replacement cost analysis we used Gaylord's total cost per room to build the National property, $500K ($1B total cost/2,000 rooms), and applied a 25% discount to this rate (to account for higher labor and material costs in the DC area) for the remaining rooms (total: 5,800) at Gaylord's Orlando, Dallas, and Nashville properties. Using $500K/room for National, $375K/room for the remaining properties, and adding back other non-core assets and subsidies from local tax authorities that are worth slightly over $400M, we come to a net of debt portfolio replacement value of $56/share. It should be noted that this "sticks & bricks" replacement cost analysis ignores any brand value the company has developed through its premium convention offering.

GET shares also appear to be undervalued based on similar asset valuations in the private market of 12x-15x EBITDA. For instance, Hilton Hotels was purchased last year for 14x EBITDA. Using a conservative 10.5x estimated 2009 EBITDA (excludes stock option expense) for GET's operating hotel properties, 7.5x for other income-producing assets, plus a couple dollars per share of land/expansion value, we arrive at a net of debt private market asset value of $46/share. Add in another $5.50 of value for subsidies, and the total value increases to $51.50/share. At our average purchase price of roughly $28 we feel that we have acquired a unique set of assets run by an excellent management team at almost a 50% discount to the average of our valuations.

Raymond James Financial, RJF. For the first time in our long history of working with RJF, we decided to purchase its common stock. RJF has grown its business over the years in a conservative manner under the excellent stewardship of Tom James, son of RJF's founder, Robert James. The James family today owns roughly 15% of the company. Perhaps there is no greater example of Tom's conservatism in managing RJF than the complete absence thus far of any write-offs stemming from investments made in the variety of financially engineered products recently discovered on so many brokerage and bank balance sheets. Way to go, Tom!

RJF is one of the last publicly traded independent brokerage firms left after Wachovia's purchase of A.G. Edwards last year. RJF is diversified, but with a solid retail emphasis: roughly 60% of revenues stem from retail distribution, with the balance coming from investment banking, asset management (including its ownership of the Heritage Family of Funds), and its recently formed retail bank. We purchased RJF at roughly 1.4x book value and 10x earnings. Edwards was purchased for over 3x book and 20x earnings by Wachovia. Thirteen company officers and five directors have made numerous open-market purchases year to date. Finally, Tom has always maintained a discipline of paying no more than 1.5x book for company stock buybacks: recently the company instituted its second $75 million stock buyback program. We can attest to the quality of RJF as one of its clearing clients and from a relationship that dates back 15 years. In our mind, RJF represents a conservatively managed, terrific franchise purchased at a deep value price.

The Washington Post, WPO. The Washington Post is a holding company of education and media businesses that includes (in descending order of EBITDA): Education-Kaplan Test Prep & Education; Cable-Cable One, a small market cable operator; Broadcasting-six television stations, including four located in markets ranked 10th to 20th in size; Newspapers-The Washington Post and several regional weeklies; and Magazines-Newsweek, Slate, and other niche publications. Over the years, the Post has morphed from a traditional print media company to primarily a for-profit education provider and cable properties manager. In fact, the Newspapers and Magazines segments contributed only 18% of total firm-wide EBITDA in 2007, and these segments' relative contribution to company profits is expected to continue to decline. This is the second time we have invested in WPO.

The thesis behind our investment in WPO is to buy stock at a meaningful discount to a conservatively derived sum-of-the-parts private market valuation of the Post's five distinct pieces. At our average purchase price, we acquired WPO shares at roughly a 20% discount to our estimated fair market value. We also find the Post's multiple levers appealing in that even if the print businesses were deemed worthless (a stretch at this point), their input in our valuation constitutes a meager 6%. Kaplan, the largest component in our sum-of-the-parts analysis at just under half of total valuation, was internally valued by WPO management for year-end 2007 compensation purposes at roughly 12x forward EBITDA estimates. Even if we assume that WPO management is applying a 50% EBITDA multiple premium to its internal valuation, a scenario that we view as highly unlikely considering the stewardship of Don Graham and a board of directors that includes Warren Buffett, our valuation still yields a stock price slightly higher than our cost.

Disclosure: The specific securities identified and described do not represent all of the securities purchased, sold, or recommended for advisory clients and the reader should not assume that investments in the securities identified and discussed were or will be profitable. The top three securities purchased in the quarter are based on the largest absolute dollar purchases made in the quarter.

Back to Quarterly Letters

Equity Composite contains fully discretionary equity accounts and for comparison purposes is measured against the S&P 500, Russell 2000, and Russell 2000 Value Indices. The S&P 500 Index is used for comparative purposes only and is not meant to be indicative of the Equity Composite performance. In presentations shown prior to March 31, 2005, the composite was also compared against the Nasdaq Index. The benchmark was eliminated since it did not represent the strategy of the composite.

Roumell Asset Management, LLC has prepared and presented this report in compliance with the Global Investment Performance Standards (GIPS®).

Roumell Asset Management, LLC is an independent registered investment adviser. The firm maintains a complete list and description of composites, which is available upon request.

Results are based on fully discretionary accounts under management, including those accounts no longer with the firm. Past performance is not indicative of future results.

The U.S. Dollar is the currency used to express performance. Returns are presented net of management fees and include the reinvestment of all income. Net of fee performance was calculated using actual management fees. Net returns are reduced by all fees and transaction costs incurred. Wrap fee accounts pay a fee based on a percentage of assets under management. Other than brokerage commissions, this fee includes investment management, portfolio monitoring, consulting services, and in some cases, custodial services. As of December 31, 2006 and 2007, wrap fee accounts made up 33% and 36% of the composite, respectively. Wrap fee schedules are provided by independent wrap sponsors and are available upon request from the respective wrap sponsor. Returns include the effect of foreign currency exchange rates. Exchange rate source utilized by the portfolios within the composite may vary. Composite performance is presented net of foreign withholding taxes. Withholding taxes may vary according to the investor’s domicile.

The annual composite dispersion presented is an asset-weighted standard deviation calculated for the accounts in the composite the entire year. Dispersion calculations are greater as a result of managing accounts on a client relationship basis. Securities are bought based on the combined value of all portfolios of a client relationship and then allocated to one account within a client relationship. Therefore, accounts within a client relationship will hold different securities. The result is greater dispersion amongst accounts. Additional information regarding the policies for calculating and reporting returns is available upon request.

The investment management fee schedule for the composite is as follows: For Direct Portfolio Management Services: 1.75% on the first $200,000, 1.50% on the next $300,000, and 1.00% on assets over $500,000; For Sub-Adviser Services: determined by adviser; For Wrap Fee Services: determined by sponsor. Actual investment advisory fees incurred by clients may vary.

The Equity Composite was created January 1, 1999. Roumell Asset Management, LLC's compliance with the GIPS® standards has been verified for the period January 1, 1999 through December 31, 2007 by Ashland Partners & Company LLP. In addition, a performance examination was conducted on the Equity Composite beginning January 1, 1999. A copy of the verification report is available upon request.

Balanced Composite contains fully discretionary balanced accounts (consisting of equity, fixed income and cash investments) and for comparison purposes is measured against the Thomson US Balanced Mutual Fund Index. In presentations shown prior to March 31, 2006, the composite was also compared against the Lipper Balanced Index. Additionally, in presentations prior to December 2006, the composite was measured against the Vanguard Balanced Index Fund. The Thomson US Balanced Mutual Fund Index is a blend of over 500 balanced mutual funds and is therefore deemed to more accurately reflect the strategy of the composite.

Roumell Asset Management, LLC has prepared and presented this report in compliance with the Global Investment Performance Standards (GIPS®).

Roumell Asset Management, LLC is an independent registered investment adviser. The firm maintains a complete list and description of composites, which is available upon request.

Results are based on fully discretionary accounts under management, including those accounts no longer with the firm. Past performance is not indicative of future results.

The U.S. Dollar is the currency used to express performance. Returns are presented net of management fees and include the reinvestment of all income. Net of fee performance was calculated using actual management fees. Net returns are reduced by all fees and transaction costs incurred. Wrap fee accounts pay a fee based on a percentage of assets under management. Other than brokerage commissions, this fee includes investment management, portfolio monitoring, consulting services, and in some cases, custodial services. As of December 31, 2007, there are no wrap fee accounts in the composite. As of December 31, 2006, wrap fee accounts made up less than 1% of the composite. Wrap fee schedules are provided by independent wrap sponsors and are available upon request from the respective wrap sponsor. Returns include the effect of foreign currency exchange rates. Exchange rate source utilized by the portfolios within the composite may vary. Composite performance is presented net of foreign withholding taxes. Withholding taxes may vary according to the investor’s domicile.

The annual composite dispersion presented is an asset-weighted standard deviation calculated for the accounts in the composite the entire year. Dispersion calculations are greater as a result of managing accounts on a client relationship basis. Securities are bought based on the combined value of all portfolios of a client relationship and then allocated to one account within a client relationship. Therefore, accounts within a client relationship will hold different securities. The result is greater dispersion amongst accounts. Additional information regarding the policies for calculating and reporting returns is available upon request.

The investment management fee schedule for the composite is as follows: For Direct Portfolio Management Services: 1.75% on the first $200,000, 1.50% on the next $300,000, and 1.00% on assets over $500,000; For Sub-Adviser Services: determined by adviser; For Wrap Fee Services: determined by sponsor. Actual investment advisory fees incurred by clients may vary.

The Balanced Composite was created January 1, 1999. Roumell Asset Management, LLC's compliance with the GIPS® standards has been verified for the period January 1, 1999 through December 31, 2007 by Ashland Partners & Company LLP. In addition, a performance examination was conducted on the Balanced Composite beginning January 1, 1999. A copy of the verification report is available upon request.

Back to Quarterly Letters