Second Quarter Summary
In the second quarter of 2005 our accounts continued to increase in value. Coupled with the first quarter’s modest gains, our year-to-date positive equity returns contrast with the negative equity returns associated with major market indices. Investor concerns over high energy prices, the direction of interest rates and the overall strength of the economy seem to be the main culprits explaining this year’s negative returns (through the end of the 2nd quarter). As our investors are well aware, we simply look for exceptional entry points into securities based on quantifying a company’s value and pay little attention to overall market considerations. We approach the third quarter cautiously…is there really any other way?
|Annualized as of 6/30/05|
|2Q 2005||YTD 2005||1 Year||3 Year||5 Year||Since
|Vanguard Bal. Index||2.63%||0.95%||7.77%||8.36%||2.36%||4.02%|
|Lipper Bal. Index||1.79%||0.50%||7.12%||7.69%||2.70%||3.71%|
* Please refer to performance disclosures at end of document.
Three years ago, a long-time client noted that in studying our stock selections in depth he discovered a very high percentage of them were successful. However, he also noted that a high percentage of the unsuccessful investments were dismally so (read, real dogs). It was a fair criticism. It troubled me that in the instances where we went wrong, we seemed to be terribly wrong. I was determined to minimize real losers.
Avoiding significant losses makes life much, much easier. If you start with 25 equally weighted positions, and three of them drop 75%, your remaining 22 positions need to appreciate over 10% to simply get back to your starting value. Wealth is created over time, which is a limited resource. If one has to utilize this valuable commodity of time to simply earn back investment losses, it makes growing wealth more difficult. We have gotten religion on this point so to speak. That is not to say that significant losses will never occur (in fact, chances are it will happen in the normal course of business), but we will be diligent in trying to avoid these situations in the first place and seek to quickly identify any mistakes soon after they occur.
Truth be told, some of our earlier blow-ups turned out fine (they were market disasters in that they had been temporarily sold off but not real business disasters), and were simply sold prematurely by us. I’m concerned here about avoiding the miscalculation of a business’ value and/or not understanding its industry dynamics sufficiently such that shareholder value is destroyed over time, however slowly. We cannot do much of anything about general market risk, i.e., the daily re-pricing of securities based on primarily short-term considerations. It is critical that our investors understand the difference between real permanent impairment of capital resulting from business destruction and/or real asset write-downs, and the market’s tendency to price and re-price securities based upon current company outlooks and/or current macroeconomic assessments. In terms of avoiding real business losses, we will continue to be mindful of Warren Buffett’s adage sometime ago that in investing, unlike in baseball, one can stand at the plate and wait for his pitch as long as he wants.
Our Three Top Purchases in the 2nd Quarter
Triquint Semiconductor, TQNT. Triquint designs and manufacturers various analog and mixed-signal integrated circuits using proprietary gallium arsenide chips. Although these chips are more expensive, they are said to have better performance characteristics as compared to the more widely used silicon chips. The company’s primary end-markets are wireless handset, wireless infrastructure equipment and defense. Major customers include Ericsson, Nokia, Motorola, Boeing and Samsung Electronics.
TQNT is an extremely well-capitalized company possessing valuable technology that we believe is in the midst of a turnaround. The company is generating positive free cash-flow which should only get better given its recent decision to sell its cash-draining optical components business. There is evidence that the company’s investments in new products (designed for cell phones) are beginning to pay off and that it is well positioned to benefit from an increase in infrastructure spending as well. Though CDMA (Code Division Multiple Access) based applications accounted for 78% of revenues from its cellular business in 2004, down from 2003’s 84%, GSM (Global System for Mobile communications) products accounted for 21% of revenue, up from a 9% a year ago. GSM is the most prevalent standard, utilized primarily in Europe and many parts of Asia with a growing presence in the U.S. This standard accounts for over 60% of total phone sales and subscribers worldwide. Designing products for this end market is an important element of TQNT’s overall business strategy. Total revenues for wireless phones increased about 8% in 2004 due to the overall strength in end market demand.
TQNT’s infrastructure market includes base stations, satellite systems, and broadband cable where industry capital expenditure cutbacks were significant in recent years. Despite this trend, TQNT’s revenues in this market increased 28% in 2004 compared to 2003. Base stations accounted for approximately 60% of infrastructure revenues. Base stations are used to handle calls from wireless phones. As usage of mobile phones increases, the demand for more and better base stations grows. TQNT believes that the increase in cell phone usage in recent years (without a corresponding increase in infrastructure spending, particularly abroad), sets up an inevitable scenario where such spending must increase significantly to keep pace with the steady rise in cell phone users.
What did we pay? We purchased our shares of TQNT below tangible book value wherein its net cash assets accounted for roughly 40% of its market capitalization (at the price we paid). Interestingly, TQNT purchased Sawtek a few years back for roughly $1 billion (in stock). Even if you discount that price by 50% to $500 million because of a non-cash currency, we paid less than that for the combined operations of Sawtek and Triquint (similar sized companies). We paid roughly 80% on an enterprise value to 2005 revenue basis. Knowing what we know about private market transactions in this end of the world, it would be hard to imagine a buyout for less than 150% of revenue plus net cash which would equate to over a 50% gain at the price we paid. TQNT is a turnaround without current positive GAAP earnings, but it is free cash flow positive. Given its exceptionally strong balance sheet, valuable portfolio of technological know-how and evidence of growing end-market demand, we feel it presents an exciting investment opportunity.
American Equity Investment Life Holding Company, AEL. AEL is a full service underwriter of a broad line of annuity and insurance products. Its business primarily consists of the sale of fixed rate and indexed annuities. The company markets its products through 46,000 independent agents and currently ranks fourth in the indexed annuity market based on sales. In 1995, AEL was formed by David Noble. Mr. Noble, AEL’s CEO, has been in the insurance industry for over 50 years and previously built up and sold The Statesman Group. He brought his core management team from The Statesman Group to AEL. AEL had its initial public offering in December 2003 at $9. It is rare that we would purchase shares of a company above a recent IPO price. However, it is our belief that the IPO went out at a discount to its initial projected range of $10.50-$13.50 due to unusual circumstances. Insiders own approximately 14% of the business and are not allowed to sell any shares unless they are prepared to leave the firm. In addition, independent agents own 5% of AEL. Also of note is a recent open market purchase by CFO Wendy Carlson. It appears that management interests are strongly aligned with shareholders’ interests.
The price of AEL’s shares fell when AEL announced it was firing Ernst & Young as its auditor because it was unhappy with the level of service it received. At the same time, AEL reported a material weakness in internal controls related to deferred policy acquisition costs (DAC) and deferred sales inducements (DSI). The company stated that these issues were unrelated. In our opinion, the market overreacted to this news as the material weakness was related to the documentation of processes as opposed to inappropriate accounting of its DAC/DCI asset. The company recently announced it has hired KPMG as its new auditor. AEL has a conservative balance sheet where 99% of the fixed maturity securities in its investment portfolio are investment grade. We purchased shares of this rapidly growing, small cap life insurance company (on July 11th, AEL reported record high quarterly sales) at a P/E ratio under 8x and less than 1.3x book value.
The Phoenix Companies, PNX. Phoenix is a provider of wealth management products and services to high net worth and institutional clients. PNX offers life insurance, annuities, asset management and private placement products through a network of affiliated financial services and asset management firms. In June 2001, Phoenix demutualized and became a publicly traded company at $17.50. There is a five year restriction on takeovers of companies that demutualize. Phoenix’s five year anniversary is June 2006. Dona Young was appointed CEO in January 2003 and has been with PNX for 25 years. Ms. Young instituted stock ownership guidelines for directors and senior officers based on multiples of their salaries. As in the case of AEL, management’s interests are strongly aligned with shareholders’ interests. There is a further vote of confidence by industry player State Farm. State Farm owns about 6% of Phoenix and participated in a secondary offering to maintain its ownership interest.
We have been acquiring shares in Phoenix over the past several years. At our recent purchase price, we bought shares of Phoenix at about 50% of estimated 2005 book value. As you know, we incorporate private market transactions in our analysis whenever possible. In 2003, The MONY Group was acquired by AXA for 75% of book. MONY is very similar to Phoenix both in size and operations. MONY was poorly managed and had an ROE of less than 1%. Phoenix’s ROE was 3.9% in 2004 and is estimated to be 4.6% in 2005. Clearly, there is a disconnect between how the stock market is valuing PNX versus what a strategic buyer paid for a comparable company. Valuing PNX at 75% of book would result in a 45% gain based on the price we paid. As the demutualization anniversary approaches, we believe that Phoenix’s value will be realized by either the public or the private market.
A Growing Team
We are pleased to announce that Jason Nelson recently joined Roumell Asset Management as an analyst. Jason comes extremely well prepared to begin his duties as a deep value equity analyst. This past May, Jason graduated from The College of William and Mary with a Masters in Accounting and had the honor of being class valedictorian. Prior to getting his Masters, Jason was with Global Securities Information, Inc. where he evaluated and summarized mergers and acquisitions transactions for the firm’s proprietary web-based legal and financial information service database. He also has worked on the Equity Capital Markets Desk of Wachovia Securities, Inc. Jason received his BA in history from Hampden-Sydney College in 1998. Before hiring an analyst, I have always provided worthy candidates with a research assignment. Suffice it to say, Jason did a terrific job. On a personal note, Jason enjoys fishing, hiking and reading Benjamin Graham in his spare time. We are happy to have Jason join our firm and add to its analytic resources.
Once again, we want to thank you for the trust and confidence you have placed in us. We will continue to watch what the market appears to make cheap, diligently research those ideas and, in the end, select our investments cautiously. If you are aware of individuals who would benefit from our approach, we would welcome the opportunity to talk with them. You can always direct such individuals to our website, www.roumellasset.com. Additionally, as we have mentioned in the past, we have lots of terrific restaurants in our neighborhood and would be happy to take you and a friend(s) to lunch to discuss our investment approach. As always, please feel free to contact us directly about your account.
Investment Strategy: Roumell Asset Management, LLC (“Roumell”) employs a value investment strategy in managing client portfolios. Roumell Equity accounts can have up to 100% of assets invested in stocks; Roumell Balanced accounts typically have 65% of their assets allocated to stocks (though the figure can range from 50% to 80% depending upon the needs of the client).
Calculation of Rates of Return: First and foremost, readers of this letter should recognize past performance is no guarantee of future results. Returns are reported net of all management fees and applicable trading costs; annualized returns are the result of linking quarterly returns (only accounts present for the entire quarter are included in a given quarter’s performance composite); returns are time-weighted; returns reflect reinvestment of dividends and other earnings. These returns are based on a composite of Roumell’s accounts and therefore were not necessarily duplicated in any specific account. These consolidated performance numbers include all of Roumell’s fully discretionary accounts within each category. Discretion is defined as the ability of the firm to implement its intended investment strategy without restriction.
Inclusion of Accounts: Currently, in the performance calculations for Roumell Equity, there are 212 equity portfolios totaling $71.0 million. This represents 51.7% of total portfolios and 45.1% of total dollars under management. Currently, in the performance calculations for Roumell Balanced, there are 134 balanced portfolios totaling $68.8 million. This represents 32.7% of total portfolios and 43.7% of total dollars under management. A complete list and description of the firm’s composites is available upon request.
Comparative Indices: Because Roumell utilizes an all-cap (large, medium and small companies) investment strategy, there is no perfect index for comparison purposes. We have included two equity indices and two balanced benchmarks to allow readers to judge our performance against benchmarks that collectively offer good comparative illustrations.
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.