First Quarter Summary
Our composite Equity account was up 8.11%, between the returns of the S&P 500 and the Russell 2000. Our composite Balanced account was up 6.64%, outpacing both the Lipper and Vanguard Balanced indices. We remain steadfast in our belief that the best way to manage risk (market, industry, company or other) is to be highly price conscious. We continue to seek compelling investment stories wherever the markets make them available and will stay safely in cash in the absence of such ideas.
|Annualized as of 3/31/06|
|1Q 2006||1 Year||3 Year||5 Year||Since
|Vanguard Bal. Index||2.98%||9.57%||12.68%||5.68%||4.53%|
|Lipper Bal. Index||3.25%||10.01%||13.09%||5.25%||4.43%|
* Please refer to performance disclosures at end of document.
Does inside ownership matter? We think it does and consequently pay close attention to how much stock management owns when we select investments. Does it guarantee success? Of course not. However, we believe that investing alongside a management team whose incentive structure (sources of compensation) mirrors how passive shareholders will ultimately be rewarded is superior to one where the principal sources of compensation lie in some combination of wages and benefits. Shareholders are in the end dependent on dividends and price appreciation (resulting from market recognition and/or private market transactions that monetize a company’s underlying value). To wit, all shareholders are treated exactly the same in terms of receiving such benefits. That is, in order for management to create wealth for its own shares, outside passive shares must participate as well.
We particularly like managers who own stock as a result of having founded the company and/or accumulated stock through open-market purchases. Founders, and their successive heirs, typically (though not always), believe deeply in their companies and are committed to achieving long-term shareholder value by prudently allocating company resources while exploiting savvy opportunities to gain market share. Ownership effects behavior. Compare how your attitude and behavior is different between the home you own today and the apartment you once rented.
Ultimately, what guides management owners seems to be about two distinct items: (1) dollars on the line (particularly as a percentage of one’s net worth) and (2) prestige as it relates to one’s life work. Both are important and both are considered. For instance, a management team that owns 3% of a $10 billion capitalization company has ten times the amount of dollars on the line versus one that owns 10% of a $300 million company. However, the smaller company’s team is likely headed by a founder whose near total net worth is on the line. Additionally, such a small company founder is often highly motivated to see his life’s handiwork pay off in terms of the deeply satisfying emotional experience of having built a company of enduring value. In the first quarter, we benefited greatly by the buy-out of one of our firm’s largest holdings, Datastream, a small software company headed by its founder and largest shareholder, Dr. Larry Blackwell.
Dr. Blackwell, armed with a Doctorate degree in Environmental Systems Engineering, founded Datastream, Inc. in 1986 to assist manufacturing companies in managing the replacement of hard assets. If companies can know when certain assets are going to wear out, and replace them beforehand, they can save time and money. Dr. Blackwell built the company from scratch, which probably had a lot to do with his refusing a hostile take-over several years ago that he believed did not adequately reward shareholders. He’s an engineer at heart, so he never really took to the road to promote the company to Wall Street (very common among these types of founders). He did create some wonderful software; a fact fully corroborated in our conversations with several Datastream clients. The firm’s resources were also managed quite well: for a company with just $100 million in revenue they had about $50 million in cash, no debt and consistently generated strong free cash flow. To boot, the company owned its headquarters which provided shareholders with some additional value (albeit somewhat hidden since real estate is carried at cost on the company’s balance sheet). At the time of Datastream’s buy-out in the first quarter, no sell-side brokerage firm covered it. The fact that Larry Blackwell owned 12% of the company and that it was a very nice small business with a promising future given its products and balance sheet, did not apparently persuade any analysts that it was worth following. We accumulated the company’s shares over the past two years – having reached the point where we owned about 5% of the outstanding shares of Datastream – before the company received a $10.26/share all cash offer from Infor Global Solutions.
A review of Roumell Asset Management’s current holdings demonstrates our attitude about finding investment co-owners, and not in simply hiring management teams that far too often seem to come and go (with all the attendant business disruptions that occur with serial management changes). Currently, 58% of the companies we hold possess inside ownership of 10% or greater. Further, 27% of our companies possess inside ownership of 25% or greater. As we discussed in last quarter’s report, we do not believe in any silver bullets that when employed guarantee investment success. This premise pertains to inside ownership as well. As we said in that letter, “…nothing takes the place of tearing apart a company from many angles…” As we look to pay close attention to the individuals we are going into business with, and what their motivating economic and egoistic incentives might be, we simply are looking to increase our odds of attaining a successful investment outcome.
Our Three Top Purchases in the 1st Quarter
Putnam Managed High Yield Trust, PTM. PTM is a closed-end bond mutual fund with a diversified portfolio of high yield bonds. Closed-end funds are a unique investment class, a hybrid of traditional open-end mutual funds and stocks. Because closed-end funds are often inefficiently priced (funds often trade at a discount to their underlying net asset value), they present an opportunity to add value to our fixed income security selections. As many of you know, when an extremely compelling fixed income investment opportunity presents itself, we attempt to buy the security across all client accounts.
PTM has approximately $67 million in assets – a small fund by industry standards. We began slowly accumulating our position in PTM about one year ago. At our purchase price, the fund was trading at over a 10% discount to its net asset value with a yield of about 7.5%. With significant purchases in the first quarter of 2006, we accumulated roughly 18% of the fund’s outstanding shares; on average, a 5% holding in our client accounts. We contacted PTM’s board of directors to inquire about putting forth a proposal to other shareholders to merge PTM’s assets into an existing open-end Putnam high yield fund to realize the 10%+ discount. In mid-March, after careful deliberation, Putnam took it upon itself and announced that the board approved merging PTM into Putnam High Yield Trust, an open-end fund pursuing similar investment objectives. The discount to net asset value has closed significantly and will, of course, be eliminated at the merger date sometime late summer/early fall. We will continue to seek similar discounted closed-end fund opportunities for our clients.
Pioneer Natural Resources, PXD. Pioneer Natural Resources is a familiar story to us. Our first foray into Pioneer was in 2004. Headquartered in Irving, TX, Pioneer is an independent exploration and production (E&P) energy company. Simply put, it has proven oil and gas assets in the ground. The premise this time around is the same as last time: Pioneer is selling at a significant discount to recent merger and acquisition activity in the oil and gas industry.
E&P companies report their proven oil and gas reserves annually. At year-end 2005, Pioneer reported reserves of 5.9 tcf (trillion cubic feet) on a gas equivalent basis. At the price we paid, Pioneer had an enterprise value of approximately $8.0b. Therefore, Pioneer was trading at about $1.35 (i.e., $8.0b/5.9 tcf) per mcf (million cubic feet). We compared this price to recent merger and acquisition activity in the oil and gas industry. Transactions announced in the first quarter were as follows: Chesapeake Energy bought private properties for $3.02 per mcf; XTO Energy bought assets from Total SA for $2.50 per mcf; Noble Energy bought US Exploration Inc. for $1.66 per mcf; and Forest Oil bought private properties for $2.32 per mcf. On average, competitors seem to be paying about $2.35 per mcf for reserves. Although Pioneer may have longer-lived assets than many competitors which would explain part of the discount, at $1.35 per mcf, Pioneer is trading at over a 40% discount to the recent average industry transaction price. In addition, management has been proactively searching for ways to unlock shareholder value. For instance, in order to reduce the riskiness of its reserves in the eyes of the investment community, Pioneer recently sold its Argentina and Gulf of Mexico assets. Our Pioneer investment is not a bet on the direction of commodity prices. It is an investment based on the mispricing that currently exists between actual merger and acquisition activity for oil and gas assets and the price at which Pioneer’s proven reserves are valued given its current public market price.
Dell, Inc., DELL. Dell designs, develops and sells computer systems and services to customers throughout the world. Dell’s business model is unique in that it sells its products directly to the customer; bypassing the retail channel that its competitors rely upon. Dell’s direct-to-consumer sales approach coupled with a best in class inventory management and production system maximize the company’s profit margin. Dell is also making headway in to the printing, networking and peripherals business in an attempt to diversify its revenue stream from its bread and butter computer business.
Our investment in Dell is based on a going concern analysis. A primary metric that we examine when valuing a mature company such as Dell is its free cash flow yield (free cash flow/enterprise value). We find value in companies that have a consistent cash flow yield that exceeds that of the 10 year U.S. Treasury. In the case of Dell, we discovered a company generating roughly a 6.3% free cash flow yield based on its prior three years average free cash flow and our average purchase price. This 6.3% yield compared favorably with the 4.75% yield of the 10 year Treasury bond at the time of purchase. In our view, Dell’s free cash flow is likely to grow. In addition to Dell’s attractive free cash flow yield, the stock is trading at five year trough price-to-earnings and enterprise value-to-sales multiples. Of course, Dell is not growing revenue and earnings at the rate it once did; in fact, this appears to be the main reason its shares have dropped nearly 30% over the past eighteen months. In our opinion, any potential North American market share losses have the chance to be offset by international sales growth and/or application of its distribution model to new products.
Although fundamental analysis is the bedrock of our valuation technique, other non-quantitative information often underscores an investment thesis. As discussed above, we are attracted to companies where management maintains a significant economic interest in the future of the business. Michael Dell, founder and Chairman, maintains a 10% ownership interest ($6.6 billion market value) in Dell, Inc. Management integrity is another intangible that is a requirement among our portfolio companies. In a 2005 Barron’s poll of professional investors, Dell ranked as the seventh most respected company in the world. In short, people matter and Michael Dell along with his management team have a significant interest to guide Dell in a direction that is in the best interest of shareholders over the long term.
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, we have lots of new terrific restaurants in our new Chevy Chase 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.
Pertinent securities laws require us to make available to you every year the latest version of our ADV brochure (filed with the SEC) which has been prepared in accordance with current regulations. If you would like to receive a copy of our ADV, please contact us via email or letter.
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. Returns include an insignificant number of accounts that utilize margin. 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 343 equity portfolios totaling $129.7 million. This represents 61.9% of total portfolios and 56.7% of total dollars under management. The standard deviation for Roumell Equity in this quarter is 0.9%. Currently, in the performance calculations for Roumell Balanced, there are 147 balanced portfolios totaling $76.7 million. This represents 26.5% of total portfolios and 33.5% of total dollars under management. The standard deviation for Roumell Balanced in this quarter is 1.2%. A complete list and description of the firm’s composites is available upon request. Additional information regarding policies for calculating and reporting returns 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.