Quarterly Letters


Quarterly Update

January 23, 2006

Fourth Quarter Summary - Celebrating Seven Years

The year 2005 marked Roumell Asset Management’s seventh year managing equity and balanced accounts as an independently registered investment advisor.  The total returns for our clients since inception show strong real rates of return that meaningfully outperformed relevant benchmarks.  2005 was another year that enhanced our overall performance record since inception, as indicated in the table below.  The graphs showing our performance since 1999 on a hypothetical $100,000 investment are provided to illustrate our firm’s historical performance. 

Performance Summary

  Annualized as of 12/31/05
  4Q 2005 1 Year 3 Year 5 Year Since
Roumell Equity 3.92% 12.48% 21.34% 16.33% 16.42%
S&P 500 2.08% 4.91% 14.38% 0.54% 1.76%
Russell 2000 1.15% 4.61% 22.18% 8.25% 8.30%
Roumell Balanced 2.25% 8.17% 17.34% 12.07% 11.61%
Vanguard Bal. Index 1.52% 4.65% 11.11% 3.77% 4.26%
Lipper Bal. Index 1.70% 5.19% 11.20% 3.51% 4.11%
* Please refer to performance disclosures at end of document.

Guiding Principles to Our Investment Approach

In thinking about our performance and how we’ve gone about selecting investments over the years, we’ve put together a list of principles that have guided us in our process (or perhaps have been violated on occasion to our detriment). As our clients know, we are “deep value” investors. We are eclectic in discerning value. We are willing to own just about anything (large, mid, small, foreign stocks and/or bonds) so long as we can quantify a meaningful discount to a situation that doesn’t entail undue risk in our opinion. Listed below are investment principles that have guided us in our purchases over the past several years, and will continue to serve as an operating constitution of sorts.

  1. Invest in individual securities because of precise reasons.
  2. Demand a significant discount to an intrinsic value derived using a straightforward valuation technique(s).
  3. Invest in companies with strong balance sheets.
  4. Assess management. Are they competent and do they possess integrity?
  5. Invest in easy to understand businesses and stay within the scope of our competencies.
  6. Ignore the general markets.
  7. Ask, does the company create wealth, destroy it or stand still?
  8. Would we feel comfortable owning the whole business if there was no stock market?
  9. After all the analysis, does it feel right – gut check.
  10. P:\branches\custom\pylecunninghamAdmit mistakes and move on.

There are no black boxes in our opinion to insure investment success. There are newsletter writers, academics and a myriad of others who claim to have discovered the technique that, if applied properly, will guarantee great performance: Dogs of the Dow, low price to book or earnings quadrant stocks, monster growers and many other models. The truth as we see it is that nothing takes the place of tearing apart a company from many angles, valuing its pieces using several methods, wrestling with understanding its past, current and potential future industry position and arriving at a valuation that honors economic reality (the best we know it). Finally, be highly price conscious.

The debate that rages in the public square between constitutional literalists (the word is the word) and those who believe in a living, breathing constitution (strict principles need to be applied to changing times) is instructive – we are “living, breathing” folk who are deeply guided by principles, but hopefully never imprisoned by them. For instance, will we buy a company with a low return on equity? Sure, perhaps we can buy at a steep discount to a solid book value. Will we buy companies with no real current earnings? Perhaps, the company may own substantial real assets that can be monetized. The entire entity must be viewed from multiple angles to render an informed total investment judgment (not just a current operational judgment). Of course, all else being equal, we would like to own beauties – wide moats, growing margins, solid management teams in healthy industries. In the end, we choose which devils we can live with and which ones we cannot (but everything is on the table in light of pricing). We believe that there are no shortcuts to selecting superior investments – just lots of arithmetic and diligent detective work. It’s an approach that we believe is straightforward and sensible.

Our Three Top Purchases in the 4th Quarter

Tejon Ranch Company, TRC. Though TRC was one of our top 4th quarter purchases, we have been invested in the company for many years. Founded in 1843 through several Mexican land grants, Tejon Ranch spans over 270,000 contiguous acres in Southern California. It is located just 75 miles north of downtown Los Angeles with the vast majority of acreage in Kern County and the remainder in Los Angeles County. Tejon is a diversified real estate development and agribusiness company. The attractiveness of this investment lies in the fact that there are many, many options that can be potentially exercised by management in order to unlock value. Tejon does not market itself to Wall Street. In fact, there is no analyst coverage.

Our investment in Tejon is based on a discount to net asset value analysis. In analyzing Tejon, we estimated the value of its various parts: Tejon Industrial Complex, including Petro Travel Center; Centennial project; Tejon Mountain Village project; Agricultural and Grazing business; Land Conservation project; and net cash.

Tejon Industrial Complex (TIC) is located along Route I-5, a major north/south artery between Los Angeles and San Francisco. In February 2005, Tejon reached a development agreement with Rockefeller Group Development Corp. for a joint venture at TIC. 500 acres at TIC were designated as a Foreign Trade Zone (FTZ), providing tax benefits for warehouse/distribution businesses with locations in the FTZ. The partnership is 50/50. Rockefeller is putting in $65 million. The total acreage of TIC is 1,500. If 500 acres of raw land is worth $65 million, then it is reasonable to estimate the value of 1,500 acres to be $195 million (65x3). In addition, there is a Petro Travel Center at TIC (on the west side of I-5) that is owned as part of a partnership. The Petro stop is the most heavily trafficked travel center in California. The total value of TIC is estimated to be $225 million (inclusive of the value we assign to the Petro stop).

Centennial is a traditional master planned community. The proposed size of Centennial is 11,700 acres with 23,000 units to be built over a period of 20 years. Centennial will be located 75 miles north of Los Angeles on the southern end of the Ranch. TRC has partnered with a consortium of home builders who are financing the entire entitlement process. We based the value of Centennial on a comparable transaction: Lennar’s 2004 acquisition of Newhall Land. Applying the per unit value of the Newhall transaction and, then, applying a wide discount (over 50%) for the fact that Centennial is about 20 miles further north and faces a myriad of titling obstacles, we arrive at an estimate of $340 million.

Tejon Mountain Village (TMV) is an area of 28,000 acres located in Kern County, of which 23,000 acres would be dedicated to open space. The plan calls for only 3,450 units to be built (one home for every eight acres on average), along with hotels and golf courses. TMV will be completed over the course of 15 years after approval. Based on discussions with management, we estimate the value of TMV to be equivalent to Centennial given its scope and cash flow projections. TMV is likely to be approved prior to Centennial given a more developer-friendly Kern County.

The agricultural and grazing business is rooted in the history of Tejon. Ranchers have utilized Tejon for grazing for many years. Crops such as almonds, pistachios, walnuts and grapes are grown as well. The value of these businesses is based on a price per acre. We estimate a value of $30 million.

In connection with the Trust for Public Land, Tejon is planning to cordon off 100,000 acres as a land preserve that will never be built upon. Based on a discount to a recent similar sale of the Hearst property (and discussions with leading environmentalists), we estimate this acreage to be worth $1,500 per acre, or $150 million.

Though difficult to estimate, TRC’s pieces, conservatively valued, total between $65 to $70 per share (providing our 4th quarter purchases with a 35% discount to NAV). Moreover, our analysis does not include the multitude of development possibilities that management is sure to consider in the ensuing years, i.e., doubling the amount of land put in trust, adding another petro stop, etc. We visited the Ranch in the 4th quarter, met with management and local officials, and concluded that although difficult to quantify with any real certainty, TRC offers us a compelling investment opportunity.

Washington Post Company, WPO. There’s more than meets the eye with the Washington Post Company. The Washington Post is one of the most respected and renowned newspapers in the world. However, the Post and the rest of the newspaper division is only one of five businesses that comprise the Washington Post Company. The Post’s other assets include magazines (Newsweek), cable television, broadcast television, and education (Kaplan). The Post is a family run business having been under the stewardship of the Meyer/Graham family since 1933. The Graham family owns 20% of the company (Classes A and B).

The melding of different businesses under one corporate umbrella can create confusion within the investing community. For example, the first thing that comes to mind when one thinks of the Washington Post is the newspaper business. The newspaper industry, in general, has been declining, and Wall Street seems to have unjustly penalized the Post as a strict going concern newspaper company. In fact, although the Post is the face of the company, its contribution to the WPO’s overall profitability will be less than 20% in 2006 based on projected EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) estimates. The newspaper division ranks fourth among the company’s five segments in total EBITDA. The primary contributor to the Post’s profitability is the Kaplan education business, 33% of total EBITDA.

Our investment in WPO is based on a discount to net asset value. In arriving at a sum of the parts value, we applied conservative multiples of recent private market transactions to each of the various components of the Washington Post’s portfolio of businesses. We determined that the stock was trading at roughly a 25% discount to our intrinsic value estimate. Looking at the investment from a different angle, we essentially acquired the newspaper business of the Post for free. You don’t have to be a value investor to understand the appeal of getting something for nothing.

POSCO, PKX. Located in South Korea, POSCO is one of the world’s largest steel producers. It is the dominant player in Korea and has a growing presence in China and India. POSCO used to be government owned, but now is a private company.

Due to the fact that PKX is in a commodity business, its shares have perennially traded cheap. The company has a solid balance sheet and is a strong free cash flow generator. In fact, its historical three-year average free cash flow yield is 14%. POSCO’s ADRs (foreign shares listed in the U.S.) were bought at about 1.0x book, 2.0x EBITDA, 6.0x forward P/E and 0.8x forward EV/Revenue (unbelievably cheap...even if the future is 50% of recent years’ operating strength). Bolstering our going concern value, we believe that recent merger and acquisition activity underscores that PKX shares are cheap. Most recently, Arcelor SA, the world’s second largest steelmaker, launched a hostile bid for Dofasco, a Canadian steel company, at approximately 8.0x EBITDA. Subsequent to the initial offer, there have been several increases in the offer price due to competitive bidding suggesting that there is real value to owning steal capacity.

We’re moving at the end of March to: 2 Wisconsin Circle, Suite 640 Chevy Chase, MD 20815. We’ve signed a long-term lease and are excited about moving into larger space currently being built-out and equipped to our specifications. Our new phone number will be (301) 656-8500 (fax 8501). We will keep you apprised. All of us wish you and your family a healthy and prosperous New Year.

Performance Disclosures:

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 312 equity portfolios totaling $102.7 million. This represents 60.9% of total portfolios and 51.6% of total dollars under management. The standard deviation for Roumell Equity in this quarter is 1.1%. Currently, in the performance calculations for Roumell Balanced, there are 142 balanced portfolios totaling $73.5 million. This represents 27.7% of total portfolios and 36.9% of total dollars under management. The standard deviation for Roumell Balanced in this quarter is 2.1%. 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.

Additional Disclosures:

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.

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