During the first six months of 2014 our Equity accounts advanced 6.95% compared to a 7.14% return for the S&P 500 and our Balanced accounts returned 5.26% compared to a 5.61% return for the benchmark (which is weighted 50% S&P 500 and 50% Barclays Aggregate Bond Index).
Returns in the first half of the year benefited from outsized performance among several investments offset by continued large cash balances. More specifically, total return from our individual investments outpaced the S&P 500 with an increase of 9.3%, as 15 out of 19 positions produced gains. Although the returns achieved year-to-date failed to outperform the benchmark, it bears repeating that short-term performance is not the best yardstick to measure success or failure for an investment philosophy that relies on a long-term opportunistic approach. Periods of underperformance are inevitable, but the ultimate objective remains unchanged: deliver superior long-term returns with a limited amount of risk.
Below is a chart which lists, in order, the top 5 and bottom 5 contributors to performance so far in 2014:
The largest contributor to performance was our position in Level 3 – which advanced 32% during the first six months of the year. This return follows a 40% gain in 2013. As we have discussed in recent Quarterly Letters, Level 3 is executing at a very high level and starting to fulfill the long-held promise of its unique internet backbone asset. Furthermore, in June the company announced the much anticipated acquisition of Time Warner Telecom for approximately $7.3 billion. While the strategic rationale and potential cost-saving synergies of the deal are compelling, the company paid a steep price for this asset which will limit the overall benefit of the transaction. Although we recently trimmed our weighting in Level 3, the stock continues to trade at a discount to fair value and remains a core holding.
Activity levels during the first half of the year remained muted (as we will describe in more detail below). We added one new investment to the portfolio (Blackhawk Network) and sold three core long-term holdings (Legg Mason, Sprint, and Crosstex Energy). These three sales were based purely on valuation as the current prices no longer afforded us an adequate margin-of-safety.
Limited Volatility = Limited Opportunities
The lack of new investment opportunities mentioned above can mostly be attributed to a trio of forces dominating the market today: low volatility, high correlation, and above average valuations. Despite geopolitical turmoil and economic uncertainty, the stock market continues to exhibit a steady tranquility in mostly a positive direction. By almost any measure, the length and magnitude of this benign atmosphere is virtually unprecedented in recent history.
Unfortunately, this is bad news for opportunistic value investors who rely on periods of euphoria or despair to find mispriced investments. While you might find this viewpoint perplexing, volatility is indeed our friend. We thrive in environments which allow us to deploy capital when others run for the exits; and, conversely, raise capital when others are willing to pay us a lofty price. When neither situation is evident, we are forced to sit on our hands like a young child at the dinner table staring at their vegetables waiting patiently for dessert to be served.
Our level of frustration is difficult to communicate given the amount of interesting investments we have recently passed on solely because the price was too high. The list is a long one. Yet, we firmly believe that the single best action any investor can take to reduce risk is to pay the right price. This requires discipline and a large dose of patience, but is absolutely vital in order to avoid owning risky assets.
The result is a sustained period of low activity and higher than normal cash balances. However, if history is any guide, we are confident that at some point volatility will return and our patience will be rewarded.
We are pleased to announce that Adriana “Ana” Parker has joined Carmel Capital Partners as our new Operations Manager. Ana was previously with US Bank for over six years. We are excited to have her on the team and encourage you to contact her directly with any operational questions or comments you may have.