Where's the rest of this moose?
-- Arthur Bach
Dear Fellow Independence Fund Shareholder:
Would you eat a sandwich from a can? Mark Kirkland, founder of Utah-based MarkOne Foods, hopes that you will soon be doing just that. MarkOne has developed the Candwich, which it hopes to sell out of vending machines. At present there are three flavors, barbecue chicken plus two types of PB&J. Two more, pepperoni pizza and French toast, are in development. I love the Candwich story -- an entrepreneur comes up with a crazy product idea, develops it, does some market testing, and goes out to raise money from investors. Ultimately, the Candwich may be as common as shelf-stable cookies, credit cards, and the airplane, which were similarly outlandish in their own times. Crazy ideas can hit it big, rewarding both inventors and the investors who back them with enormous fortunes.
An investor named Travis Wright hopes the Candwich is a huge hit, since he backed Kirkland's company to the tune of several million dollars. But there's a problem here. According to an SEC complaint, Wright allegedly raised $145 million telling people they were buying loans to secure commercial real estate. Instead, the vast majority was diverted into other investments like MarkOne Foods, or more insidiously, Wright's own expenses, including a driveway for his home made with cobblestones imported from France. Even if prosecution of Wright is successful, these investors are unlikely to recover most of the money they entrusted to Wright. It's unrecoverable. It evaporated. They're left to hope that Mark Kirkland is right about the sandwich-in-a-can market.
Why mutual funds are kinda awesome
I have been investing for many years now, and have tracked the industry for more than a decade. In that time, I've seen passive minority investors get ripped off in dozens of different schemes. And while we all look at things like Nigerian confidence scams and wonder how anyone ever falls for them (yet thousands do, every year), the thing is, some frauds are extremely well-papered, allowing them to go on for years. Such frauds can come in the form of hedge funds, private investment schemes, straight Ponzi schemes, private offerings, tax shelters, or other pooled investment vehicles.
Many have marveled that Bernard Madoff hoodwinked his clients for so long. I doubt it was that complicated; after all, he provided his investors official (albeit wholly fabricated) statements, and when they asked for distributions, the checks he sent always cashed. Besides, it's tough to get someone to believe something when their beneficial interest comes from believing the opposite. Thankfully, the rules covering mutual funds have created a fantastic structure that makes it extraordinarily difficult for a fund management company to rip off its clients.
Certainly there are incompetent fund managers out there, and as the mutual fund scandal of 2003 demonstrated, where there are large pools of money there will always be those trying to take advantage. But the Investment Act of 1940 (the key piece of legislation covering mutual fund management) has substantial protections in place for outside investors.
For example, though Motley Fool Asset Management is the Advisor for the Independence Fund, your assets are actually held by a custodian, the highly reputable Bank of New York Mellon. We don't get to touch them. Similarly, mutual funds, unlike many hedge fund structures, have strictly limited management compensation rules. There is little incentive for a mutual fund manager to "roll the dice" to get at a bonanza under a "2 and 20" or similar structure as exists throughout the hedge fund industry. The Financial Times estimates that if Warren Buffett were two people, one the manager of a hedge fund, the other a client of the same hedge fund, his $62 billion fortune would have been split $57 billion for the manager and $5 billion for the client. That's a 90% decrease for the client!
Mutual funds must have their financial results audited annually, and they can only incur debt under heavy restriction (neither the Independence Fund nor its trust have ever borrowed). And finally, mutual funds have requirements to maintain diverse portfolios if they wish to receive pass-through treatment from the Internal Revenue Service.
What you have, in the end, is an investment vehicle that is reasonably well-balanced. Mutual fund management firms earn ample but not obscene levels of compensation, and the industry is by and large profitable. So while our parent company, The Motley Fool, has made a career out of criticizing the mutual fund industry (and there are many areas where the industry can improve), the fact is that whether through grand design or divine circumstance, the rules that govern mutual funds have afforded clients of these funds (more than half of all American households) a degree of safety unavailable to those who, for example, unwittingly invested in the great Candwich hype machine.
I don't think that word means what you think it means
One of the big news items this month was the enactment of the Dodd-Frank bill, the much-ballyhooed legal reforms designed to prevent financial crises. As University of Chicago economist Gary Becker wryly noted, the very fact that this bill is 2,300 pages long indicates that many "political compromises" took place in order to bring about its passage. Where politics collide with economic orthodoxy, you may rest assured that politics usually win out. Many components of the Dodd-Frank bill are no different.
Despite the hype from the bill's sponsors, most knowledgeable observers believe the bill would fail to prevent a financial crisis, and a modicum of critical thinking reveals why this would be the case. At its core, the global financial system is based upon a mix of leverage and confidence. The financial crisis of 2008 was caused by a set of factors that had not previously been observed, driven by financial instruments such as credit default swaps and CDO-squareds that had only recently come into widespread usage. How could a financial regulation bill possibly prevent future financial crises when they're likely to be fueled by financial instruments that don't even exist at present? It's the equivalent of traffic regulations for space travel.
Dodd-Frank has its positives, but the bill's deficiencies are substantially more important, and could have a deeply negative impact on the American economy, again, without particular preventive efficacy. Dodd-Frank gives government agencies extensive discretion to act in prevention of a financial crisis, but it's not like these agencies lacked authority before. The Federal Reserve, for example, certainly could have stepped in and stopped predatory lending practices, but it didn't.
These 2,300 pages of new regulations fail to address the fact that our regulators are captured by the entities they're meant to oversee. This doesn't mean that they're corrupt, per se. But because financial instruments are subject to constant enhancement and alternative usage, regulators are dependent upon bankers to describe what these things are and how they're used. In 1999, credit default swaps were generally thought of as insurance. By 2005 they comprised a multitrillion-dollar speculative market unto themselves, yet many regulators still viewed them as they existed years before. Unless some bank official tipped regulators off to the systemic risk the metastasizing CDS market represented, they were quite unlikely to have fully understood the change.
Most damningly, two entities that deserve substantial blame for the crisis, Fannie Mae and Freddie Mac, rated barely a mention in the bill. In 2008, these two government-sponsored companies held over half of all U.S. mortgages and almost all of the subprime mortgages, and unlike most banks, actually have cost taxpayers hundreds of billions of dollars. Instead, the bill adds regulations and costs to many financial transactions that had next to nothing to do with the crisis, ones that have unknowable (but potentially very negative) impacts on the economy. For example, the bill's designation of "qualified mortgages" greatly restrains lenders from developing new loan products, potentially lowering consumer choice and making credit both less generally available and more expensive. I'm at a loss to understand why this could be viewed as a good thing.
Big in Japan
In the aftermath of the fiscal crisis it may be unwise to seem to rise in defense of American banks, but all bitterness aside, it must be emphasized that there will be no financial recovery in the U.S. without the participation of our banks. We need them to be healthy, which means that we need them to be profitable. Historically, financial distress either wipes out or deeply impairs weaker competitors, leaving the remaining banks to rebuild their balance sheets while they generate substantial profits from the banking services that are and always will be central to economic growth. Banks can typically earn considerable spreads on their loans even with extremely low interest rates.
But there is a historical anomaly -- Japan. Following its financial crisis, Japan lowered its interest rates to absolute zero, and bank lending in the country -- which was already paltry -- ground to a halt. To this day Japanese banks have trillions upon trillions of yen to lend, and no one to lend them to, because Japanese corporations are not borrowing. I contend that Japan has never recovered because the government has never allowed its walking-dead companies to fail, rather allowing good capital to be squandered after bad. We own a single Japanese company -- Unicharm Corp. – because it is one of a very few Japanese companies we have found that generates returns above its cost of capital.
The Japan experience is one of which we should be wary. Like many U.S. banks, Japanese banks have strong deposit franchises, but it's awfully hard to make money on deposits when interest rates hover near zero. This lack of revenues and profits means that Japanese banks are vulnerable to even tiny credit losses, because there are no operating profits to compensate for them.
The Independence Fund has no direct investing exposure to U.S. banks. Many investment managers we know have taken the opposite approach and have been buying bank stocks hand over fist. I suspect many of these trades will be enormously profitable, because the massive shadow banking system that competed with banks earlier this decade has evaporated. American banks tend to have much stronger lending franchises than their Japanese counterparts, and this fact is core to their potential return to profitability. This won't happen over the next quarter -- we'll see what happens over the next 3-5 years.
What can be stated, unequivocally, is that credit results are far, far better than bears (or even many bulls) had predicted a year ago. Banks have been the go-to punching bag for politicians and citizens bemoaning the condition of the American economy, and not without justification. Still, economic recoveries do not happen without banks -- at some point we need to root for them to become healthy and profitable.
I am confident that the Independence Fund investment team will at some point find an American bank in which we want to invest.
Monthly results
The Independence Fund gained 8.2% for the month, compared with a gain of 8.1% for the MSCI World Index. After several months of underperformance, European markets led the way with double-digit gains in July -- though the rest of the world wasn't too shabby either. This rebound gave a nice boost to some of our recent acquisitions, like Hellenic Exchanges and Telefonica, although we still remain relatively light in Europe compared to our benchmark.
More than anything, July was noteworthy for us because of our lack of activity. After spending most of June deploying cash into our favorite companies, we had the chance to let the markets do the heavy lifting. Roughly 90% of our holdings increased in value during the month, and we made very few trades as our Top 11 holdings remained identical to last month's list.
While we don't fret over short-term stock price changes, we love taking advantage of them. Through the first seven months of the year our index has been stagnant, declining by a total of 2.2% -- that's a smaller net amount than we've seen the market move on several individual days this year. But those interim gyrations have given us plenty of opportunities to deploy your cash into companies we believe to be undervalued. With earnings season now upon us, we're counting on the market's volatility to provide us with more great values.
As always, my team joins me in thanking you for your trust. Please know that we welcome your correspondence at askbill@foolfunds.com.
Foolish best,
Bill Mann
Portfolio Manager, Independence Fund
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International investments are subject to special risks not ordinarily associated with domestic investments, including currency fluctuations, economic and political change, and differing accounting standards that may adversely affect portfolio securities.