Letter to Investors: Fourth Quarter 2016

Dear Partner,

We continue our series of our quarterly letters to investors with this annual edition.  As a reminder, the purpose of these letters is to keep you informed about what’s going on with your portfolio and provide the “why” behind some of our investment decisions.  Let’s begin by reviewing what happened in 2016…

2016 In Review

When we reflect on the events in 2016 and the resiliency of the stock market, we’re reminded of our hometown baseball team, the Kansas City Royals in one of the greatest games we’ve ever seen: the 2014 American League Wild Card game between the Royals and the Oakland Athletics.

We put together a graphic that shows 2016 major market events on the left, and the corresponding events from the game on the right.  We think you’ll agree that the similarities are quite uncanny.


When it was all said and done, the S&P 500 was up 9.54% for the year.  If you include reinvested dividends, it was up 11.96% for the year.  Just like the 2014 Royals, the market overcame many challenges and uncertainties to finish 2016 on a positive note.

And just like any good baseball manager, we would be well-served to look for learning opportunities based on the events of the past year.  So what can we learn from 2016?

No Crystal Ball

As we think about everything that happened in the past year, a couple of themes emerge: the future is uncertain and experts can be lousy forecasters

For example: 

Experts predicted that China’s collapse was imminent and would produce a ripple effect to other economies in the beginning of 2016. 
This never materialized, and markets recovered rather quickly. 

Experts predicted that a Brexit vote would create shockwaves across Europe and send markets into a tailspin. 
Although the market had an initial negative reaction to the Brexit vote, it only took a few days to recover those losses.

Experts predicted Hillary Clinton would win the US presidential election. 
Wrong again. 

Experts predicted that a Trump victory would spell trouble for the economy and that the stock market would fall sharply if he was elected. 
It remains to be seen what effect a Trump presidency will have on the US economy, but the stock market actually moved up in the wake of Trump’s election (market pundits are dubbing the market reaction a “Trump Bump”).     

So-called “experts” may have access to data and analysis that the average person doesn’t have, but at the end of the day, nobody knows what the future holds.  These experts make the wrong call at times, and they will continue to do so, because even in the age of big data and artificial intelligence, nobody (nothing) knows what will happen in the future.  We believe this to be an enduring truth, as the Bible clearly states in Proverbs: “Do not boast about tomorrow, for you do not know what a day may bring.”

Therefore, we can safely say that there is no way to consistently and accurately predict the future.  Anybody who claims to “know” what will happen in the future should be viewed with a high degree of skepticism.

How to Invest When You Know You’ll Be Wrong

Since we know that there is no way for experts to reliably predict what will happen, what’s the hope for investors?  After all, investing requires that we take positions that will be affected by future developments, and therefore the active investor must make predictions about the future.  So how can we invest if the only certainty about the future is that it’s uncertain, and we know that our predictions will be wrong?

When investing, we use four strategies that help dampen the risk of being wrong: invest in businesses we understand, employ a margin of safety, use conservatism, and diversify.

·         Investing in businesses we understand gives us a better chance of making correct assumptions about the future developments of the business.  This doesn’t mean we’ll always be right, it just means that our assumptions will be educated guesses rather than just guesses.

·         Employing a margin of safety gives us wiggle room to be wrong.  When we invest using a margin of safety approach, we’re saying, “We think the company is worth $10 per share, but we know we could be wrong, so we only want to buy it if it’s trading at $5 per share.”

·         Using conservatism when we make estimates about future developments is prudent because the future is so uncertain.  Since we know we’ll be wrong when making assumptions about the future, we’d rather err on the side of caution.

·         Diversification is a staple concept in the financial industry.  But long before the financial industry existed, King Solomon taught that diversification is wise when he said, “Invest in seven ventures, yes, in eight; you do not know what disaster may come upon the land.”  Diversification is a tried and true method to protect against the risk of being wrong.

These four strategies are pillars of our investment philosophy.  To learn more about our investment philosophy, click here.

4th Quarter 2016 Results

The following discussion of performance refers to the performance of a representative client equity portfolio, after fees.

The stock market as measured by the S&P 500 Index was up 3.25% in the fourth quarter of 2016.  As mentioned previously, the quarterly gains are mostly attributable to the stock market rally that took place following the presidential election.

The equity portfolio gained 5.85% for the fourth quarter of 2016, outperforming the S&P 500 Index by 2.60% after fees.  This quarter’s outperformance was driven by the following companies: ArcBest (ARCB), Independent Bank Group (IBTX), Magellan Health (MGLN), and Spirit Airlines (SAVE).

·         ARCB was up approx. 45% this quarter.  We still think this Arkansas trucking and logistics firm is undervalued and are maintaining our current position.

·         IBTX was up approx. 41% this quarter.  This community bank stock is currently trading above our estimation of fair value, so we will likely trim/sell this position in the near future.

·         MGLN was up approx. 40% this quarter.  This health insurer was one of our largest underperformers last quarter, but we saw opportunity and increased our position at the beginning of the fourth quarter.  Now the stock is a bit closer to our estimation of fair value, but we still think it has more runway, so we’re maintaining our position.

·         SAVE was up approx. 36% this quarter.  This airline stock has reached our estimate of fair value, and we feel that they are up against tough industry headwinds, so we’re considering trimming or selling our position. 

The two largest detractors in the quarter were Fitbit (FIT) and Syntel (SYNT).

·         FIT was down approx. 54% this quarter.  The electronic device-maker saw a 30%+ stock price decline after reporting soft fourth quarter guidance.  We took the price decline as an opportunity to add to our position and essentially doubled our stake in FIT.

·         SYNT was down approx. 27% this quarter (adjusted for dividend).  This IT outsourcing firm paid a one-time $15/share dividend in the quarter to return overseas cash to shareholders.  SYNT is trading well below our estimate of fair value, so we’re considering adding to our position.

Also, we sold our position in OSI Systems (OSIS) as it exceeded our estimate of fair value during the quarter. 

We ended the quarter with about 10% cash in the portfolio, which was a slight drag on performance.  We expect cash to increase as a percentage of the portfolio due to anticipated stock sales and inadequate opportunities to put cash to work.  We’ll continue to dig, but as we write this letter, we’re coming up short on finding satisfactory investment opportunities.

Overall, our goal is simply to provide our investors with long-term outperformance by investing in good companies trading at a discount to their fair value.  While we’re pleased with the recent results, we’re focused on positioning the portfolio for outperformance in the long run.  If you have any questions about the portfolio, please call or email us.

Parting Thoughts

Thinking back once more on the 2014 Kansas City Royals and their amazing postseason run, the team ultimately lost in game seven of the World Series.  But the very next season, against all odds, the Royals won it all, bringing the first World Series title back to Kansas City since 1985. 

Maybe the stock market will follow in the Royals’ footsteps and have an even better year in 2017 than it did in 2016.  Or maybe it won’t.  We have no idea and we won’t try to guess. 

When John Pierpont Morgan (founder of J.P. Morgan) was asked over 100 years ago what he thought the market would do, he simply responded: “It will fluctuate.” 

Now there’s a market prediction we can get behind.

“It ain’t what you don’t know that gets you into trouble.  It’s what you know for sure that just ain’t so.”
-Mark Twain


Ben Malick, CFA, CKA


The information contained herein reflects the opinions and projections of Three Nine Financial (TNF) as of the date of publication, which are subject to change without notice at any time subsequent to the date of issue.  TNF does not represent that any opinion or projection will be realized.  All information provided is for informational purposes only and should not be deemed as investment advice or a recommendation to purchase or sell any specific security.  TNF has an economic interest in the price movement of the securities discussed in this presentation, but TNF’s economic interest is subject to change without notice.  While the information presented herein is believed to be reliable, no representation or warranty is made concerning the accuracy of any data presented.

Past performance is not indicative of future results.  Actual returns may differ from the returns presented.  Reference to an index does not imply that the funds will achieve returns, volatility or other results similar to the index.  The total returns for the index do not reflect the deduction of any fees or expenses which would reduce returns.

Positions reflected in this letter do not represent all the positions held, purchased, or sold, and in the aggregate, the information may represent a small percentage of activity.  The information presented is intended to provide insight into the noteworthy events, in the sole opinion of TNF, affecting the portfolio.