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August 31, 2015

The easy money has been made. This is a phrase you might hear hanging out among traders after an
investment has rebounded sharply from prices which, in hindsight, reflected too much pessimism1. It is
not a phrase you are likely to hear very often today as the easy money is very hard to find.
Monetary policy has left investors with very uncomfortable choices - accept zero returns on cash or
stretch for yield in liquidity-driven and increasingly speculative risk assets. There are no easy choices.
There is certainly no easy money. Choose wisely.

Divergent
Over time, monetary cycles across the globe have become more synchronized. Central banks now react
to similar developments with similar tools in an increasingly connected global economy. However,
interest rates can and will diverge from time to time, and when they do, monetary policy demands
greater attention as divergences can have a significant impact on relative asset prices.

I can assure you that there is no such thing as easy money in this business as buying at the point of
maximum pessimism is one of the most challenging and lonely endeavors of the contrarian investor.

Today, uneven economic performance around the world has created sharp contrasts in monetary policy.
Until recently, the symptoms of divergence have been greatest across interest rates and currency
markets where volatility has been most extreme. JPMorgan Chase Chairman and CEO, Jamie Dimon, for
example, referred to the intraday swing in the ten-year bond last October as a 7-8 standard deviation
event that is supposed to happen about once every 3 billion years2.
Domestic equity markets, on the other hand, traded in their tightest band for the first half of any year
since 1928. The S&P 500 Index had gone almost 1,000 days without a 10% correction3. The absence of
volatility had lulled investors into complacency.

Beneath this seemingly calm surface, cracks are appearing in our aging bull market. Momentum is
waning. Market breadth is deteriorating. Earnings expectations are falling. Oil prices are collapsing.
Uncertainty is increasing around the stability of a certain monetary union. And the effectiveness of
government intervention in a certain mainland stock market is being called into question. As a result,
stocks were largely unchanged through the first half of the year - the worst start to a pre-election year
since 1941.

The normal distribution is a severely flawed construct for modeling risk and volatility, yet most
institutional investors continue to depend on mean-variance models to manage portfolios and rely on
VaR (Value at Risk) to gauge risk exposure. Consequently, extreme volatility can be self-reinforcing with
extreme unintended consequences as well.
3

The benefits of procrastination, as related to quarterly letters, are abundantly clear perfect hindsight.
For the record, our friends at Dropbox inform me that the first version of this letter was saved on August
9th with the S&P 500 at 2077. Last weeks action has shaken some of that complacency out of the market
leaving most major indices down double digits for the month.
The Broyhill Letter - Divergent | Page 2

Against this backdrop, investors continue to obsess over the impact tighter monetary policy will have on
elevated stock and bond prices4. While it is true that tightening monetary and credit conditions have
preceded most bear markets, experience suggests that tops are more often processes than discrete
events. It takes time for asset prices to respond to tighter credit conditions. The first hike rarely convinces
anyone that the party is over. The chart below illustrates this process. During the last two hiking cycles,
it took multiple rate hikes (dashed blue line) over the course of several years for tighter monetary policy
to stall the aging bull market in stocks (grey line).

The First Rate Hike Is Rarely Last Call

The experience in bond markets has been similar and understandably counterintuitive. During the last
cycle, the fed funds rate climbed from 1% in 2004 to 5.25% in 2006. Over that period, the ten-year bond
yield barely nudged higher while the thirty-year bond yield actually declined. A rising policy rate is more
often coincident with a flattening yield curve. If the past is prologue, a flattening yield curve would,
should translate into healthy gains for several closed-end municipal funds in the portfolio today.
Despite ongoing apprehensions permeating high yield credit markets, we see little cause for concern
outside of the energy sector. It is important to note that credit spreads have historically behaved similar
to equity markets in response to policy changes. As illustrated below, high yield credit spreads (grey line)
actually compressed during the Feds last hiking cycle (dashed blue line). Counter to conventional
wisdom, spreads didnt widen until the Fed actually began cutting rates.

Developments last week may have eased these concerns in the near term. In fact, a number of
intelligent investors are now speculating that, The Feds Next Move Will Be To Ease.
The Broyhill Letter - Divergent | Page 3

Credit Spreads Compressed During The Last Hiking Cycle

Corrections are natural and inevitable occurrences within stock and bond market cycles, but the worst
sell-offs have typically been associated with recession5. While there are a number of indicators flashing
yellow today, we do not yet see the traditional signs of a looming bear market that would warrant a
significant reduction in risk. Outside of recession, we believe our current allocation to event-driven,
distressed credit represents a compelling value today with the average bond in the portfolio trading near
70 cents on the dollar and a yield approaching 10% - a coupon far greater than the expected returns on
offer across broad equity indices.

Risk Management & Value Investing


Stocks entered the year overpriced based on any objective, long term measurement. But valuations can
stretch a long way before they break. We know major stock indices are very expensive (those arguing to
the contrary have a different agenda). We know major stock indices have fallen spectacularly from
previous peaks of this magnitude. And we know another bear market is inevitable. We just dont know
when (those that claim they do likely have the same agenda as noted above). We also know that most
investors will overact when it does.
5

Bear markets can arrive without warning, but Mr. Market often offers some clues in advance. Bear
markets that have coincided with an inverted yield curve have lost roughly one third of their value over
360 trading days on average. The median decline for all other bear markets has been less than 20% and
has lasted less than 150 days.
While no one rings a bell at the top and no indicator is perfect, the yield curve has the single best track
record in identifying tightening monetary conditions which often precede recession. We explored this
relationship in our Annual Letter to investors.
The Broyhill Letter - Divergent | Page 4

Short term market volatility is notoriously difficult to time and most long term investors are better served
to ignore it. This has certainly proven to be the correct approach over the last several years as declines
have been particularly short and shallow. Nonetheless, we believe an emphasis on capital preservation
over capital gains will prove prudent in the seasonally weak period ahead. We are not hiding in the
basement with guns and ammo. Instead, we are preparing our shopping list and hope to be buyers of
good businesses at lower prices in the future (perhaps sooner than we had initially thought). In the
interim, we have taken some precautions.
In the absence of a severe economic contraction, it would be foolish to liquidate risk assets and sit on the
sidelines for an unknowable period of time. Risk management is not the same as risk avoidance.
Eliminating risk eliminates returns.
Rather, managing risk means working hard not to lose money. Most of the time, this can be accomplished
by buying right. Buying right also provides the value-oriented investor with a margin of safety.

Consequently, value investing is synonymous with risk management.

Most value investors stop here. Knowing that they have invested with a margin of safety, they choose to
remain fully invested at all times, so as to maximize their exposure to the long term growth of the
economy which is ultimately reflected in the long term uptrend in stock prices. There is nothing wrong
with this approach so long as investors are willing (and able) to ride out large intermittent drawdowns6.
Many of the top minds in the business have generated impressive long term returns doing just this. It is
worth noting, however, that their investors actual returns are often significantly lower than reported
returns.
Since the average investor tends to buy after a good run and sell after a bad run, actual returns to
investors in more volatile strategies are often lower than those generated by more conservative
approaches. The results are a predictable consequence of human behavior.

A word of caution: some of these intermittent drawdowns may seem long term if you are 100%
invested in risk assets. Consider that the Dow Jones Industrial Index reached 300 in 1928 only to surpass
this level again in 1954. Would you consider a quarter century a long term investment horizon? Once
the Dow reached 1000 in 1966, it took Mr. Market nearly two decades to advance much further. Can you
wait twenty years for markets to recover?
Recent experience hasnt been quite that dramatic yet investors still had to watch half of their wealth
disappear TWICE to generate a 5% annual return on an investment in the Dow since 1999. Those that
trusted their wealth to Messrs. Standard & Poors fared worse. In fact, an investment in 10 year treasuries
would have outperformed both while providing more Zs than Nyquil.
The Broyhill Letter - Divergent | Page 5

The Average Investor Rarely Enjoys Average Returns

At Broyhill, value lies at the heart of our investment process. We construct portfolios piece by piece,
conducting rigorous fundamental research on various opportunities, but limiting purchases only to those
securities trading at a discount to fair value. Buying right is the single most important determinant of our
long term success, but it requires patience and discipline.
Today, stocks and bond prices are greatly distorted and trading at elevated valuations. There is
increasing evidence of herding among market participants. Buying right is a much greater challenge in
more speculative, liquidity-fueled markets.
Rather than follow the herd, we have allowed dry powder to build in portfolios. This is a natural byproduct of our patient and disciplined approach. Holding cash over the past three years has without
question resulted in lower returns than what we might have achieved if fully invested. The upside of
holding cash is lower volatility. Since inception, our equity strategy has captured two thirds of the
markets gains while only participating in one third of the markets losses7. The result is a portfolio which
has generated acceptable returns with lower risk.
7

The capture ratio is a statistic that is often cited to compare performance in down markets with returns
generated in up markets. Statistics are nice for us math nerds, but real world examples are often more
helpful in promoting a general understanding. So lets consider what might happen if the market were
to lose half its value (again).
A $1 million investment in a market index fund would be valued at $500,000 while a manager with one
third of the downside risk would still be sitting on $833,333 ($1m principal $500K loss 1/3 downside
capture). If we assume that the market went on to double from this trough (again), then our index
investor would be back to even note that even in this case, is strictly a measure of portfolio value.
More than likely even would come with less hair and a few more pounds. A manager demonstrating a
similar capture ratio as the one noted above, however, might capture two thirds of this rebound,
generating a cumulative gain of 39% with nearly $1.4 million in value ($833K principal + $833K doubling
of stock market 2/3 upside capture). Simply put, boring is better.
The Broyhill Letter - Divergent | Page 6

During speculative rallies, our investors should expect very strong absolute returns which may trail
broader indices. During bear markets, we demand much stronger relative returns given our focus on
capital preservation. When you put the two together, we expect this combination to generate superior
long term returns with lower volatility. This is consistent with our long term objectives and consistent
with what our clients expect from us. Furthermore, the experience of our average investor is likely to be
very similar to our own. This is explicitly by design.

Portfolio Strategy: Keep Your Pants On


Losing your shorts in a bear market and bailing at the bottom is not a particularly healthy long term
investment approach. Yet this is the script followed by many who commit capital to a fully invested
manager who has just had a good run.
The best trailing five year records at this point in the game were likely generated with an equivalent
amount of risk by fully invested and unhedged heroes. We doubt the same brave group will come out on
top over the next five years. There are no guarantees in this business, but its a safe bet to assume that
this approach will greatly increase the probability that the next wave down takes your pants and your
capital with it.

Dont Let The Next Wave Down Take Your Pants

Keeping our pants on is the cornerstone of our strategy at Broyhill. Like value investing, it sounds simple
enough, but is much harder than it looks. Resisting certain urges is key. Perhaps the most difficult is the
urge to lower our standards the longer the party goes on. It is natural to take another look at
opportunities we quickly passed on earlier. Were we too judgmental? Were we too strict in our definition
of quality? Maybe two or three of those other opportunities could provide similar returns while we wait?
Those balance sheets really arent that bad, are they?

The Broyhill Letter - Divergent | Page 7

This is the type of thinking that normally precedes losing your pants. We wont do it. We wont lower our
standards or settle for relative bargains because absolute bargains are more difficult to find. We will keep
looking and we will keep learning to deepen our understanding of both our existing investments as well
as our pipeline of opportunities while we wait.
Despite inflated valuations, we are still finding a modest stream of new ideas, but have raised the bar in
terms of committing capital to new investments. We made no new purchases last quarter (although we
did increase a few existing positions on weakness). We performed extensive due diligence on several
businesses, leveraging research on existing positions to expand our circle of competence. We passed on
two financial companies that lacked an adequate margin of safety and continued our work in the
industrial sector where poorly timed energy acquisitions have weighed on otherwise good businesses.
One was recently acquired by Berkshire Hathaway before we completed our research a disappointing
result after many hours of research, but perhaps a clue that we were on the right track. The other is still
a work in progress.
Maintaining your standards and your pants also requires an ongoing evaluation of existing portfolio
holdings to ensure that ones margin of safety has not dwindled since the initial investment was made.
When markets are high and rising, many investments, once shunned by peers, come to be viewed in a
more favorable light. Others dont quite turn out as they seemed. We parted ways with one of each
during the quarter. We eliminated our position in Post Holdings, locking in a healthy gain despite nervetesting volatility. Shares are more fully valued today and the leverage in the business does not leave much
margin for error. We hope to have another affair with Mr. Stiritz in the future, but on a cheaper date.
Realized gains at Post were more than offset by one large realized mistake in Awilco, which weve
discussed in prior letters. Clients who wish to learn more are welcome to request our post-mortem on
this investment, which reviews our initial thesis and the evolution of our thinking over time. This is a
learning exercise we perform on every sale with the intent of avoiding the same mistake twice.

Waiting For The Next Shoe


Successful investing requires a heavy emphasis on avoiding mistakes because protecting capital through
challenging times is inconsistent with maximizing returns in good times. The key to capitalizing on
periods of market turbulence is coming through with your capital and your judgement intact, while most
participants are paralyzed by fear and losses (as often happens when one loses his pants). Allowing cash
to build in the portfolio as we liquidate holdings, rather than redeploying capital into our next best idea,
provides us with this peace of mind.
It is impossible to navigate through market disruptions without planning ahead. But planning ahead
requires patience which can and will be tested while waiting for the next shoe to drop. At Broyhill, the
flexibility to hold cash in the absence of opportunity is a significant advantage in this regard. Our rigorous
approach to research which results in concentrated portfolios rather than diversified baskets of
mediocrity is another advantage relative to our peers.

The Broyhill Letter - Divergent | Page 8

These aspects of our process are ongoing and continually refined. They are also complemented by the
occasional use of options to hedge a portion of the portfolio or limit capital at risk. We discuss a few
approaches below.
Lets start with the basics since we tend to keep these positions extremely simple for our own benefit. An
investor worried about declining stock prices may purchase put options to hedge against a decline below
a pre-specified price. If the stock were to decline below that price, the value of the option would increase
by the same amount. That being said, we rarely hedge individual positions and rarely buy put options.
They are expensive. They represent an ongoing drag on performance. And the timing is particularly
difficult to get right. However, at the right price, and under certain conditions, we will consider hedging
a portion of our risk through the purchase of index put options.
When equity market volatility is low, and consensus sentiment is high, these options are often priced too
cheap. We felt this was the case last summer and allocated a small percentage of the portfolio to index
put options prior to Octobers flash crash. We began adding them back last quarter and increased our
position later in the summer as turmoil in Europe and China increased the odds of another shoe dropping.
While we have sold a portion of our hedges on last weeks spike in volatility, we intend to maintain a fairly
consistent level of protection across portfolios during the seasonally weak period ahead8.

Spikes in volatility also provide us with an opportunity to sell or write put options against positions we
would like to own at lower prices. If exercised, we will own businesses at prices we want to own them. If
not, we will settle for handsome returns on our cash while waiting for lower prices and a wider margin of
safety. We did not sell any options during the second quarter, but recent volatility post quarter-end has
allowed us to increase our exposure to a couple core holdings.

As of July month-end, these positions represented less than 10 basis points of discretionary assets after
losing more than 70% of their value since our initial purchases. As of last week, however, we have since
realized over $100,000 in gains on our hedges and still maintain over 10 basis points of discretionary
assets in index hedges.
The Broyhill Letter - Divergent | Page 9

Both of the strategies discussed above are short term in nature with maturities often ranging from three
to six months. Longer duration options can also represent compelling opportunities for value-oriented
investors as the option market is very idiosyncratic and Black Scholes is not particularly useful beyond a
few months. At quarter-end we held one long term call option on a core position marked at a loss. As
we are working to uncover additional mispriced options amidst the current sell-off, we are providing this
transparency for investors to better understand our existing holdings and decision-making.
Unlike most option market participants, when analyzing long term options, we always start with the
fundamentals of the underlying business and a range of estimates for fair value. At the right price, we will
consider buying long term options to increase our position and further leverage our research efforts.
Importantly, we do not look at options through the same lens as consensus. We are not short term
traders. We are not quants. And we certainly dont rely on the Greeks. The decision to invest is driven by
simple rules: one, set the strike price at the lower end of our estimate of fair value; two, confirm our
estimate of fair value in two years is substantially higher than the strike price; and three, limit option
purchases to those opportunities which provide at least 10x leverage to the portfolio.
While these positions will always represent a very small percentage of our assets, they may have a
disproportionate impact on volatility and returns. Consequently, it is important to recognize that they
will be sized accordingly and losses are always limited to how much we have invested. Our goal is to
magnify our returns over time while minimizing the amount of capital we put at risk.

House Cleaning
When I write, I feel like an armless, legless man with a crayon in his mouth.
- Kurt Vonnegut
Writing quarterly letters has a similar impact on my well-being. While I love to write and benefit greatly
from the experience and the opportunity for self-reflection, the quarterly deadline weakens this process.
I imagine most managers do it because it is expected of them, because it is standard practice in the
industry, or because they always have. These just arent good reasons. We prefer to write when we have
something unique to share rather than when the calendar demands. Given our longer term investment
horizon, our views and our portfolios just dont change much quarter to quarter. Consequently, we plan
on writing to you semi-annually going forward. We will continue to publish our more in-depth research
from time to time and wont resist the urge to write if we have something to say in between. In the
interim, feel free to visit The View From The Blue Ridge if you are suffering from withdrawal.
Finally, please do your best to embarrass Mike Loeb by sending a congratulatory email to
mike@broyhillasset.com. Mike recently passed Level II of the Chartered Financial Analyst exam, barely
making note of it around the office so as not to draw any unnecessary attention. The pass rate this year
was 46% - people bleed for this exam. Mike took it to the woodshed. I can assure you that any blood at
his desk was from our weekly pre-market boxing sessions and not the CFA. Two down. One to go.

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