Portfolio manager Cale Smith on investing, Spoke Funds®, and Islamorada in the Florida Keys.

Just a heads-up for any portfolio managers in the crowd…

Next Monday, May 16, from 4:00 to 5:00 EST, I’m going to be joining Zack Miller of Tradestreaming.com for a webinar called:

“From the ground up: How to build a successful money management firm.”

The pitch for it is below. Join us if you can, eh? Gonna be fun.

And please reserve your webinar seat at:
https://www3.gotomeeting.com/register/545041518

Is your investment practice what you want it to be?

Many professional investors have changed their business models over the past few years. Wirehouse brokers are breaking out and going independent. Many are choosing to start or join existing RIAs. Many others are creating their own hedge funds.

Everyone is looking for the right business model, the right structure for their investment business.

Cale Smith, founder of Islamorada Investment Management, believes he’s built a better investment business mousetrap.

Called Spoke Funds®, these structures solve some of the problems associated with mutual funds (underperformance, tax inefficiency) and hedge funds (compensation schemes masquerading as an asset class).

The Spoke Fund® structure aligns incentives by ensuring the investment manager invests most of his liquid net worth in the same portfolio he’s selling to investors.

In this webinar, you’ll learn:

- Why the existing vehicles for your business (mutual/hedge funds) are broken
- How Spoke Funds® solve these problems
- Why Spoke Funds® are perfect for managers who are value investors
- How they lower start-up costs and get into business faster
- How their transparency is attracting a new class of investor

Please join Zack Miller of Tradestreaming.com and Cale Smith of Islamorada Investment Management for a frank and open chat about the future of the investment management business.

Here’s that registration link one more time. And after registering you’ll receive a confirmation email with more detailed information on joining the webinar.

Thank you!

This week saw a couple of potential catalysts arrive for two of our companies in Tarpon. First, the unexpected one.

Pentwater Capital Management, the fifth-largest holder of shares in Leap Wireless (LEAP), is going activist. As in, it’s nominating three directors to the board to give the existing directors and management a few swift kicks in the pants. My words, not theirs. Pentwater does believe Leap is “significantly undervalued” though – I’ve been saying the same thing – and they have apparently had enough.

Here’s a link to the letter Pentwater wrote to the LEAP board. A little hyperbolic to be sure – the fourth quarter was strong for LEAP – and though most activist investors are often just whiners with clout, in general, I’m all for Pentwater turning the heat up a bit over there.

The second catalyst was expected, although the timing of it was uncertain until today. According to this filing, North American Financial Holdings or NAFH, which owns 83% of Capital Bank (CBKN), has scheduled a conference call with its investors to disclose that it is seeking regulatory approval to combine the three banks it owns – Capital Bank, TIB Bank down here in the Keys and NAFH National Bank (which contains three formerly failed banks it bought on the cheap from the FDIC). NAFH will likely seek to combine its holding companies, too.

Disappointingly, the authors of several of the press reports I read this afternoon seemed to be shrugging their shoulders at what happens next. Well, I’ll tell ya what I think happens next: exactly what page 48 of last December’s CBKN proxy said would happen. Specifically:

“…the Purchaser intends to use the logos, brands, trademarks and service marks of the Company and the Bank to market the businesses of other banks and bank holding companies in which it has a majority equity interest.”

Which, when corroborated by a handful of local news stories up in North Carolina, would seem to mean there is a high probability that all the banks NAFH owns will soon be under just one masthead…that of our little ol’ CBKN. And that new and improved version of the bank will have assets of about $4.5 billion and a footprint stretching from Raleigh to Miami.

No guarantees and a lot more to it, of course, including some fuzzy accounting rules and some contingent value rights, and, yes, the consolidation could happen in any number of ways, some of which could be detrimental to us newer minority CBKN shareholders…but for a number of reasons, I doubt it. Margin of safety and all. Here’s the slide from the annual meeting a few weeks back that mentioned our investment in Capital Bank.

In any case, Tarpon is also sitting on some cash right now, so I’m back in the cave on a handful of potential new companies. Could be a bit, so shoot a flare if you need anything.

In the meantime, here’s to hoping we see a few more down days in the market. Where’s a completely irresponsible emerging market government when you really need one?

Disclaimer: My investors and I own shares of Leap Wireless and Capital Bank. This post in no way constitutes investment advice. Commentary on this blog should never be relied on in making an investment decision. So, if you go out and buy shares in either company based on the above, you are on your own, knowwhatImean?

It’s right there on page 227 of my 1990s copy of Random Walk Down Wall Street.

By the time the portfolio contains close to 20 equal-sized and well-diversified issues, the total risk (standard deviation of returns) of the portfolio is reduced by about 70 percent. Further increase in the number of holdings does not produce any significant further risk reduction.

Academic literature backs this up.

My problem is that mutual fund managers never seem to have read any of it, because when I look up the number of holdings of most mutual funds, I’m stunned.

Fidelity’s Magellan Fund – 249 different stocks. As in, a quarter-of-a-thousand.
American Funds – Investment Company of America – 154 stocks and 111 bonds.
American Funds – Growth Fund of America – 275 stocks.

And these are some of the biggest funds in the world.

Now you might ask: isn’t owning 200 stocks just diversification? Isn’t that a good thing?

Before I answer, let me clarify one point for those who have heard me rant about diversification before.

Should the opportunity ever present itself, I would theoretically consider putting my entire net worth in a single investment. As investors in my portfolios know, I believe strongly in taking meaningful positions in the stocks you own. Great opportunities are just that rare. However, if you were to next ask me how often I really expected to be presented with the kind of opportunity that deserved all my net worth, I’d say: never. Those opportunities don’t exist in the stock market.

So, back to that question about owning 200 stocks. I do believe that some diversification is a good thing. However, and this is really my point, over-diversification is not. It’s bad. Very bad, actually, since over-diversification is by definition added expense with no reduction of risk.

What those fund companies above are doing is creating “closet index funds” that basically mirror the broader stock market, while charging you actively managed fund prices. As John Bogle, the godfather of index funds, once said about mutual funds, “The scandal is not what’s illegal. It’s what’s legal.”

If you get proper diversification with 20 stocks, then why pay the extra expense of researching 200 more? That added expense doesn’t lower investors’ risk – it just decreases their returns. From the fund company’s perspective, though, it certainly decreases the odds that investors leave the fund.

Now, to be clear, this isn’t entirely the fault of mutual fund managers. The funds themselves have restrictions on how much of their portfolio they can invest in any one holding, and as these funds approach behemoth size, there are effectively more restrictions on them. That’s a good argument for investors to stay away from behemoth mutual funds, too, by the way.

But I do think some managers hide behind those fund-imposed rules, too. They are simply protecting their collective behind. It’s that old saw, “It is better to fail conventionally than to succeed unconventionally.” And that manager knows if he spreads out his client’s dollars across hundreds of holdings and one does poorly, no one will notice.

I take a different approach at my firm. And so do these other Spoke Fund® guys. I have 16 companies in my main portfolio – and that number will likely drop before the end of this year. I’d like to think my investors get what they pay for – and that’s not a manager that over-diversifies and hides his stock picks in a forest of holdings. I do my homework, pick a few great companies, and stay on top of each of them. And if my investors call with questions about the companies we own, we actually talk about them.

You think a mutual fund manager is really on top of the 233rd holding in his fund?

Quick note on that picture above:

Happy Veterans Day.