Video of the speech will be posted once edited.

And a special thanks to the gracious Gil Bento for setting it all up!

Here, on the other hand, was a set of questions I received this week from a long-term investor who saw that interview and had been looking for a portfolio manager that shared a philosophy with Warren Buffett. Great questions, and exactly the kind of investor who is a good fit for Tarpon. Here’s the back and forth we had:

Q. Do you have any track record returns on your fund other than the one mentioned on your site?

A. The website contains all the public track record info about the Tarpon Folio. You can see a month by month breakdown of returns in my letters to investors, listed in the News & Articles section.

Q. Who do you consult with regarding your picks (who is your Charlie Munger?)

A. I have yet to find my Charlie Munger. (They all seem to want to be Buffett, too.) I read voraciously, though, and will talk to the analysts of the various research reports I subscribe to as needed. I am careful to stay within my circle of competence and try hard to buy things that don’t need a second opinion.

Q. If you publish all your holdings regularly, what is to stop someone from simply replicating the fund?

A. The short answer is that nothing is to stop anyone from owning the same securities I do, but the kind of people who would replicate my fund aren’t the investors I’m looking for, anyways. My investors can see what we own anytime day or night, but they want me to handle everything, full stop. Prospects and potential replicators (too sci-fi?) may see a list of holdings one-time, but they won’t know the portfolio weightings and won’t know of any full sales or new positions until my next letter to investors.

Q. Really enjoyed the SeekingAlpha article on Tandem, and have liked a lot about your fund set up and investing approach. Seems like you have really bent over backwards to let people know you are trying to do it right. Read some of the articles you wrote cited on the website, and liked them.

A. Thank you for noticing. I try to be as transparent as possible, and believe that helps explain our success the first year.

Q. I read your bio and website, but could you give me some more info on what got you into value investing?

A. I don’t think I really “got into value investing” in the literal sense as much as I found something that was a great fit, and that happened to be value investing. My grandfather worked on the Street, and we’d chart the Dow together on that graph paper with the little green squares, but investing still didn’t really take with me until many years later. In the interim, I became a world class cheapskate, grew skeptical of most institutions, and I suppose I grew a naturally analytical noggin. A dozen years ago I read an article about Warren Buffett one night after slogging thru the efficient market theory at business school, and that was the original spark. Knew what he was doing not only made the most intuitive sense to me, but that I would really enjoy working hard at it to get better. So, I did.

Q. How do you go about assessing management? Do you actually visit many companies, or mainly just go by the numbers?

A. Never got much out of talking to management. I think it can compromise your judgment as an investor…particularly if you don’t recognize the soft sell and/or view it as a shortcut to doing the work. So, I mainly go by the numbers, but that does include reviewing management’s salary and stake. Bios are mostly meaningless, and talking to management usually ranks far below listening to what they tell others. Sometimes company or store visits can be useful in better understanding the business, but in general, I don’t want to invest in too many businesses with a wide gap between what the numbers say and what management does in any case.

Q. Why do you think you’ll be better than so many other value investors out there?

A. There are at least four reasons I like my horse in this race. The first is that I include certain technologies and telecom in my circle of competence, while most value investors do not. Over the next three decades, I believe those skills will on balance be more valuable for my investors than if I possessed similar expertise in, say, banks, healthcare and insurance companies. Tech will simply grow faster as a percentage of GDP, and there are hardly any value guys chasing the best opportunities in what will be the fastest-growing sector. Neutral Tandem is a recent example.

The second is that I am literally alone on an island, which is how I believe value investing should be done. I am a better investor living here in the Keys than I would be anywhere else.

The third is that I’ve successfully managed and run businesses before. I believe former operators and small businessmen tend to make the best investors.

And the fourth is that, well, I think I can outwork almost every other investor out there. Will leave it at that for now, but could go on all night…

So, if you’re interested in Tarpon, and you think about picking a fund manager the same way as the gentleman above, please contact me anytime.

Look away, short-timers!

Q. How should I think about risk when investing in stocks?

A. Risk is a highly theoretical, strongly debated topic when it comes to investing. I wrote a partially tongue-in-cheek answer to this question last fall, but I’ll try again without the lame humor.

When it comes to investing in stocks, Wall Street and academia have traditionally described risk using a metric called “beta,” which quantifies the movements of a stock’s price compared to both the market as well as the price of other stocks. The general rule of thumb is that a beta greater than 1.0 means the stock will fluctuate up and down more than the broader stock market, while a beta lower than that threshold means it will fluctuate less – or even in the opposite direction. By this logic, high beta stocks are riskier, and low beta stocks are safer.

Here is the problem with that approach, however. It measures the fluctuation of stock prices, not business value. Rational investors should not be concerned with stock price changes – except when you can take advantage of them. The only thing that really should matter is how the stock price compares to the long-term value of the business.

Relying on beta can fly in the face of common sense. For instance, Google shares had a higher beta at $260 per share at the end of 2008 then at $700 per share at the end of 2007. Now, I ask you…when was the riskier time to buy?

To value investors, beta is useful only when it confirms something you probably already know – that the stock price is volatile because the company’s long-term prospects are, too. Otherwise, I think it’s better to think of risk in common-sense terms. Specifically, what are the odds that you’re going to lose all of your money, or see a permanent decline in your investment?

You should attempt to minimize that kind of risk every way possible – starting with sticking to companies with clear and consistent future prospects. But you’ll miss some great investment opportunities if you confuse volatility in stock prices with real risk.

The Hidden Costs of Mutual Funds

Portfolio managers can rack up steep expenses buying and selling securities, but that burden isn’t reflected in a fund’s standard expense ratio.

How much does it cost you to own a mutual fund? Probably a lot more than you think.

In selecting mutual funds, most investors know to check the expense ratio, the standard measure of how costly a fund is to own. U.S.-stock funds pay an average of 1.31% of assets each year to the portfolio manager and for other operating expenses, according to Morningstar Inc.

But that’s not the real bottom line. There are other costs, not reported in the expense ratio, related to the buying and selling of securities in the portfolio, and those expenses can make a fund two or three times as costly as advertised.

“These trading and transaction costs are very real,” says Stephen Horan, head of professional education content and private wealth at CFA Institute, a nonprofit association of investment professionals. “While it’s very important to look at that expense ratio, it’s just not going to capture” all of the costs, Mr. Horan says.

Read the entire article here. Morningstar’s estimates of the average fund expense ratio in the above is lower than the industry’s own estimates. I compare mutual fund costs to spoke fund costs here. And sign up here to receive my article “Ten Things You Must Know Before Investing in Mutual Funds.”

On successful investing:

We’ve put a lot of money to work during the chaos of the last two years. It’s been an ideal period for investors: A climate of fear is their best friend. Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance. In the end, what counts in investing is what you pay for a business – through the purchase of a small piece of it in the stock market – and what that business earns in the succeeding decade or two.

On the bailouts of last year:

In my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control. If he’s incapable of handling that job, he should look for other employment. And if he fails at it – with the government thereupon required to step in with funds or guarantees – the financial consequences for him and his board should be severe.

It has not been shareholders who have botched the operations of some of our country’s largest financial institutions. Yet they have borne the burden, with 90% or more of the value of their holdings wiped out in most cases of failure. Collectively, they have lost more than $500 billion in just the four largest financial fiascos of the last two years. To say these owners have been “bailed-out” is to make a mockery of the term.

The CEOs and directors of the failed companies, however, have largely gone unscathed. Their fortunes may have been diminished by the disasters they oversaw, but they still live in grand style. It is the behavior of these CEOs and directors that needs to be changed: If their institutions and the country are harmed by their recklessness, they should pay a heavy price – one not reimbursable by the companies they’ve damaged nor by insurance. CEOs and, in many cases, directors have long benefitted from oversized financial carrots; some meaningful sticks now need to be part of their employment picture as well.

And, in case you’re wondering – yes, although it looks a bit odd, apparently it is acceptable to spell “benefitted” in the above with two t’s. But I had to Google that to be sure.

Uh, did I mention I get a bit obsessed with these letters?

Anyway, the best quote attributed to Charlie Munger:

Are we supposed to applaud because the dog that fouls our lawn is a Chihuahua rather than a Saint Bernard?

And the closing thought:

At 86 and 79, Charlie and I remain lucky beyond our dreams. We were born in America; had terrific parents who saw that we got good educations; have enjoyed wonderful families and great health; and came equipped with a “business” gene that allows us to prosper in a manner hugely disproportionate to that experienced by many people who contribute as much or more to our society’s well-being. Moreover, we have long had jobs that we love, in which we are helped in countless ways by talented and cheerful associates. Indeed, over the years, our work has become ever more fascinating; no wonder we tap-dance to work. If pushed, we would gladly pay substantial sums to have our jobs (but don’t tell the Comp Committee).

Here’s the letter in its entirety.

And if you’re thinking about going to Omaha for the annual meeting on May 1st, please let me know!

A. I’d like to clarify two points for new readers. The first is that I believe that the majority of long-term investors are best served by investing in an index fund – a widely diversified, passively managed fund built just to match the performance of the whole stock market.

The second point is that if you’re going to build a focused portfolio containing a limited number of stocks, you either have to really know what you’re doing or find someone that does. One of my favorite quotes sums this up well: “Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.”

My own beliefs about diversification are the opposite of conventional Wall Street wisdom. In short, while diversification can play an important role in protecting overall wealth, I believe it is of limited use when you are trying to really grow a specific portion of your assets. It is simply a mathematical fact that the more stocks you own in your portfolio, the lower the odds are that you’ll be able to outperform an index fund.

In addition, putting your money to work in your best ideas also just makes more intuitive sense to me. If you own four stocks and one increases by 50% while the rest stay flat, your total portfolio will gain 12.5%. If you own 100 stocks and one increases by 100%, your portfolio is only up 1%. Why put money in your 76th best idea?

I believe you can reduce risk by deeply understanding the companies you invest in, as well as knowing their real value, not by spreading the risk across more companies. I see danger in owning too many investments because it becomes too hard to closely follow the progress of too many businesses.

So you probably don’t need to know more than a dozen companies really well over the course of your life to become wealthy. But you do have to know them very well.

Click here to read the entire article over on the Seeking Alpha site. And here’s a recent slideshow from the company as well.

And here’s a chart from Visual Economics that might lead you to a similar conclusion as the clip above…a little less theatrically. Click on the below for the larger version.

Stay thrifty, people.

This would be an informal get together, meaning that while it’s not going to be the caliber of my recent investor meeting, there will be coffee, WiFi, and plenty of good info. Exact location will depend on the number of people who attend, but if nothing else, I’ve got a conference table for eight in my office. And there is nothing quite like talking regulatory statutes over a few beers in an old dynamite warehouse…

Plus, the tarpon will be thick under the bridges down here by that weekend, and we could definitely do some fishing.

I’ll put together a more formal curriculum of sorts closer to the day, but in general, think we want the weekend to basically be “How To Build A Spoke Fund” and cover everything from A to Z.

We’ll talk marketing strategy, review some things on the FOLIOfn back-end (and Interactive Brokers, too, if warranted), and I’ll walk you thru the operational and tech side of my business to see how things work.

Also thinking I may be able to convince one of the folks from RIA in a Box to come down to handle any compliance-related questions, and I’ll see if one of the support guys from FOLIOfn can come to get more in the weeds on their platform if needed. If there is interest, can tap someone to talk about social media and/or Google Adwords, too.

All ears on any suggestions for the weekend, obviously.

And to be clear…this is free. I would ask that you pick up the costs of whatever materials we end up printing and handing out, but I can’t imagine that will be more than $20.

Who is in? Email me at caleinthekeys@gmail.com to RSVP, eh?

In an effort to regain some momentum, I’m including some email exchanges below that I’ve had with other portfolio managers about spoke funds over the last few months. (Names have been removed to protect the revolutionary, but otherwise I made very little if any edits to the original emails.) I suspect others may have similar questions about setting up a spoke fund. So, here you go.

I also am very delayed in acknowledging Jason Blair, a hard-working value investor who runs Blair Advisers up in New York City. Jason also set up his own spoke fund a while back, officially making him the Second Spoke Fund Manager in The Entire World. Congrats, Jason! Keep us posted on things, eh?

In addition to the below, you can also find out more about spoke funds on my blog here. If you’d like to learn how to build your own spoke fund, you’re welcome to sign up for our email list here, or join the Spoke Fund Managers Group on LinkedIn. You can find that group here.

Now for that Q&A…

Q. Can you comment on what the advantages of starting a “spoke fund” are vs. a mutual or hedge fund? Potential drawbacks?

A. Advantages of a spoke fund compared to a mutual fund would be much lower start-up costs, more flexibility in investment style and strategy, easier administration, more transparency and lower opex. A drawback might be that it’s a direct sales model, so it can be harder to attract assets than, say, when paying an army of brokers to sell your mutual fund for you. I think that’s better for investors, mind you – lower costs, less conflict – but it is unequivocally a different kind of marketing. Think Geico versus State Farm.



Same advantages compared to hedge funds, with the exception of the investing style one…can’t short in a spoke fund, or at least not yet. Not an issue for me, but could be for some. The biggest advantage a spoke fund has over a hedge fund, though, is that you can advertise. I suppose a comparative drawback would be that it’s not nearly as lucrative…at least not in terms of income. But, hey, few things are…and depending on how much you invest in your own fund, it may be a non-issue for you, too. Probably a whole different philosophical discussion in there related to that.

Q. I’m an investment adviser on the other coast (California), and really like your idea of a spoke fund. Do you use Folioinvesting or Folioadvisor? How much do they charge you and your clients? Do you still think this is the best way to set up a spoke fund?

A. Thanks for reaching out. And yes, I use FOLIOfn’s Advisor platform for the spoke fund.

FOLIOfn’s fees start at 0.30% per account and ratchet down at certain breakpoints depending on size of account. And to date, I still think FOLIOfn is the best option. That said, always looking at others, and hope to post more should I find anything real useful. And if you and your clients get a better deal from FOLIOfn than I do, by all means let me know!

Q. How do I start up an investment advisory business like yours? I am essentially trying to set up a partnership fund similar to what Buffet did in his early days. Like yourself, I am planning to put a significant amount of my own savings in the fund (six figures also) but will focus on investing for friends and families only – at least initially. Fund size would likely be less than $1 million.

Also, if I want to plow back my investment management fees into the fund (like Buffett did), do I technically have to flow thru the $$ from the funds to the advisory LLC and back into my partnership? Doing that would require me to sell shares. Is there a more efficient way to increase my ownership stake in the fund from the fees that I earn? My style will be long-term oriented so I do not want to buy and sell securities unless warranted for valuation purposes — and even less so for compensation to myself!

A. On the legal structure thing…does not apply to a spoke fund – at least in the sense that you don’t need to go form another LP. The core of the spoke fund is simply a regular taxable brokerage account in your name, set up on the Folio platform once you’re a registered investment advisor (RIA).

So your investors are not purchasing shares in a mutual fund, nor interests in a partnership…they’re buying shares in the companies themselves that are in the portfolio.

Doing it this way is actually more tax efficient for you and your investors, as opposed to forming a hedge fund as an LP, having to issue K-1s every year, etc. In a spoke fund, you have very granular control over the tax lots in your and your investors accounts (more on this in a bit), and the custodian Folio tracks all taxes, issues 1099s to your investors, etc. You don’t have to lift a finger, and all the tax issues are taken care of for your guys. In that sense, you won’t get taxed until you sell or receive a dividend…just like a normal taxable brokerage account.

On reinvesting your fees…it’s simpler, too. You get paid as often as you want (I do quarterly billing) and fees are automatically deducted from your investors’ accounts by Folio, according to the fee schedule you work out with them and disclose to your clients. Those fees go to your business’ house account, and come in as revenue to the firm, at which point you can pull them out as salary and then just invest them back in the core portfolio through your own personal account that is set up just like another investor’s account would be. So, there is no need to sell more shares or another interest in the partnership…just add profits to your own spoke account and you’re there.

Q. Why did you choose to go with a separately managed account approach instead of launching a registered fund or hedge fund? Clearly the Tarpon Folio gives you a bit of the best of each. Still, you don’t get to share in any of the performance (except through incrementally higher fees).

A. Here’s the long version:

http://www.caleinthekeys.com/2009/05/why-i-built-a-spoke-fund/

Short version…wanted to build a business that I’d actually want to invest in. Mutual funds = broken – for both investors and PMs. Hedge funds = no moat and no marketing combined seemed like poor odds out of the gate, and being on an island certainly wasn’t gonna help me.

Thought about a Buffett style partnership for a long time, but in the end, thought it was unlikely to work out well for me given my circumstances (down here, no prior public track record as PM, not tied into enough HNW circles, etc). Kept chewing on an alternative until I landed here.

Performance fee thing was a nut I couldn’t crack. Law seemed pretty clear that you could only use ‘em with accredited investors. And practically speaking, billing for performance fees was going to be a big pain. Couldn’t scale that part – at least not with FOLIOfn and just me in the shop.

And I basically subsidize smaller accounts. Had a way to service them profitably, but in the end was getting to be too much of a pain. Even if it costs me $100 a year, cheaper than acquiring them some other way. Plus, assets attract assets, ya know?

Irony is that the only way to lower the minimum profitably is to raise your AUM fees, so to let a lot of small accounts come in, you’d have to charge them more. And that doesn’t smell right. But FOLIOfn does fractional shares, so even my waitress friend who wants to invest $1,000 tomorrow can still own a piece of a share of Google at $440, along with pieces of every other company in the portfolio, too. So, the accounts I subsidize end up being a fantastic deal for little guys. Just can’t build a business around them exclusively.

I’m thinking of it all like open source software at this point…put the code out there on the blog and see what happens. Should others find it and run off to create their own spoke funds, awesome. If all it ever does is get people thinking about what a rip most mutual funds are, that’s okay. But if it happens to completely change the face of Wall Street as we know it and spark a global movement of epic proportions that makes the managing of other people’s money a noble and dignified profession again…well, I’m down with that, too.

Q. I’m a value guy RIA – left a bigger boutique firm, moved and hung out my shingle. I went from planning to start a hedge fund w/ family/friends money just in time for the market to crash, everyone to start hating hedge funds, and having 2nd thoughts personally about the fairness of the hedge fund model and my management style’s suitability for that format. Since I am a value, long only, long-term guy why did I have the right to charge hedge fund fees? Not that that has stopped a lot of other folks….

So I was interested in your spoke fund idea. I too looked at the mutual fund structure and agree it is a joke and of course the industry as a whole is a joke. That has long been one of my main motivators in this business, having come into it from a science background 12 yrs ago. Nowhere else does an industry charge so much to destroy so much value. I read your posts on spoke funds, and would be interested in any additional info you have on the structure. It appears that it simply automates trading in all accounts based on trading in the central account? Anything more to it than that? Doesn’t seem so based on your funds’ website. What I really like is the potential to manage small accounts, which was one of my early goals since the small investor is so poorly served. Yet the typical RIA structure just makes small accounts uneconomical. The spoke structure looks to be the answer….

A. Yeah, it’s not much more complicated than you gathered. Don’t know if you know the guys at FolioFn or not, but their advisor platform basically lets you apply separately managed account principles in a scalable way. I just included all my own money in there, put some new process around it, and decided to go direct to the investor with it. Features are by far better. So, stay tuned on the old blog and will keep putting it out there. Been surprised by the reaction so far…and I’ve barely got anything up. Clearly lot of folks thinking about things the same way we are, ya know?

Follow-up Question: I did some poking around FolioFn, so yeah I got the basic rundown. Have not spoken to them though. The biggest question I have is, do you think you can scale it enough?? At 60bp net to you that is a lot of $20k accounts to get critical mass. Let’s just say you want $250k in revs, that’s 42M in AUM or 2100 $20k accts… I agree with your pricing, and I suspect Folio’s cut goes down as AUM grow. I guess Folio handles all the admin, so it is very little add’l work for you for each acct. And everything is electronic so, if you can find enough folks I guess it could work. Best of luck, still not sure it makes sense for me to give it a whirl, but we’ll see.

A. Yep, it’s scalable, but under a couple of different assumptions. First is that I’m good with revs much lower than that. Built it so I can run it all as a one-man shop with virtual assistants and contract help, and about to get a particularly nice deal on office space. Don’t need a big salary, either…most disposable income would go right back into my investment in the fund, anyways. And I’ve already got all the toys I’ll ever need.

Second is that our median account size is higher than $20k, so our overall margin is slightly higher cuz as you guessed Folio’s slice drops off. Would be an interesting study…how many folks I’ve waived our $12K minimum for, only to have them refer a HNW type. The Keys are funny like that. Assets attract assets and what not.

Third is that there will be some heavy spend on sales and marketing in the Keys, which we’re now starting to get into. Lot of local economies of scale I’m finding, which is translating into some solid ROI.

How well we do will be related to our marketing, which almost goes without saying…but I find it odd that the three professions – medicine, law and finance – are each so horrible at doing it. I’m no expert, but I’m getting better. So, game on.

Q. Let me first offer my sincere thanks for offering to share information about how to go about simply doing the portfolio management without getting bogged down with too much outside activities. I do love investing and am passionate about it. I am trying to research how to go about starting an asset management firm. I read lots of thing and came to conclusion that I can go with individual portfolio management style but that also requires doing lots of thing which adds cost for you and ultimately for your clients. I stumbled upon your site and found the articles written by you so far very interesting and although I don’t know how to go about this, if you can share further information it will be really helpful for me.

I saw the post which had “My next post in this series will identify the critical path activities that I think most deserve your initial attention.” I am waiting for the information and if you have it documented I can’t wait to read it even if it’s in raw format. I really appreciate folks like you who are ready to share information with others.

A. Here’s that post!
http://www.caleinthekeys.com/2009/06/building-a-spoke-fund-critical-path-items/

Q. I started following you on Twitter a while ago and really like your approach to your business. I think the Folio approach (hub and spoke fund) is a great way for the retail investor to get all of the positives of a managed portfolio and a manager, with very little of the negatives. I am a retail Financial Advisor and have been in the business for 18 years. Some day (maybe soon) I would really like to be doing what you are doing. I really appreciate the way you have posted all of the steps that you took to set up your business.

It has really been helpful, but I still have a couple of questions. Before you started to manage other people’s money, how did you establish a track record? Do you get your results audited and if so, how and by who? Thanks in advance and keep up the good work!!

A. Thanks for reaching out! Hope to put more out soon on the blog about spoke funds from the portfolio manager’s perspective. In the meantime, fire away with questions anytime.

I’d been an analyst for some time prior to starting my own firm, but I did not have a public track record I could point to being solely responsible for as a portfolio manager. The friends and family who originally invested with us knew of my success in the general sense that came from managing my own family’s money for some time, but I never tried to formalize that.

Professionally, I had buy/sell recommendations I could point to, and annual returns from a small hedge fund I did research for a few jobs back, but they weren’t reflective of just me by any means.

So, I haven’t used anything when it comes to citing a prior record. The question comes up, obviously, but our funds simply won’t have three year track records any earlier than three years. Irony is that I’m finding most people so far don’t care. You’d have to ask them, but I think the fact that my family’s net worth is in the funds I manage might speak to a level of conviction that a track record alone doesn’t address.

That said, had I had a decent public record prior to getting going, we’d probably be ramping assets sooner, but the pace to date is okay with me.

Q. We were not able to locate prospectus for below-mentioned fund on your Internet-homepage. Could you please provide us, by e-mail, with the prospectus and SAI (statement of additional information) of your funds?

We are especially interested in the legal aspects/forms of the funds – e.g. if it’s about Limited Partnerships or Limited Liability Companies. May we kindly ask you to indicate to us (or if available, of course to provide to us) whether there are any subscriptions documents are available when a client/customer wants to invest? Furthermore, we would like to know if the funds contain special liabilities like capital calls or clawback clauses.

A. Different animal. A spoke fund is not a hedge fund. We are basically taking a separately managed accounts approach to managing a single strategy. It’s better for our investors, and easier for me as the portfolio manager to administer. We call the model a “spoke fund.” It’s all invested in listed securities, and there are no capital calls, clawbacks or any other silliness. You own the underlying shares directly in a secure account held by our custodian. I simply manage it from there.

There are no subscription documents, but we do have an investment advisory contract that our investors execute. That agreement among other things grants us approval to set up an account for the investor at our custodian and gives us full discretionary authority over that new account.

The process to invest consists of three steps.

1 – Investor provides basic background info to us, via phone call or online sign-up form. That form can be found by going to the http://www.islainvest.com website and then clicking on the “How to Invest” link in the Quick Links menu at left.

2 – We’ll incorporate that client data into our standard investment advisory agreement, a document that is sent via email for execution by all parties using electronic signatures.

3 – We open a new account for the investor at our custodian, FOLIOfn. Then we’ll provide the investor with instructions on how best to transfer assets into the new account. Once the assets arrive, I’ll invest them in the Tarpon Folio.

We can handle any manner of traditional account (individual, joint, revocable trust, business) and tax-deferred accounts, too, including IRAs.

Q. Two questions. I contacted the FolioFN guys and they told me that each client has to pay $290 a year. It seemed very high to me especially for the clients having very little money. I saw that you had 0.30%, 0.20% and 0.10% deal with them based on total assets under your management. Did you get some promo deal or negotiate?

You are doing fantastic job to educate people and have been inspiration to me to start, which is in the best interest of clients as well. That’s the reason I am trying to dig information. I really appreciate your time and reply.

A. That Folio fee thing sounds odd – are you sure you’re talking to the institutional guys and not the retail folks?

And there is no such thing as a prohibition on publishing performance results that first year – assuming, of course, that your returns as shown from inception through the year-to-date. The regulators distinguish between recommendations and actual performance, and you’d probably want to clarify the rules around the former with counsel. As far as performance, though, while you’ve got to be sure to disclaim everything, that’s all the time, and not just the first year. Believe me, I’ve paid the lawyers enough by now that I’m confident our compliance is solid across the board.

Q. I have read all the info on your site about spoke funds and am still somewhat vague on the details. I see you can buy fractional shares. I am assuming that you have some way of trading these fractional shares, or are they just the percentage the investor owns in the hub set of funds?

Actually, that doesn’t make sense either, since as the hub grows with new investors my share percentage would decrease. Is there some tutorial on how the hub and spoke fund works for each individual investor? I am aware of hub and spoke structures as a way of off-shoring investments, but this seems quite different.

A. Our custodian FOLIOfn allows us to buy “fractional shares.” Everyone is subscribed to the same portfolio weightings (say, 9.0% in Paychex, 5.2% in Google, etc.) and with fractional shares all those percentages can stay exactly the same across everyone’s accounts. Eliminates the problem of, say, only being able to buy whole numbers’ worth of shares for companies like Google that trade at $525+.

There is no impact on your ownership of anything based on new investors coming into the fund – or leaving. When everyone comes in, they are independently subscribed to the most recent portfolio weightings I have established (as opposed to whatever their current market-based weights may be). So, you own shares in the same companies we all hold, in the optimal percentages…as opposed to owning shares in a third party entity, like you would at a mutual fund or hedge fund. Then your returns would be impacted by others’ actions. But, this way it is not.

You can also think of it like this…the spoke fund structure is a way to link all investors, including my family, to the same identical “model” portfolio – only the “model” was funded with real dollars within seconds of being created. So, a change to the core model changes everyone’s account the same way, and at the same time. Fractional shares allow us to own more of the companies we want to in a simple, pragmatic way.

Follow Up Question: Ok, I think I understand. When new money comes in, say $50k or $100k, the investor would get the same percentage weighting as the other investors, it is just that their number of shares would be proportionately greater. Right?

When you buy/sell into the core account, I would assume that would affect all the percentages of all the members individual stocks, including the stock you just sold and bought new, and their fractional shares would change. Do I have that correct?

A. Yes on the first question…percentages stay the same, but shares would be greater.

On the second question, not sure I follow ya, but as I read it, the answer is “Yes, except we minimize meaningless trades.” By that I mean that when I make changes to the core account model, I have thresholds I can set to eliminate small onesy-twosy trades in investors’ accounts whose real-time portfolio weightings already closely resemble the optimal portfolio weightings in the core model.

Say I have a Google weighting of 5.25% in the core model. A month later I want to adjust the core model position in Google from 5.25% to 5.00% and at the same time increase CarMax from 5.0% to 6.0%. So, I can tell the system to (1) only sell Google shares in an individual account if the real-time weighting in that account is more than, say, 0.25% different than the new weighting in the core account, and then (2) don’t do anything if an investors’ individual account is already within 0.15% of the new 6.0% core model weighting in CarMax – which could happen based on when the investor came on board and initially bought CarMax, as compared to the core account.

Ton of criteria I can use, but the point is that I set them up to try and minimize redundant and/or silly trades. Not perfect, but still pretty good…and much better than a mutual or hedge fund.

This part help explain that second question, too, at least as I read it originally. Otherwise, might just be FYI stuff:

All buys and sells are done either in the open market, or within FOLIOfn’s internal clearinghouse, after it looks for better pricing among all institutional clients. Here is an example:

Say I want to buy shares of GE in the portfolio. So, I make GE a 5% position in the core “model”, and tell the system to automatically execute the orders in everyone’s account to bring each individual’s account in line with that 5% position in GE as well.

If I decide to buy those shares during one of two “windows” during each day that FOLIOfn offers, then we can buy those shares without paying a commission. (I have always used “window trades” to date). During those windows, FOLIOfn matches up all my clients’ buy orders for GE, and sees how many other institutions on its platform are selling GE during the same window. Then it compares the pricing on those internal-to-FOLIOfn-shares to ones it can get on the open market. We get the shares that are the better deal for us…meaning the cheaper ones, obviously…and every account buys those shares at the exact same price. (That’s another reason for fractional shares…so everyone gets the same pricing and there is no post-trade allocation).

So, I make a change during a window, FOLIOfn finds us the best pricing either internally or on the open market, then everyone’s accounts automatically update to reflect that change – within pre-determined tolerances that are meant to minimize small, meaningless trades among individual accounts.

Second Follow Up Question. Thanks for the prompt replies. Here is how I think I understand: There is a large core account that is composed of your and your family’s money. This money is invested across a diversity of individual stocks. As a new investor sends in money, a spoke account is created where their money resides and is invested in the same stocks at the same percentages as the core account. When you want to make a change in the core account – e.g. reduce one position in order to increase another position or even to take a new position to add to the core – something automatic happens and all the spoke accounts get adjusted proportionately and the stock change happens everywhere. Since all spoke accounts are fully invested (probably as the core account is) to take a new position would pretty much always require reducing another position(s) to pay for the new one. Then everything happens automatically in the core and all spoke accounts. OK so far?

Now, the next question. Suppose I need money out of my account at some point. Do you sell off across all positions to keep the percentages the same so as not to unbalance everything between the core and the spoke? This seems like the complicated part.

A. Yep, think you got it there. And on the withdrawing money part…yes, I will sell off across all positions to keep the percentages the same. There is also a little wiggle room in the cash that is held outside the portfolio. So, withdrawals have not been an issue between both…can raise cash and/or take requested funds out pretty easily, and without disrupting anything between that account and the core account.

Q. Cale – Thanks for the info on this blog and congratulations on Gecko and Tarpon results. I am considering starting a spoke fund in Texas and have a few questions for you.

4) Are there other required/necessary documents to run a spoke fund beyond those provided by RIA in a Box?

A. Good questions. In quick order, then…

1. On the FOLIOfn platform, a spoke fund is a model portfolio that is synced to the manager’s account quite literally within seconds of creating the model. That way there is no difference between the model and the manager’s account in terms of cost basis, future tweaks, fees, performance measurement, etc. In my case, that account is in my name, and though you’d want to verify the tax effects, there is no reason it couldn’t be in your company’s name. So that “hub” concept probably won’t resonate with FOLIOfn reps yet (working on it!), but it doesn’t need to, either, for you to set things up the way you want.

That said, been kicking the tires on setting up a spoke fund using Interactive Brokers lately, and in that case, it appears the hub there would actually be an account. No real difference from either my or the investors side there than at the FOLIOfn back-end, but my interest was piqued due to lower costs….IB costs appear lower on more accounts. Couple of other things need to be checked out over there, and some IB features are not as user friendly for investors, but I hope to summarize and pass on info at some point.

2. Yes, all fees apply to the manager’s account(s) as well. I charge myself the same thing I charge all my investors. Right thing to do.

3. Registration requirements are very much state-to-state. A good rule of thumb is that once you have more than five investors from one specific state, you’ll need to register there as well. Doesn’t work for all states, though. Practically speaking, that may mean you only take on bigger accounts from out-of-state to more quickly recoup the costs of registration there. RIA in a Box can definitely help register wherever you need.

4. RIA in a Box can also help with all the regulatory and compliance documents you will need to get up and going. (They should be paying me for these plugs!). Highly recommend them.

I’ve also used lawyer Todd Schwartz (just started his own firm, Schwartz Law Group) for help on things that I needed definitive answers from a lawyer on, as well…the content of ads, disclaimers, reviewing online materials and a handful of other one-off things basically related to the marketing of spoke funds.

That said, there are plenty of other documents, spreadsheets, and/or process-related things you’ll need to actually run a fund. I consider all that to be “Operations Manual” material, and while some of that will be specific to your business, there is quite a bit that all spoke fund managers using FOLIOfn, for instance, will have in common. Not quite ready to post my manual online yet, but suppose I could be convinced to some day.

In any case, that’s exactly the sort of thing that makes me think I should have some kind of informal get-together with guys like yourself here in the Keys at some point this spring. Think folks could get a crash course in all of this without having to wait for me and/or my Operations Manual. Love talking about all this, but also gotta keep my primary job front and center. Blowing it all out in a weekend would probably be much more efficient for everyone.

Q. I was really excited to read your blog on “building a spoke fund” as I had been researching the ins and outs of starting my own hedge/mutual fund. I’ve read and reread your blog and have been on your site for your fund and was really impressed with what you put together. I know you must be very busy but was wondering if you could answer some questions or point me in the right direction to get the answers I need.

Thanks in advance for your response.

A. In short order…

1. Easiest way to answer that first question is here:

http://www.caleinthekeys.com/2009/05/why-i-built-a-spoke-fund/

2. Still looking for a good (read “competent and cheap”) auditor. Trying to find an auditor in South Florida – ground zero of what seems like Ponzi scheme central – has been challenging to say the least. The local firms I’ve talked to are saying they’d have to go get additional insurance, which puts the costs way too high. It’s not like I trade much, so verifying returns thru a bigger firm up north simply won’t take that long…but they want to charge like it does. In any case, my next call about this will be to a firm in Chicago that comes well-recommended.

In the end, though, I may just post all statements, tax forms, and trade confirms online on the blog or something, so anyone can verify things all by themselves. I suppose an audit would be quicker and have the patina of a third party endorsement…but if the purpose of an audit is transparency and verification, it sure seems like posting all statements online would do the same thing.

An audit isn’t as much of an issue in a spoke fund as a hedge fund in any case, because each investor can log-on anytime, day or night, to see their funds and returns. But I recognize I’ll need to do it at some point, anyways, though the cheapskate in me cringes.

If you’re aware of any good auditors, though, I’m all ears.

3. Boy, I’d like to write an ebook. A year ago I thought I’d have it done by now…but the reality is I’ve barely started. Hope to fix that before too long.

4. FOLIOfn will let you go long any listed domestic stock. So anything other than plain vanilla investing wouldn’t work on FOLIOfn. That said, I’ve been kicking the tires on Interactive Brokers a bit, and that may give us more options. Stay tuned.

5. There’s the business breakeven, and the account breakeven. Both can vary a bit based on the variables involved, and I need to get more in the weeds on this for everyone, but in general, given all my variables, I will be fat, dumb and happy at $20M in assets. We’re at about $7M right now, after a little over a year, so I’m confident my girth will be increasing.

Q. Thanks again for giving up some of your time to help a young aspiring spoke fund manager. Almost done studying for the Series 65, although I had to take a small break due to some training (I’m active duty military right now).

Once again, thanks for all the help. If I bug you too much with these questions (I’m sure I’ll have many more), let me know. Thanks man.

A. Here are some rough numbers as I think they might apply for you, based on reviewing my own firm’s financials at the end of the year:

Advertising = I spent almost exactly $10k in 2009. This will go up in year two…but I should also get a better return on that money, too. Lot of local advertising lessons learned last year.

Legal fees = I paid out a little over $8K – but will be about $500 total in 2010, I’d say. I spent what felt like a ton of money on lawyers and compliance guys on things specific to spoke fund model and compliance set-up (i.e. mock compliance audit, etc). So, one-time in nature…and if I can communicate things well enough, you won’t need to spend that money, either.

Office expenses = About $5k…but also includes a ton of one time things So, again, lot lower in 2010.

Stationary & printing = about $1500. Probably will go up 50% this year.

Research = Call it $5,000. (I spent twice that in year one but will halve that the next year). Then will be static…costs of a ton of different subscriptions.

Phone, IT & Internet = $2500 (includes webhosting, cell, office, and handful one-time set-up fees).

Figure about $2000 in licenses, travel, client meals, civic group dues, etc.

So, as a baseline, around $25,000 in opex is probably a reasonable bogey for a first year, truly from scratch spoke fund (i.e. no pre-existing clients) – and assuming you advertise as heavily as the above, and pay up to read everything you can get your hands on. You could run it very light at $10K a year if you come with client relationships already in place, work from home with the office gear and get selective on research.

Don’t really need an office that first year if you’ve got coffee shops/restaurants nearby…but after about a year people will start to look at you funny if you’re still working out of the home. I jumped a little early cuz I got a great deal on an office lease. And I would pay up for a good web site, logo, and presentation folders (in “stationary” above)…skimping there shows.

Also, cash starts kicking in the first quarter you get a client, so it’s not all necessarily coming out of pocket. Probably best to plan like it could be, though. You’ll also note the above assumes no salary in year one, and though that will change in year two over here, I leave that particular line item up to you.

Q. I’ve read your articles about spoke funds and really enjoyed the article about the 4 critical path items to building a spoke fund. Is a spoke fund only available through 1 broker (i.e. Foliofn)? And can you show me some additional funds that follow the spoke fund model?

A. FOLIOfn is my primary custodian, but I am also looking at Interactive Brokers, too, which appears to have similar technology. Neither calls their solutions “spoke funds”…I basically made that term up, but the functionality exists at both places.

There are a zillion separately managed accounts out there, but only mine and one other managed by Blair Advisers up in NYC that are “spoke funds” per se – at least that I know of so far. Hope to compile a list as more get launched.

Also – hoping to have a get-together for spoke fund managers here in the Florida Keys before too long. Will announce something on the blog soon!

Any other questions? Post ‘em in the comments section!

A. I believe value investing is the only rational way to invest. Some analytical ability is required, but investing intelligently is not nearly as difficult as Wall Street would like you to believe.

There’s a central concept behind value investing that people seem to get immediately or it eludes them forever. The concept is that a publicly-traded company has two values – its actual or ‘intrinsic’ value, and the value the stock market assigns to it.

Intrinsic value changes infrequently, while stock market value can change every few seconds. By determining the intrinsic value of a company, and comparing it to the stock market’s assessment, we can buy small pieces of the best businesses which are the most underappreciated.

Purchasing shares only at prices far less than what they are truly worth is critical for two reasons. First, it protects you from permanent loss. This “margin of safety” concept is unique to value investing.

Second, buying well below intrinsic value presents the potential for substantial appreciation once the market recognizes the company’s true long-term value. And it rarely fails to do so.

Where is the proof that value investing works? In at least two places.

First is at the very top of the list of the world’s richest people. There you’ll find Warren Buffett, the most famous practitioner of value investing.

There is a simple math proof, too.

Say Corley buys shares in a company for 50% of their intrinsic value. The intrinsic value of the company then grows 12% per year by doing nothing more than retaining its own earnings. Even if it takes four years for the market price to reflect the company’s true worth, her investment will still have compounded at 30% per year.

Mathematically, two thirds of that return comes from the gap between market price and intrinsic value closing. Only one third comes from the business value growing. So growth is essential when looking for companies to invest in, but it’s less important than buying shares at a low price.

Hello again, island investors! I’m happy to say my column is back on a regular schedule.

I’d like to pick up by introducing myself to new readers in Key West and the Lower Keys. Last year this column ran for six months in the Upper Keys Weekly and was originally intended to answer questions about investing. I planned to give away a free T-shirt to anyone who emailed a question, which I would then answer in my next column. As it turned out, however, I got no questions from anyone except my mother. Zero. Zilch. Bupkus.

Being the analytical type, though, I did not take it personally. There was a simple economic explanation obvious to anyone who has ever walked down Duval Street – there is already a staggering oversupply of cheap T-shirts being hawked in the Keys. Mine never had a chance.

That lack of questions turned into something even better than my original plan, though, because it gave me the flexibility to cover all sorts of topics. I wrote on everything from index funds to credit default swaps to inflation to psychological biases, and based on the comments I’d hear at Winn-Dixie, people seemed to enjoy it. So, next week I’ll start again.

Regarding my background – I am a portfolio manager at an independent firm I founded in 2008, Islamorada Investment Management. All I do is analyze stocks, I have zero ties to any Wall Street firms and all my family’s life savings are invested in the funds I manage. I cannot give advice on specific investments here, but I think I can help you learn how to think independently about investing. I’ve also taken a fiduciary oath, which among other things means that while my columns might be opinionated, they won’t be conflicted.

I have many opinions about the way Wall Street treats individual investors. As one of them, you really have two choices when it comes to your own financial future. You can either be a consumer of financial products, or you can learn to be a real investor.

This column is about the latter.

Cale Smith is the portfolio manager of the Tarpon Folio and Gecko Folio. His firm’s website is www.islainvest.com and his blog is www.caleinthekeys.com.

The MBA sold its headquarters building on a short sale for $41.3 million…a little more than half the $79 million it originally financed in 2007.

I’m not sure how they could even attempt to spin that. Sums up this mortgage crisis pretty well, though, don’t ya think?

The frenetic pace. Silly banter. Faux controversy. Flashy things.

I’d say they nailed it.

The 15th Annual Gigantic Nautical Flea Market will be held February 20-21 at Founder’s Park here in Islamorada. You’ll find great prices on all things nautical…boats, dive gear, fishing rods, lifevests, and anything else you can possibly imagine.

It’s put on every year by the Upper Keys Rotary, easily the smartest and best-looking Rotary club in the world. Last year we had 25,000 people come by, and we grossed about $150,000. All profits go exclusively towards scholarships for kids in the Upper Keys.

Good time, good cause. And did I mention the $5 all you can eat breakfast?

Here’s more info about the flea market. And if you come, stop by the food tent and say hello!

Toby Shute: Ken, can you outline your operating philosophy at Contango, and describe how your current operations reflect that philosophy?

Ken Peak: I got a Ph.D. in the risks of too much leverage … in my 26-year career prior to starting Contango in 1999. Three guiding principles from the lessons I’ve learned are: Only low-cost producers survive and prosper in a commodity business. Secondly, reserves and geophysical talent are log-normally distributed, but [Vilfredo] Pareto had it wrong. It’s the rule of 95/5 not 80/20. Thirdly, “incentives drive behavior” is a fundamental principle of life, and thus everyone associated with Contango must have incentives aligned with our owners.

It’s a great intro to Ken’s philosophies about a lot of things, some of which may look familiar to attendees of a certain annual meeting in the Keys.

My personal page on Facebook is here. And while at times I am not sure why, I am also on Twitter @CaleInTheKeys.

Thank you!

“[The business of investing] should be about giving honest-to-god, down-to-earth human beings the chance to accomplish their own financial goals.”

Witmer: My first pick is Compass Minerals [CMP], which trades at 72 a share. It has 33 million shares and debt of $500 million. Recently volatile results in potash have obscured the long-term positive trends in its salt and potash operations. Compass owns perhaps the best rock-salt mine in the world, in Ontario, next to Lake Huron. The reserves are huge, and unlike most salt mines, capacity can be increased easily due to the width of the salt seam. Compass expanded this mine from 2.5 million tons in the 1980s to seven million tons, and it is expanding it to nine million tons. Transportation is cheap and easy over the Great Lakes, to the snowbelt states.

Compass also owns mines in Louisiana and the U.K, and evaporation facilities in the U.S. and Canada to produce consumer and industrial salts. These are used in food processing, water softening, chemicals and agriculture. Compass has the leading consumer-salt brand in Canada, Sifto.

Barron’s: Is the salt market growing?

Witmer: Volume usage grows just 1% to 2% a year, and pricing grows about 3% a year. But Compass’ revenue has grown 11% a year, and its profit 14%, since 2003. That is because the company has one of the only easily expandable mines, and captures most of the growth in the rock-salt market. The salt industry has consolidated, with just a few players selling a product that is economic to sell only to a limited geographic area.

Compass also produces sulfate of potash, or SOP. It is a specialty fertilizer that typically sells at a premium of $150 to $200 a ton to commodity potash. This potash is used to grow green vegetables, avocados, pecan and citrus trees, potatoes and other specialty crops, which account for 4% of harvested acreage in the U.S. but 40% of crop value. It isn’t used on commodity crops such as corn, soybeans and wheat. Compass produces about half its potash at the Great Salt Lake, using solar and wind evaporation. It is expanding its evaporation ponds, and has leases on virtually all the commercially viable SOP production areas of the lake. It also has a nascent document-storage business in the U.K., with virtually unlimited storage capacity in an old salt mine. That could become a very valuable business in its own right.

Barron’s: Tell us about earnings.

Witmer: There is some variability due to the weather and potash pricing. Compass should earn about $5.20 a share for 2009 and $6 this year. The company has earnings power of $8 to $9 in 2011 or 2012. The stock sells for about 72. My earnings estimates reflect capacity additions, normalizing potash volumes and small price increases in salt. Every 10% increase in the price of salt yields $2 more in earnings.

MacAllaster (another panelist): What is the earnings breakdown between potash and salt?

Witmer: It depends on potash prices, but it is about one-quarter potash and three-quarters salt. Compass should trade at a minimum of 13 times earnings. Our one-year target is 100 a share, or more.

Is Compass sexy? Not at all. Does it have a moat? Yes, a huge one. Like Contango, it’s another firm with a strong competitive advantage based on being the lowest cost producer in a commodity industry.

This site and the above are for educational and informational purposes only. Nothing contained here should be construed by anyone as an invitation or solicitation to buy or sell any security. This site does not contain personalized legal, tax, investment, or financial advice. Users of this site should consult with a qualified adviser to obtain advice suited to their personal circumstances. Any links provided here to other web sites are for informational purposes only.

Photo by Kevin Wadlow at The Keynoter

For some reason, the sub-head of the story about it in the local paper struck me as even funnier. It reads like the voiceover for a really bad movie trailer, no?

Boat ’stolen’ a second time from Tavernier medical center.
This time, it’s just an image, not a vessel.

Mariners Hospital’s benefit boat vanished again before dawn Saturday — one year to the day since a notorious 2009 theft.

But this time, the culprits had to settle for a life-size picture, not the actual vessel.

“The reaction here was amazement,” said Sheila Konczewski, Mariners spokeswoman. “When I got the call Saturday morning, I had to drive in to see it.”

A sign promoting a Mariners Hospital Foundation benefit drawing for a 14-foot Boston Whaler boat remains at the hospital’s entrance, at mile marker 91.5 in Tavernier.

A gaping hole flaps where the photo image of the boat used to be, before a vandal cut it out.

In January 2009, thieves made off with the actual boat, motor and trailer — a package worth $15,000 — from the same spot.

“After that boat was stolen, we decided not to chance again and put up a billboard instead,” Konczewski said.

Both the 2009 theft and the 2010 sign defacement were reported to the Monroe County Sheriff’s Office on the same day, Jan. 23.

If the sign vandalism was intended as an anniversary prank, authorities were not amused. The sign cost the Mariners foundation $935.

“They literally took the boat,” Konczewski said. “They cut it out very well and even left the trailer.”

Thankfully, the recent Bougainvillea Ball was a smashing success in spite of the above, and a lot of money was raised for all the right reasons.

The rest of the article from The Keynoter is here.