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YPO

FORUM
LINVILLE, NC
SEPTEMBER 2014
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Market Cycles
Current Valuation
Dont Fight the Fed
Current Sentiment
Thoughts on Allocation
A Few Good Men Ideas
MARKET
CYCLES
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STOCK MARKET SINCE 1900
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AVERAGE ANNUAL CHANGE IN THE STOCK MARKET & GDP
Source: Crestmont Research
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Source: Hussman Funds
CURRENT
VALUATION
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Risk is counterintuitive. The riskiest thing in the world is the widespread
belief that theres no risk.
Fear that the market is risky can render it quite safe.
As an asset declines in price, making people view it as riskier, it becomes less
risky.
As an asset appreciates, causing people to think more highly of it, it
becomes riskier.
Holding only safe assets of one type can render a portfolio under-
diversified and make it vulnerable to a single shock. Adding a few risky
assets to a portfolio of safe assets can make it safer by increasing its
diversification.
HOWARD MARKS OVER-ARCHING COMMENTS ABOUT RISK
Source: Oaktree Capital Management, Risk Revisited
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LOW YIELDS
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THE LONG HISTORY OF LOW YIELDS
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PEAK VALUATIONS
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THE LONG TERM GRAHAM & DODD P/E
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AVERAGE 10-YEAR S&P 500 REAL RETURN BASED ON PRICE/AVERAGE 10-YEAR EARNINGS
Source: Broyhill Asset Management, Ned Davis Research
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There are two fundamental and very different ways in which
equity markets can be measured.
One of these is q, by which the market value of companies
is compared to the real value of their assets. This follows
from the basic principle that, in any reasonably competitive
economy, the value of anything depends on the cost of
creating it.
The other way treats equities as financial assets and values
them by discounting the expected future returns at an
appropriate rate. Cape is based on this approach and
depends for its validity on the data for any particular stock
market being consistent with the theory behind it.
In any economy where sufficient data are available to value the
market in terms of both q and Cape, the results must agree.
If different measures of value disagree; they cannot all be valid
and using demonstrably invalid measures must be absurd.
- FT, Andrew Smithers
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"As of yesterday my price earnings ratio was 26.3,"
said Shiller to This Is Money. "There's only three major
occasions in US history back to 1881 when it was
higher than that. One is 1929, the year of the crash.
The other is 2000, which I call the peak of the
millennium bubble, and it was also followed by a crash.
And then 2007, which was also followed by a crash.
Robert Shiller
CYCLICALLY ADJUSTED PRICE-TO-EARNINGS RATIO
CURRENT
SENTIMENT
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STOCK ALLOCATIONS AT RECORD HIGHS
CASH LEVELS AT RECORD LOWS
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DONT FIGHT
THE FED
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NOMINAL AND REAL 10-YEAR TREASURY YIELDS
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Source: JP Morgan Guide to Markets
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CENTRAL BANK POLICY CAN CREATE DISTORTIONS & CONSEQUENCES
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Source: Bienville Capital Management
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In the old days central banks moved interest rates to run monetary policy. By watching the flows, we
could see how lowering interest rates stimulated the economy.
All that changed when interest rates hit 0% - "printing money" (QE) replaced interest-rate changes.
Because central banks can only buy financial assets, quantitative easing drove up the prices of
financial assets and did not have as broad of an effect on the economy.
The Fed's dilemma is that its policy is creating a financial market bubble that is large relative to the
pickup in the economy that it is producing. If it were targeting asset prices, it would tighten
monetary policy to curtail the emerging bubble, whereas if it were targeting economic conditions, it
would have a slight easing bias.
We expect this limit to worsen. As the Fed pushes asset prices higher and prospective asset returns
lower, and cash yields can't decline, the spread between the prospective returns of risky assets and
those of safe assets will shrink at the same time as the riskiness of risky assets will not decline.
Said differently, at higher prices and lower expected returns the compensation for taking risk will be
too small to get investors to bid prices up and drive prospective returns down further. If that were
to happen, it would become difficult for the Fed to produce much more of a wealth effect. If that
were the case at the same time as the trickling down of the wealth effect to spending continues to
diminish, which seems likely, the Fed's power to affect the economy would be greatly reduced.
Source: Bridgewater Associates
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We think that US monetary policy is nearing a new test that will require wisdom and creativity along
the lines of that which was required to deal with those problems. The basic issue is that quantitative
easing is a much less effective tool when asset prices are high and thus have low expected returns
than it is for managing financial crises.
Now, there is a flood of liquidity and asset prices are high relative to underlying fundamentals. So
the impact of additional asset price increases on demand is much less. Quantitative easing today is
driving asset prices to unsustainable levels, without stimulating much additional activity. That leaves
a much clearer tradeoff between driving up asset prices today and lowering future returns.
The dilemma the Fed faces now is that the tools currently at its disposal are pretty much used up, in
that interest rates are at zero and US asset prices have been driven up to levels that imply very low
levels of returns relative to the risk, so there is very little ability to stimulate from here if needed. So
the Fed will either need to accept that outcome, or come up with new ideas to stimulate conditions.
We think the question around the effectiveness of continued QE (and not the tapering, which gets
all the headlines) is the big deal.
In other words, we're not worried about whether the Fed is going to hit or release the gas
pedal, we're worried about whether there's much gas left in the tank and what will happen
if there isn't.
Source: Bridgewater Associates
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PROFIT RECOVERY EXCEEDING JOB RECOVERY ARE YOU SMARTER THAN A FIFTH GRADER
Source: Zero Hedge
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Investment Outlook | 38
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HIGH MARGINS HISTORICALLY LEAD WEAK PROFIT GROWTH
Source: Hussman Funds
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THE MOST IMPORTANT TEST OF ANY VALUATION METRIC IS THE PREDICTABILITY OF RETURNS
Source: Hussman Funds
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THE RATIO OF MARKET CAP TO GDP PROVIDES A SIMILAR VIEW
Source: Hussman Funds
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BUFFETT PARTNERSHIP LETTER, 1959
Most of you know I have been very
apprehensive about general stock market levels
for several years. To date, this caution has been
unnecessary.
The present level of security prices contains a
substantial speculative component with a
corresponding risk of loss. Perhaps other
standards of valuation are evolving which will
replace the old standard. I don't think so.
I may very well be wrong; however, I would
rather sustain the penalties resulting from
over-conservatism than face the
consequences of error, perhaps with
permanent capital loss, resulting from the
adoption of a "New Era philosophy where
trees really do grow to the sky.
BUFFETT PARTNERSHIP LETTER, 1960
My continual objective in managing
partnership funds is to achieve a long-term
performance record superior to that of the
Industrial Average.
However, I have pointed out that any superior
record which we might accomplish should not
be expected to be evidenced by a relatively
constant advantage in performance compared
to the Average.
Rather it is likely that if such an advantage
is achieved, it will be through better-than-
average performance in stable or declining
markets and average, or perhaps even
poorer-than-average performance in rising
markets.
ASSET
ALLOCATION
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Its the job of investors to strike a proper balance between offense and defense,
and between worrying about losing money and worrying about missing
opportunity. Today I feel its important to pay more attention to loss
prevention than to the pursuit of gain.
Todays ultra-low interest rates have brought the prospective returns on
money market instruments, Treasurys and high grade bonds to nearly zero.
This has caused money to flood into riskier assets in search of higher returns.
This, in turn, has caused some investors to drop their usual caution and
engage in aggressive tactics.
And this, finally, has caused standards in the capital markets to deteriorate,
making it easy for issuers to place risky securities and consequently hard
for investors to buy safe ones.
HOWARD MARKS OVER-ARCHING COMMENTS ABOUT RISK
Source: Oaktree Capital Management, Risk Revisited
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If I could say one thing to your investors,
it's try to achieve balance.
As an investor you need to diversify your
portfolio and understand that in the type
of world we're living in, your returns are
going to look like this: 1% on cash, 3% on
bonds, 4% on equities.
It's a low yield world, and you should plan
accordingly.
- Ray Dalio,
Davos World Economic Forum
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"An investor cannot decide to think harder or put in overtime in order to
achieve a higher return. All an investor can do is follow a consistently
disciplined and rigorous approach; over time the returns will come."
-Seth Klarman
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FORWARD LOOKING RETURNS AT HISTORIC LOWS
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The investors portfolio of common stocks will represent a small cross-section of that immense
and formidable institution known as the stock market. Prudence suggests that he have an
adequate idea of stock-market history, in terms particularly of the major fluctuations in its
price level and of the varying relationships between stock prices as a whole and their earnings
and dividends. With this background he may be in a position to form some worthwhile
judgment of the attractiveness or dangers of the level of the market as it presents itself at
different times.
The sound reason for increasing the percentage in common stocks [beyond 50%] would be the
appearance of bargain price levels created in a protracted bear market. Conversely, sound
procedure would call for reducing the common-stock component below 50% when in the
judgment of the investor the market level has become dangerously high.
- Benjamin Graham, 1949 The Intelligent Investor
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WEALTH CREATION VIA VALUE-BASED ASSET ALLOCATION
Source: Emerald Asset Management
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RANGE OF STOCK, BOND AND BENDED TOTAL RETURNS
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Source: JP Morgan Guide to Markets
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Cash is like oxygen. You dont
notice it 99% of the time, but if
its absent its the only thing you
notice.
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THE STRUGGLE FOR YEAR THREE
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A FEW GOOD
MEN IDEAS?
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BROYHILL ANNUAL LETTER
We have a long term objective of producing attractive returns, lightly correlated with
highly volatile stock markets a dual focus on income generation and capital
preservation remain our priorities today as they always have. Over the short term,
however, equities can and do exhibit periods of leadership. Our process does not
attempt to catch every market twitch. Our discipline means we tend to be a provider of
liquidity rather than a taker of liquidity, buying assets that others want to sell and selling
assets that others are chasing higher. Today is a terrific time to be a seller of assets, but
it is much more challenging to find compelling ideas that meet our return requirements.
Tomorrow, we expect to be a buyer of assets as prices ultimately return to fair value and
expected returns increase.
One of the most underappreciated keys to generating consistent long-term returns is to
minimize losses. Losses are almost always caused by taking too much risk, as many
investors feel forced to do today. If you avoid large losses, the gains take care of
themselves. Our current positioning allows us to generate consistent income in a high
risk environment, while keeping our powder dry to seize more attractive investments the
next time opportunity knocks. When youre one step ahead of the crowd, youre a
genius. When youre two steps ahead, youre a crackpot.
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Our external investments with like-minded, long-term investors complement our internal
capabilities, expand our investable universe, and deepen our understanding of financial
markets. Simply put, External Managers, expand our circle of competence.
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Source: BIS, The Asset Price Bubble in Japan
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FIRST STOP JAPANESE BUBBLE
THIRD STOP IRELANDS BOOM
SECOND STOP US RECOVERY
NEXT STOP SPANISH CASTLES
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EUROPEAN EARNINGS REMAIN DEPRESSED EUROPEAN MARGINS WELL BELOW THOSE IN US
FALLING INFLATION FORCING ECBS HAND
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ARCO TAST FRGI PNRA CMG
Market Cap ($ millions)
1,370 255 1,330 4,060 21,180
Total Debt ($ millions)
884 150 67 (125) (470)
Enterprise Value ($ millions)
2,254 405 1,397 3,935 20,709
Locations
2,062 564 320 1,777 1,681
EV per Store ($)
1,093,394 719,574 4,366,547 2,214,406 12,320,018
Equity per Store ($)
664,403 453,617 4,156,250 2,284,750 12,599,643
Debt per Store ($)
428,990 265,957 210,297 (70,343) (279,625)
Sales per Store ($)
2,500,000 1,176,806 2,000,000 2,400,000 2,307,000
Operating Margin
6% 4% 9% 8% 16%
Profit per Store ($)
150,000 47,072 180,000 192,000 369,120
FCF Yield
16% 5% 4% 9% 3%
Source: Company Filings, Broyhill Asset Management Estimates
You can build a McDonalds in LatAm for about $1.5 million. Or you can buy the companys LatAm store base
for less than $1.1 million today and earn significantly higher returns on your capital if margins normalize.
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Source: Matisse Funds
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HISTORY OF CLOSED-END FUND UNIVERSE
Source: Matisse Funds
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APPENDICES
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DISCLAIMER
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
This material has been prepared solely for the purposes of illustration and discussion. Broyhill Asset Management is the marketing name for
the investment management business conducted by Broyhill Asset Management, LLC. and its affiliates. Broyhill Asset Management, LLC is an
SEC Registered Investment Advisor.
Under no circumstances should the information contained herein be used or considered as an offer to sell, or solicitation of an offer to buy any
security. Any security offering is subject to certain investor eligibility criteria as detailed in the applicable offering documents. The information
contained herein is confidential and may not be reproduced or circulated in whole or in part. The information is in summary form for
convenience of presentation, it is not complete and should not be relied upon as such.
Any information, data, statement, opinions, or projections made herein may contain certain forward looking statements, projections, and
information that are based on the beliefs of Broyhill Asset Management as well as assumptions made by, and information currently available to,
Broyhill Asset Management. Such statements reflect the view of Broyhill Asset Management with respect to future events and are subject to
certain risks, uncertainties and assumptions (including, but not limited to, changes in general economic and business conditions, interest rate and
securities market fluctuations, competition from within and without the investment industry, new products and services in the investment
industry, changes in customer profiles, and changes in laws and regulations applicable to Broyhill Asset Management). Should one or more of
these other risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those
described herein.
All information, including performance information, has been prepared in good faith; there are no representations or warranty expressed or
implied, as to the accuracy or completeness, of the information, and nothing herein shall be relied upon as a promise or representation as to the
past or future performance. This material may include information that is based, in part or in full, on hypothetical assumptions, models, and/or
other analysis (which may not necessarily be described herein). No representations or warranty are made as to the reasonableness of any such
assumptions, models, or analysis. The information set forth herein was gathered from various sources which are believed, but not guaranteed, to
be reliable. Unless stated otherwise, any opinions expressed herein are current as of the date hereof and are subject to change at any time.
Accordingly, neither Broyhill Asset Management nor its principals or affiliates make any representations as to the timeliness of any information in
this presentation.
Broyhill Asset Management
Christopher R. Pavese, CFA
chris@broyhillasset.com