Paul Lountzis is an instructor at Latticework 2016.

We will touch on several topics in this letter including: US stock market returns and valuation levels; volatility is here to stay; global stock markets; disruptive global forces; the steroid age of startups; global issues impacting financial markets; the US economy; valuation of businesses and people; our investment process and managing risk; debt, debt and more debt on a global scale; portfolio of activities-equities and fixed income.

US STOCK MARKET RETURNS AND VALUATION LEVELS

The US stock market finished 2015 with a small gain. Using the S&P 500 as our proxy, the market rose 1.4% with dividends reinvested. The market’s very strong returns from 2009-2014 included double digit returns in 5 of the 6 years before finally slowing down in 2015. Here is a breakout of the S&P 500 returns over the past eight years.

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The outstanding stock market returns generated in the 2009-2014 period reflected the significant amount of undervalued equities that were available in late 2008 and early 2009. As companies began recovering from the recession, both corporate revenues and earnings rose significantly and valuations were further fueled by unusually low interest rates from December 2008 through December 2015 before the Federal Reserve finally raised the federal funds rate to 25 basis points. It is highly unlikely that the soaring returns generated from 2009-2014 will be repeated in the next few years.

The current stock market, as of year-end 2015, represents fair value all the way through to over-valuation, depending upon the various industries and specific companies we value within those industries. The table below illustrates the current S&P 500 forward multiple of 16.1x which is slightly above the historical average of 15.8x.

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Valuation levels vary depending upon various industry segments. The table below breaks out many specific financial characteristics of several industry sectors within the S&P 500 for 2015. Technology, healthcare, consumer discretionary and consumer staples are trading at higher price to earnings multiples, while industrials, financials, telecom and utilities are selling for lower multiples. Interestingly, given the low yields available on fixedincome securities many investors have gone out the risk curve and are investing in equities primarily for yield, helping to account for some of the rising valuations in high dividend paying securities.

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We like to review historical stock market valuation levels utilizing Warren Buffett’s preferred method of Corporate Equities, as a percentage of Gross Domestic Product (GDP), and followed by another valuation measure utilizing a broader index, the Wilshire 5000, with both shown on the following page. Both charts illustrate an overvalued stock market relative to the past and going back to the 1950s. In fact, only during the technology, media and telecom bubble of 1999/2000 was the stock market selling at a higher valuation than current market levels.

We have found that these tables and others that we follow provide a sound fundamental framework from which we can evaluate in a simple way overall stock market levels at a given point in time. While many factors may be different over the various time periods, such as interest rates, unemployment, median incomes, overall economic conditions, and other factors, we believe they provide an intelligent proxy for comparison.

There are periods of time when it is appropriate to take on carefully evaluated risks with your investments, and there are other times such as now, when it is most intelligent to focus upon reducing risk and preparing for opportunities that lie ahead.

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The table on the following page compares median price/sales ratios and median price/earnings ratios for the years 2000, 2007 and today. It clearly illustrates the overvaluation today from prior market peak levels, providing a cautionary stance on current stock market valuation levels.

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Finally, we believe that US stock market returns will be reduced in the years ahead, given the outstanding performance between 2009 and 2014 where 5 of the 6 years generated double digit returns. This six-year period of excellent performance has borrowed from returns in future years, which is likely to result in gains below the historical stock market average, since 1926 of 9-10%.

Jeremy Grantham at Grantham Mayo Van Otterloo (GMO), a leading investment firm that manages over $100 billion, publishes a 7-Year Asset Class Real Return Forecast on a regular basis. It has been quite accurate for many years and GMO believes that from current elevated market levels, returns from the following asset classes over the next seven years will be quite limited as shown below.

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VOLATILITY IS HERE TO STAY IN 2016

The chart below illustrates the extreme fluctuations and volatility in the S&P 500 since 1997, reflecting the peaks achieved in 2000, 2007 and through the end of 2015.

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Given the market’s volatility throughout 2015, especially in August and in the fall, as well as, in early 2016 we believe that volatility will be a common factor throughout the rest of this year. The table below illustrates the stock market’s volatility over the past several years.

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Furthermore, current stock market levels have been driven by only a few securities that have had a disproportionate impact while the great majority of stocks have performed poorly in 2015 and early 2016. The newly coined “FANG” stocks (Facebook, Amazon, Netflix and Google) gained $415 billion in market capitalization through the end of 2015, a 55% increase. In 2015 Amazon rose 118% and Netflix rose 134% providing the majority of the increases in the stock market indexes. In 2015 the S&P 500’s 10 largest stocks by market capitalization rose almost 23%, while the remaining 490 stocks declined about 3.5%. This period is reminiscent of both the Nifty Fifty era in the late 1960’s and early 1970’s as well as the technology, media and telecom boom of 1999-2000. This narrow leadership in the stock market has historically been followed by a period of underperformance as in the two periods described above.

According to Bespoke Investment Group, the S&P 1500 index, which includes a broad basket of large, mid and small cap companies, on average have experienced almost 27% declines from their 52 week highs. Clearly, we have a two-tiered market, with a few large companies selling at very high multiples and accounting for virtually all of the index gains while the vast majority of stocks are down for the year and many by large amounts.

Laurence D. Fink, the chief executive of BlackRock, the world’s largest money management firm, was recently quoted saying, “Technically we are in a bear market…There is just a broad reassessment of risk right now.”

The stock market volatility that has continued in early 2016 may provide outstanding investment opportunities in both the equity and fixed income markets. We welcome the volatility and are eager to take advantage of valuation discrepancies to purchase securities for our clients. In the past, these periods of volatility have provided attractive entry points and we hope those periods continue throughout 2016.

GLOBAL STOCK MARKETS IN EARLY 2016

While the US stock market has begun 2016 with its worst performance in history, global stock markets have also declined. Since January 1, 2016 global stock markets have declined by $6 trillion as shown below.

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The following chart illustrates the stock market declines for several major world indexes, through February 12, 2016.

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The US stock market capitalization is almost $13 trillion higher today than it was from the market bottom in 2009 and over $1.5 trillion higher than the peak achieved in 2007, as illustrated below and followed by the Japanese and European stock market capitalizations.

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CHANGING GLOBAL FORCES

As our ever-changing world continues to evolve there are many broad changes that are having profound impacts on companies, industries, and countries, and are touching every continent in our globally interdependent world. For example, consider demographic changes, namely the aging of the global population, which are impacting many countries and the economics of companies and industries on a global scale. While demographic changes happen very slowly over many years, the implications are often quite profound. Europe has several countries that will have fewer people at the end of 2016 than they began the year with, while Japan, with a population of 130 million today, may have half that number in 30 years.

Timothy Beardson’s excellent book, Stumbling Giant: The Threats to China’s Future describes several major demographic issues that China will face in the years ahead. First, China’s youthful population provided a fast growing work force that enabled low wage rates and propelled China into the world’s low-cost manufacturer of a broad range of products to sell to the world. That is changing, as since the early 1970’s there have been 40% fewer births resulting in a declining youth work force. Second, China has a rapidly aging population, with over 100 million people over age 65 today, which will rise to over 300 million by 2040. This challenge will create enormous burdens on Chinese government entitlement programs. Third, gender disparity, with 6 boys being born for every 5 girls, will result in 40-50 million young men that will never marry which will create crime problems and instability in China’s major cities.

In addition to demographics, there are many other disruptive forces that are fundamentally changing our global economy and they are described in the book, No Ordinary Disruption: The Four Global Forces Breaking All the Trends, by Richard Dobbs, James Manyika and Jonathan Woetzel. The four disruptive forces they speak of are:

  1. The Age of Urbanization
  2. Accelerating Technological Change
  3. Aging Global Population
  4. Global Financial Interdependence

These four disruptive forces are illustrated and described in the following charts.

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Each of the forces illustrated above will have profound effects upon countries, industries, specific companies, workers and investors around the globe. These broad changes and perhaps others need to be kept in mind as we commit client capital in both domestic and international companies.

I vividly recall just a few years ago, before investing in a company, contemplating the impact that China may have on their competitive position. For example, many lower value added manufacturing companies have been wiped out by Chinese firms, while other companies, such as Yum Brands are directly impacted with large operations in China. As one considers investing in retailing today, technology has forever changed the landscape, and one should never invest in any retailer without deeply understanding Amazon and its enormous implications on the domestic retailing industry. In our sale of Bed, Bath & Beyond we spent a great deal of time studying Williams Sonoma, Wayfair, Target, Wal-Mart, and especially Amazon to more clearly understand the competitive challenges they posed for Bed, Bath & Beyond. In the end, despite being one of the finest retailers we have ever studied, we concluded that gross margins and operating margins would continue to decline, negatively impacting the firm’s long term profits and success, primarily due to ferocious competition from Amazon.

The Internet and broader technology continue to create enormous disruption in many industries including: cable networks, video distribution (cable or satellite), music, retailing, medicine, education, and banking to name a few. It is imperative as an investor to be well aware of the many disruptive forces that are rapidly changing industries and companies as never before. While we never invest based upon these trends, they are an important part of our research and we will continue to focus upon current and future factors that may impact the competitive positions of the companies in which we seek to invest.

BUBBLE VALUATIONS – THE STEROID AGE OF START-UPS

Over the past several years there have been several areas of excessive valuations in public companies, including biotechnology, healthcare, and technology. However, a particular area of sky high valuation levels is currently in the venture capital area, where there are over 173 “unicorns”-private companies, valued at over $1 billion. In 2015 alone 60 more companies passed the $1 billion threshold as the voracious pace continues. However, unlike the technology, media and telecom bubble of the late 1990’s which featured similar high valuations of publicly traded companies, the current unicorns are private and will result in significant losses with no liquidity available to current investors. As Keith Rabois, a Khosla Ventures partner has stated, “We may be seeing the end of the steroid era of startups.” Rabois sees values declining, from 25% to 75% for many companies.

The estimated value of the unicorns exceeds $585 billion, however without any market clearing mechanism (no public market and a closing IPO window) the true long term values are impossible to assess. Several mutual fund companies, such as Fidelity, through its mutual funds, have invested in several of these unicorns, including Airbnb, Dropbox and Uber, while other firms such as BlackRock, T. Rowe Price and Vanguard have also invested in this trendy area. Given the recent declines in public market values for several technology stocks such as Tableau Software, LinkedIn, and Twitter, many of the unicorns will likely be marked down by the mutual fund managers. How they value them remains a mystery, but nevertheless they are sure to be revalued downward, though it is anyone’s guess by how much. Venture capitalist Jim Breyer recently stated that, “There will be blood in the water and 90% of unicorns will need to be substantially restructured or revalued at much lower levels.”

The table on the following page illustrates the many unicorns and the rapidly increasing number of companies beginning in 2014.

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GLOBAL ISSUES AND CONCERNS IMPACTING FINANCIAL MARKETS

There are always numerous popular issues that create concerns for investors around the world. Today, there are so many concerns and uncertainties that it seems impossible to know what their impact either individually or collectively will have on the global economy, including global stock markets. The world has always faced enormous challenges and today is no different, though it does appear that in my 30 years of investing we are experiencing an unusually large number of concerns impacting countries, industries and companies in varying degrees. These include: oil prices, inflation, deflation, interest rates, global economic growth, geo-political risks, income growth, terrorism, global debt levels, earnings and central bank policies around the world to name a few.

We have no ability to determine how any of these factors will play out and we recognize that trying to extrapolate the future from past trends is often a fatally flawed approach. Nevertheless, we do realize that many of the issues listed above will have profound effects and it bears being cognizant of some of these issues. We remain focused on trying to understand what may happen or at least what the probabilities may be and their potential impact on our investments, both real and perceived. As Wilbur Ross has stated, “We like to take perceived risks rather than actual risks, since you get paid for taking a risk that people believe is risky, while you do not get paid for taking actual risk.”

During stock market fluctuations, such as we have experienced since August, we are reminded of the 1994 Berkshire Hathaway Shareholder Letter where Warren Buffett wrote,

“We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%.

But, surprise – none of these blockbuster events made the slightest dent in Ben Graham’s investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.”

As Mr. Buffett’s quote indicated, no one can foresee future global events. However, by always focusing first upon risk, combined with patience and perseverance in finding outstanding companies with capable management teams at attractive valuations, we believe our results over the long term will be more than satisfactory.

We believe the stock market volatility which began in August will continue as various macroeconomic events around the globe continue to unfold in 2016 and beyond. Historically, periods of stock market volatility have often resulted in enormous opportunities to buy outstanding companies at significant discounts to their long-term value. Be assured the world’s problems are not going away, and to the extent various events impact stock prices, resulting in price declines for our holdings or new investments, it is our job to assess their staying power, competitive positions and long-term prospects in order to purchase more of our existing holdings and to take advantage of new investment opportunities.

THE US ECONOMY

The US economy appears to continue to muddle along at a slow pace, far below the pace of past recoveries, with economic growth at 1-2%. Despite our country’s slow growth, surprisingly, we are in far better shape than most other economies around the world. Several areas continue to do well including auto sales, housing and consumer goods, as illustrated below:

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Household balance sheets, debt service levels, and net worth are all doing well as illustrated below:

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Despite the above described positives on our economy, many mixed signals remain in evaluating our current economic situation as illustrated below:

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Inflation remains minimal and continues to stay below the Federal Reserve’s 2% target level and has remained below that level for years. The table below illustrates the inflation rates for November 2015 as compared to the prior 50-year average.

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The Federal Reserve faces some serious challenges going forward as it tries to move away from the ZIRP (zero interest rate policies) employed since December 2008, by initiating its first increase of 25 basis points in December 2015. The Federal Reserve anticipates raising the fed funds rate an additional 4 times in 2016 resulting in a year end 1.25% fed funds rate. Given the current domestic and global economic environment it is unclear whether the fed will follow the plan from their December meeting. Ray Dalio, the founder of Bridgewater Associates, a leading money manager with over $180 billion in assets recently stated, “The Fed should remain flexible. It shouldn’t be so wedded to a path,” Dalio said. “We’re going to have a lower level of growth six months from now … about 1.5 percent…The risks are asymmetric on the downside, because asset prices are comparatively high at the same time there’s not an ability to ease,” he added. “That asymmetric risk exists all around the world. So every country in the world needs an easier monetary policy.”

The current artificially low global interest rates are unprecedented and have never before been tried by so many central banks around the world. Charlie Munger, the legendary partner of Warren Buffett recently commented, “I was flabbergasted when interest rates went so low, when they went negative in Europe – I’m really flabbergasted. How many in this room would have predicted negative interest rates in Europe? Raise your hands. [No hands go up]. That’s exactly the way I feel. How can I be an expert in something I never even thought about that seems so unlikely, it’s new territory… Anyone who confidently thinks they know the consequences are witch doctors. If interest rates go to zero and all the governments in the world print money like crazy and prices go down – of course I’m confused. Anybody who is intelligent who is not confused doesn’t understand the situation very well. If you find it puzzling, your brain is working correctly.”

We are clearly in unchartered territory and the world has never before been in this position with rates so low, economies growing at slower rates and dealing with the largest global debt levels in history.

I discussed at length in prior letters that several countries had raised their interest rates only to lower them a short time later as their economies continued to stagnate. While I am not assuming that will be the case in our country, clearly the possibility exists that the Federal Reserve may abandon its plan to raise the Federal Funds rate further in 2016 and may even lower the rate once again. The reality is that despite over seven years of zero interest rates our country has experienced the slowest recovery from a recession in history and continues to muddle along with mixed signals.

We believe the artificially low interest rates were necessary after the Great Recession, however the Federal Reserve kept rates at 0% for too long, resulting in risks being mispriced and capital being misallocated. Low financing costs have fueled rising auto sales and improvements in housing starts, both of which have risen from historic lows. Low interest rates have also fueled stock buybacks and encouraged companies and countries to borrow resulting in the rising global debt levels which continue to negatively impact the global economy.

DEBT, DEBT AND MORE DEBT ON A GLOBAL SCALE

The levels of global debt have continued to rise since the global financial crisis of 2008- 2009. Global debt has risen from $87 trillion in 2000 to $142 trillion in 2007 and $199 trillion, as of the 2nd quarter of 2014. As the table below illustrates, global debt has increased by $57 trillion since 2007.

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We believe that these elevated global debt levels will continue to impact global GDP growth as more resources are allocated to paying down debt levels, rather than making productive investments that grow economies.

The table above reflects debt levels from the 2Q of 2014 and it is now estimated that global debt today exceeds $225 trillion creating even more challenges for governments, households, and corporations. Global debt to GDP levels are among the highest they have ever been for many nations around the world, creating enormous challenges.

Furthermore, the continued decline in oil and other commodity prices will place additional pressures on many countries, both developed and emerging, dependent on commodities for the majority of their revenues, including Russia, Saudi Arabia, Venezuela, Brazil, Canada, Nigeria and many others. Should commodity prices continue to stay at current levels or even decline for a prolonged period the consequences may be devastating and could result in unpredictable geo political responses, particularly in countries such as Russia, Venezuela and Nigeria and many others. Nigeria recently asked the World Bank and the African Development Bank for $3.5 billion in emergency loans to fill the void from collapsing oil prices.

The table below illustrates the increase in global debt levels including, government, household and corporate since the last Federal Reserve rate hike in June 2006.

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These global debt levels will continue to play an important role in our ever more interdependent global economy. The emerging markets today represent over 40% of global GDP and have accounted for over 60% of global GDP growth since 2010. These emerging markets are experiencing unprecedented challenges and now pose enormous threats to the continued growth of the global economy. China’s rapid growth over the past several decades has helped many commodity based economies flourish such as Australia, Brazil, Canada and many others. Now that the commodity super cycle has ended the impact has been devastating illustrating the interdependence of our global economy to a greater extent than ever before.

We remain deeply concerned with global debt levels and unless they are addressed soon, global economies are at ever increasing risk of default with rising global instability.

VALUATION OF BUSINESSES AND PEOPLE IS AN ART FORM

Investing requires a deep understanding of the both the quantitative and qualitative factors in evaluating companies and their management teams. At our firm, we work diligently to understand the financial characteristics of the businesses we are studying as well as the industries in which they compete. We also spend a great deal of time evaluating the qualitative characteristics such as their products, management, customer loyalty, and many other factors that may lead to success.

In Warren Buffett’s letter to his partners in 1967, he clearly articulated the importance of both quantitative and qualitative factors in evaluating securities and making investment decisions.

“The evaluation of securities and businesses for investment purposes has always involved a mixture of qualitative and quantitative factors. At the one extreme, the analyst exclusively oriented to qualitative factors would say “Buy the right company (with the right prospects, inherent industry conditions, management, etc.) and the price will take care of itself.” On the other hand, the quantitative spokesman would say “Buy at the right price and the company (and stock) will take care of itself.” As is so often the pleasant result in the securities world, money can be made with either approach. And, of course, any analyst combines the two to some extent – his classification in either school would depend on the relative weight he assigns to the various factors and not to his consideration of one group of factors to the exclusion of the other group. Interestingly enough, although I consider myself to be primarily in the quantitative school (and as I write this no one has come back from recess – I may be the only one left in the class), the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a “high-probability insight”. This is what causes the cash register to really sing. However, it is an infrequent occurrence, as insights usually are, and, of course, no insight is required on the quantitative side – the figures should hit you over the head with a baseball bat. So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.”

Valuation is truly an art form and combines a broad range of quantitative and qualitative factors in assessing both businesses and leaders. To illustrate, I was reminded of the NFL Scouting Report on a quarterback in the 2000 NFL Draft. Several quantitative measures were used to evaluate this quarterback, along with comments, which are listed below:

  • One of the slowest quarterbacks ever timed in the 40-yard dash (5.2 seconds)
  • Very poor vertical jump measurement
  • Lacks great physical stature and strength
  • Lacks mobility and the ability to avoid the rush
  • System type player who can get exposed if forced to ad lib
  • Lacks a strong arm and does not throw a really tight spiral, cannot drive the ball down field
  • Poor build, skinny, gets knocked down easily

The analysis given above focuses primarily upon physical skills that can be evaluated quantitatively with numbers such as speed, arm strength, vertical jump, overall strength and quickness to name a few. Unfortunately, there is a broad range of characteristics and qualities that are not quantifiable and measurable such as desire, resiliency, intellect, composure under pressure, ability to overcome obstacles, ability to quickly read defenses, persistence, emotional makeup, work ethic and many other unquantifiable qualities.

This quarterback was the 199th player chosen, drafted in the 6th round of the 2000 NFL Draft, as 6 quarterbacks were chosen ahead of him. Each one had far better physical skills, as measured at the NFL Combine, which evaluates players on a broad range of attributes. In fact, in the 32 years of the NFL Combine, 576 quarterbacks were evaluated and his scores were dead last at number 576.

The quarterback I am describing is Tom Brady of the New England Patriots who has played in 6 Super Bowls and won 4 of them. The Patriots easily could have won the other 2 Super Bowls and they lost in 3 AFC Championship games, or he may have played in 9 Super Bowls. He has virtually every playoff record for a quarterback including: most career playoff games played, touchdown passes, and passing yardage to name a few. Steve Young, a Hall of Fame quarterback for the San Francisco 49’ers stated,”Tom Brady has done more with less talent around him than any other quarterback in history.”

If one studied his life and career in depth, several key attributes become apparent. While playing for the University of Michigan, the only real school that recruited him, he repeatedly led the team to several comeback victories. His coach at the University of Michigan, Lloyd Carr stated, “This game is a struggle and Tom Brady embraced that struggle more than anybody I have ever known.”

In his final game at the University of Michigan, they faced Alabama in the Orange Bowl and fell behind 14-0, then tied it and fell behind again 28-14 and tied it again before winning in overtime 35-34. Lloyd Carr stated, “As fine a quarterback performance as I have ever seen and there is no greater leader than Tom Brady.”

Tom’s entire career has been a fierce struggle of always trying to prove himself at every level. He was not highly recruited out of Serra High School in California, while at Michigan he shared the job with Drew Henson his senior year and he was the 199th draft pick in the NFL after 6 other quarterbacks were chosen. Coach Lloyd Carr received only one phone call from an NFL team about Tom and he stated to them, “You will never regret drafting Tom Brady.”

Those struggles and obstacles served to strengthen his resolve and have helped make him arguably the greatest NFL quarterback in history.

Tom Brady’s story resonated with me, because evaluating businesses and people go hand in hand and it is so very difficult to determine the qualities and characteristics that lead to success. In fact, none of the hundreds of scouts, coaches and general managers in the NFL were able to recognize the qualities in Tom Brady that made him unique, illustrating how assessing people (and I might add businesses) is very, very difficult and truly an art form.

OUR INVESTMENT PROCESS

Investing remains one of the world’s most humbling businesses. Despite long hours, diligent research, and years of experience the markets continue to unfold in unanticipated ways. The only thing that is certain is that the future is inherently uncertain. We will continue to maintain our discipline and focus seeking unique insights and exercising sound judgement.

Investing often requires following a road less traveled, guided by your own research, experience and insight to formulate conclusions. We continue to focus on enhancing and improving our investment process at Lountzis Asset Management, LLC.

Being skeptical is an important trait as an investor. In the first century B.C, two ancient Greek philosophers, Pyrrho of Elis and his follower Aenesidemus created Pyrrhonism or the school of skepticism. The Pyrrhonian method was to deeply develop both sides of an argument before making a final decision. It involves carefully suspending judgment, a constant challenging of one’s own knowledge, and seeking to avoid ideology and biases.

We seek to create an environment that spawns individual creativity and in Ray Dalio’s words “Thoughtful disagreement which leads to the beginning of understanding. People and culture are all that matter. We seek meaningful work and meaningful relationships through radical truth and radical transparency.”

Intellectual honesty sets the foundation for all relationships within an organization and in all external dealings with clients and vendors. Every individual brings a unique set of skills as people are smart and talented in very different ways. We remain focused upon building a unique culture as Peter Drucker says, “Culture trumps strategy.”

We seek to question everything we can, including conventional wisdom, in order to learn as much as we can about where we are allocating our hard earned client’s capital. Voltaire, the French philosopher wrote, “Judge a man by his questions rather than his answers.”

Mistakes are unfortunately unavoidable, though we do hope to minimize their frequency and their impact. We also sincerely hope to learn from our mistakes and never repeat them. Will Rogers said, “Good judgement comes from experience and a lot of that comes from bad judgement.”

In order to avoid mistakes at our firm, we continuously evaluate our process. Let me share with you some of the principles we utilize in our investment philosophy and research process.

  1. We always focus, first, upon assessing the risks of any investment and what the potential downside is before evaluating potential returns.
  2. We utilize a field-based approach, speaking to competitors, management teams and consultants to augment our analysis of financial statements, and to bring the numbers to life. We believe our research process gives us an edge.
  3. We always seek a margin of safety in our purchases that is a long-term value significantly above the current purchase price.
  4. We focus our research on individual companies within our circle of competence not on guessing where the economy, interest rates, or other economic factors are going. Our approach remains bottoms up.
  5. We attempt to minimize portfolio turnover, holding stocks for several years, thereby, reducing both trading costs and taxes.
  6. We believe in prudent concentration of investments in our best ideas, typically 10 to 20 issues, not the wide diversification employed by most management firms.
  7. We seek clients whose investment philosophy is consistent with ours. Thus, assuring us the flexibility in managing their assets to invest only when we deem the risk reward characteristics in our favor.
  8. We define risk as permanent capital loss not short-term declines in stock prices. Volatility or the fluctuation in prices provides us the opportunity to buy when prices are cheap and sell when prices are high.
  9. We seek to balance confidence with humility while avoiding arrogance and fear, which lead to investment mistakes or making no investments at all. Humility is critical and an important quality in all outstanding investors.
  10. Learning is a never ending process and we attempt to continuously improve our knowledge through deep and thoughtful questioning across industries, companies and leadership teams. Mr. Munger calls Mr. Buffett a learning machine.
  11. Simplicity is a key component in any analysis and investment. The ability to simplify every investment into a few key points is critical. In the words of Mr. Buffett, we focus upon what is knowable and important.

While each of the investment lessons noted above is very important, I want to discuss a couple of them in more detail.

First, being intellectually humble is a critical quality required by all investors. No matter how hard one works, how solid your investment process is, or how successful you may have been, it is impossible to clearly know the future and to always achieve outstanding results. Investing is one of the most humbling businesses in the world where you are constantly being challenged with regard to your analysis and judgment. A successful investor must maintain a delicate balance between being confident but not arrogant and humble yet not fearful. It is a difficult balancing act that one must vigilantly seek to maintain in a highly volatile, short-term oriented and emotional investing world. As Warren Buffett has stated, “Temperament is more important than IQ,” and I could not agree more. We will continue to remain humble yet confident while avoiding arrogance and fear as we navigate the current very challenging global financial markets.

Second, keeping things simple is profoundly important and a critical component of investment success. Complexity needs to be simplified in order to be clearly understood. If an idea cannot be simplified it is often not well understood. We agree with the great investor Peter Lynch in the illustration below.

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Simplicity is universal in its appeal and importance, not just in investing. In the words of author and editor, Michael Korda, “Great leaders are almost always great simplifiers, who cut through argument, debate and doubt to offer a solution everybody can understand and remember.”

We seek leaders that have this quality and are constantly looking for the best executives we can find, and it has been our experience that the best executives are great simplifiers. One executive for whom we have enormous respect, but unfortunately have never owned the stock is Jeff Bezos at Amazon. Bezos is truly a genius and possesses a broad range of unique gifts not unlike Warren Buffett that have enabled him to create an extraordinary organization with many talented colleagues. Simplicity is a key tenet of Amazon’s success.

In 2009 Jeff Bezos articulated Amazon’s simple philosophy, “It is the basics. It is focusing on selection, low prices and reliable, convenient, fast delivery. It’s the cumulative effect of having this approach for 14 years. I always tell people, if we have a good quarter, it’s because of the work we did three, four and five years ago. It’s not because we did a good job this quarter.”

Peter Lewis and his team at Progressive Insurance focused relentlessly on developing analytical tools to better segment the market and customers to generate better pricing, as well as providing the best claims and always looking years ahead to anticipate the future, which has resulted in Progressive being a key player in the rapidly growing direct segment of the auto insurance industry along with the industry leader Geico.

One of the finest group of executives I have ever met was the team at Norwest, whom I met with my colleague Andy Kneeter over 25 years ago. Dick Kovacevich, Les Biller and the outstanding team at Norwest and later Wells Fargo developed and implemented a unique vision and many concepts within the banking industry. They sought to create a diversified financial services company-far broader than just a bank, one with geographic diversity, product diversity and broad range of capabilities to limit the historical cyclicality of traditional banks focused only on lending activities. Furthermore, they successfully implemented their concept of cross selling which is easy to identify as a valuable capability but extremely difficult to successfully implement. In fact, very few companies have successfully done so in banking or in any other industry. They also implemented many other concepts at Norwest and later Wells Fargo making it one of the finest financial institutions in the world. Finally, they successfully integrated Norwest and Wells Fargo, which had very different corporate cultures, into an outstanding diversified financial institution, despite a great deal of skepticism from Wall Street.

Wells Fargo has built a unique corporate culture that has continued to build on their platform of disciplined credit underwriting, diverse revenues, cross selling, geographic diversity and many other initiatives that they continue to excel in. However, in having studied the bank for over 25 years, a key component has been their steadfast focus on disciplined underwriting and risk management. From 2005-2007, when the residential mortgage origination business was exploding, I estimated that Wells Fargo gave up almost $600 billion in mortgage originations to competitors, during those 3 years, reducing their market share and revenues, because they were unwilling to underwrite the loans being made by many of their competitors. Ultimately, that discipline served them well, but was very, very difficult to do. Our hope is that the Wells Fargo culture continues to maintain the disciplined underwriting standards of its past and that in the current challenged industries of energy, metals and mining and perhaps commercial real estate, they will continue to successfully manage their lending risks.

While simplifying concepts is critical to success for any investor and leader, the challenge lies in successfully implementing those simple concepts into successful investments and a successful organization.

Finally, in our business, we seek to work with first-class clients, company management teams, vendors, etc., that are run by first-class people. We strive to invest in the best management teams and we also seek to deliver excellence in all we do as a firm serving our clients. The following quote best describes how we like to view the management of companies in which we invest, and how we hope our clients, vendors, and others with whom we deal with, view us.

Tony La Russa the St. Louis Cardinals manager recently described Albert Pujols, baseball’s best player, “He isn’t colorful and he isn’t controversial – he’s just great.”

In the current tumultuous stock market of early 2016, Will Rogers’ 1933 quote is now in vogue, “I am not so concerned with the return on my money, as the return of my money.”

As many investors have become reacquainted with investment losses during the past 15 years, the stark realities of future gains required to break even have come into focus. The economics of investment losses are best illustrated by the following table.

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The analysis of any investment must consist of assessing both the more commonly discussed RETURN, as well as the often neglected component RISK.

2015 PORFOLIO ACTIVITY–EQUITIES

As the stock market has continued to rise since the market lows in March 2009, we have gone from being very active buyers to active sellers in 2015. During the first six months of 2015, we sold our entire positions in Mercury General (MCY) and Bed, Bath & Beyond (BBBY) both holdings which we began buying 8 years ago in 2007. Both of these long-term holdings reflect our emphasis upon buying outstanding businesses, led by strong management teams, available at attractive prices and holding them for many years, often a decade or longer. This long-term approach is far less common in the investment world today than it was years ago, but we believe the ownership of great companies for long periods of time is the essence of true investing and also enables capital to grow over many years, resulting in deferring taxes, a wonderful byproduct and important benefit of our approach.

Mercury General is a leading automobile insurer in California, which generated over $2.8 billion in net written premiums in 2014 and has been led by the legendary George Joseph, currently in his 90’s, who remains a major shareholder. The company has an outstanding franchise in California with strong distribution through independent agents, a solid balance sheet, and a large investment portfolio that has paid a dividend yield that has exceeded 6%. However, as the stock rose over 54% during an eighteen-month period, and was selling for over 1.7x book value, had limited geographic diversity (as California represented about 80% of the company’s business), and was not well positioned in the consumer direct issuance of auto insurance, we felt it was an appropriate exit point. We believe the future of the automobile insurance industry will continue to migrate to the direct writers such as Geico and Progressive, both of which we own, Geico through our ownership of Berkshire Hathaway, and Progressive directly. While we believe that MCY continues to represent an attractive acquisition for an insurer looking to gain entry or increase their presence in the California automobile insurance market, the purchase price will not represent much if any of a premium to our sale price. We appreciated the privilege of being owners for 8 years along with an industry legend and large shareholder in George Joseph.

Bed, Bath & Beyond is the leading home furnishing retailer with fiscal 2014 revenues of $11.9 billion, operating earnings of $1.6 billion and fully diluted earnings per share of $5.07. Bed, Bath & Beyond is one of the finest retailers we have ever studied with an outstanding management team, excellent merchandising capabilities and a solid balance sheet. We made our first purchases in 2007 and were long-term shareholders for 8 years. The stock price rose to near its all-time high and we felt that was an attractive exit price given our concerns going forward. While Bed, Bath & Beyond is an outstanding company, competitive threats from Amazon and other ecommerce retailers are continuing to reduce the firms’ profitability as gross margins and operating margins have continued to decline. The company was also late in focusing on building an outstanding e-commerce platform to augment its solid legacy store base of over 1,000 Bed, Bath & Beyond stores. While they have made significant investments in e-commerce and have done a solid overall job we believe their future will continue to be adversely impacted by Amazon and other e-commerce competitors resulting in continuing declines in profitability.

Throughout 2015, we have selectively trimmed our investments in several of our core holdings, some of which we have owned for over a decade including: Bank of New York Mellon, LabCorp, Lowe’s, Martin Marietta Materials, Mohawk Industries, PepsiCo, Progressive, US Bancorp, UnitedHealth Group, and Wells Fargo. As we have been active sellers throughout 2015, our selling reflects elevated company valuation levels that we believe lack an adequate margin of safety and represent greater risks than rewards. During much of 2015, the elevated valuation levels made it increasingly difficult to find securities that met our valuation thresholds, which is with an adequate margin of safety selling for 30% or greater discounts to our estimate of the companies’ intrinsic value 3-5 years out. However, we hope the recent stock market declines and perhaps further declines will yield some attractive investment opportunities in 2016.

In 2015 we purchased a few of our current holdings for new accounts including Berkshire Hathaway, US Bancorp and Wells Fargo during company-specific price declines and we purchased one new holding: Precision Castparts (PCP).

Precision Castparts is a leading global manufacturer of a broad range of highly engineered specialized components used for aircraft engines and industrial gas turbines. PCP operates through three product segments: investment castings, forgings, and airframes. The company generated 2015 fiscal year revenue of just over $10 billion and $1.5 billion in net income, or $10.66 per diluted share. The company’s broad array of products, cost-driven focus, solid acquisition record, leadership positions in most of its segments, and the long-term outlook for the commercial aerospace industry, should deliver many years of continued growth. While the company has experienced short term challenges over the past couple of quarters due to an explosion at one of its facilities, a temporary inventory issue at one of its customers and the continued decline of sales to the oil and gas industry, we believe each of these factors are temporary in nature, and have resulted in a stock price decline of almost 30% allowing us an opportunity to establish a position in this great company. Our analysis was confirmed as Precision Castparts was acquired for $235 per share by Berkshire Hathaway on January 29, 2016.

2015 PORTFOLIO ACTIVITY – FIXED-INCOME

The fixed-income markets remain challenging. After over 30 years of declining interest rates, virtually all fixed-income investments are yielding historically low yields including; Treasury Bills, Notes and Bonds, Municipal Bonds, Corporate Bonds, Agency and Mortgage Backed Securities, Bank Loans and High Yield Securities. We continue to find the majority of fixed income securities to be unattractive as the risk/reward is simply unfavorable so we have avoided Treasury securities, corporate bonds and municipal bonds. The only area we believe solid value exists is fixed/adjustable rate preferred stocks of the finest financial institutions in the country.

We have continued to selectively purchase several fixed rate/adjustable rate preferred stocks of outstanding companies with coupons ranging from almost 5% to 7% and with yields to the call from over 5% to 8%. We have discussed several of these securities in detail in our past letters and believe them to be excellent choices for high quality income, tax benefits, and interest rate protection when held to the callable dates.

We purchased several of these preferred stocks below, at, or slightly above, par over the past year. The dividend payments on each of these at purchase were yielding approximately 400-600 basis points above 10-year treasury obligations while providing significant tax benefits. They also begin as fixed rate securities and convert to an adjustable rate if they are not called by their respective issuers. This rare adjustable rate feature reduces both interest rate risk and the security’s duration.

The key risks we see are: 1) they are perpetual securities with no maturity or mandatory redemption date, 2) credit risk, as they are junior to most securities other than common stock, 3) regulatory risk, as Dodd-Frank and other regulations may change, resulting in the banks redeeming these securities early at par and, 4) tax law changes that may impact the qualified dividend treatment for these issues, 5) interest rate risk, mitigated some by the adjustable portion.

Another short-term risk is that the prices of these securities will fluctuate, often rising above and even falling below their par value. In fact, several of our holdings have risen as much as 20% above par and some have declined as much as 3-5% below par and in the current volatile markets these price fluctuations may increase and result in prices well above or well below par. These fluctuations do not concern us, rather they provide opportunities to purchase more of these outstanding securities particularly when trading below par. So we caution our clients to please focus on the long-term income returns generated by these securities and not to focus on the price fluctuations up or down. We anticipate holding the majority of our holdings until the call date, with a few exceptions. Please remember we view risk in terms of the probability of permanent capital loss not short-term price fluctuations.

An important benefit for our clients with taxable accounts is that these dividends represent qualified dividend income, or QDI, and are considered dividend income for federal tax purposes, which is taxed at favorable capital gains tax rates. For most of our clients that will be either 15% or 20%, which now includes an additional 3.8% tax from the healthcare bill’s medical surtax, resulting in rates of 18.8% to 23.8%. These rates are still well below the ordinary income tax rates approaching 40%.

Our primary focus in our fixed-income investments remains capital preservation and secondarily income. While rates of return remain at historically low levels, we are unwilling to either reduce our credit quality standards or take undue interest rate risk by purchasing far out maturities. With rare exceptions, we always hold our fixed-income securities to maturity.

EQUITY HOLDINGS

ABBOTT LABORATORIES (ABT) is a leading diversified healthcare company operating in the following areas: pharmaceuticals, diagnostics, nutritionals and medical products. In 2015, the company generated sales of $20.4 billion from four diverse business units: nutritionals 34%, medical products 25%, established pharmaceuticals 18% and diagnostics 23%.

Abbott has leading market share positions in several businesses, and in addition to a broad portfolio of products and services, is geographically diverse with 30% of sales in the U.S., 30% in other developed markets and 40% in the more rapidly growing emerging markets. Abbott’s new Hepatitis C drug offers excellent potential in the years ahead with sales estimates rising to over $3.5 billion in the next couple of years.

BANK OF NEW YORK MELLON (BK) is a leading trust bank with assets under custody and management exceeding $28.5 trillion. It is a global leader in several segments in which it operates. Few competitors have their global reach and scale. Approximately 80% of its revenues are reoccurring and fee-based, focused on institutional services with less reliance on the higher credit risk from lending.

In 2015, BK generated operating revenue of $12.1 billion and pre-tax income of $4.2 billion or a 35% pre-tax operating margin. Low interest rates continue to negatively impact results as they have over the past few years, while the bank continues to work diligently on its initiatives to cut expenses and selectively raise prices on many of its products. We believe the bank can earn $2.90 to $3.00 in 2016 representing a multiple of 11x earnings, while paying a 2% dividend yield.

BB&T (BBT) is a leading financial services holding company based in Winston-Salem, North Carolina operating 2,139 financial centers in 15 states and Washington D.C., offering a broad range of consumer and commercial banking, securities brokerage, asset management, mortgage and insurance products and services. The company’s geographic footprint includes the more rapidly growing southeastern United States with a presence in North Carolina, South Carolina, Georgia, Florida and Texas.

For the full year 2015, BB&T generated $5.6 billion in interest income and $4.0 billion in non-interest income for total revenues of over $9.6 billion and net income of $2.1 billion or $2.56 per diluted share. The company’s solid credit culture, geographic and product line diversity provide us with a solid institution well positioned to continue to grow organically and through acquisitions in the years ahead. We believe BB&T should earn in excess of $2.90 to $3.00 in 2016, representing a multiple of 12x earnings.

BROWN & BROWN (BRO) is a leading insurance broker with an outstanding corporate culture that helps generate the highest margins in its industry. Total 2015 revenue was $1.6 billion, an 8% increase from 2014, while adjusted earnings rose 3% to $1.67 per share.

After several years showing sparse growth, Brown & Brown has begun to grow organically while continuing to maintain the highest profit margins in the industry. In fact, during the 1997 to 2007 insurance cycle, Brown & Brown grew EPS at 20% per year but, since that 2007 earnings peak, organic growth slowed significantly. In fact, earnings growth continued in 2015 from solid growth in 2013 and 2014.

LAB CORP (LH) is the second largest provider of clinical laboratory testing services in the United States. Lab Corp should generate revenue of $8.5 billion, EBITDA of $1.4 billion, a 17.1% operating margin and free cash flow of more than $700 million. The Covance purchase continues to progress well and significantly diversifies LabCorp’s revenues though the purchase price was certainly a full one and we believe that free cash flow will now be applied to paying down debt rather than stock repurchases which has been a key use of free cash flow over the past several years.

LOEWS (L) is a holding company with interests in several companies including: CNA, the 8the largest U.S. Property and Casualty Insurer; Boardwalk Pipeline Partners, a Gulf Coast based midstream MLP that transports, stores, gathers and processes natural gas and natural gas liquids; Diamond Offshore, a leader in offshore drilling, serving the energy industry around the globe with 50 offshore drilling rigs; and Loews Hotels, a luxury hotel chain. Loews has an outstanding track record as its stock price has doubled the return of the S&P 500 over the past 50 years with a 16% compound annual growth rate and has a shareholder-oriented management team that continues to buy back stock. Two of the firm’s largest investments, Boardwalk Pipeline Partners and Diamond Offshore, are experiencing significant challenges in the current oil and gas industry upheaval, resulting in very low valuations that in time with their parent Loews and its $5 billion in cash, should rise in value in the years ahead. Loews represents a more conservative way to invest in the energy industry as the company is currently selling below stated book value and at a 30-40% discount to the company’s long-term intrinsic value.

LOWE’S (LOW) a leading home improvement retailer generated revenues of $59.1 billion in fiscal 2015 with net income of $3.1 billion. Diluted earnings per share were $3.30 and we see that rising in 2016 to $3.75/share. The company continues to generate significant free cash flow exceeding $3.7 billion in 2015 providing for a solid dividend yield of just under 2% with continued share repurchases. While Home Depot continues to perform better than Lowe’s, as measured by same store sales and operating margin, we believe that Lowe’s will continue to improve its merchandising operations, raise margins to over 10% and continue to buy back significant amounts of stock. Lowe’s stock price appreciated 40% in both 2012 and 2013, 39% in 2014 and 11% in 2015.

MARTIN MARIETTA MATERIALS (MLM) is the second largest domestic producer of construction aggregates and a producer of magnesium based chemicals and dolomitic lime. Aggregates refer to the business of selling crushed stone, rocks and sand and is an attractive business. It enjoys significant barriers to entry, including the challenges in gaining permits for new quarries, as well as the low value to weight ratio of aggregates creating local oligopolies that enable solid pricing power. As I mentioned in prior letters, it is one of few businesses I have ever studied that have experienced enormous volume declines yet have been able to continue to raise prices illustrating the power of their business model.

The company purchased Texas Industries in July 2014, which expanded their geographic presence and market share in several markets, and provides additional products; they are on course to generate $100 million in synergies by the end of 2016, an increase of over 40% from their initial projections.

MLM remains well positioned for solid growth in its largest markets, and achieved a 34% increase in 4the quarter earnings from the prior year. While the acquisition accounted for a large portion of the increase the company’s aggregates volumes rose 7.1% and prices rose 8% for the year. Revenues rose to $3.3 billion from $2.7 billion and adjusted operating income rose to $495 million from $369 million in 2014 with adjusted earnings per share of $4.50 a 20% increase.

With the significant need for rebuilding our bridges and highways we believe that MLM is well positioned to drive strong future growth as our country begins spending the required capital on our rapidly deteriorating infrastructure. The recent passage of the Fixing America’s Surface Transportation (FAST) Act, a 5-year Federal highway spending bill will continue to help the company prosper.

MOHAWK INDUSTRIES (MHK) is a leading manufacturer of flooring products whose revenues continue to increase as the economy and, in particular, the housing markets continue to rebound. Sales in 2015 should exceed $8.1 billion with net earnings of just over $750 million or over $8.50 per share.

The company continues to aggressively make acquisitions, including the 2013 purchases of Marazzi Group, the fifth largest producer by volume in the ceramic tile industry as well as Pergo and Spano. Combining Mohawk’s existing ceramic division Dal Tile with the Marazzi Group creates the largest ceramic tile company in the world on a revenue basis. Currently, about 9% of U.S. flooring consumption in value is made of ceramic tiles, a much lower percentage than in most other nations around the world. In Western Europe, tile represents 30%, and in countries like Italy tile can exceed 55-60%. In January 2015, Mohawk purchased IVC, a European based manufacturer of sheet vinyl, luxury vinyl tile and laminate sold in Europe and the U.S. The purchase price of $1.2 billion is 10x trailing EBITDA and the acquisition should be $.30-.50 accretive in the first 12 months.

We anticipate continued improvement in the housing markets and in the U.S. economy, which bodes well for Mohawk Industries in 2016 and beyond.

PEPSICO (PEP) is the leading global snack and beverage company that manufactures and markets a variety of salt and convenience snacks, carbonated and non-carbonated beverages and foods. The company operates through four segments: Beverages North America, Frito-Lay North America, PepsiCo International and Quaker Foods North America.

PepsiCo’s fourth quarter 2015 earnings were $1.06, a decline of 4.6% from 4th quarter 2014 earnings. This decline was driven by negative foreign currency as foreign sales account for 50% of PepsiCo’s revenues. Revenues generated in 2015 were $63 billion with operating income of $9.9 billion and $4.57 in earnings per share, a 1.3% decline from 2014.

The company continues its focus on cost reductions with over $1 billion in incremental savings per year over the next 5 years. We believe the company can generate in excess of $10 billion in operating profit in 2016, even while facing strong headwinds from the rising dollar, and slowing global economies, as over 50% of company sales are outside the United States.

PROGRESSIVE (PGR) is the fourth largest auto insurer in the country and generated earned premium revenues of $19.9 billion in 2015 with pre-tax operating income of $1.9 billion, or $2.15 per diluted share. We project Progressive’s net premiums written to exceed $21.7 billion in 2016 generating pre-tax operating income of $1.7 billion.

UNITEDHEALTH GROUP (UNH) is a leading diversified managed health care company serving 75 million individuals and operating through two segments: UnitedHealthcare, and Optum. The UnitedHealthcare segment serves employers and individuals, communities, states, Medicare and retirement. The Optum service businesses include Optum Health, Optum Insight and Optum RX. Overall company revenues in 2015 exceeded $157 billion with operating earnings of $6.7 billion and adjusted net earnings per share of $6.30.

The UnitedHealthcare Segment has the #1 market position in several areas including: Medicare Advantage, Medicare Supplement, and Medicaid and is #2 in commercial insurance. Furthermore, the company’s geographic and product diversity serve to reduce business risk.

The Optum segment of UnitedHealth Group is a health services business serving the broad health care marketplace, including payers, care providers, employers, government, life sciences companies and consumers. Using advanced data, analytics and technology, Optum helps improve overall experience and care provider performance. Revenues for the Optum segments in 2015 were $67.6 billion with earnings from operations of $4.3 billion. Of the three segments, Optum Insight is a leader in healthcare data analytics and generated revenues of $6.2 billion for the year including 18% growth in the fourth quarter of 2015.

The company is projecting 2016 revenues of $180 billion and net earnings of $7.60 – $7.80.

US BANCORP (USB) is one of the top 10 largest banks in the country with assets of $422 billion at year end 2015. The company has an outstanding credit culture, resulting in low credit losses and generates substantial fee income providing greater stability and predictability in its earnings. In 2015, the company generated $11.2 billion in net interest income and $9.1 billion in fee income. Operating revenues were $20.3 billion and net income was $5.9 billion or $3.16 per share.

The company’s financial metrics are among the best in the industry with a return on common equity of over 14%, and a return on assets of 1.4%. We believe US Bancorp is well positioned to continue to build upon its outstanding franchise both organically and through selective acquisitions in the years ahead. The company should earn in excess of $3.30-$3.40 in 2016 representing a price earnings multiple of just over 11x earnings-a favorable valuation for an outstanding diversified financial institution. Furthermore, with a large fee income stream the bank is better able to weather low interest rate periods than most competitors who lack such a large recurring fee income stream.

WELLS FARGO (WFC) is the fourth largest bank in the country with average assets of $1.8 trillion at year-end 2015. The company generated operating revenues of $86.1 billion in 2015 with net income of $23 billion and diluted earnings of $4.15 per share.

The company is a diversified financial services company operating in a broad range of markets including the east and west coasts of our country, and through several business segments including, banking, insurance, investments, mortgage, and commercial and consumer finance through over 8,700 locations, 13,000 ATM’s and the Internet. Wells Fargo, like US Bancorp, also generates significant fee revenues providing a more stable and recurring revenue stream less impacted by the declining interest rates that have negatively impacted net interest margins over the past few years. In 2015, the company generated net interest income revenue of $49.3 billion while generating fee revenue of $41 billion.

We believe that Wells Fargo’s diverse business model will continue to thrive in various economic environments and will benefit when interest rates rise, augmenting the net interest margin to once again exceed 4%, a level that it has fallen well below over the past several quarters. Nevertheless, Wells Fargo remains an outstanding financial services company generating a return on tangible common equity of 13%, and a return on assets of 1.3%. The company also maintains leadership positions in several businesses including a leading mortgage originator and servicer, originating one of every three mortgages in this country. We estimate the company can earn in excess of $4.40 in 2016.

WORLD FUEL SERVICES (INT) is a global leader in fuel logistics, engaged in the marketing, sale, distribution and financing of aviation, marine and land fuel products and related services. The company provides one-stop shopping for customers in this highly fragmented industry. World Fuel Services was founded in 1984 and in 2015 generated $30.4 billion in revenue and $186.9 million in net income. We believe the company has a long runway to continue to grow organically by expanding its customer base, geographic reach and additional product and service offerings, as well as through acquisitions. In early February the company announced the purchase from ExxonMobil of their aviation fueling operations at 83 airports in Canada, the United Kingdom, Germany, France, Italy, Australia and New Zealand.

ZOETIS (ZTS) is a leading animal health provider serving the livestock and companion animal markets with 2015 revenue of $4.8 billion and adjusted diluted earnings per share of $1.77. The company was spun out of Pfizer in 2013 and continues to be the industry leader operating globally in both pharmaceuticals and vaccines serving the livestock market (64% of revenues) and the companion animal market (36% of revenues). The company is the industry leader in several categories as shown in the following chart.

Zoetis’ leadership position in many segments, along with the company’s broad diversity by product, geography, therapeutic category and species, should lead to solid long-term results for this outstanding company. The company is projecting 2016 revenues of $4.7 to $4.8 billion and adjusted diluted earnings per share of $1.71 to $1.81.

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The above commentary is excerpted from the Lountzis Asset Management year-end letter for 2015.