Post by T Bhat on Nov 8, 2011 9:54:07 GMT -5
Dear Aegis Investors:
In the worst quarterly loss since the failure of Lehman Brothers reverberated through the markets nearly 3 years
ago, the Aegis Value Fund lost 20.2 percent, resulting in a year-to-date decline of 13.9 percent. Large-cap stocks
outperformed small-caps in the third quarter, with the large-cap focused S&P 500 and Nasdaq 100 Indices delivering
losses of 13.9 percent and 8.0 percent respectively, while the Russell 2000 Index of small-cap stocks dropped
21.9 percent. The Aegis Value Fund’s primary small-cap value stock benchmark, the Russell 2000 Value Index, lost
21.5 percent. Past performance data for the Aegis Value Fund and the Russell 2000 Value benchmark are presented
in Table 1 below:
* Aegis Value Fund Inception 5/15/98
Performance data quoted represents past performance and does not guarantee future results. Current performance
may be lower or higher than the performance data quoted. The investment return and principal value
will fluctuate so that upon redemption, an investor’s shares may be worth more or less than their original cost.
For performance data current to the most recent month end, please call us at 800-528-3780 or visit our website
at www.aegisfunds.com. The fund has an annualized expense ratio of 1.45%.
Echoes of 2008
The market declines that started last quarter gathered steam in recent months. Equities plunged as investors fled
to cash and other liquid securities in an effort to reduce holdings with perceived risk. Declines accelerated in
August as investors were subjected to highly inflammatory political rhetoric suggesting that the United States was
on the precipice of a debt default financial Armageddon during a politically charged debate in Congress over federal
spending and debt limits. The political fear-mongering, as well as S&P’s Treasury downgrade shortly after
proponents of fiscal restraint capitulated, gave investors a feeling of 2008 déjà-vu. Anxieties further increased in
the quarter as consumer confidence readings registered steep drops, reigniting fears that the economy was slipping
back into recession, particularly as concerns mounted over banking system exposure to European financial
system sovereign debt troubles.
Selling pressure on bank shares increased markedly during the quarter, with confidence aggravated by the illconsidered
move by the Federal Government on September 2nd to sue 17 banks for a massive $196 billion. The suit
by the FHFA alleged irregularities in mortgages purchased from the banks by Fannie Mae and Freddie Mac in recent
years and seeks to recover losses. While the ultimate settlements may only be a fraction of the $196 billion
the Government is seeking, these lawsuits introduced the prospect of new, difficult-to-quantify, tort-related liabilities
into the banking system. When combined with aggressive political rhetoric scapegoating banks for the
economy’s difficulties, the suits have left bank investors with renewed anxiety over capital adequacy and elevated
concern that any bank earnings would be increasingly siphoned off by the government.
Given the relentless cacophony of worrisome news, the apparent similarities to 2008, and the painful market declines
of 2008 viscerally burned into memory, investors decided to sell first and ask questions later. As in 2008,
investors began to sense the potential for a “Lehman moment” caused by banking system counterparty exposure
to the European debt crisis, with the prospect of recession-provoking forced deleveraging with all the commensurate
capital shortage and illiquidity aftereffects. The response was Pavlovian: Just as in 2008, small-caps were
Value Fund
Portfolio Manager’s Letter
Quarter Ended September 30, 2011
October 14, 2011
Aegis Value Fund
Russell 2000 Value Index
-20.19%
-21.48%
Three
Month
-13.90%
-18.51%
Yearto-
Date
0.87%
-5.99%
One
Year
3.36%
-2.78%
Three
Year
1.26%
-3.08%
Five
Year
7.08%
6.47%
Ten
Year
9.11%
5.03%
Since
Inception*
Table 1: Performance of the Aegis Value Fund
Annualized
sold harder than large caps. Energy stocks and industrial cyclical stocks were again among the worst hit with the
energy segment of the Russell 2000 Value Index dropping a whopping 34.27 percent in the third quarter. Many
levered investors exposed to small-caps, energy stocks, and commodities on margin were likely forced to sell as
prices fell and financial institutions tightened collateral requirements. For example, one popular low-cost brokerage
firm implemented a new collateral policy over 3 days in September, calling in loans and disallowing any future
borrowing collateralized by almost any sub-$250 million market cap equity security. Reported margin debt at
NYSE member firms dropped by $34 billion to $272 billion in August, the lowest level since October 2010. Margin
debt likely fell further as margin calls continued into September.
As the market struggled to find its footing amid this new bout of anxiety in August, the Dow experienced 4 consecutive
days of 400 point price moves, an unprecedented spout of volatility. The CBOE Volatility Index (VIX) rose to
levels above 30 and remained there for the remainder of the quarter, the longest stretch of high market volatility
since early 2009 when the market was bottoming-out during the financial crisis.
By the time August was over, investors had pulled more money out of developed market equity funds over the
previous three months than the entire amount added to these funds since the 2009 market bottom. According to
the Wall Street Journal, these withdrawals “matched the worst three-month period during the depths of the financial
crisis.” Ironically, fearful investors sought refuge in the very Treasuries whose recent downgrade had contributed
to their anxiety in the first place, driving short-term Treasury prices so high that yields actually turned negative.
Long-term Treasuries experienced so much buying pressure that yields dropped to a 55 year low. Money
funds, despite offering negligible yield, took in a massive $74.1 billion in August, the largest monthly inflow since
December of 2008, according to Lipper.
Watch the Facts, Not the Hacks
Throughout this period, investors have been bombarded with the conventional narrative that the economy is slowing
to “stall speed,” another “Lehman moment” may be on the horizon and that a “double-dip” recession is increasingly
likely, particularly in the absence of additional government intervention. Often, the politically-driven
sub-context of these prognostications is that capitalism itself is an unsustainable economic system and is naturally
prone to failure unless government is increasingly called into action. Given all the politically-motivated and often
depressing economic rhetoric, it is no wonder that the two main surveys of consumer confidence registered sharp
August declines. The University of Michigan Consumer Sentiment Index measured confidence in August at 55.7, 8
points below July’s level. August’s plunging confidence reading was the lowest since the depths of the last recession
3 years ago. These drops in the confidence surveys sparked yet another debilitating round of anxious headlines
such as “Consumer Confidence Plunges to the Lowest Since 2009 on Jobs Outlook,” which printed on Bloomberg
August 30th, or “Consumers Giving Up Hope about the U.S. Economy,” which printed in the Baltimore Sun the
next day.
It is easy for investors to become emotionally demoralized watching investments fall in price while being lambasted
with these kinds of headlines, which are often written by reporters with a political axe to grind. Yet, it is critically
important for an investor to evaluate economic conditions based on the facts and without emotion. Clearly,
the fiscally profligate and increasingly indebted Federal Government hammering private enterprise with progressively
burdensome regulation is neither healthy nor conducive to reducing stubbornly high unemployment. However,
despite the serious issues that the government is not addressing adequately, we believe the facts show the
economy is holding up much better than the pundits are claiming.
For example, in July the Commerce Department reported aggregate retail sales showing a 0.5 percent gain monthover-
month. After July’s release, the New York Times headline was “Retail Sales Rise, but Pessimism Drives Consumer
Sentiment to a 30-Year Low.” August’s retail sales were then reported flat with the previous month but up
a healthy 7.2 percent from the previous year, which sparked the downbeat Bloomberg headline, “U.S. Retail Sales
Stall on Lack of Job Growth.”
Clearly, these headlines give the impression that the economy is stalling like an sluggish aircraft about to meet its
demise. Several of these unusual headlines were noted in a September econometric study entitled “Consumer
Sentiment and Spending: Watch What I Do, Not What I Say.” In the study Ross Devol, Chief Research Officer at
the Milken Institute, concluded that the low consumer sentiment readings reported in August were actually heavily
influenced by declining confidence in government, and were not likely to be indicative of reduced future consumer
spending. September proved Devol right, with retail sales up a healthy 1.1 percent, the largest month-overmonth
retail sales gain in 7 months.
Other recent economic statistics show few signs of serious economic weakness:
The Chicago Purchasing Managers’ Index released September 30th rebounded 3.9 points to 60.4 and reported
significant gains in employment and new orders.
The Institute for Supply Management Manufacturing Index increased 1 percent from August to 51.6 percent in
September, the 26th straight month of increase. Any reading above 50 on the ISM represents growth.
Smith Travel Research just reported that hotel occupancy for the week ending October 8th was up 1.5 percentage
points while average daily rate was up 2.8 percent from a year ago.
The American Association of Railroads reported that rail traffic for the week ended October 1st was up 4.4
percent from the same week last year.
September auto sales were reported to be approximately 1.05 million units, up about 10 percent from a year
ago.
Value investor Warren Buffett, whose conglomerate Berkshire Hathaway maintains holdings across a broad crosssection
of the economy, including railroads, utilities, insurance, jewelry retailing, candy, aircraft chartering and
housing, noted in a recent interview that other than the housing related businesses, everything else was up: “If
you take our five largest businesses, all of them will either set records for earnings or just about set records for
earnings this year… I really thought in August and September with all the turmoil in the markets, you’d see a
falloff… but it hasn’t happened yet. Maybe it will, but as of today, the recovery is still underway.” The Board of
Berkshire Hathaway in a signal that shares are now undervalued, recently approved the first company stock buyback
since 2000.
2011 is not 2008
We do not believe that the capital markets today are on the cusp of another 2008 precipice where liquidity concerns,
forced debt deleveraging, and deflation are at hand. US non-financial companies have actually been building
significant cash and now hold approximately $1.9 trillion in cash and other liquid assets, reported as the highest
level as a share of corporate assets since 1959. Cash levels of the S&P 500 non-financials were reported in the
quarter to be up $400 billion from 2008 to over $1.1 trillion. As can be seen in Figure 1 , aggregate non-financial
corporate profits are up significantly from 2008, and are now even above their 2006 peak. Leverage within the
stocks of the S&P 500 are also down significantly, with Bloomberg recently reporting that the S&P 500’s ratio of
net-debt to earnings before interest, taxes, depreciation and amortization has dropped from 5 times in mid-2008
to 2.6 times today.
Banks are also in better financial shape than in 2008. Underwriting standards have been far tighter now for years
and the banks have spent nearly 4 years writing off bad loans and strengthening balance sheets. As can be seen in
Figure 2, U.S. commercial banks now have a core capital ratio of approximately 9 percent, a multi-decade high
Figure 2:
U.S. Commercial Banks Core Capital Ratio and Return
on Assets
Figure 1:
U.S. Non-Financial Domestic Corporate Profits
($Billions)
Sources: Bureau of Economic Analysis (BEA) and FDIC. Core Capital Ratio is defined as the ratio of a bank’s capital
to its risk-weighted assets. Return on Assets is defined as the ratio of a bank’s net income to its assets.
-0.2%
0.0%
0.2%
0.4%
0.6%
0.8%
1.0%
1.2%
1.4%
1.6%
6.0%
6.5%
7.0%
7.5%
8.0%
8.5%
9.0%
9.5%
1992 1995 1998 2001 2004 2007 2010
Core Capital Ratio (Left Axis)
Return on Assets (Right Axis)
$500
$600
$700
$800
$900
$1,000
$1,100
$1,200
2005 2006 2007 2008 2009 2010 2011
materially above the levels of 2008. Return-on-assets at the banks are also recovering. The housing market is no
longer in a bubble and consumer debt service payments as a portion of disposable income is down sharply. Furthermore,
there is little doubt that the shadow banking system is only a fraction of its 2008 size.
While there has been much consternation over banking exposures to the sovereign debt of Greece and other financially
profligate EU countries, we would note work by Brian Wesbury, Chief Economist at First Trust Portfolios
showing that the 5 largest U.S. banks have only $54 billion of direct exposure to the debts of Greece, Portugal,
Italy, Ireland, and Spain combined, representing approximately 8 percent of their bank capital. During the early
1980’s, when Latin American countries were defaulting, the exposure of the 8 largest U.S. banks at the time was
equal to a massive 263 percent of bank capital. While counterparty risk and other indirect exposures to the highly
exposed European banks are clearly a concern, we believe that the European Central Bank and the EU member
states are far more likely to bail out the European banks than to allow banks to fail in a disorderly manner.
While corporate America is far healthier in 2011, the Federal Government is not. Federal Government spending is
up 40 percent since 2007 and Federal Government debt as a percentage of GDP is also significantly higher. Deficit
spending equivalent to 10 percent of GDP per year is clearly not sustainable. Demand for Treasuries arising from
the Federal Reserve’s fulfillment of its QE2 money printing mission has ended, and with the Chinese Yuan now
increasingly allowed to float, it is an open question as to how much Treasury buying the Chinese will do in the
future. Treasuries currently remain well-bid on refuge demand, but it looks to us that this dynamic could also
change in a hurry, leaving the government in a lurch, and placing tremendous pressure on the Fed to resume money
printing to accommodate federal deficit spending. With higher interest rates and increased inflationary pressures
a likely outcome, we believe long-term 30-year Treasuries at yields slightly above 3 percent expose investors
to a significant amount of interest rate risk should rates rise. We continue to position the Aegis Value Fund in
securities that we believe can do well in a scenario of heightened inflation.
Small cap value stocks are attractively priced
The third quarter not only witnessed high market volatility, but also record correlations of stock movements, as
waves of mass selling and mass purchasing drowned out the movements based on the fundamental characteristics
of individual stocks. During the third quarter, correlations reached their highest level since the measure peaked
in 1987 during the October “Black Monday” crash. Highly correlated markets like those we’ve seen in the third
quarter generally provide good hunting ground for disciplined value investors to make bargain purchases from
sellers who are not adequately focused on true company fundamentals.
The dramatic decline in the stock market absent a significant deterioration in economic fundamentals has left
many stocks at bargain prices. With earnings for the S&P 500 Index forecasted to be just under $100 in 2011, and
with the index at the date of this writing at 1,224.58, the S&P 500 now trades at a modest 12-13 times earnings, a
very cheap valuation historically, particularly given today’s low bond yields. Company managements appear to
agree, and are now buying back shares through corporate repurchases at a hefty clip. Birinyi Associates estimated
that in August, 198 companies authorized new buybacks of their own shares, the highest monthly total since February
2008, with 2011 on track to be the third largest buyback year on record. We estimate that companies representing
nearly a third of the Aegis Value Fund portfolio have been recently buying back shares.
Small cap value stocks are looking particularly attractive. As can be seen in Figure 3, the number of stocks on our
watchlist ended the quarter at 545, a significant increase from last quarter and the highest level since 2009 during
the depths of the financial crisis. Many of these watchlist investment candidates already trade at prices that essentially
discount difficult economic times. We are hard at work trying to ensure that we have our capital invested
in those companies that give us the best reward for the level of risk incurred.
Our biggest Fund purchase during the quarter was Tesoro Corporation (TSO - $26.70), a $3.8 billion market cap
refining and marketing company that owns and operates 7 refineries with a combined crude oil capacity of
665,000 barrels per day (bpd) as well as a retail gasoline distribution segment with 1,185 retail stations. With
$1.1 billion of net debt and an enterprise value of nearly $5 billion, the company trades slightly above book value
of $24.82 per share. Tesoro’s book value fails to take into consideration inventories of crude oil and petroleum
products which are undervalued on the books by the amount of Tesoro’s $13.25/share last-in-first-out “LIFO” reserve.
When the $2.5 billion of net working capital, adjusted to mark petroleum inventories to market value, is
backed-off from the $5 billion enterprise value of the company, the remaining $2.4 billion empty plant and equipment
value represents approximately $3,700 per bpd capacity, well under our estimated replacement cost of
$10,000 to $15,000 per bpd capacity. Furthermore, Tesoro’s mid-continent refining capacity is currently generating
outstanding margins, as environmentally driven federal delays to pipeline-building are resulting in a glut of low
-priced mid-continent crude which is giving local refiners very low WTI-based input costs. If current margins hold,
we estimate the company should be able to generate close to $1.5 billion of earnings before interest, taxes, depreciation
and amortization in the coming year. The shares are already up significantly from our third quarter
average purchase price of $20.08. Tesoro was a 2.8 percent Fund position at the end of the quarter.
Most positively impacting the Fund’s performance in the third quarter was the gain in shares of Penn Millers Holding
Corporation (PMIC - $20.12), the third largest agribusiness insurer in the United States. We first started purchasing
shares in Penn Millers, which provides non-crop property and casualty insurance to agricultural concerns,
in March of 2010, only 5 months after this $102 million market cap company came public. Penn Millers came public
through a conversion from a mutual insurance company that left the company trading at 50 percent of tangible
book value. Management had decided to convert in order to increase capital in preparation for a better underwriting
environment, but when the harder market failed to materialize, the company initiated a series of share
repurchases. Due to the high fixed costs inherent in the business and the poor operating environment, Penn Millers’
lower premium level ultimately made much of their underwriting unprofitable. The company was put up for
sale in August following nearly two years of business restructuring, and the company soon thereafter announced a
definitive agreement to sell to ACE Limited, a much larger diversified insurer, for 108 percent of tangible book
value. Given the opportunity rich depressed market environment, as well as our assessment that another superior
offer was unlikely to emerge, we completely exited our position. Penn Millers positively impacted Q3 Fund performance
by approximately 0.5 percent. Penn Millers was the largest Fund sale during the quarter.
Most negatively impacting Fund performance during the quarter was the decline in shares of Fibrek (TSX: FBK –
C$0.77), a Canadian-based producer of Northern Bleached Softwood Kraft (“NBSK”) and Recycled Bleached Kraft
(“RBK”) paper pulp, which was discussed in last quarter’s letter. Now trading with a market capitalization of approximately
C$100 million, the company is valued at only 30 percent of tangible book value and at an increasingly
wide discount to facility replacement cost. Fibrek has been using the cash generated in the business to pay down
debt, and now has about $100 million in net debt. While NBSK pricing has weakened recently to $950 per ton from
a peak of slightly over $1000 per ton earlier in the year, the decline in Fibrek shares appears overdone, as the
company now trades at approximately 3.5 times current annual EBITDA. We continue to hold to the thesis that
the market encroachment of hardwood pulp has eased, and NBSK demand is likely to increase over time as India
and China develop. With relatively minor maintenance capex requirements we estimate at only $13 million, and
with a very strong balance sheet, we currently anticipate an eventual recovery in shares. Declines in Fibrek
shares negatively impacted Q3 Fund performance by approximately 1.6 percent.
The Fund also took a hit on its heavy exposure to energy exploration and production, oil service and commodity
companies. However, when looking broadly at the Aegis Value Fund portfolio, we believe that these holdings generally
experienced quotational declines that were significantly in excess of that justified by a deterioration in fundamentals.
From a bottom-up perspective, we have yet to see signs of a systemic slowdown in fundamental outlook, and we
are not seeing our portfolio companies experiencing stress with regard to liquidity or funding. While one can never
rule out a recession, and a downturn in business activity is always a possibility, the valuations of many of our
Figure 4:
Aegis Value Fund Historical Price-to-Book Ratio
Figure 3:
Number of Stocks Selling Below Tangible Book Value
(Market Cap. Greater Than $70 Mil)
0
100
200
300
400
500
600
700
800
02 03 04 05 06 07 08 09 10 11
20%
30%
40%
50%
60%
70%
80%
90%
99 00 01 02 03 04 05 06 07 08 09 10 11
holdings now already discount a scenario of fairly difficult economic times. As you can see in Figure 4, stocks in
our Fund trade at a weighted average 63.6 percent of book value at quarter end, significantly down from earlier in
the year. With the S&P now at 185 percent of book value, stocks in the Fund now trade at a two-thirds discount
to the broad market based on book value. The Fund sells at an even bigger discount to the S&P 500 based on tangible
book value, as intangible assets are much higher as a proportion of S&P 500 equity. Stocks in our Fund have
not sold this cheaply since late 2009.
Overall, our portfolio companies are conservatively financed, with our non-financial holdings having a weighted
average net debt to capital of only 17 percent. When we look at the financial holdings in our Fund, many consist
of overcapitalized insurance companies with outlooks for positive earnings, despite the soft insurance market.
While the Fund has recovered nicely, rising 11.3% since quarter-end as the markets have improved in the first half
of October, we would not be surprised to continue to see high volatility in the day-to-day quotations, given the
environment. Overall however, we take great comfort that the equities market is now trading at low multiples
that already discount tough economic times and that our portfolio is invested in a carefully selected, diversified
group of holdings that are among the most undervalued we are able to find in the market today. Aegis employees
have in excess of $10 million co-invested in the Fund. I have continued to add to my own holdings of the Fund
during the downturn in the third quarter, and would encourage long-term oriented investors to consider also adding
to their position at this time, given the overwhelming negativity in the market in recent months. We continue
to monitor portfolio risks within the Fund very carefully. As always, our shareholder representatives are available
via 1-800-528-3780 to answer any questions. Should you have any questions at all regarding our Fund’s investment
process or market approach, you are always welcome to call me personally at (571) 250-0051.
Best regards,
Scott L. Barbee
Portfolio Manager
Aegis Value Fund
Any recommendation made in this report may not be suitable for all investors. This presentation does not constitute
a solicitation or offer to purchase or sell any securities. Its use in connection with any offering of fund
shares is authorized only in the case of a concurrent or prior delivery of a prospectus.
The Aegis Value Fund is offered by prospectus only. Investors should consider the investment objectives, risks,
charges and expenses of the fund. The prospectuses contain this and other information about the fund and
should be read carefully before investing. To obtain a copy of the fund’s prospectus please call 1- 800-528-3780
or visit our website www.aegisfunds.com, where an on-line prospectus is available.
Risks associated with investing in the Aegis Value Fund include: investing in common stocks, value-oriented investment
strategies, investing in smaller companies, real estate investment trusts, foreign securities and a managed
fund, risks of political and international crises.
Performance data quoted represents past performance and does not guarantee future results. Current performance
may be lower or higher than the performance data quoted. The investment return and principal value
will fluctuate so that upon redemption, an investor’s shares may be worth more or less than their original cost.
For performance data current to the most recent month end, please call us at 800-528-3780 or visit
www.aegisfunds.com. The fund has an annualized expense ratio of 1.45%.
The letter refers to three issues held by the Fund: Tesoro Corporation, Penn Millers Holding Corporation, and
Fibrek Inc. As of September 30, 2011, these stocks represent 2.8%, 0.0%, and 2.3% of total Fund assets respectively.
Date of first use: October 19, 2011 Fund Distributor: Rafferty Capital Markets, LLC