In This Issue

• Cale’s
  Notes:
  A new look for IIM.
• Portfolio
  Summary: Up
  13% in May, up 59% since launch.
• Value
  Investing
  101:  Competitive
  strategy, simplified.
• Get
  To Know Your
  Company: Crazy
  for CarMax.
• Ask
  the Geek:
  Big party next January
  in Islamorada.
• About
  the Tarpon
  Folio: More
  about our spoke fund.

Dear Investors,

By now you’ve noticed a different format for this month’s letter to
investors. We’ve also updated our logo and launched our new
website at www.islainvest.com. All
were long in coming and I’m glad to be able to finally unveil them to
you.

Marcus
designed our new email format, FloridaKeys.com
overhauled our website and Milos
spiffed up our logo. A special thanks also goes out to photographer and
saltwater fly fishing maven Pat
Ford, whose gorgeous photos you see in the header
above and in the backdrop of our new site.
 
May was another good month for our portfolio, as I discuss more below.
In this letter I’ll also continue last
month’s discussion on how to evaluate a management team’s
strategic choices, and introduce you to our company CarMax. I took a
little extra space in this letter to discuss CarMax given the
recent GM bankruptcy and all the angst in the auto sector in general
lately.

I’m also relieved to say that cooler heads prevailed in the Target
proxy fight I mentioned
last month. Here’s a quote
from yours truly about it in the Minneapolis media near
Target’s headquarters.

The only change I made to our portfolio in May was its name. With this
release of this letter we’ve formally changed the
name from Tarpon Fund to Tarpon Folio. Same goes for the Gecko
Folio. I made the switch to further differentiate our spoke
fund model from the legions of other financial products with
“Fund” in the name. After all, mutual funds and hedge funds are
soooooooo 2007.

For those of you here in the Keys, you’ll soon be seeing our first ads
pop up in the local papers. I’m also now writing a column called
“Island Investing” in the Keys Weekly paper
here in the Upper Keys. Here’s my
first article in case you missed it.

One final administrative note: my next letter to investors will be
published at the end of July. But as always, call or email anytime in
between.

Now, on to our May performance.

– Cale Smith, Portfolio Manager

Somebody call Mensa.

A
Small But Merry Band of Geniuses

The
market continued to treat us well in May. The Tarpon Folio increased by
13.4% during the month, compared to an increase of 5.3% in the
S&P
500. Since inception last November, Tarpon is up 58.5% through the end
of May, and is outperforming the S&P 500 over the same period
by
44.4%.

I believe our performance since inception makes you, my dear
investors, among the brightest minds in America. If there is another
fund in the country that has performed better than yours the last six
months, I haven’t heard of it yet. But now is not the time to get
heady. The economy is still far from out of the woods. And on my office
wall I have taped these words from the good pirate Han Solo:
“Great, kid. Don’t get cocky.”

I like to think that I do this
job for free, but that I get paid to worry. Regarding our results so
far, I’d like to be absolutely clear about one thing: this kind of
outperformance simply cannot continue.
 
Academics and most
financial advisors would probably describe our success to date in terms
of risk and reward. Because our portfolio owns just 15 companies, the
conventional wisdom goes, it will be more volatile than the market, and
because it is more volatile, it is deemed more risky. Put another way,
it is only by assuming more risk that we have been able to outperform
so dramatically. To that I say, “Hogwash.”

First, defining
risk as volatility in stock prices implicitly assumes that the stock
market is efficient – or in other words, that a stock’s price
accurately reflects the true value of the business. While that may be
true most of the time, it certainly was not true last November when the
Tarpon Folio launched. The last six months may very well prove
to have been the most inefficient market of my lifetime.

In addition, as Warren Buffett long ago observed,
risk in investing has
little to do with the volatility of a stock’s price. Risk is better
defined as permanently losing your money. Here’s an example, similar to one Buffett once gave, that underscores this point.
 
Last November we
bought shares of Google for Tarpon when trading at $287 each. Shares
trade at $444 today, and I believe they’re worth closer to $550. At the
time we bought Google the share price was significantly more volatile
than it had been historically. Defining risk as volatility means in
this case you believe it was somehow riskier to buy something worth
$550 for $287 than it was to buy it for $444. Only on Wall Street does
that make any sense.
 
Statistics will also demonstrate that
after purchasing six or eight stocks in different industries, the
benefit of adding more stocks to a portfolio in an effort to decrease
risk is small. After that point, overall market risk – the broad up and
down movement in the general market – cannot be eliminated by adding
more stocks to a portfolio. Owning 15 stocks in the Tarpon Folio
eliminates approximately 90% of the nonmarket risk of owning just one
stock. And I believe the increased long-term returns of a focused value
portfolio will far outweigh the slight increase in potential share
price volatility.

Not only does stock price volatility tell you
nothing about the future profitability of a business, it completely
misses on one of the most important questions an investor can ask: “How
much could I lose?” That’s why we insist on a margin of safety
– and
generally ignore the conventional wisdom on Wall Street.

My
point is this: there are a handful of factors in addition to
solid stock-picking that explain our outperformance to date. Luck is
one of them. But the idea that our large gains have come because we’ve
assumed a large degree of risk is more than just silly, it’s a fallacy.
Value investing makes it possible to generate high returns with low
risk.

So congrats on your prescience in investing with a
value manager. I knew you people were sharp.

The
Second Most Difficult Part of Investing Continued.

Here’s the
first
part of this two-part series on evaluating company
management. You may recall I ended the previous column by noting that
execution and strategic choice were two of the most important variables
when evaluating management. Execution was the most visible, but
strategic choice the more important for the long-term
investor. 

Michael Porter of Harvard Business School is
widely regarded to be the leading authority on competitive strategy.
His book Competitive
Strategy is considered the magnum opus of the field. Porter’s
Five Forces model, summarized
here, is heavily relied on by analysts, operators and
business school students alike. The fundamental question it asks is,
“Is this industry attractive?” It’s a terrific way to think about the
long-term profitability potential of an industry and the competition
within it.

If
your goal is anything but profitability – if it’s to be big, or to grow
fast, or to be a technology leader – you’ll hit problems. 

—
Michael Porter

As a value investor, however, I am less interested
in the profitability of an industry than I am in the sustainability of
a single firm’s advantages. Even though an industry can have below
average profitability, a firm in that industry with a wide moat around
its business can still generate terrific returns. So although Porter’s
work on generic competitive strategies seems at times overshadowed by
his Five Forces model, I believe the former is more useful. 

The fundamental question Porter asks at the firm
level is, “How does the firm earn sustainable superior margins?” The
answer is a great way to think about the big picture choices made by
any management team.

According to Porter, there are four generic
competitive strategies:

1 –
Cost leadership. A cost leader strives to be the low-cost
producer. A cost-based advantage can come from economies of
scale, proprietary technology or preferential access to raw materials. Cogent
Communications is a good example here.

2 –
Differentiation. A differentiator attempts to set its
products apart from its competitors on the basis of an attribute that
is important to consumers. Differentiation can be based on the
product’s
features, how it’s delivered or even how it’s marketed. The products of
these firms have a higher price and higher profitability.  For
instance, Google’s
superior search results enable it to earn a premium for placing ads.

Strategies 1 and 2 are practiced by firms with a
broad, industry-wide focus. The next two strategies are used
by firms with a narrow scope, or that target specific market segments.

3 –
Cost Focus. These firms seek a competitive cost advantage
in a narrow, attractive segment of an industry. Think of
Contago from my last
letter. 

4 –
Differentiation Focus. Firms pursuing this strategy
attempt to achieve differentiation in a narrow, attractive segment of
the market. A good example is Discovery
Communications’ exclusive emphasis on nonfiction programming.

There’s an important thing to note here that
might not be obvious: the profit margins of cost leaders and
differentiators can be equally high. Here’s another graphic that
illustrates this point:

A firm with the industry’s lowest costs can be
just a profitable as a firm that charges premium prices. The chart
above shows why it pays to look for investments in even the
ugliest industries.

To best evaluate management’s decisions, you also should know the risks
of each strategy:

Risks to
Strategy 1 – Cost leadership. Failing to achieve
differentiation parity. In other words, your customers perceive the
qualify of your product as similar to your competitors. Risks also lie
in technological change, or if too many firms attempt to be the cost
leader. Cost leaders also must be wary of challenges from cost focusers
(#3).

Risks to
Strategy 2 – Differentiation. The biggest risk to
differentiated strategies is not achieving cost parity, or keeping your
cost structure similar to your competitors. Shifts in consumer taste
and imitators both pose threats, as does competition from
differentiation focusers (#4).

Risks to
Strategies 3 and 4 – Focus. Both cost and differentiator
focus strategies will fail if the target market segment ceases to be
structurally attractive. Copycats also pose a threat, as do other firms
that focus on an even narrower segment within that market.
 
Another important note: Porter defined a “stuck-in-the-middle” firm as
one that tries to achieve both cost leadership and differentiation –
and fails at both. These firms compete at a disadvantage to those that
achieve cost leadership or differentiation, as margins get squeezed
from both sides. Once in a while a firm with a particularly innovative
technology can succeed while pursuing multiple strategies, but the odds
of most investors correctly guessing which firm that may be are
extremely low.

In summary, it’s very difficult to sustain a competitive advantage over
time. If you find a company that can do it, with shares trading at a
low enough price, it’s worth taking a meaningful position. When it
comes to evaluating the strategic choices of your management team, be
sure their future plans emerge from a disciplined process that is
determined by a competitive strategy focused on profitability.

Let it be known that in the months before General Motors went
bankrupt, investors in the Tarpon Folio were happily buying shares
of a used car dealership.

Well, at least I was happy about it. You may have been questioning my
sanity. Not to worry, though. Here’s why we all own CarMax (NYSE:KMX).

First – a point about business models. In the end, General Motors was
essentially a huge pension fund that sold automobiles as a means to
make consumer loans. CarMax has an in-house financing arm that
has contributed a significant portion of the company’s past
profits. But I view the company’s loan business as a tactical
opportunity, not a strategic imperative like I believe existed at GM.
CarMax sells used autos, first and foremost – and nobody does it
better.

Also, in a sin of
omission, I missed out on an even more compelling price for us by not buying CarMax when trading under $7 last November.
Instead we first bought shares at $11.13 in March. Consciously
or otherwise, I stuck to my telecom roots last year and bought shares
in Amdocs, only to have a change of heart this past March after things
looked more predictable at CarMax due to the Fed’s TALF
program. Let the cursing begin.

Used cars account for about half of the automobile
market, the largest
retail segment of the U.S. economy. The market is highly competitive
and fragmented, made of approximately 40,000 independent used car
dealers and millions of private individual sellers. Those circumstances
favor the entry of a well-capitalized, highly efficient operator into
the industry which will have an opportunity to achieve significant
competitive advantages. That company is CarMax.

Why
Is This a Great Business?

CarMax was founded to create a used-car superstore
chain that
operated exactly the opposite the way the used car
industry typically
functioned. The company has no-haggle sale and trade-in prices, clearly
discloses all financing terms, hires all salespeople from
outside the
auto industry and pays them a fixed-dollar commission regardless of the
vehicle sold – and no commissions on loans. This
differentiation in
service is working quite well. According to the company, 93% of its
customers
would recommend CarMax to a friend, and the company ranks consistently
among Fortune
magazine’s “Best 100 Companies To Work For.”

There is no true competitor to CarMax currently
capable of adopting a similar business model. Several years back
Wal-Mart attempted to copy the CarMax model in a trial project in Texas
but abandoned it. AutoNation, a network of predominantly new car
dealers, also once tried the used car superstore idea, but it, too,
walked away. And small newcomer Lithia Motors, which operates in rural
areas, has proven to be a much less efficient business; CarMax
has higher margins and earns 3.5 times the return on invested capital.

The company’s advantages are found in two areas.
The first is economies of scale. CarMax can simply sell more cars –
around 335 cars per month, versus 46 per month sold by publicly traded new car
dealers. Every superstore has four to five times the inventory of the
typical used car dealer – and if a particular model is not available
onsite, customers are led to kiosks at the terminal to access the
24,000 listings on CarMax.com. Customer transfers from one store to
another represent 25% of the company’s sales. 

CarMax’s scale allows it to price below smaller
dealerships. By giving any further improvements in operating expenses
back to the customer as a price decrease, as the CEO has said he would
do, the company should also be able to further increase same-store
sales while keeping competitors on the defensive.

CarMax also has an information advantage. Since
1993, the company has appraised almost 10 milion car and trucks
and sold nearly 4 million automobiles. Combining that
info with data from other sources has helped CarMax build a
sophisticated inventory and pricing system that allows the company to
buy trade-ins lower and sell them higher than the competition.

I also should mention that used cars are actually
more profitable than new cars. Because every used car is unique, CarMax
can earn better margins on these differentiated products than a new car
dealer can when selling identical products. It’s simply not as easy for
customers to call around and make apples-to-apples comparisons on used
cars.

With only 100 superstores in 46 markets, CarMax is
also still early in its growth cycle. It operates in a huge and
underpenetrated market. Despite being the largest retailer of used cars
in the U.S., CarMax commands just 2% of the 19 million unit/$275
billion market for 1-6 year old cars. More amazing is that it has
attained this share with just 100 of the more than 65,000 dealerships
in the country. Furthermore, within markets that it serves, CarMax
estimates its share at 8% to 10%. Clearly it business model has legs.
Plus, the company’s long-term goal is for 65% of the population to have
access to a CarMax store. Right now that figure lies at 45%. That
difference translates into hundreds and hundreds more stores, which the
company should be able to easily self-finance through the profits it
produces.

I agree with the analyst who believes CarMax is to
used car dealers in 2009 what Home Depot was to hardware stores in the
1980s.

Why
Is It Cheap?

Forced selling last winter by large institutions
to meet investor redemptions. Soft demand for cars due to the
recession. Inventory management woes caused by consumer
reaction to the spike and then plummet in gasoline prices last year.
Most notable, however, was the turmoil in the credit markets, which
last fall left the financing division of the company – CarMax Auto
Finance or CAF – temporarily dysfunctional.

CAF historically relied on securitization to sell
the loans the company made to its customers. It would bundle all loans
up, sell them to big investors, and report income using what’s called
“gain on sale” accounting. In addition to those securitization gains,
CAF also made money on servicing fees and interest income.

Now we’re getting to the crux of why we didn’t buy KMX
shares last year. 

The company uses an off-balance sheet
special-purpose entity to “warehouse” the auto loans
it makes before it packages them up and sells them. (If the phrase
“off-balance sheet special-purpose entity” reminds you of Enron, you
can relax – it’s all disclosed at CarMax.) 

Using what’s called a warehouse facility,
CarMax borrows money on a short-term, revolving basis to
make loans to its customers, and then pays back the borrowed
funds once the bundle of auto loans is sold.

Until the credit bubble burst, that model worked
well. Buyers could get access to credit and CarMax earned a profit.
However, when the credit crisis hit last fall, CarMax was effectively
unable to clear out its warehouse. Investors stopped buying
securitized loans of any stripe. In fact, the amount of all
securitized consumer loans in the US dropped from $1 trillion a year at
its peak to $8 billion in the last three months of ’08. 

Without buyers of CarMax’s old loans, my concern last fall (shared by others) was that the capacity to make new loans could disappear as an increasing amount of unsalable loans consumed the company’s extra borrowing capacity. That would mean the company would eventually be unable to extend more credit to its customers…and that would most certainly not be good for the company’s sales.

This spring, the Fed and Treasury eventually
launched the TALF (Term Asset Backed Securities Loan Facility) to
jumpstart the market for securitized lending. It came at the right time for CarMax, which had just $185 million left to loan out of its $1.4 billion borrowing capacity. In early April, the company announced a securitization that will effectively clear out its warehouse facility by half. Next, CarMax needs to refinance the warehouse facility itself, and I suspect TALF will be the best option to do so, too.

So, I think we’re done with the drama at CarMax.
Management still has miles to go before they can sleep, mind you, but
the business is back to being reasonably predictable in the long-term.

In case you want to know more about TALF, here’s a
good
summary by The
Wall Street Journal which contained this graphic:

And to be clear – the quality of the loans CarMax originated is not a
huge concern to me. Loans that qualify for TALF must meet strict
criteria, and the vast majority of CarMax loans are eligible.

Is
It Cheap For Temporary Reasons?

Yes. While it clearly will take some time for CAF
to begin functioning normally again, the company’s earnings power will
eventually return. Fewer cars sold in the country today means
more pent-up demand later. In the meantime, CarMax is making right
moves to address the headwinds…suspending store growth,
slashing inventory, reducing headcount and completing a securitization
using TALF. Also of note
is that in spite of those headwinds, the company was able to increase
its gross margin in the most recent quarter as it gained modest market
share and generated its first free cash flow in some time due to
inventory liquidation and reduced capital spending.

CarMax is a high fixed-cost business. When
business suffers, profitability quickly does, too.  However,
when the economy turns, CarMax will benefit from two levers in its
business – sales growth and, because of the operating leverage in the
business, higher net margins. In other words, once we’re over the hump,
profits should increase quicker than sales.

In addition, another key growth driver is that
more than half of CarMax stores are less than five years old. Consumers
historically buy cars every three to five years. So my hunch is that
same-store sales will increase, too, once formerly delighted customers
start to come back.

Hundreds of new and used car dealers are likely to
go out of business by year’s end. CarMax will also likely pick up
market share as a result. Another potential catalyst is the pending
“Cash for Clunkers” legislation making its way through D.C. Leaving
aside the political debate about the program, it’s hard to argue that
CarMax would stand to benefit greatly if used cars are included. If
not, that’s still okay. I’m happy to wait for the economy to recover,
and with it the used car market, too.

What
Is It Worth?

I believe CarMax is worth $22 a share,
though it could take a few years for industry conditions to normalize
enough to approximate my valuation assumptions. Longer-term, CarMax
could be worth much more.

I did not attempt to value the company’s auction
business, which though small in terms of revenue could be another
growth engine for the company. It’s the third largest wholesale auction
provider in North America and that scale adds value to the rest of
CarMax’s operations, too, by reinforcing that information edge
mentioned above and CarMax’s auction business is probably
underappreciated in the market.

I should also note that in the third quarter of
2007, the GEICO subsidiary of Warren Buffett’s Berkshire Hathaway
conglomerate purchased shares of CarMax at prices between $21
and $25 per share. And if you presume that Lou Simpson at GEICO also
likes to invest with a big margin of safety, he likely believes shares
were worth significantly more than my $22 estimate.  And who
am I to argue?

Q.  You
mentioned in your last letter that you didn’t want to invest in complex
businesses that were too dependent on a visionary CEO, but doesn’t that
describe Ken Peak of Contango?

A. Peak is the ultimate owner-operator and has
done an amazing job with Contango. But the business itself
is pretty straightforward. You’ll recall he outsources the
truly complex part – determining where to drill for natural gas. My
comments were intended more towards CEOs like Steve Jobs at Apple. I
have no doubt that heir-apparent Tim Cook is a fantastic operator, but
history shows that Apple previously floundered without Jobs there. It’s
a huge business with a lot of moving parts – the success of which has
had an inordinate amount to do with Jobs. I love Apple’s
products, from my MacBook to my iPhone, but history has also shown that
in the long-run, all electronic devices are basically toasters. Apple
is great at constantly pushing back that “toaster line,” but I suspect
it’s due more to what’s in Jobs’ head than any sort of systematic
process of innovation at Apple. I could be wrong, but I don’t
intend to risk any of our money waiting to find out.

That’s also why we don’t own shares in Berkshire
Hathaway, by the way. There is no bigger fan of Warren Buffett’s
investment philosophy than yours truly, but his business will
unequivocally be impacted by his eventual departure. Just how much is
an uncertainty I don’t want us to bear. 

Q.
 Along those same lines – what about IIM? You are effectively
the whole business.  What happens to our investments in the
Tarpon Folio if you are suddenly out of the picture?

You’ll remember that during sign-up you received
full contact info for our custodian, FolioFN. (You can also find it
by clicking the “Client Login” link on our new website and then the
“Contact” link in the upper right of the next page).  Should I
meet an untimely demise, you can always contact Folio and arrange to
transfer your assets elsewhere. Otherwise, our firm has an agreement
with another independent
fee-only advisory to assist you in moving your assets
elsewhere. Also, I would expect you all to spoil my girls rotten.

Q. Will there be
an IIM “Annual Report”…or will the newsletter and blog take care of
that?

A. Yes, and please mark your calendars now,
people. The first annual meeting of IIM investors will be held here in
Islamorada on Saturday,
January 30, 2010. More details will come out later,
but it will be a Keys-ey kind of affair. We’ll wear
flip flops, drink margaritas and stand around counting
our money. Stay tuned for more.

The Tarpon Folio is an innovative,
investor-friendly alternative to the traditional actively managed
mutual fund. It’s built on a model we call a spoke
fund. 

It is more transparent, takes more concentrated
positions and is significantly less expensive than the vast majority of
mutual funds. The portfolio is managed for long-term growth using value
investing principles. 

Fees are 0.90% of assets annually, assessed on a
quarterly basis. Turnover, taxes and trading are minimized in the fund,
and investors can customize their accounts in several key ways,
including tax preference. Each Tarpon Folio account is also protected
by three types of insurance for a maximum of up to $11.5 million

For more information, visit our website.
 

Here is our privacy
policy, our Form
ADV and our Fiduciary
Oath.

The historical performance data contained above
represent performance results as reported by the portfolio listed. The
performance results are for illustration purposes only. Historical
results are not indicative of future performance. Positive returns are
not guaranteed.

Individual results will vary depending on market
conditions and investing may cause capital loss. The S&P 500,
used for comparison purposes, is significantly less volatile than the
holdings of the funds listed. The performance data is “net of all fees”
reflecting the deduction of advisory fees, brokerage commissions and
any other client paid expenses. The performance data includes the
reinvestment of capital gains. 

The publication of this performance data is in no
way a solicitation or offer to sell securities or investment advisory
services.