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September 2011
You should consider the investment objectives, risks, charges and expenses of the Fund carefully before investing. For a free copy of the most recent Prospectus, visit our website at www.kineticsfunds.com or call 1-800-930-3828. You should read the Prospectus before you invest. Performance data quoted represents past performance, which does not guarantee future results. Investment return and principal value of an investment may fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. To obtain performance data current to the most recent month-end, click on the link below.
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Dear Fellow Shareholders,
The Kinetics Small Cap Opportunities Fund (the “Fund”) (No-Load Class) returned -18.39% for the three months ending September 30, 2011, compared with returns of -13.87% for the S&P 500 Index and -21.87% for the Russell 2000 Total Return Index, bringing year-to-date performance for the Fund to -18.91%, as compared with -8.68% and -17.02% for the S&P 500 Index and the Russell 2000 Total Return Index, respectively.
We believe small capitalization companies are amongst the most compelling investment opportunities in the marketplace. They are frequently dynamic and entrepreneurial businesses, and may be more nimble than larger capitalization companies in their reaction to changing market dynamics. Many are managed by their founder, who is likely to be highly vested in the success of the enterprise. While these characteristics are appealing to us as investors, we recognize that that the small capitalization stock universe is also replete with unproven management and optimistic valuations.
The Russell 2000 Index, which measures the performance of small cap U.S. equities, trades at approximately 28 times expected earnings, and approximately 3.5 times book value. While there is likely significant opportunity for many small capitalization companies, we question whether it is reasonable to accept that the 2,000 smallest-capitalization companies, in aggregate, merit such rich valuations. Consistent with our investment philosophy, we are focused on finding those small capitalization companies which we believe are available at a discount to their intrinsic value—certainly not those which trade at multiples that already discount strong growth. We seek to identify idiosyncratic companies which may be underappreciated by the market, with proven management teams and the potential to produce sustainable high returns on capital.
Fund flows into small capitalization equities over the past 1-2 years have been concentrated in passively managed, index ETFs. As such, it should come as no surprise that the Russell 2000 Index is valued at such ambitious levels—levels especially inflated when compared to high quality, large capitalization equities. This phenomenon reminds us of the late 1990s as the technology bubble developed—companies with no tangible assets and no earnings compounded in market valuation while a businesses like Berkshire Hathaway lost nearly half of its market value. As difficult as it was to abstain from investing in technology companies during this period, prudent value investors were ultimately vindicated and rewarded over time. We believe that our adherence to value principles in the Fund will deliver a similar mid to long term result.
Howard Hughes Corporation (HHC) is an example of a small capitalization company that is not included in any index or ETF that we can locate, and offers a very compelling investment opportunity in our view. HHC is a real estate company created by firms that committed capital to facilitate the reorganization of General Growth Properties. Brookfield Asset Management and Pershing Square Capital control 15.8% of the shares currently outstanding (not including warrants), and Mr. Ackman, who manages Pershing Square Capital and serves as Chairman of HHC, elected three executives to run HHC on a daily basis. These executives receive modest salaries, so their primary compensation will be through 7-year warrants (for which they paid a combined $19 million) that cannot be hedged for 6 years. The warrants are worthless if the shares do not exceed the exercise price, which is higher than the current share price. Needless to say, management is heavily vested and aligned with shareholders. The shares currently trade at less than .80 times book value, which suggests that investors believe that HHC will sustain negative earnings and/or be unable to realize the balance sheet values of their assets in liquidation. In fact, the asset values on the balance sheet are unduly low in our estimation. For instance, the South Street Seaport property in lower Manhattan is held at only $3.1 million book value, compared to operating income of over $5.0 million in 2010—and it has yet to be fully developed. The assets of HHC will take time to develop and monetize. However, management has been careful to limit asset sales at current depressed levels and to find strong strategic partners for the future property development. Due to the quality of assets, long-term vested management team and substantial discount to book value, we believe that HHC represents an attractive long-term opportunity with a more than adequate margin of safety.
Icahn Enterprises (IEP) serves as another example of opportunity within the small capitalization universe. Carl Icahn owns the overwhelming majority of IEP, which comprises $3.5 billion of his wealth. The U.S. residential real estate crisis was already a record-book phenomenon by 2008. The worst peak-to-trough experience was in Las Vegas, which from mid-2006 to year-end 2010 declined by over 55%, something Mr. Icahn is acutely aware of as he owns a home in Las Vegas. In February 2010, IEP purchased the unfinished Fontainebleau Las Vegas hotel and casino project, along with its 25 acres of land. The cost was $148 million. Since the developers had invested $2 billion in construction prior to the purchase, IEP paid roughly $0.08 on the dollar for it. The capacity to provide immediate liquidity, and to hold a dormant investment for an extended period contributed to the bankruptcy court’s acceptance of IEP’s bid. This transaction epitomizes the owner-operator; an operator willing to commit capital at highly distressed prices, despite the knowledge that a return on the investment may not be realized for several years.
By conventional measures, IEP trades close to book value. However, that figure includes, among other undervalued investments, the Fontainebleau property at 8˘ on the dollar. What if this were to be resold to a developer for $0.20 on the dollar, or $0.30, or some higher figure? That level of optionality is present in other IEP holdings as well. A more informative way of viewing the company is to use the public market value of those holdings that trade publicly, such as Federal Mogul, the car parts manufacturer, in which Mr. Icahn recently increased his stake. On that basis, and adding the company’s net cash as well as its private assets at book value, we firmly believe the shares are worth substantially more than where they now trade. That method, though, still prices the Fontainebleau property at cost, and, in our opinion, undervalues other significant properties within the portfolio.
For both of these companies, and many others within the Fund, time will be required to monetize the assets and maximize earnings. Our extended investment horizon affords us the opportunity to take advantage of the current dislocation in the markets to invest in these companies at what we view as significant discounts. While we understand the appeal of small cap companies with a novel product and rapidly rising stock price, we believe that many such companies are likely to fail, or are too richly valued to provide sustainable strong returns going forward. We believe that it is more prudent to identify and invest in companies such those described above, with proven, vested management, undervalued assets and a long-term view.
We thank you for your confidence and believe you will be rewarded for it.
The Horizon Kinetics Investment Team
Disclosure
The opinions expressed are not intended to be a forecast of future events, or a guarantee of future results, or investment advice. Additionally, the views expressed herein may change at any time subsequent to the date of issue hereof.
Because the Funds [other than The Paradigm Fund and The Small Cap Opportunities Fund] invest in a single industry, their shares do not represent a complete investment program. Internet and biotechnology stocks are subject to a rate of change in technology, obsolescence and competition that is generally higher than that of other industries, and have experienced extreme price and volume fluctuations. International investing presents special risks including currency exchange fluctuation, government regulations, and the potential for political and economic instability. Because smaller companies [for The Global and Small Cap Opportunities Fund] often have narrower markets and limited financial resources, they present more risk than larger, more well established companies.
Non-investment grade debt securities (i.e., junk bonds) are subject to greater credit risk, price volatility and risk of loss than investment grade securities. Further, options contain special risks including the imperfect correlation between the value of the option and the value of the underlying asset.
Unlike other investment companies that directly acquire and manage their own portfolios of securities, the Funds pursue their investment objectives by investing all of their investable assets in a corresponding portfolio series of Kinetics Portfolios Trust.
You will be charged a redemption fee of 2.0% of the net amount of the redemption if you redeem or exchange your shares 30 days or less after you purchase them.
Distributor: Kinetics Funds Distributor LLC is an affiliate of Kinetics Asset Management LLC, and is not an affiliate of Kinetics Mutual Funds, Inc.
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