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March 2008
You should consider the investment objectives, risks, charges and
expenses of the fund carefully before investing. For a free copy of a
prospectus, which contains this and other information, visit our website at
www.kineticsfunds.com or call 1-800-930-3828. You should read the
prospectus carefully before you invest. Please read the important
disclosure at the end of this portfolio commentary.
(Click here for most recent and complete performance information)
(Click here for the most recent portfolio holdings)
Dear Fellow Shareholders,
During the second quarter of 2008, the Kinetics Small Cap Opportunities Fund (No-Load Class) declined by 4.02%, compared to the S&P 500 Index, which declined by 2.73, and Nasdaq Composite, which had a slight increase of 0.61%.
The question that investors in Kinetics’ funds must be asking themselves is this: “Has Kinetics become so wedded to its positions that it cannot admit its mistakes, or has it been rejecting, or, at least heavily discounting, data that would invalidate its views?” In other words, has Kinetics fallen into a malaise such that it is standing by passively, watching as dire events unfold? This particular assessment, perhaps, might seem self-evident given our exposure to financial services stocks, which every other holder is reducing. In addition, it is human nature to seek out data that supports one’s views and to disregard that which does not. This mental tendency is well known to us and something we go to great lengths to avoid.
Any success that we have had historically or plan to have in the future is rooted in the facts as we understand them. Investment success is directly correlated to a correct analysis of data, one’s reasoning and temperament. We have no emotional ties to our companies and would sell them if we believed that their business returns were somehow permanently impaired. Further, we never would have purchased them if we had not believed that we were receiving value for the prices originally paid.
As a long term stock investor, one can hope to approach (receive) the actual returns of the businesses themselves, in much the same way one achieves a return from a bond coupon. A stock’s performance inevitably must be linked to the underlying business itself. One does not own a piece of paper but, rather, a fractional interest in a real company. If you purchase at par (100% of face value) 10-year Treasury notes with a 5% coupon and hold them to maturity, your annualized rate of return, over the life of the notes, will be 5%. This is true even if at the end of year three the notes trade at a price of $50. Of course, for that particular year you would have a large negative return. However, your annualized return from year three onward would be vastly higher than your original expected return, but your ultimate annualized return on original investment would be 5%. An investor who purchased the notes at a price of $50 would have a very different return profile in relation to his cost basis, but from that point forward the return to both investors (original and new) would be identical.
Prior to the recent stock market downturn, we believed we owned a collection of companies that would collectively generate a very high rate of return for our investors, with the passage of time. Nothing that has occurred over the last six months has dissuaded us from that view. In fact, based on the logic set forth above, we believe the return profile of our funds has improved dramatically as a result of the downturn, in much the same way as that of the investor who purchased the notes at a price of $50. This statement, however, does not mean that our funds cannot go lower from here, but it does mean that we believe our funds are performing well below their perceived channel rates of return. In order for them to achieve such channel rates of return, their future returns, at some point, must be far higher.
From our perspective, at the exact time when our investors are most concerned they should actually be the most optimistic. If we, in fact, did originally identify excellent businesses, which are now suffering from a temporary collective price decline, investors should be hopeful. This is the reason for our own optimism. With very few exceptions, we believe our companies have a higher intrinsic worth today than they did at the start of the year.
Even the casual observer of the stock market believes that stock prices, in the short term, are driven by fear and greed. The current decline in the market stems from the conviction that the economy is going into, or already is in, a severe downturn, principally as a consequence of the “de-leveraging” of the financial services sector, all initially stemming from the sub-prime mortgage market, which later blossomed into a full blown liquidity crisis. Thus, while the Federal Reserve has been accommodative, an earnings collapse will occur sometime in the future, making stocks a bad bet despite the absolute and relative low interest rate environment.
We are of the belief that the system is not de-leveraging. If you visit the website of the Federal Reserve at www.federalreserve.gov, you can verify this conclusion for yourself. Under the section All Statistical Releases, you can find the weekly collective balance sheet of the U.S. commercial banks. The numbers do not reveal a de-leveraging, or a meaningful diminution of credit. The net worth of the banks is fairly robust, despite the massive write-downs taken. This information can explain why Ben Bernanke, on June 10th, stated “The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so." We cannot confirm, based on Federal Reserve statistics, a massive de-leveraging. Thus, we do not believe that the primary fear driving the market has any basis in fact. Our financial system cannot function in its current form without leverage, and it appears the Federal Reserve will take the necessary steps to maintain the availability of such leverage. The prospective return profile for the financial intermediaries (which assume real capital risk) would not support a system that hopes to operate in today’s environment without leverage. Further, the de-leveraging of a Lehman Brothers does not mean a de-leveraging of the entire system.
A second website that should be visited is that of MBIA.com. Recently, the Company’s Chief Executive Officer, Jay Brown, authored several shareholder letters. MBIA resides at the eye of the credit crisis storm and has been targeted by prominent short-sellers as being effectively bankrupt. Given the current legal environment, most executives try to qualify their statements, or at least consult attorneys who would do so. Mr. Brown displays little fear for the financial health of his company and expresses a good deal of derision for the rating agencies. One cannot read these commentaries and remain neutral regarding the prospects for MBIA. Mr. Brown’s view is in accord with that of the famed value investor, Marty Whitman. We have never seen a company where two more extreme views exist among well-regarded investors (short sellers vs. famed value investors). This situation cannot go on indefinitely, as certain MBIA-related events are expected to occur, which will reveal which side has done the proper analysis. While both sides can ultimately make money, only one side is going to have an accurate perception of the company’s financial health.
Another illuminating website to visit is bankstocks.com. This website is the creation of Tom Brown and Vernon W. Hill. Mr. Brown is a highly regarded financial analyst who is known for his independent views. He has written a number of articles regarding the financial crisis that seem to be rooted in factual data, as opposed to mere opinion. Several recently published articles advance the view (a distinctly minority view) that the sub-prime loss estimates are too pessimistic. According to data analyzed by Mr. Brown, the problems in sub-prime mortgages peaked in November of 2007. This view is consistent with that of my colleague, Murray Stahl, as purported in the early part of this year, to the effect that others were making unrealistic draconian assumptions.
The default rate, by definition, must decline as the shutdown of the sub-prime market guarantees such a result. The problem vintages are becoming seasoned, and the losses have almost certainly been overstated, leaving aside the confusion over mark-to-market accounting, which would require, as shown in our Treasury Notes example above, a write-down of 50% of our equity investment, despite the fact that we know that we will receive our entire principal back.
We have listened to the views of a great number of “financial experts” and we cannot confirm, based on available data, their extreme negative views. That is not to say that the housing crisis, the liquidity crisis and inflationary pressures haven’t had their effect on the health of the economy. However, an objective analysis of these conditions does not support the type of sell-off that has occurred for many of our companies. The more interesting question investors should be asking is “Why has economic activity held up so well nine months into this crisis?” The answer, in our opinion, is that there is an abundance of positive factors (most notably the large capital expenditures going on in the utility sector) that are having a very salutary effect, but which never get written about in the financial press. A cursory reading of headlines would cause one to expect to see massive bread lines in Manhattan, one of the world’s financial capitals.
Should investor sentiment change, which we expect to occur, our funds are poised for a dramatic rebound. The last time we saw such massive dislocation was in the utility sector at the time of the collapse of Enron in 2001. Most analysts and investors had extremely negative views, unsupported by the underlying facts, which created tremendous opportunity. Companies like Williams Companies rebounded from a price of under a $1 a share to over $35 today. For us, the price of admission for excellent long term results is heightened volatility risk. This risk, while perhaps psychologically and emotionally unpleasant for most, is not synonymous with the permanent erosion of capital. Today’s conditions are, in our opinion, an investor’s dream.
We thank you for your confidence and believe you will be rewarded for it.
The Kinetics Investment Team
Disclosure
Past performance does not guarantee future results. Due to market volatility, current performance may be more or less than for the rankings shown. Investment return and principal value will vary, and an investment in the fund can lose money.
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, biotechnology and water related stocks are subject to a rate of change in technology, obsolescence, regulation 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. The Fund's share price is expected to be more volatile than that of a U.S.-only fund. Because smaller companies [for The Global Fund 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 [for all Funds], 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. Small and medium-size companies often have narrower markets and more limited managerial and financial resources than do larger, more established companies. As a result, their performance can be more volatile and they may face a greater risk of business failure.
As non-diversified and single industry funds, the value of their shares may fluctuate more than shares invested in a broader range of industries and companies.
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.
Distributor: Kinetics Funds Distributor, Inc. is an affiliate of Kinetics Asset Management, Inc., and is not an affiliate of Kinetics Mutual Funds, Inc.
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