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June 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.
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Dear Fellow Shareholders,
During the second quarter of 2008, the Kinetics Global Fund (No-Load Class) declined by 10.93%, compared to the S&P 500 Index, which declined by 2.73%, and Nasdaq Composite, which increased by 0.61%.
The Fund’s mandate was changed in early April 2008 to focus on international investments, with particular emphasis on China and other Asian markets. Since then, the markets in which the Fund had exposure continued to decline.
For the first half of the year, the Fund declined by 23.4%. While it is little consolation, many of the Asian equity indices reported even more severe declines. For example, the CSI 300 Index, which tracks the performance of the 300 most representative A-share stocks listed on the Shanghai and Shenzhen Stock Exchanges, is down 26.3% for the quarter and 47.7% for the first half of the year. The Shanghai Stock Exchange B-share Index, which tracks the performance of all B-shares listed on the Shanghai Stock Exchange, declined 18.2% and 42.7% during the respective periods. The Bombay Stock Exchange Sensex Index, which tracks the 30 most liquid stocks on the Bombay Stock Exchange, is down 13.9% and 33.6%, for the same periods respectively. More broadly, share prices in Asian markets are down between 20% and 40% as of this commentary, written in early July.
This uniformity of decline is important to note. Typically, the stock indices of disparate countries reflect the economic progress within their borders, such that equity performance varies from country to country. The commonality of performance that exists currently suggests that investors are applying a high risk premium universally in response to the liquidity crisis plaguing the U.S. The apparent reasoning for the application of this risk premium, although vastly simplified, is as follows: The liquidity crisis in the U.S. will cause a decline in the U.S. economy, particularly in consumer spending. Thus, the U.S. will enter, if it hasn’t already done so, a recessionary period in which consumption will decline significantly. As many Asian countries, especially China, export products to the U.S., it is presumed that they will suffer a decline in economic growth, leading to a decline in the earnings of individual Asian and Chinese companies. Hence, a company’s shares should be valued using a high-risk premium.
While such logic sounds reasonable, we disagree with the conclusion for several reasons. First, if the fate of emerging countries is so closely linked to that of the U.S., why would investors even bother to diversify their investments geographically? International investing is a growing field because it provides exposure to local economic conditions. Second, although the world has indeed become more intimately entwined economically, it is naïve to assert that China’s economy, as large as it is, cannot function independently from that of the U.S.
If China were to increase its standard of living to a level more commensurate with that of developed nations (on a GDP per capita basis, China’s standard of living is still a fraction of that in the U.S., despite China’s recent growth), its economy must grow at a faster rate. This is indeed occurring.
During the first quarter of 2008, China reported GDP growth of 10.6%, as compared to 1.0% GDP growth in the U.S. for the same period. This is within the range experienced in the recent past, as illustrated in the following table.
China GDP Growth *
Year | % Increase
1998 | 7.8%
1999 | 7.1%
2000 | 8.0%
2001 | 8.3%
2002 | 9.1%
2003 | 10.0%
2004 | 10.1%
2005 | 9.9%
2006 | 11.1%
2007 | 11.4%
*Figures are obtained from the National Bureau of Statistics of China (http://www.stats.gov.cn/english/).
Very shortly, the second quarter GDP growth figure will be reported, which the investment team believes will confirm the validity of our reasoning.
Our conclusion is that the shares of companies in Asia, and primarily China, are being viewed through the pessimistic prism existing in the U.S., causing a disconnect between the share price and the underlying business. This is evident in the shares of Hong Kong Exchanges and Clearing, which is one of the largest holdings in the Fund. The company recently reported first quarter earnings, the results of which are quite astonishing. Revenues during the quarter increased 63% year-over-year, while operating profit advanced by 77%. Net profits totaled HK$1.65 billion, which represented a net, after-tax profit margin of 72.1%. One would be hard-pressed to find any company generating such a high profit margin historically, including Microsoft at its peak. Nevertheless, Hong Kong Exchange's shares have declined 48.4% during the first half of the year, such that it currently trades at a valuation of approximately 18.5x this year’s consensus estimated earnings. One must then pose the question, should a company that is growing earnings at 70+%, with a 72% profit margin, be fairly valued at 18x earnings? During its growth phase, it was not uncommon for Microsoft to trade in excess of 30x or 40x earnings. It is our view that Hong Kong Exchange's share price could be orders of magnitude greater in a few years time as its earnings are capitalized at higher multiples. For example, if we estimate that Hong Kong Exchange’s 2008 annual earnings are HK$6.16 per share and forecast earnings increases of 50% in 2009 and 30% in 2010, the 2010 earnings estimate is HK$12.01 per share. Applying a P/E multiple of 25x would result in a share price of HK$300, which is to be compared to the current price of HK$106 per share.
To summarize, the problems emanating from the U.S. are having an adverse effect on the shares of companies in other countries. In our opinion, the declines experienced to date do not accurately reflect the underlying business conditions; investor uncertainty is causing a widespread increase in risk premiums, irrespective of the underlying business fundamentals of the individual companies. We believe the declines are temporary and provide the potential for superlative future returns. We thank you for your confidence and believe that you will be rewarded for it.
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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