Quarterly Letters

Quarterly Update

Listed below are 4^th quarter and year-to-date performance numbers for 2004.  Equity accounts outpaced the S&P500 handily (20.2% versus 10.8%) and our Balanced accounts performed similarly well compared to their benchmarks (16.4% versus 9.3%).  We spent most, if not all, of the year finding it difficult to discover undervalued situations.  Consequently, our performance was accomplished with significant cash on hand throughout the year.

Turbulence…in Flying and in Investing

When I’m flying in an airplane, I do not like the turbulence that causes the plane to suddenly drop, and then jolt up.  In fact, when this happens, I’m scared.  I imagine whatever air currents out there causing this phenomenon could potentially roll the plane.  Recently, I spoke to my pilot friend Harry and asked him about turbulence.  Is it dangerous?  Harry chuckled.  He explained in detail how planes are constructed to withstand air turbulence.  The design of a typical commercial aircraft can withstand about ten times more turbulence than what it actually experiences (even on a bad day).  The process by which engineers over-design is remarkably similar to Benjamin Graham’s, who is the father of value investing, margin of safety concept, i.e., pay a meaningful discount to what you surmise a company’s true worth to be so that if things don’t go as planned business wise you shouldn’t get too hurt.

Clients regularly express to me a fear analogous to my turbulence story.  Essentially, they are asking, “How dangerous is it out there?”  They experience volatile days in the market, absorb all sorts of economic data heard from the media, and often end up scared.  Underlying many of these fears is the notion that the market is a giant game of speculation and that the shares of various companies we own are little more than good black jack bets – if you’re playing properly, your odds of winning (over time) are pretty close to even.  The thinking here is that our success is dependent upon the market’s “weather”.  This is simply not true.

Of course, I have concerns about general market sell-offs.  More importantly, I have concerns about individual securities we own at different times.  The real risk lies in a  business itself and how its march toward creating economic value plays out.  The reason why I don’t worry (too much) is because of my firm belief that the ultimate success of our investments will not be determined by the market’s weather, but rather by the success of our companies creating value (be it through realizing cash flows or monetizing assets). 

Quoting Benjamin Graham, Warren Buffet has said that the most important words ever written about investing are: “Investment is most intelligent when it is most businesslike.”  The stock market for us is simply the place to do the deal, but it isn’t the “real deal.”  The real deal is the business itself – its assets, earnings power, and the likelihood of conversion events.  Moreover, we demand a discount, i.e., a margin of safety.  If the stock market shuts down tomorrow, we would (essentially) be unaffected in terms of our economic interests.  Thus, our clients should rest assured we are businesslike in our analysis, and we are adamant in demanding discounted pricing.

Since my discussion with my friend Harry, turbulence bothers me less, although the fear isn’t gone.  Some air currents move up and down resulting in planes moving similarly.  Moreover, planes are built to withstand far more turbulence than what they will ever experience.  It is my hope that our portfolios are constructed in a manner to withstand periods of turbulence and ultimately (over time) deliver our clients to their financial destination(s).  

Our Three Top Purchases in the 4th Quarter

Merck & Co., Inc., MRK.  Merck is a leading pharmaceutical company led by CEO Raymond Gilmartin since 1994.  While other pharmaceutical companies have been involved with mergers and acquisitions, Merck decided to stay independent – adhering to a policy of developing its drug pipeline internally.  Early in October, Merck pulled its arthritis and pain medication, Vioxx, from the marketplace because of studies that showed a potential increase in the risk of heart attacks for those taking the drug for 18 months or more.  The stock price of Merck fell approximately 30% on the news.  As is typical, we had been watching Merck since making a prior pharma investment in Schering-Plough (which turned out successfully).  When Merck’s stock price fell, we leveraged our previous work in the pharmaceutical industry.  As some of you may recall, several pharma transactions took place over the past few years at an average transaction price of about 4x revenue.  For instance, Pfizer paid 4.3x revenue for Pharmacia, Bristol-Myers bought DuPont’s pharma business for 5.2x and Abbott Labs paid about 3.3x revenue for Knoll.  Additionally, specialty pharmaceutical companies were paying 3x sales or more for declining branded drugs.

We evaluated Merck, taking into consideration the loss of sales from Vioxx and the lawsuits that were certain to be brought against the company.  While difficult to quantify the actual damages that may be owed as a result of lawsuits, we viewed estimates ranging from $5b to $20b.  As a point of reference, Wyatt (formerly American Home Products) has a $17b liability as a result of allegations that its diet drug Fen Phen caused heart valve damage.  If it is proven that Vioxx caused increased risk of heart attacks, the resulting liability could certainly be in this ballpark, although it may take years until it is resolved. 

In the meantime, we were able to purchase shares of Merck at 2.7x revenue and 11.8x P/E.  Recall, some of the transactions that took place were for companies that were not necessarily in the best operating condition, yet they still were sold at an average of 4x revenue.  Here, we have a company that is still going to be profitable with a pipeline of potential future drugs.  Moreover, Merck has a strong balance sheet with over $6.8b in net cash and strong free cash flow generation (’04 estimate of a 6.5% yield).  It was one of seven industrial companies with a triple-A rating from S&P and Moody’s.  Those ratings were recently downgraded to AA- (cut three levels) and Aa2 (cut two levels) by S&P and Moody’s, respectively.  Also of note is the fact that in 2008 Merck has the option to require Astra-Zeneca to buyout Merck’s interest in certain products connected with a partnership formed in 1994.  According to the restructuring agreements, if Merck exercises its put option, the payment from Astra-Zeneca will be at least $4.7b.  Finally, we receive a 5% dividend yield to boot.  Merck has had uninterrupted dividend growth over the past eight years.  According to CEO Raymond Gilmartin, “…we can say with confidence we’re not cutting the dividend.” (Last week, Merck’s patent for its  osteoporosis drug Fosamax was invalidated by a US appeals court, which allows generic competition beginning in 2008.  In 2004, Fosamax had sales of $3.2b.  We are currently in the process of further analyzing our Merck investment.)

Assured Guaranty Ltd., AGO.  Assured Guaranty is a Bermuda-based company that provides financial guaranty reinsurance and direct financial guarantee insurance.  AGO provides credit enhancement products to the municipal finance, structured finance and mortgage markets.  In April 2004, AGO completed an initial public offering at $18 per share.  ACE Ltd., which previously held 100% of the company, still owns approximately 35%.  Historically, AGO has been involved only in the reinsurance business, but it recently decided to go into the direct business because it sees a significant opportunity to profitably expand its business.  We believe the financial guarantee business is an attractive industry.  Since financial insurers receive 100% of the premium for insuring a bond upfront, but earn it over the life of the bond, they have a stated and an adjusted book value.  A company’s adjusted book value accounts for the present value of these future earnings that have already been received, but are carried as deferred revenue over the life of the bonds being insured.  Assured’s stated book value is approximately $19/share and has an adjusted book value of approximately $25/share. Theoretically, the company's adjusted book is the present value of business already on the books (with no franchise value or value ascribed to its growth).  The relationship between book value and ROE provides a useful metric when evaluating a company’s value.  We find value in a company with an ROE of 10% that trades at less than 1.0x book value.  We purchased our shares below stated book value (and at roughly 75% of adjusted book value) for a company that has a return on equity (ROE) of over 10%.  Moreover, AGO’s direct financial guarantee business should cause its ROE to rise.  Although the company has a limited operating history, we are confident in the management team.  Prior to becoming President at AGO, Michael Schozer was a Managing Director at Ambac Assurance Corp, a leading financial guarantor.

Concord Camera Corp., LENS.  Concord Camera manufactures and sells low-priced, easy-to-use digital and single-use (disposable) cameras.  It manufactures and assembles its cameras in a state of the art facility in China and markets its cameras worldwide under various trade names such as Concord, Le Clic and Fun Shooter.  Concord is low cost provider of single-use cameras.  However, its digital camera business appears to be suffering from the decline in prices of digital cameras.  Consumers are willing to pay slightly more for widely recognized brand-name cameras than for a cheaper, not as well-known brand (i.e., Concord).  We believe that management will make the appropriate decision as to whether or not to stay in this business, especially since they own 14% of the company.  The company has a tangible book value of about $4.40/share, with net cash of about $1.70/share.  We purchased shares at slightly above net cash.  In this investment, we appear to be protected by the liquidation value of the company (net cash plus plant, property and equipment) and have a free option on the potential success of the business. 

Once again, we want to thank you for the trust and confidence you have placed in us.  We will continue to watch what the market appears to make cheap, diligently research those ideas and, in the end, select our investments cautiously.  If you are aware of individuals who would benefit from our approach, we would welcome the opportunity to talk with them.  You can always direct such individuals to our website, www.roumellasset.com.  Additionally, as we have mentioned in the past, we have lots of terrific restaurants in our neighborhood and would be happy to take you and a friend(s) to lunch to discuss our investment approach.  As always, please feel free to contact us directly about your account.

Performance Disclosures:

Investment Strategy:  Roumell Asset Management, LLC (“RAM”) employs a value investment strategy in managing client portfolios.  RAM Equity accounts can have up to 100% of assets invested in stocks; RAM Balanced Accounts typically have 35% of their assets allocated to fixed income investments (though the figure can range from 50% to 80% depending upon the needs of the client).  

Calculation of Rates of Returns:  First and foremost, readers of this letter should recognize: past performance is no guarantee of future results.  Returns are reported net of all fees and applicable trading costs; returns are from only those accounts present for the entire period; returns are time-weighted.  These returns are based on a composite of Roumell Asset Management’s accounts (present for the entire quarter) and therefore were not necessarily duplicated in any specific client account.  These figures include an insignificant amount of short positions.  These consolidated performance numbers include all of RAM’s fully discretionary accounts within each category.  Discretion is defined as the ability of the firm to implement its intended investment strategy without restriction. 

Inclusion of Accounts:  In the performance calculations for RAM equity, there are 121 equity portfolios totaling $40.2 million.  This represents 40.9% of total portfolios and 32.7% of total dollars under management.  In the performance calculations for RAM balanced, there are 118 balanced portfolios totaling $66.1 million.  This represents 39.9% of total portfolios and 53.7% of total dollars under management.  A complete list and description of the firm’s composites is available upon request.

Additional Disclosures:

The specific securities identified and described do not represent all of the securities purchased, sold, or recommended for advisory clients and the reader should not assume that investments in the securities identified and discussed were or will be profitable.

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