July 7, 2016 

Dear Client:

We hope this finds you well and, as always, want to thank you for the trust you have in our firm. 

We have only written a letter like this twice previously in the past twenty years, but wanted to contact you ahead of receiving our Small Cap Value strategy report for the quarter ending June 30, 2016 which will be sent next week. The Small Cap Value strategy trailed the Russell 2000 Value Index by 489 basis points during the quarter, dragging the one-year delta to –9.22%. 

The most recent one year return number is one of the weaker showings to come out of our Small Cap Value strategy in many years. In particular, the period between February and early June were difficult. Not unlike the financial crises of 1998 and 2008, the market appears to be responding to concerns about the slowing worldwide economy, and the potential for a major credit contraction. Unlike those two periods, however, the economic slowdown fears are largely being driven by concerns outside of North America. As a result, US Treasuries and other “safe havens” have become the marginal asset class of choice. 

If you have been following our last few quarterly letters, you will note that we generally do not invest in “income” proxies (Equity REITS, Mortgage REITS, and Utilities), or those kinds of investments that tend to attract investors during periods of fear. Because those areas of the market have done very well, we have lagged. 

As well, our investments in Retail and Capital Goods companies have suffered from the economic double whammy of excess capacity and a strong dollar. 

Beginning in the early fall, and through mid-February, as Companies began announcing their full-year results and hinting at how the first quarter’s orders were progressing, we completed a bottom up review of all of our holdings. On several occasions we did adjust our pricing models to reflect what appears to be some structural changes in profit expectations (most notably in the Retail industry). As a result, our turnover level increased to over 30% and several new holdings were added to the portfolio. 

That increased turnover is likely to continue over the next several quarters, as we have experienced several buyouts recently, and the market volatility has increased the number of investable ideas in our universe. 

Our internal models suggest that our small cap portfolio is undervalued somewhere in the neighborhood of 35 to 40%. That discount is larger than normal, and is reflective of performance in the last several months. Historically, this kind of discount has not persisted and reverts to a market mean after some period of time. This is one of the reasons that our rolling three- and five-year performance numbers have been very strong. 

We believe that the coming year will likely not provide less volatility in the markets. The recent UK vote to exit the EU, a fragile Chinese market, and the overall reduced level of risk appetite is likely to mute expectations. And those are the hazards that we know about. 

What keeps us optimistic is that in times like these, while smaller company stocks tend to be the first to discount reduced market expectations, they also tend to be first to respond to improvement. We expect that our portfolio will benefit swiftly when that happens. 

As always, we remain committed to find good companies selling at low prices. We are invested alongside our clients for the long run. Both Dominic and I are available if you would like to discuss this note or other topics. 



Dominic Marshall
Co-Senior Portfolio Manager

Mark Cooper
President and Co-Senior Portfolio Manager