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Market Musings - January 1, 2018

We continue our blog series: Market Musings, Volume 2, Edition 1, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present 2017 in Review and 2018 Resolutions.

At the end of one year and the beginning of another, people usually pause to "take stock" (pun intended) of the year that has passed and make firm resolutions regarding the one ahead. Hope springs eternal (the future WILL BE BETTER, goshdurnit)...until early January resolutions fall by the wayside around mid-February (at the latest). But it is nevertheless a useful exercise to engage in, and, who knows, maybe we will be the exception that proves the rule in actually following all of our 2018 resolutions.

1. Year in Review: 2017: First, a look back at the year that was. For us here at SCC, 2017 was a year of promise and frustration. We performed relatively in line with the S&P 500, with funds invested (i.e., everything excluding cash, which averaged around 35% of total assets) up approximately 23% (pending a full accounting). In comparison, the S&P advanced 19.4% plus ~2% in dividends, or ~21.5% overall. While beating the S&P is always a positive, there were many obvious (in hindsight) missed opportunities we should have capitalized on. For example, there was Celadon Group (ticker CGI), a trucking and logistics company, the shares of which were were eyeing in early May after they plummeted to the $1.55/share level following disclosure of accounting irregularities:

Sadly, we let this opportunity pass without pulling the trigger (paralysis by over-analysis, perhaps), which in retrospect was an extremely large error of omission, as the stock is up over 300% since then. We should have bought a small (~3%) position, given the perceived riskiness of the company from a financial perspective--but in any event, this riskiness was obviously more than priced in when the stock was in the mid-$1 range (note that, at the time, book value per share was over $12). Had we done so, our 2017 overall performance would have improved by around 9% (to ~32% versus ~23% actual).

In addition, RMR Group (ticker RMR) was another no-brainer whiff on our part. This botch of ours actually dates back to early 2016, when the company was spun off from the various infamous Portnoy-controlled REITs (for more info, see Seeking Alpha article here). We should have capitalized on this opportunity shortly after the spinoff in 2016, when RMR traded in the low teens. But even if we had waited until the end of 2016, we still would have seen our investment appreciate 50% plus dividends over the past year:

RMR seems like the prototypical sure thing, since its income stream is almost completely protected (it consists of management fees from REITs that are basically controlled by the principal RMR shareholders). In effect, the captive REIT shareholders subsidize the RMR shareholders via egregious (one-sided) management fee contracts. Below is a summary of the bull case from the above-linked SA article:

RMR Inc. is a holding company of RMR Group LLC (RMR LLC), the company's operating subsidiary. RMR LLC was founded in 1986, so it's got quite a history. Its primary business activity consists of providing business and property management services to real estate companies (e.g. REITs).

RMR LLC currently has four REITs (Managed REITs) and real estate operating companies (Managed Operators) as clients. The majority of the revenue is derived from service provided to REITs (80.5%). This is important because the revenue from REITs is supported by a "perpetual" 20-year agreement, in that the agreement is automatically extended every year so that the agreement will end on the twentieth anniversary of every year. In the event of termination without cause, RMR LLC will be entitled to the present value of the payments.

Also worth noting is that the management fee scales with the growth of the REITs. The management fee is calculated based on either total market cap (equity and debt) or the historical cost of real estate properties, whichever is less. The rate is 0.7% for the first $250 million and 0.5% for any amount beyond that.

In addition to the management fee, RMR LLC is also entitled to incentive payments, which is based on the total return (i.e. including dividends) over a selected SNL index. What's great about the incentive payment is that there is no high-water mark.

To protect themselves, the REITs can also terminate the agreement for performance. However, the definition of poor performance is rather lax. The REIT in question must underperform the SNL index by 5% for three consecutive years and have a total shareholder return that is in the bottom tercile (bottom third) of the SNL index. Furthermore, even if the agreement is cancelled for performance, the REIT would still have to pay the present value of the management fee for 10 years.

So how/why did we miss this no-brainer opportunity? First, it simply escaped our initial due diligence filter. In other words, we were totally unaware the spinoff had occurred until it was "too late" (by the time we caught on in mid-2016 and examined the company, shares had already appreciated into the low $30s). Proving that we were still fully capable at that time of turning a mid-sized mountain into a molehill, we far-too-quickly decided that most of the juice had already been squeezed out of RMR shares and moved on. Whoops! After missing the initial double and more through inexcusable cluelessness, we have since missed nearly another double on top of that through inexcusable lazy analysis. *Sigh*

Regarding effort expended in 2017, yours truly put in a total of 4,332 hours for the year, or an average of 11.86 hours worked per day (in keeping with our lawyerly billable hour background, we keep track of this metric on a daily basis). This number was actually down 410 hours from the 4,742 hours worked in 2016 (an average of 13/day). We made a conscious decision to try to dial back on the hours in order to achieve a bit better work/life balance. Perhaps those 410 fewer hours cost us missing out on a Celadon or RMR, although the 13th hour worked in any day is likely a lower value hour due to the law of diminishing returns. Quality in hours worked is clearly as important as quantity, although it is much harder to measure. In addition, we published around 75 blog entries in 2017, or about 6 per month, and 9 Seeking Alpha articles.

2. Year Ahead: 2018: Looking forward to 2018, we have adopted the following professional New Year's Resolutions:

A. Hours Worked: Given that there are 16 non-sleeping hours in a day, it is not unreasonable to budget 12.5 of these hours for work and 3.5 for personal business (ratio of 78% business to 22% personal). This equates to 4,562 work hours total for the year, or up 230 from 2017's level. 230 more hours should be enough to account for additional expected administrative work anticipated in 2018 versus 2017 (per B below).

B. Investment Fund: 2018 will be (knock on wood) the year SCC becomes a full-fledged investment operation, complete with third-party funds under management via an official fund (rather than consisting of informal third-party advice and personal funds managed). In short order, we need to get all of the administrative apparatus assembled and completed (legal entities, management and operating agreement(s), investment advisor registration, etc.) and complete our marketing materials...and then market the heck out of SCC! Any marathon begins with the first stride--and this needs to occur ASAP.

C. Blogs and SA Writeups: Our 2018 blogging goal is to continue with our Market Musings series, publishing about 8 installments per month (~2 per week). Using our Market Musings as initial "rough drafts", we plan to prepare and publish one Seeking Alpha article per week in order to establish a more fulsome track record of investment calls and gain additional followers (and hopefully prospective investors). Thus, if all goes according to plan, 2018 should see us publish about 100 blogs and 50 SA articles.

D. Aggregate and Relative Investment Returns: If only aggregate returns could be dialed up upon request for any period during which the Earth fully circles the sun! Alas, it is not that simple, as any year's returns largely depend on the direction of the overall market. However, our main (and heretofore elusive) goal remains beating the S&P by 10% per year, including all dividends and interest payments received (incidentally, we fell about 8% short of this goal in 2017). So if the market were (theoretically)to drop 15% in 2018, we would consider being down 5% a "win", even though it would mean losing money. Conversely, if we were (theoretically) up 25% and the market were up 20% in 2018, that would be a "loss". Clearly, beating the S&P by 10% is an ambitious goal, but if one is going to participate in the investment game, why not aim high?


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