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Do Funds' Ties to Benchmarks Create Bad Decisions?

Castle Focus' Robert Mark says despite the fund's requirement to have a benchmark, he seeks to keep a loose relationship with that index to avoid losses.

Esther Pak, 08/29/2011

Robert Mark is the portfolio manager for Castle Focus MOATX. He recently answered our questions regarding both the fund's cash and gold stake and explained the rationale behind some recent sells made in the portfolio.He also commented on how management strives to avoid falling into value traps while seeking firms suffering near-term and temporary challenges.

Finally, he discussed the discrepancy between the fund's sector weightings relative to its Russell 1000 benchmark and the types of market environments in which the "defensive by design" approach either outperforms or underperforms this benchmark.

1. One of the fund's investment philosophies entails patience and discipline in the absence of obvious bargains. Given the fund's substantial cash stake (26.16%), it would seem that management is not finding too many opportunities in today's market. What are some key indicators that you are on the lookout for that would signal a market turnaround? How do you plan to deploy this cash in the future?
An important part of our strategy is to be patient. When managing Castle Focus, we use the same patient approach and strategy that we have used for private client accounts since 1999. That institutional track record is included in the prospectus for Castle Focus, and we suggest investors review that to get a better understanding of the performance. For context, it is important to appreciate that St. James has averaged about 30% cash since inception in June 1999, yet our goal is to be fully invested. As we adhere to a long-term view of the markets, it is likely that we will find the fund close to fully invested when fear is pervasive, aversion to equities is common, and great companies are offered with compelling margins of safety.

The investment process is bottom-up, though we are very cognizant of the macroeconomic environment in conducting our research. That said, it is true that we are struggling to find truly compelling investments, albeit a few deserve full allocations (5%-6%).

We don't try to market time and don't look for indicators to try and predict short-term market direction, as we utilize the macro data to assess the risk to a company's business model and corresponding cash flow. When attractive opportunities emerge to invest in great businesses well below our conservative estimate of fair value, we'll typically deploy capital in a meaningful manner.

2. What was the rationale behind the fund's most recent sells: Exxon-Mobil XOM and Walgreen WAG? The fund also has a 6.82% stake in SPDR Gold Shares GLD. What purpose does this holding serve in the portfolio?
Core to our philosophy is the contention that entry price is a significant determinant of return. Further, when a position approaches our conservative calculation of fair value, we sell. For us, fair value doesn't change meaningfully from quarter to quarter, and, if we can't redeploy capital in an equally compelling opportunity, we're satisfied to wait. Exxon-Mobil and Walgreen are two examples of positions we acquired well below fair value, and, as the margin of safety eroded (stock price appreciated), we sold.

For us the SPDR Gold Shares position is not ideal, as we would prefer to be fully invested in approximately 20-30 great operating companies at the right price. However, we contend GLD is a great surrogate for some of our cash given U.S. monetary policy. As a side note, the strategy has had exposure to gold (via publicly traded securities) since 2002.

3. Does the fund's so-called defensive-by-design approach indicate that it serves a specific role in an investor's portfolio or could it suffice as a core holding? For what kind of investor is this fund most suitable?
As an employee-owned, independent manager, we stress focusing on downside risk, not return. We believe this is a core holding because we are focused on capital preservation and stability. By emphasizing protecting capital, as opposed to keeping up with the benchmark in all environments, we believe that outcomes take care of themselves. By protecting capital in down markets and participating sensibly in up markets, the process of compounding is less likely to be interrupted.

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