February 7, 2015

Macro grandstanding is a popular affair. Extreme forecasts are a reliable tool to gain the spotlight but rarely
provide practical or consistent investment performance. Forecasting the future can generate exciting returns
when said future unfolds as expected. It can result in even more spectacular losses when it does not. As it is
impossible to predict what lies ahead, investors are best served when guided by value and when focused on
what is knowable. With that being said, wed like to share with you what we deem to be knowable today
rather than litter your circular file with another investor letter complete with short-term forecasts. Our
observations are summarized below, followed by an overview of portfolio activity and current positioning.
Growing Imbalances
Volatility is rising much more than indicated by traditional measures of risk. Markets have experienced
waterfall-like declines across seemingly unrelated assets, such as Greek banks, oil, the euro, and the yen with
some prices dropping as much and as rapidly as they had during the financial crisis. The Swiss franc is only
the most recent example of todays central bank driven imbalances.
During the twelve months leading up to the Swiss National Banks (SNB) surprise, the annual volatility of the
euro/franc was about 1.7% and over the last three months of that period volatility was less than 1% or a daily
standard deviation of about 10 basis points. The euro instantly collapsed almost 20% after the SNB scrapped
the peg, which according to modern financial models represents about 180 standard deviations. For
perspective, consider that a 7 standard-deviation move should happen about once every 390 billion days, or
about once in a billion years. Surely, this is what Drew Niv, CEO of FXCM was counting on when he told
Bloomberg Markets1 that, Currencies dont move that much. So if you had no leverage, nobody would trade.

Levine, M. (2015, January 16). No One Was Supposed to Lose This Much Money on Swiss Francs. Bloomberg.

Infinity and Beyond

Falling bond yields provided a tailwind for equity valuations for three decades, but this relationship breaks
down when central banks control the price of money. Standard valuation models simply dont work with rates
at zero or below. Theoretically, the price of every financial asset should move toward infinity at a zero discount
rate. And since tomorrows returns are negatively correlated with todays price, by definition, future returns
must be lower than recent experience. At some point, this paradox will be resolved, but the lack of a historical
precedent for a major central bank to achieve lift off poses particular challenges for policymakers and
investors alike. Price is not the only variable pushed toward infinity by negative rates; at zero, an assets
duration is also infinite, which means that minimal changes in rates have enormous impacts on value.

Broken Models
Negative rates pose a particular challenge for investors as the net present value function cannot be calculated
below zero. Valuing financial assets becomes mathematically impossible. Without a fundamental anchor,
changes in price are instead driven purely by shifts in sentiment and policy expectations. Put more simply, our
job as fundamental investors, has become much harder, as has that of the macro forecaster.
The market-based signal with the best forecasting record of recession is also controlled by our friends at the
Fed. An inverted yield curve has preceded all seven U.S. recessions since 1962, with a 9-12 month lead time.
No U.S. recession has occurred without a yield-curve inversion. But what happens to the yield curves
forecasting ability if, technically speaking, it can no longer be inverted?
Todays ten-year bond yield is not too far from its lowest level since 1920 but its unlikely (though not
impossible) it will fall below the near-zero cash rate. That means the yield curve is unlikely to invert, at least
by traditional measures. Does the yield curve lose its predictive ability when yields are artificially low?
Thankfully, no. Even if yields remain low indefinitely, the curve can invert at the longer end of the maturity
spectrum, as it has at various times since WWII. In a zero interest rate world, the long-end yield spread is our
alternative signal. History shows that the spread between the 30 Year and the 10 Year Treasury is also an able
forecaster, and actually improves in low interest rate environments.

Broyhill Annual Letter | Page 2

In low interest rate environments, the long-end yield spread neednt be negative to forecast a recession; it
need only be narrower than normal. In the past two decades, normal has been about 45 basis points.
Notably, todays spread is falling fast, from a peak above 140 basis points to Januarys low, below 60 basis
points. We arent making a forecast here; but we wouldnt be doing our job if we failed to highlight where we
are in the cycle today, which is certainly knowable.

Current Challenges
The current environment is a particularly tricky backdrop for investors. More than five years into recovery,
one would typically expect to see a pickup in defaults and other signs of distress (something worth watching
if you are an energy investor). But nothing about this cycle is normal. With rates pegged at zero, theres an
argument to be made that the cycle has been extended. The problem with that argument is that if you are
wrong, and have positioned portfolios accordingly, you are unlikely to survive long enough to make that
argument again. Thats just not a bet we are willing to make.
One of those magic eight balls able to predict the direction and timing of changes in interest rates would be
an incredibly convenient toy right now (Santa did not come through for my son Lucca in 2014, but we havent
given up on 2015 yet). There are few asset classes priced to do well in both rising and falling interest rate
environments, so finding investments whose expected returns are not dependent upon the path of interest
rates is the most prudent course of action today. Our focus is on achieving good returns with limited downside
risk so that we are positioned to buy cheaper assets when they are on offer.
Lowered Expectations
Value investing is simple, but not easy. The math behind most of our decisions is not rocket science.
Investment techniques can be easily taught. Consistent application is far more challenging. As Seth Klarman
stated in Margin of Safety, The hard part is discipline, patience, and judgment. Investors need discipline to
avoid the many unattractive pitches that are thrown, patience to wait for the right pitch, and judgment to
know when it is time to swing.

Broyhill Annual Letter | Page 3

A value-oriented approach can leave one feeling quite lonely at times as it often demands a good bit of distance
from the crowd. As such, the biggest risk inherent in such an approach is that it is guaranteed to result in a
much different portfolio than your peers. Said differently, one must be willing to trade short-term
underperformance for long-term success. It is impossible to produce superior results without doing something
materially different than consensus.
Our portfolios look different than the market and as a result, our returns do too. Over the long term, we
believe our approach will compound capital at a higher than average rate with lower than average risk, but
from time to time, it is sure to produce results below our high expectations. This was certainly the case last
year as the S&P marched higher for a sixth straight year leaving most other asset classes, and active managers,
in the dust. While we were pleased to generate positive performance across the majority of our managed
accounts, results were subpar.

The Year in Review

During the years first half, gains in several core positions, discussed below, more than offset our cash drag
and our performance remained largely ahead of global markets. This tailwind began to reverse midyear as we
sold a number of winners (good sales) realized a few losses (bad sales) and shifted capital into new
opportunities too soon. As they say, being early is akin to being wrong in the short term. As a result, our
relative performance declined in the second and third quarter (although many of those early investments
are proving their merit in 2015 resulting in positive performance despite Januarys stock market losses).
As we rebalanced the portfolio into higher conviction investments mid-year, the collapse in volatility provided
us with an opportunity to accumulate cheap index put options as a hedge against growing complacency and
stretched valuations. We looked brilliant for a brief instant in October as fear spiked, stock prices collapsed
and relative performance surged ahead of global equity markets. But such brilliance has a very short shelf life,
at least in our experience.
We purchased hedges to protect our capital against the risk of a much deeper decline. Consequently, we were
not overly anxious to remove those hedges in response to a single digit stock market decline. We booked gains
on near-term maturities but made a conscious decision to hold onto longer maturity hedges. Given the choice
between leaving our capital exposed to a more severe correction and leaving some premium on the table in
the rare event the market snapped back, we chose to accept the risk of a lower probability, and more
manageable loss. So much for short-term forecasts.
Broyhill Annual Letter | Page 4

The Good
Last years largest contributors to performance included several investments in closed-end funds, which we
discussed in our 2013 Annual Letter, Kinder Morgan, which we successfully exited after Richard Kinders
Brilliant Move2 and CDK Global, which we purchased amidst technical selling pressure post the companys
spin-off from parent ADP.
Sentiment on municipal bonds round tripped over the past eighteen months from the depths of Detroits
bankruptcy to a bullish Barrons cover story last November. After detailing our long thesis in Muni Diaries,
we trimmed our exposure on the way up as the sector posted its longest string of monthly gains in more than
two decades, closing the discount to net asset value that initially attracted us to the investment. We
subsequently repurchased several of these positions later in the year as spreads widened despite declining rates.

Our partnership with Kinder Morgan (pun intended) was shorter than normal and also benefitted from
extremes in sentiment compliments of Barrons3. We established our position on the heels of a surge in short
interest as the stock overreacted to several negative research reports. While much of the bear thesis rested on
a solid foundation, we believed it largely ignored the flexibility that the companys complex structure provided
management, in addition to the very large incentive of Mr. Kinder to create value. We exited the position with
a handsome short-term gain as the market applauded yet another example of financial engineering.
Our preference has always been to own high quality businesses where time is on our side due to the magic of
compounding, but we remain open to opportunities in all forms and certainly dont discriminate against lower
quality assets at the right price. That being said, we sleep easier at night owning a business like CDK which
generates high returns on capital, operates in an effective duopoly and is positioned to substantially increase
its margin profile post spin. On a somewhat related note, this is a pretty good example of what weve been
calling Peak Activism in Lenoir. While we were happy to see more active partners take down big stakes
in the name after we established a position in the stock, were left wondering how much active involvement
is needed in a newly public company with a freshly incentivized management team.
2

Bary, A. (2014, August 16). Richard Kinder's Brilliant Move. Barron's.

Bary, A. (2014, February 22). Kinder Morgan: Trouble in the Pipelines? Barron's.

Broyhill Annual Letter | Page 5

The Bad
Negative contributors to performance for the year included an early investment in the oil sector, a high
quality real estate portfolio where gains in net asset value were more than offset by the decline in the euro and
various investments in high yield credit.
Outside of our successful investment in Kinder Morgan and a small investment in a domestic refiner (also
discussed in last years letter) we had zero exposure to the energy sector for most of the year. Commodity
businesses have an impressive history of value destruction. While there are exceptions to every rule, and at
the right price, any asset may offer a proper margin of safety, broadly speaking our preference is to invest with
smart partners operating in industries with high structural returns. There are few moats in the oil drilling
business, but our research indicated that rigs operating in the North Sea benefitted from barriers to entry - in
the form of regulatory hurdles and excessive capital requirements - which limit supply in the region. We were
also attracted to the regions growing decommissioning work a source of demand less correlated to oil prices.
We purchased our investment in Awilco as shares declined by a third during oils descent only to watch our
investment decline by another third since initial purchase. So why do we own the stock today? Unlike most
equity investments where the majority of a companys value is in the discounted value of long-term cash flows,
Awilcos value is front-end loaded. The way we see it, current contracts should generate about half of the
stock's present market capitalization in dividends over the next year. Beyond that, Awilco represents a cheap
option on higher oil prices at some point over the rigs seventeen year useful lives.

We detailed our investment in Kennedy Wilson in a report last year and continue to hold shares in the
management company which have generated a 25% IRR on our initial cost. As shares rallied, our research
shifted toward the companys European investments which were subsequently sold into a London listed
closed-end fund. We purchased shares of KWE during the year to increase our direct exposure to distressed
European property markets. Management has since invested 2 billion in high quality real estate assets
generating a net operating yield near 7% and continues to purchase shares of the closed-end fund with
ownership approaching 15% of net asset value.

Broyhill Annual Letter | Page 6

In the short term, fundamental strength has been masked by currency weakness, negatively impacting our
dollar-based investment. In the long-term, the upside potential in the form of real asset appreciation far
outweighs the potential for currency fluctuations. And while we find ourselves in agreement with the
consensus strong dollar view, lopsided sentiment combined with the potential for declining inflation to stall
the Fed, could make for a powerful countertrend move in currency markets.
We dedicated a fair amount of real estate in last years letter discussing the fixed income opportunity set,
concluding that, We think it still makes sense to own some bonds here since we are earning a premium over
cash its just the prudent thing to do in a world with no great opportunities and a significant number of
risks. Turns out that some bonds, like municipals, performed exceptionally well, while other investments
in the high yield sector, not so much. Most of the carnage in credit was driven by extremes in the energy
sector, where our exposure remains minimal. But lower quality bonds were not immune to the selling pressure.
History has shown that credit recoveries are equally stunning as the preceding carnage, so with spreads wider,
rates lower and discounts to net asset value in the closed-end fund universe offering a further margin of safety,
weve held on to these core positions and continue to add on the margin.

The Ugly
Great investors become great by objectively examining their mistakes and weaknesses and consciously
reflecting on them. Ray Dalio, the incredibly successful founder of Bridgewater Associates, uses the word
mistakes 114 times in his handbook of Principles, which provides invaluable guidance on how to approach
the markets. Charlie Ellis, who founded Greenwich Associates in 1972 and authored Winning the Losers Game,
offered up a few points to consider at CFA North Carolinas Annual Forecast Dinner a few years back.
First, be sure you are playing your own game. Know your policies very well and play according to them all the
time. Admiral Morrison, citing the Concise Oxford Dictionary, says: "Impose upon the enemy the time and
place and conditions for fighting preferred by oneself." Simon Ramo suggests: "Give the other fellow as many
opportunities as possible to make mistakes, and he will do so.
Second, keep it simple. Tommy Armour, talking about golf, says "Play the shot you've got the greatest chance
of playing well." Ramo says: "Every game boils down to doing the things you do best, and doing them over and
over again." Armour again: "Simplicity, concentration and economy of time and effort have been the
distinguishing feature of the great players' methods, while others lost their way to glory by wandering in a maze
of details." Mies Van der Rohe, the architect suggests, "Less is more." Why not bring turnover down as a
deliberate, conscientious practice? Make fewer and perhaps better investment decisions. Simplify the professional
investment management problem. Try to do a few things unusually well.
Broyhill Annual Letter | Page 7

Third, concentrate on your defenses. Almost all of the information in the investment management business is
oriented toward purchase decisions. The competition in making purchase decisions is too good. It's too hard to
outperform the other fellow in buying. Concentrate on selling instead. In a Winner's Game, 90 per cent of all
research effort should be spent on making purchase decisions; in a Loser's Game, most researchers should spend
most of their time making sell decisions. Almost all of the really big trouble that you're going to experience in
the next year is in your portfolio right now; if you could reduce some of those really big problems, you might
come out the winner in the Loser's Game.
They say mistakes are the portal to discovery. That there is no failure, only lessons. Well, we learned a lot last
year. We missed a few opportunities (as will happen when one is incredibly disciplined in the batters box) and
made a few errors in judgment (which is okay, so long as those errors improve our decision-making going
forward). While we were are not at all satisfied with last years performance, the fact that we still generated
positive returns in light of a handful of unforced errors in the portfolio, is indicative of a rigorous portfolio
construction process.
We want to invest with honest and able managers who will serve as prudent stewards of our capital. We had
our doubts about management at Avon and should have gone with our gut on this one. The company could
be a viable business under the right leadership, but could be didnt cut it here. Listening to management
repeatedly mention blocking and tackling when asked for specifics on strategy left a bad taste in our mouth,
but we believed there was enough value in the brand and the assets offered substantial upside in the right
hands. Now, in addition to that bad taste, we make this face when we see an Avon lady, which is rare given
the companys shrinking sales force. Perhaps Herbalife has more to offer?

In 2012, when we made our first investment in Avon, we speculated that 3G may have been behind Cotys
unsuccessful bid for the business. Peter Harf, chairman of the Coty board and a big supporter of the Avon
bid, was also chairman of the AB InBev board until the beginning of 2012. Cotys CFO, a Brazilian named
Srgio Pedreiro, was in charge of the financial area of the logistics company ALL for years. And an old friend
of 3G principal Jorge Paulo Lemann, Warren Buffett, provided a backstop to Cotys bid. The fingerprints of
3G were everywhere, and while we can Dream Big4 about what might have happened, what actually happened
was nothing. Despite the Coty set back, Avon proved to be one of our most successful realized investments
in 2013; the second time around was not as kind to us. Recent rumors of interest from TPG are of little solace
with the stock now changing hands in the single digits after turning down Cotys $10 billion offer.
4

Correa, C. (2014). DREAM BIG.. Primeira Pessoa.

Broyhill Annual Letter | Page 8

Coach was another round trip for the portfolio as volatility in both names allowed us to realize gains on
options sold while we waited for fundamentals to turn around. But in contrast to Avon, we actually thought
managements turnaround plan at Coach was credible. We believe the brand has tremendous value, but
execution risk remains high given recent turnover. While we correctly anticipated the pressure on operating
margins and expected continuing pressure on profitability, we failed to forecast the magnitude and duration
of the decline which served to depress cash flow much more than we expected. Our bear case for the stock
overestimated sales growth and failed to consider the potential for outright top line declines. Despite this
misjudgment, our downside estimate proved accurate. While fundamentals deteriorated much worse than we
expected, we managed to close out the position at a price within our range of expectations. In this instance,
our margin of safety was eroded by managements slow reaction to competitive challenges. In hindsight, we
should have cut our losses and paid closer attention to Charlies third guideline above.
We have learned a lot over the years but begin each day looking forward to learning more. We will make
mistakes, and from time to time, we are sure to underperform. But over the long term, we believe our approach
will produce sustainable long-term capital growth while minimizing the risk of loss. We cant guarantee
performance every quarter or even every year, but we can promise to treat your money as if it were our own
and to remain fully transparent in the decisions we make.
A New Beginning
As we turn the calendar on a new year, we believe that the underlying value of our current portfolio is
extremely compelling. We recognize that anything can happen in the short term. In the long run, our returns
will be driven by the underlying growth of the businesses we own and the discount to intrinsic value provided
by our purchase price. Increased volatility last year provided us with an opportunity to reposition the portfolio
into several new investments trading at larger discounts to their net worth and a number of situations with
pending catalysts for value creation. We exited a number of core investments during the year including two
of our top five holdings as both Apple and Microsoft appreciated toward our estimate of value. At year-end,
our five largest stock holdings across the firm were Time Warner, Oaktree Capital, eBay, General Motors and
Pfizer. Our cash balance has remained largely unchanged and continues to afford us with future buying power.
We never want to be in a position where we are forced to pass on a spectacular opportunity that comes our
way because we lack liquidity. Or as Charlie Munger puts it: Cash is like oxygen. When you have it you don't
even notice it. When you don't have it, you can't think of anything else.
We appreciate your continued confidence and trust as we work hard to earn it each day. Your shared longterm time horizon is critical to our mutual success and we thank you for it.
Sincerely,

Christopher R. Pavese, CFA

Broyhill Annual Letter | Page 9

Broyhill Asset Management, LLC

Broyhill Asset Management is a private investment management boutique. We believe that capital preservation coupled with
consistent, compounded returns is the key to long term wealth generation. We are conservative investors for our partners and for
ourselves. Our objective is quite simple - superior risk-adjusted performance.
Since the sale of Broyhill Furniture in 1980, the Broyhill family wealth has been managed as a single family office. Today, we are
privileged to be able to offer the same level of expertise developed and refined over a quarter century within the Broyhill Family
Office, to additional families and investors. We have the highest respect for the trust our investment partners have awarded us, and
pledge to always treat non-family investments as if they were our own.
Our Services
The philosophies and strategies we endorse for our investors are only those we have developed and deployed for ourselves. We
currently offer investors three different investment strategies, each of which is fundamentally driven by the same objective income
generation and capital preservation. Each is consistent with our own goals and leverages our expertise in asset allocation, in equity
research and in credit analysis.

The Broyhill Portfolio is a diversified, multi-asset

class
investment
strategy.
Macroeconomic
fundamentals and long term investment themes
drive the portfolio construction process which is
routed in a strict valuation discipline. Embedded in
our approach is a relentless focus on the
preservation of capital and the belief that risk
management begins with portfolio construction.
The objective is simply maximum total return,
commensurate with the given risk profile of global
capital markets and best suited for investors with a
long term time horizon.

The Broyhill High Quality Dividend Portfolio

is a concentrated equity strategy invested in a select
group of exceptional businesses judged to be
competitively entrenched market leaders, trading at
reasonable prices. Our research seeks to identify
outstanding
companies
with
sustainable
competitive advantages, rather than speculate on
mediocre businesses with uncertain futures. The
result is a portfolio of profitable businesses which
offer the potential for full participation in up
markets while mitigating the brunt of down
markets, delivered to investors in the form of
attractive dividends and consistent earnings
growth.

The Broyhill Opportunistic Fixed Income

Portfolio is a separately-managed individual bond
portfolio focused on short duration, high-yielding
fixed income securities. The portfolio aims to
combine a high probability of the safe return of
principal with a current return superior to a portfolio
of US Treasury securities. A rigorous research
process drives the selection of only those securities
that meet our requirements based upon an
independent assessment of each issuers
fundamental strength. The result is a cash-generating
portfolio focused only on our highest conviction
ideas.

For more information on our services, please

contact: info@broyhillasset.com
To subscribe to our research, please click here:

Broyhill Asset Management, LLC

Post Office Box 500
800 Golfview Park
Lenoir, NC 28645
(828) 758-6100
www.broyhillasset.com
www.viewfromtheblueridge.com

Broyhill Annual Letter | Page 10