Investor Letter - Fourth Quarter 2007
Issue #13
 January 2008
In This Issue
2007: Average Client Account Up 17.2% Versus 5.5% for the S&P 500
Using Tailwinds & Headwinds To Your Advantage
A Recent Investment: Short Sale of Choice Hotels
Year-End 2007 Commentary on Client Holdings
What To Watch For
Dear Client/Friend,
 
We're excited to have provided another full year of high absolute returns in a low-risk and uncorrelated fashion using our value-oriented approach. As you'll see below, our outperformance this year was significant and was achieved despite the volatility that shook the markets over the last six months. Performance continues to translate into new business; Client asset levels are up over 50% this year, due to new clients, additional deposits by existing clients and account appreciation. At the end of this report, we provide our popular annual holding-by-holding review.

Thanks again for your trust and your referrals -- they are the highest form of compliments.
 
Sincerely,
 

Charles Goldblum, CFA
Average Client Account Up 17.2% Year-To-Date Versus 5.5% for the S&P 500

In 2007, a composite of accounts managed by Hurley Capital rose 17.2% after all fees and expenses. In comparison, the S&P 500 rose 5.5%, including dividends.

Returns Q407

2007 outperformance was due to both industry focus and stock selection. Our investments in strong industries, such as energy and technology, and avoiding or even shorting weak sectors, such as financials and transportation provided the bulk of 2007 returns. Leading gainers in 2007 were Datamirror (technology), a short position in Arkansas Best (trucking), Discovery Holdings (media), and Chesapeake Energy. More importantly, we avoided significant losses, with just one investment out of 18 held across client accounts losing more than 5% (Avid Technology down about 14%).

"We're looking first for cases in which we clearly have a supportable variant view.Then, if you can identify... a tailwind to your long-thesis, or a headwind to your short, then that's a good combination."

-         Kian Ghazi, Hawkshaw Capital Management, from Value Investor Insight Interview, July 29, 2005


Using Tailwinds & Headwinds To Your Advantage

A great investment opportunity requires two components, a cheap valuation and a positive industry trend. A positive industry tailwind drives improved corporate performance that often translates into earnings and earnings multiple growth. A worldwide squeeze in energy inventories has been a tailwind for energy exploration and service companies> Falling domestic freight volumes and freight rates has been a headwind for US trucking companies. Too often, we hear investment recommendations for cheap homebuilders or specialty retailers, despite the stiff headwinds of a weak customer base and excessive competition. While there are surely stocks in these industries that will go up, why fight the tide? 
 

A Recent Investment: Short Sale of Choice Hotels

Choice Hotels (CHH $33.20 on 12/31/07) is a leading hotel franchisor, focusing on mid-priced and economy brands such as Comfort Inn, Sleep Inn and Econo Lodge.  Choice is facing the following strengthening headwinds:

  • Choice is most exposed to a weakening consumer spending environment.  78% of its hotel rooms are in the U.S. and most of its business comes from leisure travellers. Furthermore, with most of its rooms in brands ranging from limited service (Rodeway Inn and Econo Lodge) to mid-scale (Comfort Inn and Sleep Inn), its lower-income customer base is most negatively affected by rising oil prices and housing costs. 
  • Choice has two principal profit-producing revenue streams; the first is royalty fees, which is Choice's piece of gross room revenues. While price per room continues to rise,  occupancy has flattened out across the Choice network. Falling occupancy levels often lead falling room rates, and certainly don't indicate rising room rates. This trend will not help Choice's royalty fee growth.
  • The second CHHrevenue stream is franchise fees,which include one-time sign-up fees by new or existing franchisees that want to add their hotel to the Choice network. Hotels are added in two ways, as a conversion from another 'flag' or as new construction. While Choice's backlog of new hotels has grown nicely over the past few years, the mix has skewed from less than 50% new construction in 2004 to 70% at the end of 2006 to 74% at the end of September 2007. With credit availability constrained across the U.S. economy and demand weakening, it's reasonable to assume that some of these new construction hotels in the pipeline may not be built.
  • Should Choice go from being seen as a high-growth company to a slower growth one, its valuation will contract.  Choice's busiest season is the summertime. We should know where we stand on this investment by then.
There are two primary risks with this investment, which we are now comfortable with, but are always watching:
  • The consumer crunch that is affecting new car sales, retail sales, and housing prices does not affect Choice enough to cause meaningful deceleration in corporate performance.
  • Choice Hotels is a high margin, and high-free cash flow company. Continued stock buybacks and growth, albeit slower, may appear to be a relative safe-haven, should the rest of the stock market really falter.
Year-End 2007 Commentary on Client Holdings

Arkansas Best Corporation (ABFS): Short Position. Headwinds for the U.S. trucking industry have resulted in subpar performance for truckers. In October, management indicated that they might have to take on $700 million in debt to buy themselves out of a union pension plan. Oversupply of trucking capacity continues in 2008. This stock may have further to fall. Clients have made 48% on ABFS' decline since April 2007.

Avid Technology (AVID): We discussed our investment thesis at length in the Q307 Investor Letter. Since then, a new CEO, Gary Greenfield, has arrived. We know Gary personally and recommended him for the job. With the Bain consultant providing a roadmap for margin improvement, a turnaround should begin to take shape in 2008. A protracted Hollywood writers strike could certainly delay the payoff here. Avid is down 14% since April 2007.

Canadian Natural Resources (CNQ): Positives from high oil prices, strong internal growth opportunities, and the Horizon Oil Sands project nearing first production outweighed negatives of falling natural gas prices, a rising Canadian dollar and new royalty regime in Alberta making some natural gas prospects untenable. CNQ rose 44% last year.

Chesapeake Energy (CHK): High-growth natural gas player made an important shift to funding growth from internally generated cash instead of selling stock and issuing bonds. Stock rose 37% last year. When market believes that (1) this trend is sustainable, and, (2) that natural gas prices are unlikely to return to $1-$3/mcf from $7 today, CHK should have a bright future.

Choice Hotels (CHH): Short Position. See above.

Coca-Cola (KO): Anti-dollar, defensive investment, benefitting from worldwide rollout of Coke Zero and turnaround of underperforming regions/bottlers. Stock rose 27% in 2007.

Costco (COST): Benefitting from weak consumer environment as more people trade down to low-cost alternatives.

Dell Inc. (DELL): Revamped management and revamped strategy should allow Dell to grow its market share and already strong free cash flow. Dell stock was down 5% in 2007. We discussed why our clients own Dell in the Q206 Investor Letter.

Enbridge Energy Management (EEQ) / Enbridge Energy Partners (EEP) / Magellan Midstream Partners (MMP) / Teppco Partners (TPP): These stocks are limited partnerships that own oil/gas pipelines. They are a nice substitute for fixed income investments for many portfolios, with the relative advantages of increased tax efficiency, rates of payment, which are typically over 2 percentage points higher than the 10-year Treasury bond, and potential dividend growth. The risk here is a rise in long-term rates.

Jacada (JCDA): Call-center software company closed a strong 2007 with 25% year-over-year revenue growth. The stock was up 48% in 2007. There is a list of reasons we like Jacada in the Q406 Investor Letter. With more growth on tap for 2008, much of it already booked but not yet recognized as revenues, we're expecting more good things from Jacada.

Nuveen Select Tax-Free Income (NXR): This exchange-traded fund pays 4.8% tax-free to investors, which is equivalent to a 7.4% return on a taxable bond for those in the top tax-bracket. If long-term interest rates stay steady investors will collect this return, but if interest rates rise, this investment will decline.

SK Telecom (SKM): In the Q305 Investor Letter, we discussed why we like wireless telecommunications companies in general and SK Telecom specifically. This leading South Korean wireless company was up 16% last year, despite increased competition in the somehwat saturated domestic market. The company's $1 billion investment in China Unicom has more than doubled, and the company is trying to buy a controlling stake in a large S. Korean wireline provider to offer triple-play services. SKM's valuation remains reasonable.

Stamps.com (STMP): This recent purchase is an online-purveyor of postage that enjoys a protected market and a 10% free-cash flow yield, despite increasing marketing spending. With a strong cost advantage over its competition, the best- case scenario is strong growth and earnings multiple expansion. The most likely worst-case scenario is the status quo, where the company makes $16 million/year of cash and buys back 7-10% of its outstanding shares annually.

Vanguard Health Care VIPERs (VHT): Demographics deem this industry the place to be for the next 20 years in our country. We're no healthcare experts here, so we used the cheapest way to place a bet on the whole industry, paying just 0.26% in annual fees. Up 8% in 2007 after being up 7% in 2006.

Wal*Mart (WMT): Promises of slower new store growth are being kept and WMT is using the excess cash to fund stock buyback and high-return new-store development in China, Mexico and Canada.
What To Watch For

We continue to spend our time building and maintaining conservative, value-oriented portfolios for our clients; talking to companies, their suppliers, customers and competitors. We are pleased with the results so far and look forward to providing good risk-adjusted returns for clients over the long-term. For more information on Hurley Capital, including previous newsletters, please visit our website: Hurley Capital.

Sincerely,

Charles Goldblum
Hurley Capital
 Performance Of Hurley Capital Investments
Q407 Holdings

Please Click Here to see a larger image of above information.

 
Important Disclosure

The Hurley Capital Managed Accounts Composite represents all actual client accounts invested in this strategy for the entire year.  The Hurley Capital Managed Accounts Composite allocates client portfolios in equity and fixed income investments, weighted according to Hurley Capital's proprietary investment strategy. 

Actual client accounts utilizing the Hurley Capital Managed Accounts Composite may have varying allocations between equities and fixed income investments based on individual investment preferences.   The results of the Hurley Capital Managed Accounts Composite are net-of-fees, brokerage commissions, and other expenses.  Hurley Capital's investment advisory fees are described in the disclosure statement of Part II of the Form ADV which is available upon request.

The results of the Hurley Capital Managed Accounts Composite include the reinvestment of dividends.  Comparison of the Hurley Capital Managed Accounts Composite to the S&P 500 and NASDAQ Composite is for illustrative purposes only and the volatility of the indices used for comparison may be materially different from the volatility of the Hurley Capital Managed Accounts Composite due to varying degrees of diversification and/or other factors.

Past performance of the Hurley Capital Managed Accounts Composite may not be indicative of future results and the performance of a specific individual client account may vary substantially from the composite results above in part because client accounts may be allocated among several portfolios.  Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable.