broyhill 2013 annual letter

8/13/2019 Broyhill 2013 Annual Letter

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CONTACT INFO

Chief Investment Officer:

Christopher R. Pavese, [email protected]

Fax: (828) 758 8919Tel: (828) 758 6100

B R O Y H I L L H I G H Q U A L I T Y D I V I D E N

B R O Y H I L L A S S E T M A N A G E M E N T | 8 0 0 G O L F V I E W P A R KL E N O I R , N O R T H C A R O L I N A 2 8 6 4 5

Broyhill Asset Management is an independent

nvestment management boutique built upon theong-term investment philosophy refined over aquarter century within the Broyhill Family Office.We believe that capital preservation coupled withonsistent, compounded returns is the key to longerm wealth generation. We do not target anrrelevant benchmark, but seek to provideonsistent returns with a low probability of loss.

INTRODUCTION

The Broyhill High Quality Dividend Portfolio is a concentrated equity stra

invested in a select group of exceptional businesses judged to be competitientrenched market leaders, trading at reasonable prices. Our research seekidentify outstanding companies with sustainable competitive advantages, rathan speculate on mediocre businesses with uncertain futures. The resultportfolio of profitable businesses which offer the potential for full participa

in up markets while mitigating the brunt of down markets, delivered to invesin the form of attractive dividends and consistent earnings growth.

INVESTMENT PHILOSOPHY

TOP POSITIONS

Top 10 Holdings % of Assets Yield

Cash & Equivalents 31.6% 1.0%

Closed End Funds 9.5% 5.2%

Apple Inc 5.6% 2.2%

Microsoft 5.5% 3.0%

Nestle 5.1% 2.5%

Laboratory Corp 4.9% 0.0%

Procter & Gamble 4.7% 3.0%

Tesco 4.6% 3.9%

Danone 4.4% 1.7%

Sanofi 4.1% 2.3%

Total: 80.0%

* Performance is calculated net of all fees and expenses. Management fees for separate accounts are based on a percentage of assets unmanagement and calculated on a sliding scale starting at 125 basis points and falling to 60 basis points for market values exceeding $2,500,000.

PAST PERFORMANCE IS NOTNECESSARILY INDICATIVE OF FUTURE RESULTSThis document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy the securities or oinstruments mentioned in it. No part of this document may be reproduced in any manner without the written permission of Broyhill Asset ManagemWe do not represent that this information is accurate or complete and it should not be relied upon as such. Opinions expressed herein are subjechange without notice. The products mentioned in this document may not be eligible for sale in some states or countries, nor suitable for all typeinvestors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates, or other factoPerformance numbers are calculated using a time-weighted rate of return. Additional information will be provided upon request.

PORTFOLIO COMPOSITION

Sector Analysis % of Assets

Consumer Defensive 36.5%

Healthcare 20.9%

Utilities 0.0%

Communication Services 5.9%

Energy 5.1%

Industrials 0.0%

Technology 18.3%

Basic Materials 0.0%

Consumer Cyclical 5.2%

Financial Services 7.9%

Real Estate 0.2%

Geographic Allocation % of A

North America

Europe

United Kingdom

Central America

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

2012 - - - - - - - - 1.4% -0.8% -1.2% 2.8% 2

2013 6.7% 0.4% 3.2% 0.6% 0.4% 0.8% 3.3% 0.5% 3.2% 3.2% 1.1% 0.9% 2

urrent Number of Positions 27

nnual Management Fee* 1.25%

Minimum Investment $500,000

trategy Inception August 31, 2012

ustodian Fidelity Investments

quidity Daily Subscriptions/Redemptions

YTD 1 Year 3 Year Incep

Broyhill High Quality Dividend Portfolio 27.1% 27.1% - 29.9

MSCI World Index 20.3% 20.3% - 26.8

PERFORMANCE STATISTICS*PORTFOLIO INFORMATION


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January 31, 2014

Investment Review & Outlook

The market climbed a wall of worry last year. Stocks outperformed bonds by the widest span since 1958only the fourth time since 1926 that the spread exceeded 45% when measured against Barclays Long TermTreasury Index. Despite concerns over central bank policy, budget sequestration, a government shutdownand an emerging market currency crisis, the S&P exhibited its lowest daily volatility since 2006 and onlyexperienced a single correction of five percent, the least since 1995. Coincidentally, 1995 was also the onlyyear with a higher Sharpe ratio in the past five decades. In contrast, bonds posted their worst losses intwenty years, and as a result, bond proxies were among the markets weakest performers.

Needless to say, moves of this magnitude are simply not sustainable for an extended period of time. This

bull is aging. The current rally has lasted almost five years and produced cumulative returns over 200%.Only five bull markets have lasted longer and only 7% have matched gains of this magnitude over the pastcentury. As the chart below shows, it has been some time since weve seen a correction in stock prices thecurrent stretch is the eighth longest on record.To put it short, we wouldnt be surprised if the turn ofthe calendar represented an inflection point in both investor psychology and market trend.

Bear markets have historically been kicked off with tightening monetary policy at the Fed in the form ofrising short-term interest rates. The two bear markets since the turn of the century are indicative of thiscause and effect relationship. Consequently, with short rates pegged at zero for the foreseeable future, thebulls would appear to have the upper hand until central banks change course.

Yet, our work suggests otherwise. Central banks are not the only entities that can tighten monetary policyand markets often disagree with the wishes of central bankers. While short rates are unlikely to move higheranytime soon, we fear that a continued increase in long term yields could pressure asset inflation and lead toa sharp decline in stock prices, particularly in the context of todays overhyped, overvalued and overboughtmarket. This is difficult to consider in the face of daily new highs and perpetually bullish commentary, bothof which are typical in the later stages of bull markets. But this is precisely when it matters most to take astep back and consider the big picture.


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Broyhill Annual Letter | Page 2

Risk assets have been pushed higher by unprecedented stimulus since the financial crisis. Broadly speaking,markets have been dominated by policy decisions. The world has become dependent upon two policieswhich remain the only game in town Chinas decision around structural reform and the Feds decisionaround quantitative easing.

The unwinding of stimulus is a delicate affair.Move too slow and risk igniting larger bubbles andgreater financial instability down the road - the worst developed world crises in the past century (in 1929, in

1990 Japan and in 2008) were preceded by extreme levels of private sector debt. Move too fast and risk abigger mess todayeach period was followed by crisis triggered by large falls in inflated asset values.

The magnitude and duration of the stimulus this time around makes this balancing act all the moredifficult, particularly as it coincides with new leadership at both ends of the globe. Bernanke has setthe tone for the Yellen Fed, which is likely to continue the reduction of quantitative easing throughout theyear. At the same time, new leadership in China has demonstrated a clear shift in policy toward growthone that favors quality over quantity.

Through our eyes, it appears as though the momentum has shifted beneath the only game in town.Investors should ask if markets are priced for such a shift in policy. They might also ask what theinsiders know that the Average Joe does not (see chart above). History is an accomplished teacher.

Running with the Bulls

Deeply stressed asset prices provided a large margin of safety for investors at the depths of the financialcrisis. As a result, our work pointed to double-digit expected returns on stocks five years ago. Today, theS&P 500 is nearly three times higher than its crisis lows and consequently, stocks are priced to deliver

negative real expected returns. In other words, that wide margin of safety has vanished. With expectationsand prices significantly greater today, risk assets are more vulnerable to inevitable disappointments andnegative surprises, given the smaller buffer to absorb adverse developments. Great businesses are not alwaysgreat investments and stocks are not always priced to generate average long-term returns. An investorsmargin of safety is always and only dependent upon the price paid. It can be large at one price. It will besmall at some higher price. And it can vanish at some still higher price. With respect to todays margin ofsafety, one word comes to mind. Poof.
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Experience has taught us that the management of return is impossible outcomes are extremelyunpredictable in investing and timing is uncertain at best. Consequently, we focus on what we cancontrol process.We do not attempt to time the markets. Rather, we sell investments as they approachour estimate of intrinsic value and as a result, during periods of overvaluation, our allocation to cash willincrease.

Patience and discipline in the absence of compelling opportunities, can sometimes be a performance drag inthe short-term, but it is the price that must be paid for longer-term outperformance. Last year was one ofthose times. While our equity portfolios performed exceptionally well on an absolute and risk-adjustedbasis, any attempt to reduce risk through diversification, resulted in reduced returns. That being said, weexpect our current positioning to dampen the downside when markets ultimately revert to reality.

The chart above illustrates the potential for mean reversion in earnings relative to trend. To more accuratelygauge downside risk in the market today, one should also consider the potential for a similar magnitude ofmean reversion in valuation multiples. Of course, most investors will chose to ignore both and plan to exitat still higher prices down the road. The challenge, as we have learned, is identifying the exit signal inadvance . . . its impossible to know when that is.Todays speculators would be well served to consider theadvice offered by John Maynard Keynes in The General Theory of Employment, Interest and Money:

There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which ismost profitable. It needs more intelligence to defeat the forces of time and our ignorance of the future than to beat the gun.Moreover, life is not long enough;human nature desires quick results, there is a peculiar zest in making money quickly, andremoter gains are discounted by the average man at a very high rate. The game of professional investment is intolerably boringand over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity

the appropriate toll. Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources forsafety and must not operate on so large a scale, if at all, with borrowed money a further reason for the higher return from thepastime to a given stock of intelligence and resources. Finally it is the long-term investor, he who most promotes the publicinterest, who will in practice come in for most criticism. For it is in the essence of his behaviour that he should be eccentric,unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in hisrashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teachesthat it is better for reputation to fail conventionally than to succeed unconventionally.


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The Flight from Safety

Fixed income investors have been spoiled by central bank bond purchases. To date, this policy has beensuccessful and as a result, capital has traveled the globe in search of yield. While increasing flows induceincreasing asset prices, a reversal in the flow of money from abroad has historically been followed by

distress and often triggered crashes. Central banks remain committed to low interest rates today, but lastsummers taper tantrum may have only provided a brief glimpse of the dress rehearsal to prepare forthe final act to come once stimulus is withdrawn.

The current generation of investors has relied on fixed income for both income generation andcapital preservation. The next generation is unlikely to do the same. Traditionally safe fixed incomeinvestments may no longer fulfill their historical role as income producers and shock absorbers in adiversified portfolio. There are certainly exceptions within the bond universe, but broadly speaking, it is safeto assume that our allocation to fixed income will gradually decline over time. This raises an importantquestion. Is there any value left in the bond markets? And if not bonds, than what? We address the firstpoint below, before moving onto the second.

As a starting point, lets consider the current expectations embedded in market prices. The chart aboveillustrates our point the single most obvious market call among strategists today is that stocks willoutperform bonds. The rationale is simple and it is an easy story for investors to latch onto. Bonds yieldsare low and have nowhere to go but up. Compared with bonds, stocks look cheap. Simple enough? Perhaps.

But when everyone is in agreement, chances are it is already reflected in the price. So if the chartabove doesnt raise your eyebrows, perhaps you should lay off the Botox. Consensus opinion is unanimouson this one and consequently, retail fund flows have followed backward-looking performance. Or as the oldadage states, What the wise man does in the beginning, the fool does in the end.


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To be clear, it is mathematically impossible for bonds to generate returns on parwith last decadesexperience. This is simply a function of the starting pointthe ten year treasury yielded about 3% atyear-end. And while a 3% return is certainly nothing to write home about, it is still nearly double the lowestlevels seen this cycle. More importantly, domestic bonds are now priced to deliver a 1% real return toinvestors, or about 300 basis points over cash. Not too shabby, particularly when measured relative to the

current opportunity set, which we discuss below.

From a portfolio construction standpoint, bonds now provide investors with a real return above cash. Sofixed income appears to be priced about right given todays interest rate environment and current inflationexpectations. But relative to the 6.5% averagereal return on stocks, the 1% real expected return on todaysbonds is almost insulting. We get that.

However, investors are not buying stocks today that are priced to deliver the average 6.5% real return.Rather, they are buying large cap stocks priced to deliver -1.7% real annual returns or small cap stockspriced to deliver -4.9% real expected returns. Against this backdrop, all of a sudden an asset priced todeliver a 1% real return looks like a bargain relative to domestic equities. Even cheap international equitymarkets are only priced to deliver the same 1% real return on offer in domestic bonds, but shouldnt equityinvestors demand a premium for the risk they take? We sure do. Bottom line: investors can still get paidfor taking some risk today, but all asset forecasts have been shifted down, compliments of the Fed.In this environment, we think it still makes sense to own some bonds here since we are earning apremium over cashits just the prudent thing to do in a world with no great opportunities and asignificant number of risks.

Todays Collectors Items

Looking ahead, it is still prudent to assume that rates are structurally bottoming and may endure a slowgrind higher in both real and nominal terms over time. This has not been a great backdrop for mostincome-generating asset classes. But one lesson stands out from historykeep duration short and pick upas much carry as possible. In a rising rate environment, you want to own those securities that provide themost yield. In a world of zero interest rates, high coupons are collectors items.


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Long dated bonds are more sensitive to interest rates because they lock investors into low rates fora longer period of time. High yield bonds, on the other hand, have shorter maturities and highercoupons which diminish duration risk. They almost never reach maturity since they are callable andmanagement refinances whenever possible. Importantly, these bonds are priced more on companyfundamentals than interest rates and over time, have actually exhibited a positive correlation with inflation

due to improved pricing power, increasing cash flows and stronger balance sheets.

For our part, we continue to believe that default rates will remain below their long-term historicalaverages, as companies refinance debts before they come due while the economy slowly improves.High yield bonds should perform well in this environment, and a carefully selected portfolio ofhigh conviction ideas has the potential to perform even better.When applied to the high yield marketstoday, we believe we can construct a portfolio of bonds with above average yields and below average risks.This can be accomplished by 1) balancing performing credits with attractive yields, 2) stressed creditssuffering from temporary issues at meaningful discounts to par, and 3) special situations trading at discountsto net asset value.

Beyond the opportunity we see in outsized default premiums, we also think the illiquidity premium remains

mispriced. In a low rate environment, where asset allocators are increasingly desperate to generateincremental yield, we think alternatives can play a meaningful role. In particular, allocators of capital mayneed to expand their conventional tool box and become more opportunistic in their approach in order toachieve long-term objectives. In this regard, we remain convinced that asset-based lending and the privatecredit markets in general, remain in the sweet spot at this point in the cycle. Specifically, we remainconstructive on assets that provide both yield and growth while we wait for inflation down the road.

Our allocation to fixed income will change with the opportunity set as will the nature of ourinvestments in the sector. Today, the balance of our fixed income exposure is invested throughvarious closed-end funds given the unique opportunity provided by recent panic in bond markets.In addition to our investment in municipal funds, discussed here,we have discovered similar opportunitiesin a number of taxable bond funds. We think this is an excellent opportunity to generate equity-like returnsas panicked, yield-starved retail investors eventually return to the space and discounts narrow.
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The Current Opportunity Set

The vast majority of investment managers are not rational allocators of capital. There areexceptions, but broadly speaking, most are fully invested all of the time, regardless of price andexpected returns. Many investors worry that they are not getting their moneys worth if they are holding

large amounts of zero-yielding cash. More often than not, these are the same investors likely to sell securitiesat any price when emotions run wild. Rather than limiting their opportunity set between earning nothing incash or earning something in stocks or bonds, investors would be better served if they considered howmuch their cash mightearn ifit were available to buy assets from forced sellers once theyve become cheap.

In his recent book,Antifragile, Nassim Taleb argues that, It is much easier to sell Look what I did for youthan, Look what I avoided for you. But when the herd is busiest bidding up prices to ridiculous levels andthe noise from the crowd becomes loudest, it is the ability to sit on your hands and do nothing that is thestuff tomorrows returns are made of. Its just a much tougher sell, as Keynes first noted in 1936.

The greatest buying opportunities arise when liquidity is in short supply and anxious investors,consumed by fear, are forced to sell securities as prices fall. Leaving the party early will almost

always result in short term underperformance during the later stages of bull markets, but it is theonly way to ensure that you have the resolve, the discipline, and the dry powder to buy in bearmarkets when risk is lowest and expected returns are highest.

At Broyhill, we have the flexibility and the patience required to commit as little or as much capitalas we determine based upon our independent appraisal of valuations and expected returns,opportunity costs and risks. The amount of cash we hold is inversely proportional to both the numberand the attractiveness of securities trading at a discount to what we believe they are worth.

Today, cash balances are high, as the current environment has created a scarcity of opportunitiesthat meet our return requirements. Physics suggests that the further the pendulum moves away from thecenter of gravity, the more forceful it will reverse direction in the future. In other words, todays gains maycome at the cost of tomorrows returns. We are quite comfortable holding cash absent compellinginvestments and spend our time in the interim, building an inventory of ideas that meet our investmentrequirements. Our primary objective is to achieve consistent returns compounded over time, whileminimizing the risk of loss. At the same time, we believe flexibility is critical as value may emerge in variousforms. The balance of this letter reviews some of the forms we are monitoring today.


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Sliding Down the Back Side

Few affairs in history have had a greater impact on global capital markets than Chinas economicdevelopment. The effects of this multi-decade expansion are farther reaching than conventional wisdombelieves and, for the most part, the implications or rebalancing remain largely misunderstood. Double-

digit growth in Chinese investment fueled demand for everything from coal to copper and fueled inflationin every corner of the world. For the past decade, investors made great sums of money simply buying whatChina needs. But the setup then was drastically different than it is today. Then, investors were on the frontend of a historical surge in money and credit. Today, we are in the uncomfortable position of sliding downthe back side.

We believe that the global financial crisis marked the end of a long period of emerging marketoutperformance that began with Chinas growing economic influence and concluded with newChinese leadership choreographing a massive shift in its economy from investment toconsumption.The crisis uncovered a number of structural imbalances across global capital markets that arelikely to weigh on emerging markets for years. These factors include slowing Chinese growth, constrainedcredit to emerging economies, a strengthening dollar along with eventual tapering, the reversal of global

wage arbitrage and the growing risk of capital flight. The handoff will be tricky to say the least, and anythingless than a perfect landing will have significant implications for the global economy.

The share of investments in Chinas GDP hovers near 50%, a level never before approached in history, andcertainly never by an economy as large as Chinas today. Many signs suggest that this may be the glassceiling for investments in China, and that an inflection point has already been reached. If true, Chineserebalancing may represent the single most important factor in financial markets for years to come.

As Chinas investment boom deflates, so too will the assets that have benefitted from Chinasinvestment orgy. If accelerating debt served to boost growth, decelerating debt will reduce it. Ifbuilding capacity has artificially lifted GDP, shutting it down will lower it.The emerging marketboom was a decade-long period where related growth stories stole the spotlight and the developed worldmassively underperformed. We expect that the structural issues we are seeing in emerging markets today,and the pending reversal of fortunes (along with capital flows) may lead to a sustained period ofoutperformance for the developed world.


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The Emerging Unwind

The bull market in commodities that spanned the last decade conditioned investors for perpetually risingcommodity prices. During this period, those companies with assets and revenues closely linked tocommodity inflation performed spectacularly, while those which faced commodity cost pressures lagged

behind. Market sentiment and corporate valuations reflected the magnitude and duration of this trend asexpectations became deeply embedded in investor psyche. The consensus is notoriously slow torecognize inflection points in long-term trends. But this is precisely where the largest opportunitiesare uncovered. As Chinese growth slows, commodity inflation is likely to follow suit, and a numberof industries are poised to benefit from margin expansion and greater returns on capital as a result.

Our previous investment in Coca-Cola Hellenic, originally discussedhere,was a profitable example of thetypes of businesses best positioned to benefit from reduced input costs. At the time of our investment, weexplained that commodity price increases had resulted in ongoing margin pressure for the company, but thatany moderation in cost pressure would drive significant upside in the stock. With the upside now behind us,we have since exited the position as shares approached our estimate of intrinsic value.

At the same time, we have been able to leverage our research on the industry to identify a newinvestment in the space, which we believe is even higher quality, while still providing the samemargin tailwinds.This particular company has an unassailable moat and high barriers to entry defensivecharacteristics which result in strong and consistent free cash flow. Moreover, we see significant long-termgrowth potential as the company is the dominant provider of low cost products to a young and risingmiddle class. Currency risk, regulatory threats and the stocks limited float combined to drive shares nearly50% lower from their recent peak, presenting us with an opportunity to begin building a position. Shouldcapital flight spark a greater currency crisis and increased volatility, we would expect to aggressivelyaccumulate shares. Stay tuned.

We constantly balance our assessment of the macro with current valuations to determine therelative attractiveness of investment opportunities.While emerging markets may appear cheap based

on various measures, we believe that the past decade of excesses have greatly distorted the true earningspower of most investments tied to the region. As a result, we currently demand a much greater margin ofsafety to commit capital to developing economies. Given the magnitude of the last cycle, history wouldsuggest that any reversion to the mean would be accompanied by a large overshoot to the downside. If weare correct in our assessment, we will likely have a great opportunity to find the baby that got thrown outwith the emerging market bath water at some point in the future. Until then, we are quite happy with theexisting opportunity set discussed below.
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Stuck in the Middle (Class) with You

This is an exceptional period to own leading developed world companies despite our expectation thatemerging economies will generally grow faster than developed economies (i.e. there is little correlationbetween GDP growth and stock market returns). These companies have world class management teams,

intellectual property and brand recognition, organizational skills and shareholder alignment and are oftenmuch better equipped to serve a wealthier, emerging market consumer.

Against this backdrop, we think there is a strong structural case for owning high quality,multinational brands at current valuations. We have found that high quality franchises exhibitlower drawdowns with less volatility and similar or greater returns than low quality stocks. Whilehigh quality does not always win from an absolute perspective, over the long haul, it has performed betterwith lower risk.We expect a massive trading up in consumption in the developing world, compounded byan even greater trading up of capital flows into developed markets.

Although we expect some emerging bumps down the road, the structural story remains intact forthe emerging middle class over the long term. Hundreds of millions of households are poised to enterthe ranks of the middle classes and consumers in emerging economies, whose desire to spend continues togrow, remain buoyant about the future. We think manufacturers and retailers that can provide consumerswith an accessible brand that they can identify with are best positioned in the current macroeconomicenvironment. We believe Coach (COH) is the embodiment of affordable luxury, with shares still trading atthe most affordable price in the stocks history, as we discussed in our original report,here.Our thesisremains intact despite near term challenges, which have allowed us to increase our position at even betterprices. More recently, we have established a position in TESCO, the UK retailer, at a price which webelieve, provides a substantial margin of safety.

BRIC & Mortar Investment

The grocery market is not particularly exciting against a backdrop of social media and another round ofinternet public offerings. Nonetheless, we expect our investment in TESCO to provide attractive returnsover our investment horizon with limited downside risk given the stocks historically low valuation, healthydividend yield, and real estate assets valued greater than the current value of the company.
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Managements first profit warning in decades and subsequent reductions to guidance have weighed onshares as investors fear the company has lost focus at home while stretching for growth abroad. Theconsensus has become extremely negative on the prospects for a turnaround despite recent managementchanges, which we support, and an increased focus on ROIC, evident as management exits unprofitablemarkets. These things take time, but given current sentiment on the stock, even stabilization at current

depressed levels should be enough to drive double-digit returns on our investment. Our upside would be fargreater if Mr. Market again decided to reward high quality dividends with higher multiples.

Bottlenecks along the Industrial Revolution

For the first time since China joined the WTO, the US is actually seeing manufacturing jobs expand. Fallingenergy costs, rising productivity, declining transportation costs, relative political stability and competitivelabor costs are all contributing to The American Industrial Renaissance. Academics estimate that domestic oilproduction could exceed Saudi within two years. Natural gas production, in just a single shale formationcould exceed all of Qatar in another two years.

The long-term implications for American industry are the stuff competitive advantages are made

of. But in the intermediate term, the ramp in production has outgrown our nations infrastructure,creating bottlenecks in transportation which will likely persist for years. These bottlenecks havecreated interesting opportunities with economics largely independent of growth.

Kinder Morgan is the largest pipeline operator in the country and represents a direct investment in thegrowing infrastructure required to support Americas shale oil and gas revolution. The company owns aworld class collection of monopoly-like assets managed by Richard Kinder who personally owns about a

quarter of the shares outstanding and earns his $1 annual salary millions times over.

The stocks recent decline - driven in part by a negative analyst report and in part due to rotationout of bond-proxiesprovided us with a compelling entry into a high quality business throwing offhigh margin, recurring cash flow from assets almost impossible to replicate. At cost, we expect ourinvestment in the GP to generate very attractive returns driven by accelerating cash flow growth, healthycash dividends and incremental cash distributions from incentive distribution rights.


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Today, oil is plentiful but infrastructure is scarce. This bodes well for the long-term earningspower of companies like Kinder Morgan. In the short-term, however, it has created persistentdislocations in the pricing of crude oil across the country to the benefit of oil refiners. Investors areunderstandably cautious given the industrys historical cyclicality and as a result, the group is priced as if adownturn is imminent. Our work suggests otherwise.

We believe margins are likely to remain elevated as shale oil continues to flood the country andwell-positioned refiners should thrive.Of all the refining assets weve analyzed, we believe Northern TierEnergy (NTI) enjoys the most sustainable margins and defensible earnings stream. The companys structuraladvantage lies in St. Paul Minnesota, where its refinery is located outside the Bakken shale and a shortpipeline voyage away from the Canadian Oil sands, providing NTI with a substantial cost advantage relativeto the competition. Heavy retail selling amidst a secondary offering, combined with a reduced distributiondue to scheduled downtime, created a unique opportunity to purchase units at a price approaching a 25%yield on our estimate of normalized earnings power.

Demographics & Policy Tailwinds

The Affordable Care Act (ACA) represents perhaps the most significant piece of healthcare reform inhistory, and stands to benefit 24 million uninsured over the next decade according to the CongressionalBudget Office. But similar to the Americas Energy Renaissance the ACA is sure to create bottlenecks in theexisting healthcare system along the way.

We expect structural bottlenecks to create headaches for a number of industries in the sector whilecreating long-term opportunities for others. When viewed in the context of low correlations to theoverall market, defensive earnings streams which generate high and rising dividends, and rock-solid balancesheets flush with cash, we dont see any reason the sector shouldnt trade up relative to the consumer staplesindustry (see chart above). Management focus has clearly shifted from building empires to buildingshareholder value and Mr. Market has begun to take notice.

Some of the best opportunities in the market are found amongst structurally advantaged companiessuffering from cyclical weakness that Wall Street is unwilling to look past. The typical phrase used bysell side analysts to describe these investments is dead money patient investors should pay particularattention when they see these buzzwords as they often signal an excellent long-term buying opportunity.


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Our previous investment in Hospira (HSP) exemplifies this dead money phenomenon as the stock hasappreciated roughly 50% since we established our position and outlined our thesishere.Fortunately, we arestill finding similar opportunities today despite the broader markets extreme valuation.

Shares of Laboratory Corporation (LH) fell 20% from their recent peak after management reduced earnings

guidance. Consensus sentiment has followed utilization trends lower, resulting in substantially reducedgrowth expectations for the industry and washed out coverage for LH. Of the 28 lemmings that follow thestock, no more than 5 rate it a buy. So what do these brave analysts see that everyone else is missing? Wecant speak for the street (nor would we want to), but we see a very high-quality, defensive business withsecular growth tailwinds priced to deliver double-digit annual returns even assuming no improvement inindustry fundamentals or relative valuation - both of which we think are likely.

We aim to publish a more thorough report on our investment thesis later this year, but since this letter isalready much longer than anyone expected, well just note that Lab Corp is the low-cost and most efficient

operator in an effective duopoly, characterized by substantial operating leverage. While the sheep aredistracted by yesterdays slowing growth, we are focused on tomorrows volume opportunitydriven by tuck-in acquisitions, a combination of steady employment growth, insurance coverage expansion, advances inpersonalized medicine, and an aging population which increases the demand for clinical tests.

Underdogs, Misfits and the Art of Battling Giants

Three thousand years ago on a battlefield in ancient Palestine, a shepherd boy felled a mighty warrior with nothing more than astone and a sling, and ever since then the names of David and Goliath have stood for battles between underdogs and giants.David's victory was improbable and miraculous. He shouldn't have won.

In his most recent book, David and Goliath, Malcolm Gladwell challenges us to think twice about obstaclesand disadvantages. The first chapter tells the story of Vivek Randive, who decided to coach his daughtersNational Junior Basketball team. He was puzzled by the mindless way Americans played the sport. It was asif there were a kind of conspiracy about the way the game ought to be played which widened the gapbetween good teams and weak teams. Good teams were tall, fast and able to execute plays with precision attheir opponents end. Randive grew up with cricket and soccer in Mumbai, so he wondered why weak teamschose to play in a manner that made it easy for good teams to do what they are good at.
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Most of the time, a team only defended about a quarter of the court, conceding the other three quarters.But Randives girls, in the heart of Silicon Valley, were the daughters of nerds and programmers. Theyworked on science projects and dreamed about careers in marine biology. If they played the conventionalway, they would fail conventionally.

Instead, the team would press and steal and do it over and over again. Because they typically got the ballunder their opponents basket, they shot layups instead of the low-percentage, long-range shots that requireskill and practice. Defense hid their weaknesses.The team attacked the inbounds pass a point inthe game where a great team is as vulnerable as a weak one.

David refused to engage Goliath in close quarters, where he was sure to lose. He stood back using thevalley as his battlefield like Randives girls defended all ninety-four feet of the court. As the playwright,George Bernard Shaw once put it: The reasonableman adapts himself to the world. The unreasonable onepersists in trying to adapt the world to himself. Therefore, all progress depends on the unreasonable man.

Capital markets are undoubtedly a greater conspiracy than junior basketball and consequently,many investors fall into the same trap. They play the conventional game and fail conventionally.As a result, the majority fail to keep up with professionals, who fail to keep up with the market. Institutionshave more information, more money, and more time to dedicate to investment decisions. They are the talland fast good teams able to execute more efficiently than weaker investors. In reality, however, the verything that gave the giant his size was also the source of his greatest weakness. The powerful and the strong

are not always what they seem.

Our ability to recognize this weakness and capitalize on it, is precisely our edge. We make our own,more rational, rules. We are patient. They are not. We arent forced to follow the herd. By definition, theyare the herd. While most institutional managers spend their days and nights rifling through meetings, sortingthrough emails and rubbernecking at Bloomberg and CNBC, we sit in a quiet room and read and think. Bydesigning our process to tune out the noise and make better decisions, we have tilted the odds in our favor.


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The advantage of being located in the foothills of the Blue Ridge Mountains (in addition to theweather) is that we are outside of the fray. Its pretty quiet out hereand the rumor mill just doesntchurn as loudly. Removed from Wall Streets groupthink, we are able to climb up the mountain andsurvey the investment landscape with a rational, long-term perspective.

We simply operate under a different mandate. Our process does not attempt to catch every market twitch.One of the most underappreciated keys to generating consistent long-term returns is to minimize losses.Losses are almost always caused by taking too much risk, as many investors feel forced to do today. If youavoid large losses, the gains will usually take care of themselves.

Our current positioning allows us to generate consistent cash flow in a high risk environment, while keepingour powder dry to seize more attractive investments the next time opportunity knocks. As they say, Whenyoure one step ahead of the crowd, youre a genius. When youre two steps ahead, youre a crackpot.

Sometimes, it pays to be a crackpot.

Christopher R. Pavese, CFA


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The Broyhill Portfolio is a diversified, multi-asset classinvestment strategy. Macroeconomic fundamentals andlong term investment themes drive the portfolioconstruction process which is routed in a strict valuationdiscipline. Embedded in our approach is a relentlessfocus on the preservation of capital and the belief thatrisk management begins with portfolio construction. Theobjective is simply maximum total return, commensurate

with the given risk profile of global capital markets andbest suited for investors with a long term time horizon.

The Broyhill Opportunistic Fixed Income Portfoliois a separately-managed individual bond portfoliofocused on short duration, high-yielding fixed incomesecurities. The portfolio aims to combine a highprobability of the safe return of principal with a currentreturn superior to a portfolio of US Treasury securities.

A rigorous research process drives the selection of onlythose securities that meet our requirements based uponan independent assessment of each issuers fundamentalstrength. The result is a cash-generating portfoliofocused only on our highest conviction ideas.

The Broyhill High Quality Dividend Portfoliois aconcentrated equity strategy invested in a select groupof exceptional businesses judged to be competitivelyentrenched market leaders, trading at reasonable prices.Our research seeks to identify outstanding companies

with sustainable competitive advantages, rather thanspeculate on mediocre businesses with uncertainfutures. The result is a portfolio of profitablebusinesses which offer the potential for fullparticipation in up markets while mitigating the bruntof down markets, delivered to investors in the form ofattractive dividends and consistent earnings growth.

For more information on our services, please contact:[email protected]

To subscribe to our research, please click here:

Broyhill Asset Management, LLCPost Office Box 500

800 Golfview ParkLenoir, NC 28645

(828) 758-6100www.broyhillasset.com

www.viewfromtheblueridge.com

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 areprivileged 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.
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