1^st Quarter letter for 2009

The first quarter and last six weeks have shown the investor how emotional Mr. Market (Buffett’s term to personify the stock market) is and can be over time. In one month, the market is priced as though economic profits and cash flow will vanish forever versus (where we are today) that there eventually will be a recovery later in 2009.

The swings can represent opportunity for the long term investor to buy when others are selling and sell when others are buying.

It is important that the investor see the forest not just the trees today. 2010 will be a strong profits year with only a mild recovery. Operating leverage is very high and companies have aggressively lowered their costs. This should propel the market meaningfully higher.

Of course most hedge funds are momentum traders and are caught in trying to tell you which day the economy will bottom. They are not investors and are unwilling to be contrarians. Saddle Peak’s dilemma is being characterized as something we are not. Likewise, our long-only accounts which own no in the money calls are sometimes viewed with more risk than they deserve because of Saddle Peak’s expertise and use of these specialized options. Thus, it is our task to clearly communicate.

For the first quarter, the long-only account performance was -0.7% versus a decline of 11.0% for the S&P 500. For the hedge account the decline was 4.0%. Additionally, it should be noted that it was a difficult period for small cap stock investing with the S&P small cap index down 16.8%.

As we write this letter, our out-performance has continued and actually widened (Hedge: up over 20%; Long only: up over 10% versus the S&P -2.8%). The significance is not where we are today, but the process of investing. Such a process yields long term value added. An example is our investment in Goldman Sachs. During the year Goldman Sachs has appreciated in a banking sector that has meaningfully depreciated. The reasons are many but can be summarized briefly. Goldman Sachs, the world’s leading investment bank, with the best and brightest is financially sound and has a promising future. Whereas when the investment was made, some emotionally unstable believed Goldman was doomed. They never had concrete reasons or causality to justify their emotions, but they traded the stock that way. We were buying, Buffett was buying, but many were selling and selling vigorously. Taking advantage of emotion selling is the cornerstone of value investing.

Other investments such as Cymer and American Express are starting to appreciate and will likely follow Goldman Sachs. Each pathway to appreciation is different but the investment process is similar. Buy a world class investment asset when traders are emotionally giving it away and sell it after appreciation. We are not macro investors that buy themes. Buying gold stocks based on the idea that inflation is returning is very popular (a crowded trade) but is forth with risk. Especially when Fed chairman Bernanke has explicitly said they will reduce future stimulus.

In March we posted our Dividend Discount Model, DDM, analysis of Coke. The conclusion was that Coke is a very cheap stock with a very low risk profile. Similar work on Pepsi (better named Frito-Lay because of the division’s importance) produced a like conclusion. In early April we rebalanced the portfolio to reflect such conclusions. In the first quarter purchases of Polaris and Burlington Northern also took place. Both companies are very well managed with promising businesses.

Thank you for your confidence and time,

Douglas W. Grey
Partner