1^st Quarter letter for 2010

After last year’s performance, the 1st quarter of 2010 has started well with further asset appreciation without undue risk. The table below indicates our return relative to the market. It is important for the long term investor to always consider risk first and that is the basis of our satisfaction with the start to the year.

Recently, there has been increased focus in the investing world on risk which is typical given the events of the last two years. A friend of mine thought it would be a great topic to write about given there still is such confusion around the topic and how truly difficult the concept is to express. At Pacific Financial Research, I worked on communicating what risk was. We thought that the rolling relative performance was one way to characterize risk. The idea is, if an investor consistently outperforms his benchmark, he is not exposing himself to excess risk. The question becomes, what percentage of the time is his five year rolling performance outperforming? For some, including Warren Buffett who recently has written on the topic, this approach might be preferred. However, I strongly feel for many it just is not straightforward enough. I think imagery in the form of a story might be a more understandable approach. The story is told by personifying the economy and the market. Thus, I will be writing the story of Sam and Mark, and Sam’s Journey to the Bank in order to express the risks Saddle Peak sees in the economy and the market. Hopefully, the imagery and personification will leave the reader with the feeling of risk.

Sam’s Journey to the Bank

The two characters in the story are Sam and Mark. Sam represents the economy which includes the government’s interaction. Whereas Mark, is an investor who acts like the stock market. Let’s look at each in some detail. We will start with Mark for a similar character has been used by others (Ben Graham, the father of value investing used a character named Mr. Market to represent the market).

MARK

Mark (Mr. Market) has the same characteristics as Ben Graham’s version. Most importantly he is emotionally unstable. His emotional states swing from wildly optimistic to excessively pessimistic. In order to understand him think of the events of the last four years. Mark was wildly optimistic at the peak in 2007, like Greenspan, all was good and the economy had no limits. Similarly, a decade earlier he thought technology companies and their valuations were also limitless. On the other hand, He was overly pessimistic at the bottom in March of 2009. He thought the world was going to end yet the financial system was already improving. The actual crisis of September and October 2008 was almost six months old and the bond markets having stabilized in January 2009. For the purposes of this story, Mark has these characteristics but is not the market per se but an investor who has given money to Sam. Sam’s goal is to get the money to the Bank.

SAM

Sam, on the other hand, is not an overly emotional character at all. He can be characterized by his physical appearance and his actions. Sam is overweight, stubborn, slow to move, and at other times lacking courage, but he is also smart, strong, well meaning, and at times very aggressive. Sam over the years has not eaten well nor exercised because the states and US government have created huge unfunded liabilities that will affect our long term economy. Whether it’s the half trillion unfunded pension of California or the Social Security System of the Federal Government or our poor state of education relative to our competitors around the world. The diabetes that will likely occur will add negatively for our ability to manage the problem. Sam also is stubborn in that the politicians care more about the status quo rather than truly addressing our long term challenges. Likewise, given the size of our economy and the pattern of consumer consumption Sam is slow to move. The likelihood of a structural change (consumer savings more and spending meaningfully less) is not a high probability. Yes, in hard times this occurs, but it is Saddle Peak’s opinion that the consumer will spend once he starts earning money again (in aggregate). Sam’s courage issue is complex. He wants to address China’s trading with the US but he, like the US, does not do it. It is important that we express Sam’s positives because our economy did not become the world’s largest by chance. First, Sam is smart. Our human capital in technology, medicine, etc. is world leading. We can competitively compete when innovation is the driving force. Sam is also strong. Our military polices the world. Our laws and institutions are solid. Countries such as China have much to learn when it comes to serving the needs of the people. Likewise, Sam is well meaning in that business leaders, politicians, and the people attempt to do the right thing. Just look at our world’s leading charitable giving as example. Lastly, Sam is very aggressive at times. When crisis occurs, both our economy and the government moves fast. Examples include our response to 9/11 and our response to the crisis of 2008. The conclusion is that we can be aggressive when needed.

THE BANK

Let’s now look at the Bank and its symbolism because it is not a bank. It is a destination of financial success. It is like the banks of yesteryear but a lot more. They were gray, strong, solid, enduring, made of granite, where your venerable grandfather or father worked. They were secure with lots of money. At the Bank, the economy is growing at a self sustaining rate, government plays a secondary supportive role in the economy, and the government and other institutions fulfill their proper place in the world. The words natural and organic are in balance with success and achievement. As you might expect the Bank is each person’s and country’s concept of financial success. It is the utopian institution we strive for.

THE STORY

Sam’s Journey starts in 2006 when he is running down the road headed for the Bank. His friend Mark has given him some money to deposit there. The reason he is running is that he wants to put the money in the Bank as soon as possible. Similarly, our economy is growing at a great rate and everything looks good. The problem is that Sam is breathing too heavily and he can’t keep the pace up. Something is going wrong. He feels it but he continues on at the same pace as though nothing is wrong. Remember he is overweight. Likewise, he has started up a hill. The hill symbolizes the Federal Reserve raising interest rates to slow the economy. The Federal Reserve is aware that Sam is overweight, slow to move, and stubborn. They are oblivious to the fact that the largest area of marginal growth is the housing sector and it is full of unreal speculation (the subprime situation and easy real estate lending). In Sam’s terms, he has a blockage in one of his arteries and he is about to have a heart attack because the hill is too big. Fast forwarding to September 2008, his heart attack is massive, so massive that he might die. The AIG situation and financial contagion is real. Likewise, Mark is panicking because he is worried that the system will breakdown and if Sam dies he might not get his money back, much less get it to the Bank. The stock market decline reflects Mark’s panicking. However, the good news is quick. Sam’s doctors put in a stent and stabilize Sam. The Congress, the Federal Reserve, and the financial world understand the situation and act (remember Sam can act aggressively in crisis). Thus, Warren Buffett realizes that Sam and the financial world have stabilized and invests in Goldman Sachs and GE. His positive statements and investments are generally ignored for months. Remember Mark might realize Sam is not going to die, but he is emotionally unstable and he is driven by perception not reality. He needs to see Sam act better. And Sam does. The bond market spreads narrow and the government passes the stimulus bill (drugs for Sam). Sam is positively reacting to the stent and his blood is flowing again. Sam is getting healthier despite Mark’s doubting nature. Finally, Mark comes around in March of 2009. He realizes Sam is going to make it and the stock market bottoms. Put differently, Mark is going to get his money back and maybe Sam down the road is going to get his money to the Bank. Over the course of 2009, Sam continues to get better with the refinancing of Citicorp and the many financial institutions in April and May. There is even real growth of the economy in the third quarter. Again Mark seeing Sam’s progress and is feeling more and more confident about Sam and the future. The stock market continues to rise. Make no mistake, Sam is still feeling the effects of his heart attack with high unemployment and low growth, but it is growth nonetheless. Interestingly, the story has to include China’s positive role. Their stimulus plan played a major role in stimulating worldwide growth and Sam. Sam needed help from many doctors and others to get thru the crisis and the early stages of recovery. Sam’s story is not a domestic story; it is the integrated worldwide economic and financial story of 2009. Whether China is another doctor or therapist or just a drug they have meaningfully helped. Increasingly, over the years Sam is not just the US GDP, he also has a world component. Similarly, Mark is affected by worldwide events not just what goes on in the US.

Time has past and it is now April of 2010. How is Sam doing? What are Mark’s feelings about Sam and his health? By answering these questions, Saddle Peak and others can better understand the investing risks today.

Sam has continued his improvement. He is out of the hospital and he is walking again to the Bank, but he has lots of issues. First, he now has a stent and there are many questions about his general health. Secondly, Mark might see him walking down the road, but it is hard for him to believe it. However, in typical fashion Mark has to believe Sam is healthier because he is indeed out of the hospital and walking toward the Bank. Sam’s pulse is normal and Mark is becoming more optimistic almost on a daily basis. Likewise, both the economy and the market are improving. Areas such as the technology sector are booming with the commodities sectors fully recovered. Some of Sam’s health questions remain: When is he going to get off the drugs? The artificially low short term interest rates are steroids for Sam. They make him feel and act healthier than he is. In the past they created some of the expectation problems that lead to the housing sector problems of his past. Yet the Federal Reserve is conflicted by a dual mandate which includes low unemployment rates without regard to the natural level at any point in time. Likewise, Sam has real long term issues such as his weight which have been totally disregarded thru the crisis. Why would Sam be eating like crazy and putting on more weight when he already is overweight? The US government’s trillion dollar budget deficits are not healthy and must cause problems in the future. The states are also in horrible shape. They too have both budget deficits combined with unfunded liabilities. Education also has not been improved, just talked about. Sam cannot get to the Bank if he is still overweight. New health risks could arise such as oil or commodity based inflation. What we know is the chances of another heart attack have increased with his increased weight. Mark is very aware of Sam’s weight issue, but will only act if Sam is in a crisis. That is just how Mark works. Sam’s stomach is upset. Is it the increased trade friction with China? Is it the high unemployment? Is it the reduced long term confidence in the US economy? Is it the inability to afford the response to a natural catastrophe? Or is it just gas or maybe nerves? Mark and Sam are both sensing another issue. What about the next hill that is coming. The landscape has been too flat. Potentially, long term interest rate might be too low. What happens if inflation comes back? What happens when the Federal Reserve raises short term interest rates? Will Mark panic? The next hill may be bigger than the past. Will Sam’s increased weight be a factor in another heart attack? Remember Mark does not anticipate the long term future. He emotionally reacts to Sam. Could Sam be fine? Will Mark panic because he feels the past will repeat itself? The Greece example comes to mind. Greece’s financially impact on the US economy is minimal, but it is the fear of financial contagion that can scare our markets and Mark. Mark can send the markets down on fear alone. It is important to consider Mark’s memory of the past. Sam’s near death experience in varying degrees will be with Mark and our markets indefinitely.

This story was written to try to create imagery in regards to our economy and markets today. Hopefully, the investor shares Saddle Peak’s view that having cash today is a prudent choice given the risks and the markets Mark like reaction. The issue is not whether the economy is a V, a W, or an L. What Sam’s Journey to the Bank shows us is that there are many risks today both from Sam’s (economy) viewpoint and from Mark’s (The market). Predicting when opportunities will occur is an exercise in probabilities, but the more important exercise is to react to them when they occur. We look forward to watching Sam’s continuing journey to the Bank, but we will invest based on Mark’s reactions to Sam’s journey.

Portfolio changes during the first quarter

During the course of the quarter the largest portfolio change was raising additional cash by selective selling of stocks and options. On March 31, 2010, cash was 22% of the portfolio. Given the risks, as depicted above, and the overall valuation of the marketplace, we are opportunistically looking for a time to be fully invested. The valuation of the market is very dependant on interest rates and long rates have started moving higher. Note that short rates around the world are also moving higher. During the quarter, we sold Meredith Corporation when it reached our estimate of its intrinsic value and continued to sell more Starbucks. Additionally, we sold our entire General Electric option position with partial sales of American Express and Coca-Cola. We purchased additional 2012 options of Intel, Wal-Mart, and Pepsi. Smaller purchases were also made in 2012 options of American Express and Coca-Cola. The premium for the additional year continues to be small. We look forward to being fully invested. We can not predict whether it will be the second quarter of 2010, but we are not worried for we don’t have to swing at every pitch, we just have to make sure we hit the hanging curveball out of the park (Please refer to Warren Buffett’s comments on this topic).

Thank you for your confidence and time,
Douglas W. Grey

The Fund is a long/short equity fund that invests in U.S. common stocks and options on broad-based securities, indices, and individual companies. The investment process is a concentrated, multi-cap value strategy and biased toward long positions. Historically the Fund has used both options and leverage. Leverage was only used for the periods of January to April 2009 with the maximum leverage of 30%.