Letters
July 21, 2009
Dear Investor:
As the table below indicates the second quarter was a dramatic quarter of asset appreciation. However, this representation is lacking for it does not express the low level of risk which took place to achieve such performance. Risk to Saddle Peak is the probability and the actual permanent loss of capital. On both measures, risk was low.
| Saddle Peak Asset Management Performance | 2nd Quarter (Net of Fees) | YTD (Net of Fees) | Since Inception (Annualized) |
|---|---|---|---|
| Saddle Peak Hedge | 54.4% | 48.1% | 4.7% |
| Saddle Peak Long Only | 35.7% | 34.4% | 2.9% |
| S & P 500 | 15.9% | 3.2% | (6.4)% |
In January (2008 4th quarter letter) I believed and stated that "the next twelve months will produce a large capital gain," but little did I know it happened within six months or in the second quarter of this year. The reason for the capital gain was straightforward, Stocks Were Too Cheap! The margin of safety was huge. Thus, in such times the long term investor is exposing himself to less risk and a higher probability of a large capital gain. Likewise, today, stocks in general are selling below intrinsic value so more gains are in store with less risk. It is a higher risk when one buys a fairly valued or an overvalued asset. Put differently buying a dollar for a dollar, or buying a dollar for a dollar and a quarter, is more risky than buying a dollar for 75 cents, much less than 50 cents. In January the market was "at least 30% undervalued "and "the portfolio was substantially cheaper," thus the prediction of a capital gain was based on reasoning and rational conclusion. The market could have gone lower and it did, but it was only getting cheaper and cheaper. Remember, capital formation was already on the mend, "the corporate bond market has rallied from the lows of October and capital is available for quality corporations".
Some economic thoughts may put things into perspective. Today, the economic commentary is extensive but few communicate the overall picture. For instance, two years ago, car and truck sales in calendar 2007 were 16 million units as they had averaged over the last decade. For 2009, most are projecting 10 million units. The difference known as pent-up demand will mean sales will be above normalized demand in the future. Such is the course of cyclical businesses. There is no good supporting data which indicates core demand for car and truck sales falling 6 million units. Thus, there will be a boom in the future. Interestingly, the cost structure of the industry continues to fall. Breakeven analysis for most companies is now below 12 million units. The only question becomes, "when will it correct?" Doom and Gloom types are missing the big picture. Likewise, the record stock issuance of the last quarter will have a profound impact on the future. When a corporation issues stock two things occur. One, the company’s interest expense falls and their coverage goes up, which makes them less risky. Secondly, the company hurts it’s per share future earnings because the increased number of shares means earnings per share fall (from what they would have been without the issuance). Thus, companies in mass in the second quarter said they want to be less risky and gave away future upside. This tradeoff is usually not that significant. However, it is when it is done in record numbers the way it occurred in the most recent quarter. The world is now less risky with a somewhat reduced upside. Lastly, it is important to put the government’s actions into perspective. The government saved AIG and others from liquidation. The free market economists are fuming. They wanted more bankruptcies and liquidations. They did not care about the transitory economic effects. Some even believe suffering and quick job losses are good for the system. Having attended the University of Chicago (Free Market U) I fully understand the argument, but I believe a financial collapse of our system would have cost more than the negative effects of government intervention. We should all thank Mr. Paulson for a job well done. Moving forward we should see a better economy which should produce economic profits.
Different markets are for different people. The second quarter was a stock picker’s market as active management significantly outperformed passive management. Our portfolio stock picking was uniformly good with the non-performers being the exception. The performance for the long only composite shows we were not a one trick pony. Many stocks appreciated meaningfully. For the hedge fund, our leverage in the form of in-the-money calls added to such performance, but that is what is supposed to happen when the portfolio was so cheap. Looking forward we cannot time when appreciation is going to occur. We believe the portfolio is significantly undervalued. The portfolio has changed as we indicated in the first quarter’s letter. Our largest concentration is in large dull companies such as Pepsi and Coke. We still have a large technology and financial weighting, which are dominated by our four largest holdings, Intel, Cymer, Goldman Sachs and American Express. Other names purchased during the quarter include Microsoft, McDonald’s, Wal-Mart and Equity Residential. Some positions such as Sanderson Farms and Tyson were sold while other weightings were reduced. In summary, the portfolio has been repositioned for today’s prices and values
Thank you for your confidence and time,
Douglas W. Grey
Partner
