Letters
October 24, 2007
Dear Investor:
We appreciate the opportunity to periodically update you regarding Saddle Peak Asset Management’s (“Saddle Peak”) investment outlook and our performance. In the future, we intend to issue a newsletter after every quarter to communicate with our investors.
If you believe the stock market predicts the future, one could infer that investment prospects appear very positive. The old adage “bull markets climb walls of worry” has been true since the market bottomed in 2002. However, as value investors, we are concerned that there may be some clouds on the horizon. What are some of the possible issues confronting the market? First, the enormous debt bubble that has spawned over the last several years could conclude with much more difficulty than the stock market indicates. Sub-prime may be the beginning of a long, painful economic correction. Second, sharp housing corrections usually do not end in soft economic landings. Earnings estimates in no way reflect a recession and in fact, profit margins are at historically peak levels. Finally, the Federal Reserve is attempting to perform a delicate operation, lowering interest rates without stoking inflation and dollar fears. Our worry is it may not have as much flexibility to lower rates as the economy needs or investors desire.
The market could continue to move upward as it has since 2002, but history shows that stock markets do not progress forward indefinitely without difficult and sustained corrections. The fact is we have not had a sustained correction in a very long time. Because of these concerns we have remained highly disciplined in our investment decisions, including the decision to maintain cash positions generally higher in comparison to other periods of time.
Although we have trailed our S&P 500 benchmark this year, most of the typical “value” investment strategies have underperformed the index as well. Saddle Peak is essentially a multi-capitalization, value investor. This strategy, as well as small and mid-cap value, has meaningfully lagged the S&P 500 this year. The variance was most notable in the third quarter. Growth portfolio managers are enjoying terrific returns. Thus, while one of our largest positions, Amgen, trades at what we consider an inexpensive multiple of earnings, the market focuses on Internet and tech giants such as Research in Motion, Google, Amazon and Apple. Even with their enormous market capitalizations, the market is betting that their accelerated growth has much further to go. We think that assumption entails enormous risk, and sooner or later something will shift the market back to a more balanced perspective between value and growth.
Saddle Peak lags the S&P 500 through the first 9 months of 2007. Although we remain very confident with our portfolio’s long-term potential, we are obviously disappointed with the results thus far this year. We believe that our underperformance is a function of a few factors. These include short-term declines in some of our larger positions and the decision to maintain a significant cash position. Because of our concentrated portfolio strategy, declines in larger positions can greatly affect short-term performance. Two stocks in particular, Amgen and Getty Images, are the most notable positions that have underperformed.
Amgen, the portfolio’s largest weighting, was impacted by several developments. In May, FDA guideline changes for cancer treatment induced-anemia resulted in significant CMS (Centers for Medicare and Medicaid Services) reimbursement adjustments. Potential competition from generic drugs has also worried investors. These factors helped drive Amgen’s shares from a high of $77 in the first quarter to a recent low of $48.
We remain very optimistic on Amgen however. Amgen’s product pipeline is world-class, robust, and includes a revolutionary treatment for osteoporosis. We believe that Amgen’s intrinsic value is meaningfully higher than the current share price given the company’s true earnings power, growth potential from the pipeline, and abundant free cash flow. The stock has rebounded somewhat to the mid $50 level since the start of October.
In regards to Getty Images, the company has faced some hurdles as its business and customer base have shifted increasingly into more Internet advertising. We are still optimistic with the long-term potential of the company for several reasons. Internet businesses with market dominance like Getty Images generate strong free cash flow. Historically, Getty Images’ management has demonstrated an ability to both innovate and grow the business. Finally, Getty Images could ultimately be an attractive acquisition candidate for a larger Internet player.
Cash positions throughout the year in the portfolio have ranged between 15% and 25%. Obviously, with the market’s advance this year, the cash has cost us relative performance as well. The cash position reflects our desire to find companies at good discounts to intrinsic value and the concerns we discussed above.
Saddle Peak’s current portfolio consists of 23 companies. We are value investors which means that we invest in companies that are trading at a discount to what we believe are their true underlying values. Our goal is to find undervalued companies that will over time reward our clients. While it is difficult to time the purchases of these companies, we believe that over time the stock prices will reflect their true intrinsic value.
An important investment fundamental at Saddle Peak is to preserve our clients’ capital in periods of heightened uncertainty. We continue to find good companies at reasonable prices, but given current market risks we steadfastly remain focused on our value investing principles.
Thank you for your continued support of Saddle Peak.
Sincerely,
Saddle Peak Asset Management, LLC
Doug Grey
Partner
