Letters
January 10, 2010
Dear Investor:
2009 was a great year for asset appreciation at Saddle Peak. While our job is to compound assets over time we are truly humbled by the performance that took place. We had several great ideas in 2008 and 2009, and thought we would be rewarded for them. However, predicting when returns will occur is very difficult. Today, we are focused on the future and compounding assets. The portfolio is a combination of past ideas and newer ones. The market will be the market. Our job is to add value by buying a dollar for less then a dollar.
| Saddle Peak Asset Management Performance | 4th Quarter (Net of Fees) | YTD (Net of Fees) | Since Inception (Annualized) |
|---|---|---|---|
| Saddle Peak Hedge | 7.91% | 96.80% | 11.56% |
| S & P 500 | 6.0% | 26.46% | -.67% |
THE MARKET
The market is often characterized by the level of the S&P 500 which currently trades at 1135. The market has traded from a high of 1576 three years ago to a low of 666 last year. Many investors get caught in the game of trying to predict the level of the S&P 500 and some even try to predict the path of the S&P 500. Both efforts require time and effort which in Saddle Peak’s opinion are not well spent. In contrast, we broadly value the index by approximating the index’s weighted normalized operating earnings times a range of multiples (based on the level of interest rates). The conclusion is that the market appears moderately undervalued today. Jeremy Siegel, the widely acclaimed professor of finance at the Wharton School at the University of Pennsylvania, has likewise written in detail on today’s undervaluation of the market. The importance for the investor is that the market will continue to fluctuate around the market’s intrinsic value. Some days like March of last year, at 666, the market is dirt cheap and other days like December of 2007 when the level was 1500 the market was overvalued. The investor should be greedy when others are fearful (panicking) and be defensive when others are optimistic (greedy). Going against human nature is the cornerstone of value investing. At Saddle Peak, we continue to be guided by this philosophy.
Saddle Peak’s Current Portfolio
Saddle Peak continues to be conservatively positioned with a combination of a large cash position and a quality driven portfolio. In contrast, the market has recently rewarded more risky stocks and asset classes. We have determined such stocks have not been worthy investments despite their short term performance. Their risks are very high for the long term investor. We acknowledge the cash position’s return will likely be small until it is invested. We need solid long term cheapness for investment. Our investment process is clear and investments will be made when cheapness occurs. We could use some fear in the marketplace. The vix and sentiment are just too optimistic given the real risks. Please keep in context we are optimists at Saddle Peak.
Our equity exposure continues to be somewhat diverse. Our largest weighting is in Cymer, a mid-cap company with a dominant position in the semiconductor capital equipment area. Its market share is above 70% broadly defined and above 80% more narrowly defined. It has a multi-year lead on the next generation of equipment which will be sold over the next decade. It has a large cash position. It earns high returns on employed capital. It has a large moat around its franchise. It is reasonably priced given its future earnings and cash flow. Thus, it became our largest position.
Our second largest holding is Pepsi with Coke right behind it. This weighing in high quality consumer stocks is difficult to criticize. Good long term investments should be difficult to criticize. It is true that such an investment is not glamorous, but we will accept solid returns. The critical question is why investors want to expose themselves to more risk in cyclical names versus such stable ones. Please consult your psychologist for the reasons. We don’t believe the returns justify the risks. For example, many investors look to China as the demand source for cyclical and commodity demand. We agree that China is currently a great source of marginal demand, but eventually they will be tough competition in many areas. OUCH! BYD, a Chinese battery and auto company, will be on US soil this year. Even in areas without direct competition economic substitution will limit the returns for commodities.
As we wrote in the third quarter, Wal-Mart has also become a large investment for Saddle Peak. Wal-Mart’s stock decline last year was perplexing to some. We accept sometimes the market can be irrational in the short term. What we know is that the intrinsic value for Wal-Mart continues to increase. Today, there is a large margin of safety. We standby the statement that Wal-Mart and the in-the-money call options should provide excellent returns without exposing us to capital risk. Sorry if we continue to be a little boring and consistent.
Likewise, we have sold or reduced the weightings of several investments. American Express and Starbuck’s are two great companies which have both substantially appreciated. In each case, as the price to value ratios have increased we reduced our weightings for each. In another case, we chose to sell our entire investment in Equity Residential when our estimate of its intrinsic value was reached.
On the exciting side, we have been researching numerous names some of which are close to purchase. A market interruption would give us such an opportunity. Saddle Peak is about picking stocks that are cheap. Our long-only performance in 2009 of 72% was without leverage and was all about picking cheap stocks. Long term, picking cheap stocks is the major way we will differentiate Saddle Peak from the crowd.
Thank you for your confidence and time,
Douglas W. Grey
