Q2 2010 Portfolio Summary

Each quarter, I will be writing a brief summary “letter” summarizing the performance of the WCC portfolio during the preceding quarter, as well as describing each of portfolio’s then-current holdings. I’ll also provide some very general market commentary but will not prognosticate about short term price movements, as I believe they are by and large completely random. This is the first of the quarterly “letters”.

Market Thoughts and Portfolio Performance:

During Q2 2010, the WCC portfolio returned -5.38% compared to -11.86% for the S&P500. For the first half of 2010, the WCC portfolio returned 13.52% compared to -7.57% for the S&P500, for a difference of 21.09%.

Since inception (1/22/2008) the WCC portfolio has returned 70.32% compared to -21.36% for the S&P500.

Note that the above return figures are the portfolio’s time weighted return compounded quarterly. This method strips out the distorting effects of cash deposits and withdrawals to create a useful comparison to indices or other money managers.

The second quarter of 2010 was extremely volatile as global macro concerns really dominated the discussion. We began the quarter with general optimism about an economic recovery, consumer spending and job creation, and ended the quarter far more pessimistic about the economy’s recovery (or the chance of a double dip recession), sovereign debt levels, sovereign debt defaults and the accompanying calls for fiscal austerity measures. I feel far more comfortable holding long term positions. During the quarter, we saw the prices of many cash rich blue chip American companies once again enter bargain territory - at quarter end Microsoft now trades at less than 10x, and Wal-Mart less than 11.5x forward earnings. Healthy small cap companies were driven to even lower multiples. For as much talk as there is about general market over-valuation, American blue chips are pricing in almost nonexistent growth over the coming ten years (inflation level EPS growth for Microsoft and Wal-Mart should result in solid returns over the coming decade at today’s levels). The market also appears to be ignoring the beneficial effect of recessionary cost cutting measures at market leading companies. The best American companies have been able to increase their bottom line without expanding the top line and as a result, bottom line growth should accelerate as we exit the recession and top line growth resumes. In sum, I think a buyer of blue-chip American companies at today’s levels should be rewarded over the coming decade

Stock Holdings as of 6/30/2010:

Greenlight Capital Re Ltd.: By a wide margin, the largest holding in the WCC portfolio at 39% is Greenlight Capital Re Ltd. (GLRE), the Cayman Island reinsurance company founded by hedge fund manager David Einhorn. As you can see, I don’t shy away from concentrated holdings but instead prefer them (its hard enough to find one good idea let alone many). The company writes reinsurance policies to various primary insurers and invests its float in Einhorn’s hedge fund Greenlight Capital. The company has the potential to be a compound return machine, benefiting from profitable underwriting (thus far), superior investment management thanks to Einhorn and his team, and no corporate level taxes. I began buying GLRE when it was trading in the $11s during the market crash, a price below its tangible book value. This bargain price didn’t last long and the stock now trades at a healthy premium to book and in the $26 range (the company’s investments through Greenlight Capital also performed well in the interim, increasing tangible book value substantially). While I am not purchasing additional shares at these price levels, I don’t intend to sell the stock and will hold until I believe it trades at an unsustainable multiple of tangible book. I hope this is in the distant future after GLRE is able to compound returns for a number of years. As I continue to deposit cash, GLRE’s weighting in the portfolio will decrease. Note that Einhorn has maintained a healthy level of skepticism about the equity markets and a large short portfolio. GLRE’s investment portfolio is up .6% on the year vs. a down market.

Goldman Sachs Group Inc.: At roughly 7.5%, Goldman Sachs Group Inc. (GS) is the second largest holding in the portfolio. I bought GS two times during the quarter in the mid $140s after the announcement of the SEC’s fraud case against the investment bank. GS now trades at slightly over its tangible book value and at a mid single digit trailing earnings multiple. I think it likely that the SEC’s case against the firm will result in a financial settlement which doesn’t damage the going concern value of the firm. I also think that the market’s pessimism surrounding the financial reform bill is over blown and the large investment banks will continue to be extremely profitable enterprises over the coming decade. I’d also note that one side effect of intense regulation in an industry is a weakening of smaller players with fewer resources, while strengthening and further entrenching the larger players (see Phillip Morris in the era of intense tobacco regulation). I wouldn’t be surprised to see GS’ market share grow over the coming decade as its lesser competitors struggle in heavy regulatory environment.

Becton Dickinson & Co.: At roughly 7%, the entrenched medical supply maker Becton Dickinson & Co. (BDX) is the third largest holding in the portfolio. BDX is an incredibly efficient company with an enviable market position and growth record which trades at very modest multiples due to concerns about the new health care regulations. BDX now trades at around 12x forward earnings and 7.5x EV/EBITDA despite a 10 year EPS growth rate of almost 17%. It maintains very high returns on assets in the mid teens and returns on equity in the low to mid 20s despite the use of little debt. Note that BDX is also a holding of Warren Buffett as well as David Einhorn’s Greenlight Capital. Often one’s best ideas are borrowed. I originally entered my position in BDX by selling long term put options. Following the recent market decline, I took a realized loss on the put option by repurchasing it (which should help come tax season) and purchased the stock outright. I may look to sell additional long term put options at some point in the near future.

Noble Corp: The offshore oil driller Noble Corp (NE) is the portfolio’s fourth largest holding at 6.4%. Following BP’s Deepwater Horizon disaster and the Obama administration’s moratorium on deepwater drilling, shares in the offshore drilling companies plummeted to mid single digit earnings multiples. NE is the second largest driller in the world after Transocean, and has a long term and very profitable relationship with Royal Dutch Shell. The company recently announced several new contracts with Shell as well as the opportunistic purchase of smaller competitor Frontier Drilling in a cash transaction. NE maintains a healthy balance sheet and is able to fund the Frontier acquisition with cash on hand and borrowings under its existing credit facility. While the drilling moratorium will certainly hurt NE’s earnings this year, only around 22% of the company’s revenues come from US waters so the company will maintain solid profitability. Long term, I think we may have no other choice but to continue our offshore drilling to meet our energy needs.

Yum Brands Inc.: At 6%, Yum Brands Inc. (YUM), the operator of Taco Bell, Pizza Hut, KFC and lesser known restaurants A&W and Long John Silver’s, is the fifth largest holding in the WCC portfolio. YUM is an incredibly successful business that generates terrific returns on assets in the mid teens and is growing at a brisk pace, particularly internationally where its brands (KFC in particular) arguably have more appeal than they do in the US. There are roughly 3x the number of KFC’s in China than McDonald’s. YUM is the sort of business I get very excited about. It’s capital light, simple, has sustainable brand appeal and terrific international growth opportunities. It’s certainly not the cheapest stock in the portfolio, at around 15x forward earnings or 18x trailing earnings, but I believe it remains undervalued given its potential for growing cash flow generation and scale.

International Business Machines Corp.: At 5.13% of the WCC portfolio, IBM is the sixth largest holding. This massive tech mainstay is firmly entrenched and has unmatched scale in delivering enterprise software and hardware solutions to the world’s companies and governments. While trading near an all time high price, it trades at a 10 year low multiple of earnings (around 10.5x forward earnings). CEO Samuel Palmisano has delivered and is currently delivering on his strategy of selling off commodity hardware business and developing high end and stickier software and services businesses. The company spits off an incredible amount of free cash flow which management has historically used both for massive stock repurchases and acquisitions. Mr. Palmisano has recently announced he expects the company to double EPS over the next five years. Note that while my stock holdings of IBM only represent roughly 5% of the portfolio, I’ve also sold a long term put on IBM expiring in October, effectively increasing the portfolio’s allocation to IBM.

Vodafone Group Plc: At around 4.8%, Vodafone Group Plc (VOD) is the smallest stock holding in the WCC portfolio. VOD is an enormous international mobile telecommunications network provider with dominant market positions in Europe, a large presence in India and Asia and the US with 45% of Verizon Wireless, a joint venture with Verizon Communications, Inc. The stock is cheap (trading at less than 10x earnings and an even more favorable price/free cash flow ratio), and even cheaper if one takes into account the unrealized earnings from its ownership of Verizon Wireless. (Under accounting rules, VOD doesn’t account for its share of Verizon Wireless’ earnings on its own income statement, but rather just any dividends paid by Verizon Wireless to VOD. Verizon Wireless doesn’t pay dividends to its parent companies now, but will likely begin paying dividends soon as it has or is near paying off inter-company debt to Verizon Communications, Inc.) As VOD pays over a 7% sustainable dividend, I am comfortable holding VOD and waiting for cash flow growth and/or multiple expansion.

Option Positions as of 6/30/2010:

In addition to the IBM put I’ve sold which I reference above, several diagonal call positions make up the remainder of the WCC portfolio. These positions, on Wal-Mart Stores, Inc. (WMT), Microsoft Corporation (MSFT), Phillip Morris International, Inc. (PM) and Kimberly Clark Corporation (KMB) are designed to generate return similar to a covered call, benefiting from a flat to slightly up market, but benefiting from the use of non-recourse leverage. These positions have been generally flat through a down market in Q2 2010.