The following describes the performance of the WCC portfolio for Q4 2010 and for the full 2010 year and describes the current positions in the portfolio.
Portfolio Performance:
During Q4 2010, the WCC portfolio returned 9.32% compared to 10.2% for the S&P500. For all of 2010, the WCC portfolio returned 35.60% compared to 12.78% for the S&P500.
Since inception (1/22/2008) the WCC portfolio has returned 103.44% compared to -4.04% for the S&P500.
The above return figures reflect 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 internal rate of return for the portfolio reflects a somewhat different return.
Market Thoughts:
During Q4, we saw equity markets continue to rise as economic activity appears to be picking up and concerns about a “double-dip” recession faded. Deflation concerns are lessening and bond yield are beginning to rise (from historical lows). Its now quite apparent that while unemployment remains high, blue chip corporate profits are experiencing a full-fledged recovery and many companies are in a stronger position than they were pre-recession. Record-low cost of debt capital combined with decreased labor cost structure and a focus on corporate efficiencies have increased margins. And now we’re beginning to see revenue growth. Extremely well run companies like IBM and Johnson & Johnson have been able to issue bonds with unreasonably low yields, adding low-cost leverage to their capital structures. While stocks are up, I continue to think that top-tier blue chip stocks remain reasonably priced (especially in the tech sector) with earnings yields in the 7-9%. Stocks look even more attractive when compared to treasuries and corporate bonds. In particular, I want to hold blue-chip stocks with strong international and emerging market operations - I want to be on the right side of an inevitable long-term depreciation of the US dollar against emerging market currencies. While there will certainly be ups and downs, the relative wealth of the United States and Western Europe vs. the rest of the world will almost certainly decline over the long term. That being said, American companies are the best-run in the world, and a top-tier American company with substantial international operations trading at a reasonable multiple seems to me to be the ideal long-term investment.
As the market continues to rise, I’ve begun to look for potential shorts of overvalued and challenged businesses. I’ve also explored a number of other ways of hedging downside risk in a cost-effective manner. If the market continues to inflate, it is likely I add some short exposure in 2011.
Stock Holdings as of 12/31/2010:
During Q3 and Q4, I began shorting levered short ETFs (a short of a short) as a long term investment, including DPK (a 3x short of the developed market index EFA), SDS (the 2x short of the S&P500) and QID (a 2x short of the NASDAQ index). I also own put options on each underlying index as a hedge against short term declines. Due to a mathematical phenomenon known as the “constant leverage trap,” levered ETFs are a disaster as a long term investment (especially when volatility increases). This conceptually makes sense - a levered ETF is forced to re-balance daily in a manner designed to perform poorly over the long term. When its underlying investments increases in value, the ETF adds leverage, and when its underlying investments decrease in value, the ETF decreases leverage. At their core, levered ETFs buy high and sell low. The end result is that while levered ETFs do accomplish their intended mission (which is to replicate 2x or 3x the return or inverse return of an index daily), over a longer period of time, they are practically designed to do worse than their intended purpose. By shorting the levered short ETFs, I’m on the right side of the constant leverage trap, while utilizing zero-cost leverage on a long-term investment. These positions in the aggregate now make up the largest holding in the portfolio. Note that as a short, as the underlying indexes rise and the positions make money, the investment will actually decrease in value and importance (unless I decide to add to the position). During the quarter, I sold the stock holding in Raytheon for a small loss to free up cash for these positions.
Greenlight Capital Re Ltd. (GLRE), the Cayman Island reinsurance company founded by long-short hedge fund manager David Einhorn, continues to be a very large holding in the portfolio at roughly 30% as of year-end. As I’ve discussed in the past, the company has a number of advantages designed to result in very strong compound returns over many years - no corporate-level taxes, a superior investment manager, seasoned and prudent underwriters and a low cost structure. While my original purchases of the stock in 2008 and 2009 were at below tangible book value (net asset value), the stock now trades at 1.25x to 1.3x book value, which I believe is a reasonable price, while no longer a bargain. Nevertheless, I have no intention to sell this holding in the short term, as I believe the company has the potential to benefit from high returns on equity over many years. Einhorn’s investments had another strong year in 2010, earning 11% with a portfolio only modestly net long.
Goldman Sachs (GS) is the third largest holding in the portfolio through both a stock position, and an outstanding cash-secured put expiring January 2012. While GS has risen in recent weeks, it continues to trade at a single-digit earnings multiple and is well positioned to capture banking and trading fees and revenue as economic activity picks up. GS’s legal challenges are subsiding, and while GS’s incredible franchise took some populist hits after the banking crisis, its reputation within the business community is unbeatable (see the new Facebook private placement), and it continues to hire the best and the brightest on Wall Street. As I’ve noted before, I wouldn’t be surprised to see GS’ market share grow over the coming decade as its lesser competitors struggle through new financial regulations.
Through cash-secured puts, expiring Jan 2012 (MSFT) and Jan 2013 (CSCO), each at the $30 strike price, Microsoft and Cisco Systems represent the fourth and fifth biggest positions in the portfolio (in terms of risk). Each trades a a low-teens earnings multiple (before taking into account massive cash balances), generates incredible free cash flow and is well positioned to benefit from a global boom in technology spending. In early November, CSCO’s stock stumbled from the mid $20s to the high teens after John Chambers delivered a disappointing outlook on a conference call. I believe the market largely overreacted, focusing (as the market often does) too much on short term factors, and ignoring the long term strength of the CSCO franchise, its free cash flow generation, and its valuation. Note that CSCO is also purchasing an enormous amount of its shares, one reason I like the risk-profile of the cash secured put.
Medical device maker Becton Dickinson & Co. (BDX) is the fifth largest holding in the portfolio. BDX’s stock price has drifted upwards along with the market, but continues to trade at a reasonable earnings multiple. As discussed in past posts, BDX has an entrenched franchise, a strong international business (roughly 60% of revs come from outside the U.S.), and generates high returns on equity utilizing limited debt. As discussed above, BDX is the sort of blue-chip, well run business with international operations that makes for a compelling long term investment. As long as BDX’s earnings multiple stays within a reasonable range, I do not anticipate selling any time soon.
Offshore driller Noble Corp (NE) is the sixth largest holding in the portfolio. NE’s stock declined in April and May in connection with the BP Deewater Horizon incident. Given that the company had no involvement with the incident, and that only a modest percentage of its business came from US waters (a little over 20%), the sell-off appeared to be a market overreaction. Notwithstanding an over 30% increase in price since my original purchase, the stock still trades at a single-digit earnings multiple. Oil prices have risen substantially as economic activity has increased, and it appears that we’re unlikely to reduce offshore drilling over the next several decades. Following the Deepwater Horizon incident, NE management also completed an opportunistic acquisition of a competitor, Frontier Drilling, at a depressed price utilizing its large cash balance. Given NE’s low earnings multiple, conservative capitalization, opportunistic management, and the prospect of increasing energy costs, I continue to like NE as a medium to long term holding.
The remainder of the portfolio is made up modest stock holdings of three very strong international businesses, Yum Brands, IBM and Vodafone, which I continue to like over the medium to long-term based on their cash flow generation and valuations. The Q2 2010 summary includes longer descriptions of these holdings.
