BLUEGRASS HOLDINGS
                              "Investing in Our Common Wealth"

Dear Valued Partner,

Your account ended 2009 at $###,###. A similar investment in our benchmark S&P 500
would be lower, by a large %; we won't sweat the details. These should be acceptable
results considering our benchmark still sits about 25% off its 2007 high and those that
panicked during the bottom (many of them the “professional” managers of everyone’s
mutual and pension funds) are so far behind that they may never catch up. Your account
is up some 300% from its nadir at the peak of the financial crisis ("sit in cash and pray for
the next crash" may well become our new mantra). This is also up 140% for the calendar
year, which puts us right at the top of all reported performances I’ve seen for 2009. It has
been an exciting and deeply humbling ride.

History is only enlightening if we take time to reflect on it, and after the ride we’ve had,
now is a good time to do so. A list of all of our realized gains and losses since May 2007
follows this letter. And mostly to indulge myself, I go into detail on a few of our past
ventures (all losses because they may have the most to teach us). But I explain these also
because I attempt to educate people that this is not some type of casino in which we
gamble. Investing is the determination of an assets value and attempting to profit when
the current price does not match that value. Price is what you pay; value is what you get.
Contact me and I’ll be more than delighted to go into detail on any of the others.


                        Arbitrage in the Energy Space: Bad Gas

Value - Burning one unit of oil releases exactly the same amount of energy as burning 6
units of gas. So theoretically crude oil and natural gas prices should have a 6 to 1 ratio.
The chart below shows that in reality this ratio does not always hold true, mostly because
oil is easily transported and its price is therefore set based more on global factors, while
gas prices are subject mainly to local factors. Thus the ratio fluctuates within a “fair”
range (~ 6-12x).

Price - The spike at the end of the graph represented a shift from beyond what I consider
a “fair” range. For a whole slew of purely economic reasons, this ratio was simply
unreasonable. The prices meant that either oil was too expensive or that gas was too
cheap. I believed gas was too cheap, which have proven to be the case, but instead of
making that wager, we took the “guaranteed” money and began selling oil and using the
proceeds to buy gas, thus locking in a profit that would be generated when the ratio
returned to “fair”. This process of selling an expensive asset and buying the same asset
cheaper is known as arbitrage. The “asset” we were arbitraging in this case was energy.

Results - We were buying gas near $3.50 and sold when it hit $6 for a 71% gain. We
borrowed oil and sold it at $62 and then bought it back for $78 and returned it for a -26%
loss. Thus the arbitrage profit should have been for net gain of 45% over a period of 6
months. Now that’s “fair”! And so the thesis of this investment played out completely as

Life, however, is not always fair and we got burned by how we put our theory into
practice. The instrument we used to make our bet on gas prices, turned out to be “bad
gas”. This instruments stated purpose is “seeking to replicate the performance, net of
expenses, of natural gas,” but obviously they sought in the wrong place, way or we can
give them the benefit of the doubt and blame it on the regulators who intervened on how
this instrument operates and possibly screwed that up too (I’m not fond of the
government intervening in the markets, by the way).

The implications being that while gas prices increased 71%, our means of tracking the
price declined 20%. To an accountant this means we lost 20%, ho-hum, to an investor
this means we lost at least 91% (the actual loss plus what should have been a gain), but
we could go on to add what we’d have made on that additional money or what other
investments would have returned had we not had our money in this one and so on. In
other words, this hurt a lot.

In a world where great investment ideas are hard to come by, it almost sickens me to find
a great one, to act upon it, to be proven correct and then after all that to lose your money.
I can’t bear to talk about it anymore, so I’ve added the charts that tell the story. Where
you see the finger in the charts is where we bought. We closed out the trade at the end of
the year to harvest the tax loss.

Actual Natural Gas Price

Natural Gas Tracking Instrument

Actual Oil Price

Oil Tracking Instrument

                                    A Cinderella Story

There are only so many truly great businesses in the world. And as the world becomes
smaller and moves faster the statistics show that corporations last shorter spans of time.
All the great buggy manufacturers and oil lamp producers of their time fell by the
wayside or were replaced by new technologies or were rolled into some other entity. GE
is the only company currently in the Dow Index that was there 100 years ago (and they
just recently maintained that honor only by way of being bailed out).

Because of the fallibility of business endeavors, when one shows up in the world that
grows and grows and grows and appears to have all the staying power of a truly great
business, it is reasonable that people place a relatively high value on this asset and pay an
equally high price. Affiliated Computer Services (ACS) is one of these phenoms. ACS
was founded in 1988, went public in 1994 at $4.50 a share and 16 years later just reached
an all-time high of $65. During the worst economic crisis of its lifetime, this $6B+
business has actually been able to grow its sales. All signs of a valuable and enduring

We first bought into ACS at prices around $58 in Jun 2007 in the midst of a
founder/chairman led buyout. The founder owned 42% of the company, so the deal could
not get voted down and had the offer had just been raised to $62 a share. The deal was
supposed to go through in a short matter of time, so the idea was to trade large quantities
for small profits on daily stock price fluctuations. An offer had also been made for the
company in 2005 around the same $62/share and the total price, yielding 9% (~$550MM
a year in free cash flow for $6B), seemed fair for one of the world’s great businesses.

The world was in the midst of an M&A boom, driven by cheap and easy credit, allowing
us to profit in the same way from several other opportunities. After the first hedge fund
blow up due to subprime mortgages in Feb 2007 the credit market slowly began to thaw
(this was a Bear Stearns fund, coincidentally, as they were also the first investment bank
to blow up). And right about the time we got all in on this deal, subprime had fully reared
its ugly head and the buyout partners could not get the credit needed to consummate the
deal. The stock instantly cratered as all the people looking for a quick buck just like us
took their money and ran. We bought more as it fell, knowing that the value was still
there and hoping to be redeemed, but the waiting is the hardest part. So we took our loss.

We now sit here, 2 and a half years later, almost back to the heights we reached before
taking our losses on ACS. At the same time Xerox has recently come out with what will
be the final offer for this long coveted asset, paying ~$65/share. So wouldn’t you know
that after all that turmoil and toil between then and now, had we just stayed where we
calculated there to be value, we’d be at an all-time high too. I just grin and bear it. When
you spot Cinderella at the ball, you can rest assured she’ll find a suitor before turning into
a pumpkin!


I discussed this one briefly in a previous letter, and the point is simple so I will be brief
here again. A buyout we were involved in fell apart because the purchaser happened to be
linked to the 2nd largest Ponzi scheme in history, behind Madoff. The assets were still
good and about to get better as a new product cycle was about to unfold in their business
space. On top of that they had a ton of cash and minimal debt. The failed offer was made
at $62MM, but after this fell through a competitor swooped in with a $39MM bid which
was accepted by the clowns running the circus. If I recall this was almost the net cash our
company had in the bank. My original comment was, ”I do feel our board accepted a low-
ball bid either out of weariness, feelings of desperation or both and we suffered as a
result.” At the time we got robbed, our acquirer was selling for $58MM, pricing the
combination at $97MM. I believe I am vindicated in my beliefs as the combined
company is now being acquired only a year later for $217MM. That is mathematics of
taking two cheap companies, putting them together and selling them for the price of three.

                                   Collecting Premiums

You will see on the second half of the realized gains and losses the section titled “Short
Activity”. These are the returns we have made by “shorting” stocks. As far as I can tell,
the practice of shorting is completely foreign to the general public, the government, the
academics, the “professional” money managers and everyone else who tries to grasp the
concept. I might suggest that is why there is so much green on that section of the report,
but I’m not convinced any of those parties know how to invest the other way either.
Simply put, shorting is betting that the price of an asset with decline.

Often times we use this as an “insurance” against general movements in the market.
Since we have just learned from the recent crash that when the market goes down, all
stocks go down, not just the ones that should, it is nice to have profits to take at the
bottom that can be rolled into the stocks that should not have gone down. Since our net
on this side of the list is a gain, this insurance has essentially paid us the premiums. So
we were able to have our cake and eat it too.

There four losses on the short activity are easily explained. One was part of our energy
arbitrage and it did not matter if this was a loss because it should have been offset by a
gain in the natural gas side, in theory at least, as explained above (I hate having to sound
like those professors I berate so much, but really, this was different.) The other three
loses were simply a matter of not being able to bear the losses. Shorting is dangerous
because the potential losses are actually unlimited, while the upside, barring any use of
leverage, is only 100%. In the end though, all three of those stocks went from around $30
when we were shorting them to around $2 dollars. One is now at $0.73, another at $5 and
the other has worked it way back up to $12. We were spot on in our analysis, just dead
wrong on how much pain we could bear.

*Quick aside on shorting, because it has to be defended these days: The government went
as far as banning the practice at the height of the crisis. They don’t even know what the
hell it is! I’d love to hear them offer up an explanation of the practice. It was a modern
day witch hunt and the shorts got singled out because no one even knew what they were
doing. Did you hear about the plane that emergency landed because of a Jewish prayer?
Not sure how but it’s so ridiculous that I’m sure it relates. Did the companies we shorted
approach bankruptcy because we did so? No, it was because they were run on unsound
economic principles by incompetent managements. Do shorts spread rumors to try and
decrease prices? Surely! Do buyers of stocks spread rumors to increase prices? That’s
rhetorical, but no one ever outlawed buying stocks because of it. The smartest guys in the
room were all the ones shorting stocks. They tried to warn everyone well in advance but
no one really wants to understand why or what or how. The average Joe just wants the
plane to land immediately and to have the guy doing something strange put out.


I detailed some of our losses here in hopes of not repeating the same mistakes. The one
high side to any of our investments, wins or losses, is the knowledge gained in the
process. We now know more about the natural gas industry than probably 90% of the
people in the world. The failed ACS deal was almost a full year before the masses would
fully realize there was a massive problem in the markets. The cost was high, but the
losses we took on this investment alerted us early to what was coming. We know about
the healthcare technology product cycle because of the other failed merger mentioned.
And we know how to short stocks, unlike seemingly 99% of the world. I even recall your
accountant not knowing how to account for a short sale, the guys been in business for
decades and must have never seen it done before. Insights like these are the hidden
compounding interest that one gains through a lifetime of investing. And it is likely they
will pay dividends in the future.

As far as the markets and world economies are concerned, they are all still a mess. We
are all the way back to overvalued in almost every asset class around the world. From
these levels, only the most discerning of investors will make fair returns for some time
out. We like to think of ourselves as discerning and hope we will be rewarded as such.

Just found an interesting historical read that has so many ties to today and shows how
situations repeat themselves again and again. One thing you won’t know from the story
though is that surviving entity led to the greatness that was ACS. You just can’t make this
stuff up!
S&L Crisis Story


Spencer Chambers, General Partner


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