Whitney R. Tilson and Glenn H. Tongue phone: 212 386 7160
Managing Partners fax: 240 368 0299
January 4, 2011
We hope you had wonderful holidays and wish you a happy new year!
In each of our annual letters we seek to frankly assess our performance, reiterate our core investment
philosophy, and share our latest thinking about various matters. In addition, we discuss our 12 largest
long positions so you can better understand how we invest, what we own and why, and why we have so
much confidence in our fund’s future prospects.
Our fund had a solid year, though due to a lethargic last four months we ended the year trailing the S&P
500 for only the third time in our 12-year history (all three times, our underperformance was in single
December 4th Quarter Full Year Inception Inception
T2 Accredited Fund - gross 0.3% -4.0% 12.9% 260.8% 11.3%
T2 Accredited Fund - net 0.3% -3. 3% 10.3% 184.9% 9.1%
S&P 500 6.7% 10.8% 15.1% 26.5% 2.0%
Dow 5.3% 8.0% 14.1% 65.7% 4.3%
NASDAQ 6.3% 12.2% 17.8% 24.8% 1.9%
Past performance is not indicative of future results. Please refer to the disclosure section at the end of this letter. The T2 Accredited Fund
was launched on 1/1/99. Gains and losses among private placements are only reflected in the returns since inception.
This chart shows our performance since inception:
Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11
T2 Accredited Fund S&P 500
The GM Building, 767 Fifth Avenue, 18th Floor, New York, NY 10153
Overview of 2010
We had four huge winners in 2010, each accounting for more than four percentage points of return (in
descending order of contribution): General Growth Properties, our biggest winner for the second year in
a row, which emerged from bankruptcy as two companies; Berkshire Hathaway, thanks to our big bet
early in the year that the stock would be added to the S&P 500; Liberty Acquisition Corp. warrants,
which skyrocketed when the merger with Grupo Prisa was consummated; and BP, in which we correctly
anticipated that the company would weather the Gulf of Mexico crisis.
We had no losers of note on the long side – the biggest was Winn-Dixie, which fell 28.5% and cost us
0.6% of performance – but we took quite a beating on the short side. Among the most costly shorts,
each costing us more than 1% of performance, were Netflix, MBIA, DineEquity, and Lululemon
Athletica. We short both to make money and protect our portfolio from a market downdraft, but in 2010
we only succeeded in the latter, as we discuss further below.
Our first priority is always capital preservation, so we are usually playing defense, even if this means we
sometimes trail the market when it’s ripping upward. On rare occasions, however, in periods like late
2008 and early 2009, the market offers enough opportunities that we can go on offense and practice get-
rich-quickly investing. We wish we were in such a period today, but don’t believe we are. Instead, we
are in a time of “unusual uncertainty” (to quote Ben Bernanke), yet the market is complacent, so we
think it’s prudent to be quite defensive, both by maintaining a robust short book and also, on the long
side, by focusing on big-cap, blue-chip stocks with strong market positions, cash flows and balance
In every year-end letter we repeat our performance objectives, which have been the same since our
fund’s inception (no changing the rules in the middle of the race): Our primary goal is to earn you a
compound annual return of at least 15%, measured over a minimum of a 3-5 year horizon.
We arrived at that objective by assuming the overall stock market is likely to compound at 5-10%
annually over the foreseeable future, and then adding 5-10 percentage points for the value we seek to
add, which reflects our secondary objective of beating the S&P 500 by 5-10 percentage points annually
over shorter time periods. While a 15% compounded annual return might not sound very exciting, it
would quadruple your investment over the next 10 years, while 7-8% annually – about what we expect
from the overall market – would only double your money.
Since inception 12 years ago, we have not met our 15% objective, thanks in part to one of the worst
periods ever for stocks. We have, however, outperformed the S&P 500 by 7.1 percentage points per
year, near the midpoint of our 5-10 percentage point goal. There are few funds that have beaten the
market by this margin over the past dozen years, but nevertheless we are not satisfied with our
performance and aim to improve it.
In light of our objectives, we’d give ourselves a B for the year. To understand why we give ourselves a
good grade, despite neither earning a 15% return nor beating the market, one must understand how we
approach managing our fund. We do not trade rapidly in an attempt to get rich quickly; rather, we are
content to get rich slowly while investing conservatively, with a primary focus on capital preservation.
As evidence of this, consider the four months in 2010 when the S&P 500 (with dividends reinvested)
declined: January (-3.6%), May (-8.0%), June (-5.2), and August (-4.5%). During these months, the
S&P 500 declined 19.7% in total – but our fund was down a mere 1.3%. During the other eight months
when the market rose, our fund did okay, gaining 11.8%, but this trailed the market’s 43.3% return.
In summary, we earned a double-digit return while simultaneously being positioned very defensively,
which is satisfactory to us.
Why We Missed the QE2 Rally
The fact that our house didn’t burn down doesn’t mean that we regret having bought insurance.
However, with the benefit of hindsight (which is always 20/20), we bought too much insurance. As a
result, we went from crushing the market over the first eight months of 2010 to ending the year trailing
it. The market is really quite remarkable in its ability to keep you humble. Just when you’re feeling
really smart, it tends to come along and kick you in the shins, which is what happened to us during the
last four months of the year.
As we discussed in recent monthly letters, our underperformance wasn’t due to bad stock picking – even
on the short side, we’d argue that in most cases we made investments that have moved against us
temporarily, not permanently – but rather due to completely misreading the short-term impact of the
Fed’s second round of quantitative easing (so-called “QE2”). We interpreted the Fed’s move as
validating our assessment that the economy continued to suffer from many areas of weakness, most
notably a terrible housing market and persistently high unemployment, and questioned whether QE2
would achieve its objectives – both of which made us cautious about the market. As a result, we
continued to position our portfolio somewhat defensively, which turned out to be precisely wrong as the
market jumped 20.6% in the last four months of the year. The gains were driven by the frothiest, most
speculative stocks, which are precisely the ones we tend to be short, so our profits on the long side were
offset by losses on the short side such that we missed this big rally.
The market surge was driven by two factors: fundamentals and froth. Regarding the former, while
unemployment remains a vexing problem, corporate earnings have been strong and the overall economy
is showing some signs of life. That said, the data remains mixed and we still think the “muddle
through” scenario we outline below remains the most likely outcome over the next 2-7 years: “weak
GDP growth (1-3%), unemployment remaining high (7-9%), and continued government deficits. Under
this scenario, the stock market would likely compound at 3-6%.”
A bigger driver of the market’s upward surge, we believe, is froth: the expectation (followed by the
implementation) of QE2 triggered a “don’t fight the Fed” burst of optimism across the market and, in
particular, a speculative orgy among the most popular momentum stocks, which ripped upwards,
irrespective of valuation. It is nothing short of mind-boggling that a mere two years after utter panic and
paralysis in the market, animal spirits have returned and reckless risk-taking is occurring in many areas
of both the debt and equity markets. We think this will end badly and we will not participate. As
Buffett once wrote: “We have no idea how long the excesses will last, nor do we know what will change
the attitudes of the government, lender and buyer that fuel them. But we know that the less prudence
with which others conduct their affairs, the greater the prudence with which we should conduct our own
Nobody likes being left out while a big party is going on – but sometimes that’s the price a prudent
investor must pay for long-term outperformance, so it’s important to put four months of sideways
performance in the context of the results our fund has delivered over time.
Thoughts on Shorting
Our long portfolio (discussed at length in Appendix A) performed beautifully in 2010, but we incurred
significant losses in our short portfolio for the second consecutive year, so we’d like to discuss it further.
The first question to address is why do it at all? Shorting is an awful business, for 11 reasons we
highlighted in the chapter on shorting from our book, More Mortgage Meltdown: 6 Ways to Profit in
These Bad Times (see: www.tilsonfunds.com/ShortingMMM.pdf). Yet we still do it for reasons we
outlined in the January 2006 edition of Value Investor Insight. Here’s an excerpt:
Given the long-term upward trend in equity prices and frequent bouts of excessive investor optimism –
“Markets can remain irrational longer than you can remain solvent,” John Maynard Keynes once warned
– one might ask why make bearish bets at all. This question is particularly relevant to us given the money
we’ve lost in this area over the past couple of years.
After carefully studying our experience, we’re not swearing off negative bets for two main reasons: First,
we still think we can make money on them. In addition, they remain a great tool for hedging against
…[In addition,] 1) It reduces risk, defined as the permanent loss of capital; 2) In the event of a major
correction, it will provide us with substantial cash to invest at bargain prices, thereby enhancing returns;
and 3) It allows us to remain invested in certain stocks we otherwise might sell prematurely, which also
should enhance returns.
All of these reasons were on display during the market crash from late 2007 through early 2009. Our
short book not only protected us from huge losses during the decline, but also allowed us to invest
aggressively at the bottom, so it materially contributed our returns during the rebound.
Of course, in a perfect world, we would only be short just before major market declines, but we’re not
good enough market timers to do that. In truth, we hope to break even on our short book when the
market is going up, in which our good company and industry analysis offsets the general rising tide of
the market, and make a lot of money when the market is tumbling.
Our favorite shorts generally involve one or more of the following characteristics: outright frauds (our
very favorite), industries in decline or facing major headwinds, lousy or faddish business models, bad
balance sheets, and incompetent, excessively promotional and/or crooked management. In general, we
prefer to short businesses with these traits, even when their stocks trade a seemingly low valuation
multiples, rather than shorting the stocks of good businesses with strong managements, even at high
valuations. Sometimes, however, the valuations become so extreme that we will short the latter, but
generally only when we believe there is a catalyst that will impact the company and cause the stock to
Our Current Short Book
Given the recent losses in our short book, are we ready to issue a mea culpa, cover the shorts that have
hurt us the most, and get on board the momentum bandwagon? In a word, no (though we carefully
manage risk, in part through position sizing, so we’ve trimmed some of our short positions and/or
converted them to put options).
We’ve carefully analyzed our entire portfolio, especially the stocks on which we’ve lost money in our
short book, looking for a position we wouldn’t hold if we were reconstructing our portfolio from scratch
– and can’t find a single one. We don’t hold losing positions in a desperate and irrational attempt to try
to make back what we’ve lost. The price at which we initially established a position, the amount of our
losses to date, and whether we will ever make back these losses are completely irrelevant to our decision
to hold a position today.
Our 10 largest short positions going into 2011 reflect the different types of opportunities we find on the
short side (in alphabetical order): AIG, homebuilders (various plus an ETF), InterOil, ITT Educational
Services (and other for-profit education companies), Lender Processing Services, Lululemon Athletica,
MBIA, Netflix, Salesforce.com, and St. Joe.
We believe our short book represents a win-win right now: it should provide excellent protection in the
event of a general market downturn, but even if this doesn’t occur we still think we’ll make money on it.
In fact, we’ll go so far as to say that, after the recent burst of froth, foolishness and speculation, we think
our short book is the most attractive it’s ever been, with the exception of early 2008.
Speaking of which, it might interest you to know that the last time we suffered such big losses in our
short book and felt like covering everything was in late 2007. But after evaluating each position at that
time, we weren’t willing to cover things like MBIA, Ambac and Lehman Brothers around $70, or Allied
Capital and Farmer Mac around $30 – and thank goodness we didn’t!
How We Manage Positions That Move Against Us
Since we rarely buy a stock at the very bottom or short one at the very top, having a position move
against us, at least initially, is a common occurrence. When this happens, we reevaluate our analysis
and investment thesis and make one of three decisions: add to the position, do nothing, or trim/exit.
Making the right decision here is critical – it’s often more important than the initial investment decision
– and there’s no easy answer or rule of thumb. (In our experience, we’d guess that we add to a position
40% of the time, do nothing 40% of the time, and sell/exit 20% the time.)
It’s often a hard decision, both for fundamental and emotional reasons. Regarding the former, the fact
that a stock’s price has become more attractive doesn’t necessarily mean it’s a better investment. A
stock typically moves because something has happened to the company, industry or world, so the
change in the fundamentals must be weighed against the change in the share price.
The emotional side can be even more difficult. Numerous studies of investor behavior show that once
an investor has a position in a stock, there are tremendous biases to seek confirming information, ignore
disconfirming information, and not admit a mistake. We don’t claim to be immune from these
emotions, but we’ve studied them extensively and do our best to block them out. One of the simplest
techniques we use is to ask ourselves, “If our portfolio were 100% cash and we were investing from
scratch, would we establish this position and, if so, how big would it be?”
While we always keep open minds, look for contrary opinions, and are willing to admit mistakes, we are
also very stubborn when we’re convinced we’re right. To quote Ben Graham, we view the market as
our servant, not our guide, so we are unperturbed when one of our positions moves against us. As value
investors, we make money by betting against the consensus view – by deviating from the herd – and, of
course, being right more often than wrong. It’s hard enough to be right on the fundamentals and then
also get the timing exactly right as well, so we find that we’re often early – but our experience is that we
are usually rewarded for our patience and willingness to endure short-term, mark-to-market pain.
Netflix and Why We Sometimes Go Public With Our Analyses
Netflix was our biggest loser in 2010, so it’s a good case study of what we do when a position moves
against us. First, to manage risk we trimmed our short position as the stock rose and replaced part of it
with put options, so that we can only lose the amount we paid for the option (vs. shorting, where losses
are potentially unlimited).
Then, we wrote up our investment thesis in great detail and, after sharing it first with our investors,
published it (see http://seekingalpha.com/article/242320-whitney-tilson-why-we-re-short-netflix). This
is unusual for a number of reasons: most hedge funds maintain a low profile in general and certainly
don’t speak or write in detail about any particular stocks. And to the extent they do, they certainly don’t
talk about short positions and/or stocks in which they’ve lost a lot of money.
So why did we take this unusual step? It’s not for marketing or ego reasons, nor is it an attempt to move
stock prices so we can exit at a better price – we are value investors, not traders, and harbor no illusions
about our ability to move markets. Rather, it helps us make money, in four primary ways:
1) It helps clarify our thinking to put our investment thesis in writing, especially on complex and
controversial positions. For example, on June 11th we published an 11-page analysis
(www.tilsonfunds.com/BP.pdf) of why we were buying BP’s stock amidst the panic at that time
(it was then at $33.97 and closed the year at $44.17).
2) When it is widely known that we have a position in a particular stock, we often hear from other
investors who share valuable information or analyses.
3) Invariably, some people have the polar opposite view of a particular stock and, in sharing it with
us, they can help us identify things we might have missed in our analysis. If information or
analyses exist that would cause us to change our view, we want to hear about it!
4) When we share our ideas, it creates reciprocity and others share their best ideas with us.
In the case of Netflix, we think it’s particularly healthy to disclose and fully analyze our mistakes
(although in this case we are not yet conceding that we’ve made a mistake in our analysis, but we
obviously made a mistake in terms of timing our entry into the position).
Our analysis of Netflix generated much more attention than we anticipated, which resulted in dozens of
emails with great feedback, both agreeing and disagreeing with us, which is what we’d hoped for. The
most interesting feedback, which we hadn’t expected, was from the CEO of Netflix, Reed Hastings, who
emailed us in a friendly way, saying he had no problem with short sellers, but disagreed with our
analysis and published an open letter telling us why we shouldn’t be short his stock
your-short-position-now). He made some good points and it helped us learn more about him and his
company – and we appreciated his friendly tone (other CEOs should take note that, if one is going to
respond to a short seller, this is the best way to do it…). He sure makes it tough to be short his stock –
he’s been a great CEO and how do you not like a guy who served in the Peace Corps for two years in
As we made clear in our letter, we think highly of Netflix, just not its valuation – and as value investors,
price matters a lot. If we were to summarize the main deficiency in Hastings’s letter and nearly all of
the bullish-on-Netflix emails we’ve received, it’s that there’s no discussion of valuation. They would
read the same if the stock were trading at 15x earnings or 75x earnings…but from our point of view, that
5x valuation gap is the difference between a great long and a great short.
A final step we took was to ask our friends who are Netflix subscribers to fill out a short online survey
(see www.surveymonkey.com/s/N9ZLZVS) to tell us about their experience with the company, in
particular its new streaming service. To date, over 380 people have filled out the survey. We’re still
analyzing the results, but can say that the most important insight so far is that Netflix subscribers appear
to like the streaming service more than we expected, despite the weak content library, viewing it as a
good value because of Netflix’s low, all-you-can-watch monthly price.
With Netflix, as with all of our investments, long and short, we’re always testing our investment thesis
by collecting and analyzing new information and viewpoints. If we conclude that our thesis is weaker
than we thought (or flat out wrong), we quickly adjust our portfolio accordingly.
We hesitate to share our big-picture views because one might come to the mistaken conclusion that
we’ve abandoned our bottoms-up stock picking and industry analysis that has been (and always will be)
the core of what we do. But the biggest lesson for us over the past two years is that our estimates of
intrinsic value, which are generally rooted in estimates of future cash flows, aren’t worth much if the
economy and/or financial system fall apart. Thus, we build our portfolio from the bottom up, based on
company- and industry-specific analysis (which we discuss in depth in Appendix A), but when
determining overall portfolio positioning we do factor in our macro outlook and adjust our portfolio
Our net long exposure has ranged over the past two years from a low of 20% in early 2010 (90% long,
70% short) to 90% in early March 2009 (120% long, 30% short), and today we are closer to the more
conservative end of that spectrum at 40% net long (100% long, 60% short).
We don’t know for sure what the future holds for the U.S. economy and stock market, but overall we
remain cautious. Our best guess is that the economy will face significant headwinds for a number of
years, mostly due to the aftershocks of the bursting of the greatest asset bubble in history. The major
concerns we have include:
Interest rates have risen materially, despite QE2’s primary aim to lower interest rates. 10-
year Treasuries rose from 2.47% at the end of August to 3.38% at the end of year (a 37%
increase), and 30-year Treasuries rose from 3.52% to 4.43% (a 26% increase);
The jump in interest rates largely reflects growing optimism about an economic recovery, but
also creates a headwind for the housing market, which was already feeble and on government
life support. The housing market has worsened recently, with sales and prices weakening;
The economy has failed to produce enough jobs to keep up with the growth of the job
market, resulting in unemployment rising from 9.6% to 9.8% in recent months;
Corporate profits have been strong, but this is mainly due to cost cutting, not robust demand,
so further profit gains may prove elusive, especially if commodity prices continue to surge;
American consumers, who account for 70% of GDP, are under enormous pressure due to
severe job losses and hours being cut back, the collapse in housing prices, and the need to
deleverage after decades of excessive consumption and declining savings;
Continued high levels of fiscal and monetary stimulus combined with unaffordable pension
and healthcare promises made to millions of people will lead to large deficits and enormous
budgetary pressures on governments at all levels;
The European sovereign debt crisis reared its ugly head once again, requiring a bailout of
Ireland and raising fresh concerns not only about Portugal and Greece, but also Spain, Italy
and Belgium; and
Last but not least, South Korea (the world’s 15th-largest economy) was shelled by North
Korea, the world’s most unstable, unpredictable and dangerous regime, dramatically raising
tensions in one of the most volatile areas of the world.
In light of these factors, we believe that we are in uncharted waters and there is a very wide range of
possible outcomes over the next 2-7 years. Broadly speaking, they fall into three scenarios:
1) A V-shaped economic recovery with strong GDP growth (3-5%), a falling unemployment rate,
and reduced government deficits. Under this scenario, the stock market would likely compound
2) A “muddle-through” economy with weak GDP growth (1-3%), unemployment remaining high
(7-9%), and continued government deficits. Under this scenario, the stock market would likely
compound at 3-6%.
3) A double- (and triple-, and quadruple-) dip recession where periods of growth are followed by
periods of contraction, with no overall GDP growth, unemployment around 10% (with the actual
level higher due to people giving up looking for work), and large deficits as the government tries
to stimulate the economy (but with little impact). Under this scenario, which looks like what
Japan has gone through for more than two decades, the stock market would be flat to down.
Both as investors and as Americans, we’re of course hoping for the V-shaped economic recovery, but
think that the “muddle-through” scenario is most likely. Weak GDP growth is not a catastrophe – it was
only a short while ago that we were facing the very real possibility of Armageddon, the chance of which
has receded materially, thank goodness – but it will likely keep a lid on corporate profit growth and the
The stock market, however, as we discuss below, is now priced for the V-shaped scenario, as if the seas
are calm and the skies are clear. Hence, we are positioning our portfolio more conservatively, trimming
some of our longs, adding to our short book, and increasingly shifting our long portfolio into big-cap,
strong-balance-sheet, dominant-market-position blue chips like AB InBev, ADP, Berkshire Hathaway,
Kraft and Microsoft, as well as shorter-duration, special situation investments like General Growth
Properties, BP, and Grupo Prisa (all discussed in Appendix A).
For further background on the risks that exist, we’ve attached insightful letters by two wise investors,
Bill Gross and Jeremy Grantham. Here’s an excerpt from Gross’s letter (see Appendix B):
Investors are faced with 2.5% yielding bonds and stocks staring straight into new normal real growth rates
of 2% or less. There is no 8% there for pension funds. There are no stocks for the long run at 12% returns.
And here’s the opening paragraph of the excerpt from Grantham’s letter (see Appendix C):
The idea behind “seven lean years” is that it is unrealistic to expect to overcome the several problems
facing most developed countries, including the U.S., in fewer than several years. The purpose of this
section is to review the negatives that are likely to hamper the global developed economy, especially from
the viewpoint of how much time may be involved.
Here are Grantham’s 10 “negatives that are likely to hamper the global developed economy” and lead to
“seven lean years”:
1. Over-indebtedness of consumers in certain countries, including the U.S., the U.K., and several
2. Dangerously excessive ﬁnancial system debt was moved across, with additions, to become
dangerously excessive government debt
3. We have lost a series of artiﬁcial stimuli that came out of the steady increases in debt levels and
the related asset bubbles
4. Very bad things may lie ahead in Europe, and banks in general are undercapitalized and reluctant
5. Runaway costs in the public sector, particularly at the state and city levels, have run into a brick
wall of reduced taxes
6. Unemployment is high and will also suffer from the loss of those kickers related to asset bubbles
7. Trade imbalances and the explosion of domestic sovereign debt levels
8. Incompetent management in Spain, Greece, Portugal, Ireland, and Italy allowed the local
competitiveness of their manufactured goods to become 20% or more uncompetitive with those
9. The general rising levels of sovereign debt and the particular problems facing the euro bloc and
Japan are leading to the systematic loss of conﬁdence in our faith-based currencies
10. Widespread over-commitments to pensions and health beneﬁts
We would underscore #9 and note that while the current focus is on Europe, we think Japan (with a GDP
that is 3x larger than Spain and Portugal combined) could be a wild card. Its ratio of sovereign debt to
GDP, at 225%, is nearly double that of Greece, Italy or Ireland, and as Japan’s economy continues to
stagnate while its population ages, the situation looks to worsen rapidly. Low interest rates and the
ability to fund deficits entirely with domestic savings have allowed Japan to put off the day of
reckoning, but both of these factors are changing. The possibility of a sovereign debt crisis in Japan
reminds us of what Alexis de Tocqueville once said: “Events can move from the impossible to the
inevitable without ever stopping at the probable.”
If stocks were as cheap as they were in March 2009, we wouldn’t let our macro concerns deter us from
buying aggressively, but they’re not, as the markets have rallied substantially from the lows of early
2009. To see how expensive stocks in general have become, consider this chart, which tracks the P/E
multiple of the S&P 500 based on inflation-adjusted average earnings over the past 10 years (we’re
skeptical of valuation methodologies that use estimates of future earnings, which are usually far too
optimistic). One can see that the S&P 500, at 22.7x, is trading at a 39% premium above its 130-year
average of 16.3x, which reinforces our view that while we don’t think stocks are extremely expensive,
they’re far from cheap.
Long-term P/E Current
40 average: 16.3x P/E: 22.7x
Long-Term Interest Rates
Cyclically Adjusted 10
30 P/E Ratio
Interest Rates 2
1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Source: Stock Market Data Used in “Irrational Exuberance” Princeton University Press, 2000, 2005, updated, Robert J.
Deliberate Practice and Review
We recently read an excellent book, Talent Is Overrated: What Really Separates World-Class Performers
from Everybody Else, by Fortune magazine’s Geoff Colvin. In it, he argues convincingly that world-
class performers in a wide range of areas – from sports, to music, to academia and, yes, to investing –
aren’t born with innate supernatural gifts, but rather become great through a series of specific steps,
most importantly, a lot of hard work and “deliberate practice.” This excerpt really resonated with us,
because it’s exactly what we try to do to become better investors over time:
The best performers observe themselves closely. They are in effect able to step outside themselves,
monitor what is happening in their own minds, and ask how it’s going. Researchers call this
metacognition – knowledge about your own knowledge, thinking about your own thinking. Top
performers do this much more systematically than others do; it’s an established part of their routine.
Metacognition is important because situations change as they play out. Apart from its role in finding
opportunities for practice, it plays a valuable part in helping top performers adapt to changing
conditions…[A]n excellent businessperson can pause mentally and observe his or her own mental
processes as if from the outside:…Am I being hijacked by my emotions? Do I need a different strategy
here? What should it be?
After the work.
Practice activities are worthless without useful feedback about the results…
…Excellent performers judge themselves differently from the way other people do. They’re more
specific, just as they are when they set goals and strategies. Average performers are content to tell
themselves that they did great or poorly or okay. The best performers judge themselves against a standard
that’s relevant for what they’re trying to achieve. Sometimes they compare their performance with their
own personal best; sometimes they compare with the performance of competitors they’re facing or expect
to face; sometimes they compare with the best known performance by anyone in the field…
…If you were pushing yourself appropriately and have evaluated yourself rigorously, then you will have
identified errors that you made. A critical part of self-evaluation is deciding what caused those errors.
Average performers believe their errors were caused by factors outside their control: My opponent got
lucky; the task was too hard; I just don’t have the natural ability for this. Top performers, by contrast,
believe they are responsible for their errors. Note that this is not just a difference of personality or
attitude. Recall that the best performers have set highly specific, technique-based goals and strategies for
themselves; they have though through exactly how they intent to achieve what they want. So when
something doesn’t work, they can relate the failure to specific elements of their performance that may
…Since excellent performers go through a sharply different process from the beginning, they can make
good guesses about how to adapt. That is, their ideas for how to perform better next time are likely to
work…They approach the job with more specific goals and strategies, since their previous experience was
essentially a test of specific goals and strategies; and they’re more likely to believe in their own efficacy
because their detailed analysis is more effective than the vague, unfocused analysis of average
performers. Thus their own effectiveness help give them the crucial motivation to press on, powering a
Discussion of Our 12 Largest Long Positions
In Appendix A, we discuss our 12 largest long positions across all three hedge funds we manage, which
are (in descending order of size, as of 12/31/10):
Position 2010 Performance*
1) Grupo Prisa (PRIS & PRIS.B) 153.6%**
2) Microsoft -8.4%
3) Berkshire Hathaway 21.4%
4) BP -23.8%*
5) General Growth Properties 81.0%
6) CIT Group 70.6%
7) Kraft stock/warrants 15.9%
8) Seagate Technology -17.4%
9) Iridium stock/warrants 2.7%/-11.8%
10) Automatic Data Processing 8.1%
11) Resource America 69.8%
12) AB InBev 9.7%
* Certain positions were acquired during 2010, such that the 2010 performance does not reflect our actual gains or losses.
For example, BP was one of our most profitable investments in 2010 because we bought it after the stock had collapsed.
** 153.6% was the gain in Liberty Acquisition Holdings Corp. warrants from the beginning of the year ($0.69) to the merger
with Grupo Prisa ($1.75).
Quarterly Conference Call
We will be hosting our Q4 conference call from 12:00-1:30pm EST on Tuesday, January 11th. The call-
in number is (712) 432-1601 and the access code is 1023274#. As always, we will make a recording of
the call available to you shortly afterward.
New Redemption Option
Effective immediately, we are making a second redemption option available to all existing and new
investors. The current redemption option permits limited partners to withdraw all (or any fraction) of
their investment once a year, on the anniversary date of the first investment, with 45 days notice.
Some (primarily institutional) investors need quarterly liquidity to match their own redemption policies,
so to accommodate this, we’re now offering a second redemption option that allows limited partners to
withdraw ¼ of their investment each quarter, with 45 days notice. Note that this option is in place of,
not in addition to the current redemption option.
Existing investors don’t need to do anything – they will continue to be able to make full redemptions
once a year – unless they wish to change to the new redemption option, in which case they should
contact Kelli Alires at (212) 386-7160 or KAlires@T2PartnersLLC.com. All new investors going
forward will need to select one of the options.
We want to acknowledge and thank Damien Smith, who has been an outstanding analyst for us for
nearly eight years, Kelli Alires, who does a fabulous job as office manager, and Joe DeJulius, another
outstanding analyst who joined us this year. Joe started his business career in the Fixed Income Division
of Lehman Brothers, was a senior executive with two international tech/consulting companies, and was
an analyst at Quilcap Management, an equity long/short hedge fund. He has a BS degree in Engineering
from the U.S. Military Academy at West Point and an MBA in Finance from Columbia Business
Thank you for your continued confidence in us and the fund. As always, we welcome your comments
so please don’t hesitate to call us at (212) 386-7160.
Whitney Tilson and Glenn Tongue
Appendix A: 12 Largest Long Positions
Notes: The stocks are listed in descending order of size as of 12/31/10.
1) Grupo Prisa (formerly Liberty Acquisition Holdings)
It would be hard to find something more off the beaten path than Liberty Acquisition Holdings Corp., a
Special Purpose Acquisition Company (SPAC) that recently merged with Grupo Prisa (PRIS and
PRIS.B), a Spanish media conglomerate with a good business but a bad balance sheet. This transaction
was ideal for both parties: Liberty deployed its cash at an attractive valuation while Prisa reduced and
restructured its debt burden.
Our positions in Liberty stock and warrants – one of our biggest winners in 2010 – converted to cash
and stock in Prisa, which we continue to hold because we think the underlying business, with a new,
stronger balance sheet, will do well. In the near term, however, the stock could be volatile because the
distribution of shares will initially be to unnatural shareholders (the original SPAC shareholders). Over
time, however, we expect that the stock will migrate to intrinsic value.
We presented our analysis of Prisa and its value at the Value Investing Congress on October 13, 2010:
www.tilsonfunds.com/Octpres.pdf (pages 32-46).
Here’s a Wall St. Journal article from November about the deal, with the key part highlighted:
Liberty Turns Leader of the SPAC
The Wall Street Journal
Heard on the Street
November 1, 2010
By JOHN JANNARONE
Some blank checks are tough to cash.
Special-purpose-acquisition companies became popular in the boom, raising cash through initial public
offerings that could be invested in virtually any business. The catch is that SPAC investments require
approval from shareholders, who became skittish in the crunch. Of the $17.1 billion raised by the 50 largest
SPACs since 2000, some $5.8 billion was returned to shareholders minus expenses, according to Dealogic.
And among SPACs that managed to make investments, shares in the companies they bought generally have
But not all SPACs have cracked. Liberty Acquisition Holdings, the largest of the group with a $1 billion IPO
in 2007, has proposed a deal giving investors a stake in struggling Spanish media firm Prisa. The deal looks
likely to get approval because Liberty shares trade at $10.50, 6% higher than the $9.87 cash liquidation value
of the trust. In contrast, most other SPACs traded at a discount even after announcing a deal because many
shareholders planned to vote deals down and take cash.
Setting aside the complex deal structure, the investment makes sense for simpler reasons. First, the deal helps
solve Prisa’s key problem: financial distress. Having binged on acquisitions, net debt reached 7.6 times
earnings before interest, taxes, depreciation and amortization at the end of 2009, says Citigroup’s Thomas
Singlehurst. Assuming the deal goes through and Prisa continues to reduce leverage, net debt will be just 3.5
times Ebitda at the end of next year, he says.
And because the family controlling Prisa faces heavy dilution, Liberty investors get a reasonable price with
some downside protection. Each Liberty share will convert to a mix of cash, Prisa shares, and convertible
Prisa bonds. Discounting the value of the convertible’s dividend at 10%, Liberty investors essentially pay
five times Mr. Singlehurst’s expected 2011 earnings for their Prisa shares. That is far lower than
multiples above 10 times for many media companies.
Admittedly, Spain’s economy remains troubled. But, for local advertising, the worst may be past. Ad
spending for both television and newspapers fell 23% in 2009, says media-buying firm
ZenithOptimedia. The fall is much less this year, and spending is forecast at roughly flat in 2011. Prisa
owns the leading Spanish newspaper and broadcast-TV channel, which may win share at the expense of
smaller competitors if the market stays soft.
But Liberty’s potential success isn’t a ray of hope for SPACs in general. Even those run by well-known
investors like Nelson Peltz, have failed to get deals done. Prisa may prove an exception because its
controlling shareholders know they need Liberty’s cash to set the company free.
Microsoft reported spectacular earnings in late October, handily beating analysts’ estimates, yet the
stock has barely moved so we’d added to our position.
Adjusting for the deferral of Windows 7 revenues last year, Microsoft reported revenue, EPS, bookings,
and operating cash flow growth of 13%, 19%, 24%, and 34%, respectively. The company’s results were
strong across the board, riding a wave driven by its three main profit drivers, Windows, Office, and
Server & Tools.
Capital allocation was excellent, as Microsoft has (so far anyway) avoided doing what so many other
large, cash-rich companies are doing, making a big, overpriced acquisition, and has instead wisely
ramped up returning cash to shareholders: $5.5 billion last quarter via $1.1 billion of dividends (the
stock currently yields 2.3%) plus $4.4 billion of share repurchases (up 3x year-over-year, leading to the
diluted share count falling 3.2%). At this rate, the company will retire nearly 8% of its outstanding
shares in the next year.
The stock closed the year at $27.91 and the company has $3.85 of net cash ($4.91 if one includes
“Equity and other investments”), so the stock, net of cash, is at $24.06. Trailing earnings are
$2.32/share, so that’s a P/E multiple of 10.4x. That’s insanely low for a company with Microsoft’s
characteristics: dominant and stable market shares across various products, 81% gross margins, 33% net
margins, an infinite return on capital, prodigious cash flows, and one of the strongest balance sheets in
The consensus view is that Microsoft is an incompetent, lumbering dinosaur, declining rapidly toward
the dustbin of history. Newspapers, check printers and paging companies, look out! The problem with
this view is that there is no evidence for it. Despite endless predictions over the past decade of how
Apple or Linux or Google Apps are going to erode Microsoft’s dominance in its key product categories,
the company’s market shares are stable or rising. Revenues and profits, rather than falling, are rising
Yet analysts persist in ignoring the overwhelming evidence of Microsoft’s powerful new product cycle
and are projecting flat revenues and EPS down 8.1% for the current quarter (ending December 2010),
and flat earnings for the remaining three quarters of the 2011 fiscal year. In light of such low
expectations, we believe Microsoft will continue to handily beat estimates over the next year, with
earnings growth in the mid-teens. This, combined with likely multiple expansion, should result in the
stock appreciating to at least the mid-$30s range with a year.
We presented Microsoft at the Value Investing Seminar on July 13, 2010:
www.tilsonfunds.com/Julypres.pdf (pages 27-35).
3) Berkshire Hathaway
Under Warren Buffett’s direction, Berkshire’s performance has been nothing short of remarkable over
the past two years. His disciplined capital retention looked overly conservative for many years, but
when the crisis hit there were few buyers and waves of panicked sellers, so he was able to deploy tens of
billions of dollars in some terrific businesses, on highly favorable terms. Thus, ironically, while
Berkshire’s stock is down 15.0% since the beginning of 2008 (-31.8% in 2008, up 2.7% in 2009, and up
21.4% in 2010), the company’s intrinsic value has risen markedly, which we believe makes it an
exceptional bargain today.
While the stock was up 21.4% in 2010, we made a much higher return by correctly anticipating that
Berkshire, once it completed the acquisition of Burlington Northern, would replace BNI in the S&P 100
and 500 indices. We estimated that index funds would have to buy approximately $38 billion worth of
Berkshire stock, which would cause the price to jump, so we significantly increased our position – and
were quickly rewarded when the stock popped 15.5% in January.
We have posted a detailed slide presentation of our analysis of Berkshire at:
www.tilsonfunds.com/BRK.pdf. Page 14 highlights the impact of the Burlington Northern acquisition:
Berkshire’s investments per share only declined slightly from the end of 2009 to the end of 2010, despite
paying nearly $11 billion in cash as part of the acquisition, yet Berkshire’s operating earnings have
increased hugely, driving our estimate of intrinsic value to $160,000/A share, a 33% premium to the
year-end price of $120,450.
The overall story of BP’s Gulf of Mexico disaster is well known, so we won’t repeat it here. As an
investment, there are two stories, reflecting two quite different investment opportunities.
The first was in June at the depths of the crisis, when the stock hit a 14-year low amidst hysteria that the
company might have to file for bankruptcy. We started buying BP’s stock in early June around $37 and
bought all the way down to its late-June low of $26.75 (including some call options near the low). Our
average cost at that time was around $29.
Our investment thesis, which we released publicly (see our June 19th article in Barron’s at:
http://online.barrons.com/article/SB50001424052970203296004575308800681560686.html and our full
analysis at: www.tilsonfunds.com/BP.pdf), rested on the following beliefs: the well would be capped
sooner than most investors expected; the environmental damage would be less than feared; the clean-up
costs, fines and legal liabilities would be at the low end of estimates; and the company had the assets and
cash flows to meet all eventualities. In less than two months, our investment thesis was almost entirely
validated – most importantly, the well was capped – and the stock soared nearly 50%.
At that point, many investors seemed to think that the “easy money” had been made (there was nothing
easy about it!) and sold, leading to the stock dropping from $43 to under $35 in less than three weeks in
August. This presented a very different risk-reward equation than only two months earlier. Of course
the stock wasn’t as cheap, but the tail risk of bankruptcy was gone (given that the well was capped), BP
had reported strong Q2 operating results, and had raised $7 billion by selling some non-core assets to
Apache for a fantastic price of 2x book value and 42x cash flow. Thus, we concluded that the stock, on
a risk-adjusted basis, was even more attractive than it was in June so we bought a lot more. This, too,
has worked well as the stock has risen to $44.17 at year-end thanks to the company reporting solid Q3
earnings, strengthening its balance sheet, selling additional assets, and announcing that it will reinstate
the dividend next quarter. At its current price, the stock trades at 8.1x estimated 2010 earnings
(excluding the Gulf spill costs) and 7.3x 2011 estimates, which we believe is far too cheap, both on a
relative and absolute basis.
We presented BP at the Value Investing Congress on October 13, 2010:
www.tilsonfunds.com/Octpres.pdf (pages 19-31).
5) General Growth Properties
General Growth Properties was our biggest winner for the second year in a row. After successfully
shorting the stock from the $40s to near zero, we flipped around and purchased it in early 2009, initially
at under $1, when we realized that there might be some recovery for the equity even though the
company had filed for bankruptcy. We thought the upside potential was $20, but we kept it a small
position at the time, reflecting the high risk that the equity could be worthless.
As the best-case scenario played out month after month, we let the position continue to grow because,
like BP, the risk-reward equation kept getting more favorable, yet the stock price wasn’t keeping up, so
it remained cheap – and was becoming safer and safer as the credit crisis eased, allowing GGP to
refinance its debt and progress quickly through bankruptcy.
It wasn’t always a smooth ride, however. In December 2009, a hedge fund named Hovde Capital, which
was short the stock, published three bearish analyses that knocked the stock down. We concluded that
Hovde’s analyses were flawed and rebutted them in three published articles (see:
www.tilsonfunds.com/GGP.pdf). We ended up profiting from this volatility by adding to our position at
temporarily distressed prices.
GGP exited bankruptcy on November 9th in the form of two companies: GGP, which will operate strictly
as a mall operator, and Howard Hughes Corp., a real-estate development company. We have trimmed
the positions, but continue to own both.
We presented GGP at the Boys & Girls Harbor investment conference on February 3, 2010:
www.tilsonfunds.com/Harbor.pdf (pages 14-19).
6) CIT Group
Founded in 1908 to provide financing for horse-drawn carriages, CIT Group is a major player in
lending to small and mid-sized businesses, in particular in specialized areas such as asset-based
lending to retail suppliers, transportation leasing and equipment finance. In November 2009,
CIT filed for bankruptcy, crushed under the weight of increasing loan defaults, ill-timed forays
into non-core areas such as student lending and subprime residential mortgages, and an inability
to tap credit markets to finance its day-to-day operations. Shareholders were wiped out,
including $2.3 billion in U.S. taxpayer money that the federal government had invested in the
company a year before.
By the time it emerged from its prepackaged reorganization in December, CIT had shed $10.5
billion in debt, shrunk its asset base, and was touting a new and improved back-to-basics
Under new Chairman and CEO John Thain, CIT is refocusing on its core strengths in lending to
smaller businesses across a wide variety of commercial and industrial sectors. The lack of
competition for such business today from banks should allow CIT to not only take share, but to
do so at attractive rates and without compromising on credit quality. The company certainly has
the liquidity to lend should it choose to, with a post-bankruptcy balance sheet that sports $11.2
billion in cash.
One key challenge to investing in any distressed lending institution like CIT is gaining comfort
that the asset values on the books reflect reality. As of September 30, CIT reported tangible
book value of $42.20 per share, which we believe will prove reliable given that management had
every incentive coming out of the bankruptcy process to write down or write off problem loans
as much as possible and start off with a clean slate.
The company’s primary challenge today is its cost of financing. Its net revenue spread is low
due to CIT’s very high cost of financing, but we believe the company will be able to lower its
borrowing costs by refinancing existing high-cost obligations, using cash to buy back debt, and
generating increased low-cost deposits from its bank subsidiary.
If CIT can capture the financing-cost savings we believe are possible, we think the company
could earn around $5 per share. At a 12-14x multiple we think is reasonable, that translates into
$60 to $70 per share, a 27%-49% premium to the year-end price of $47.10. Even more
intriguing is the possibility that a healthy bank might acquire CIT, attracted by the enormous
earnings leverage available in applying the acquiring bank’s much lower borrowing costs to
CIT’s business model.
Like many of our other top holdings, Kraft is a high-quality business trading at a historically low
valuation. In addition, we believe the 2010 Cadbury acquisition will provide substantial upside.
Kraft is the world's 2nd largest food company, and owns some of the best-known brands of snack foods,
beverages, cheeses, meat products and grocery items. With the acquisition of Cadbury, the company
adds not only branded confectionery items, including gums and chocolates, but also a world-class
distribution capability that is complementary to Kraft’s existing distribution.
The stock currently trades at a market multiple, but we believe Kraft should trade at a premium given
the stable, high-margin characteristics of its branded portfolio. In addition, Kraft has the opportunity
over the next few years to materially improve its margins to industry norms and significantly reduce
costs due to synergies with Cadbury.
We believe Kraft can earn around $3.00 per share within two years, which should result in a stock price
approximately 50% above current levels.
Pershing Square Capital Management did an excellent presentation on Kraft on February 3, 2010, which
is posted at: www.tilsonfunds.com/Kraft.pdf
8) Seagate Technologies
Seagate is a leading manufacturer of hard disk drive storage devices (HDDs.) The industry has
experienced significant consolidation over the last decade, resulting in three major players. Seagate’s
market share is approximately 30%.
Consensus thinking for many years is that this is a cyclical, rapidly dying industry, and that Solid State
Drives (SDDs) will soon replace HDDs in the majority of applications. Our variant perception is that
the medium-term viability of hard disk storage is quite strong, given that HDDs have a roughly 10:1 cost
advantage over SSDs. We expect that a substantial cost advantage will be sustained for some time.
In the meantime, Seagate is a powerful free cash generator. In FY 2010 (ending 7/2/10), the company
had $1.6 billion of net income and generated $1.9 billion of operating cash flow vs. cap ex of only $639
million. The resulting in $1.3 billion of free cash flow allowed Seagate to buy back $584 million of
stock and increase its cash hoard by $836 million.
The historical cyclicality of the business has been reduced thanks to the flexible nature of the
manufacturing process and industry consolidation. Gross and operating margins in FY 2010 were 28%
and 15%, respectively, vs. 23% and 9%, respectively in 2006.
The company has allocated its capital sensibly over time, and has retired 17% of its stock in the past
three years. Continued buybacks should contribute to a materially higher valuation of the company over
If we are correct that Seagate’s business isn’t in rapid decline, then its stock is one of the cheapest in our
portfolio, trading at a mere 4.8x trailing earnings and 2.8x enterprise value/EBITDA.
Iridium operates a constellation of low-earth orbiting satellites that provide worldwide real-time data
and voice capabilities over 100% of the earth. The company delivers secure mission-critical
communications services to and from areas where landlines and terrestrial-based wireless services are
either unavailable or unreliable. It is one of two major players in the Global Satellite Communications
The company has a tumultuous history. Originally a division of Motorola, Iridium spent $5 billion
launching satellites in the late 1990s, but filed for bankruptcy in 1999 with only 50,000 customers due to
too much debt and clunky phones that didn’t work inside buildings. Since then, however, Iridium has
thrived. It is growing very rapidly and is taking market share from its competitors.
The company went public in late September, 2009 by merging with a Special Purpose Acquisition
Company (SPAC) and has been weak since then, despite recently reporting strong results.
We continue to believe that this is an excellent company and that the stock is extremely undervalued.
Comparable businesses are trading at 10x EV/EBITDA, while Iridium, which is growing significantly
faster than and taking share from its competitors, trades at under 4x EBITDA. Finally, we are
encouraged by the recent large insider purchases by both the CEO and Chairman of the company.
We presented Iridium at the Boys & Girls Harbor investment conference on February 3, 2010:
www.tilsonfunds.com/Harbor.pdf (pages 20-31 and 41-66).
We recently added another high-quality blue-chip stock to our portfolio, Automatic Data Processing.
ADP’s core business is payroll processing and we believe that it is one of the world’s great companies.
It is more than four times the size of its nearest competitor and there are very high switching costs for its
customers, so ADP has fabulous 20% operating margins and unlevered returns on equity in the mid-20%
range. It is such a pillar of financial strength that it is one of only four companies left that still have the
highest AAA credit rating (we also happen to own the other three, Microsoft, Exxon Mobil and Johnson
& Johnson, though only the former in any size). Finally, ADP has excellent management and is very
shareholder friendly, returning cash to shareholders via a healthy 3.1% dividend and share repurchases
(17% of shares have been retired in the past five years).
So what’s not to like? Two things: 1) Growth has disappeared (EPS in FY 2010, which ended on June
30th, declined 9% from the previous year, and the company only expects 1-3% revenue and EPS growth
in FY 2011); and 2) The stock doesn’t appear particularly cheap, trading at 19.3x trailing EPS, based on
2010’s closing price of $46.28.
ADP historically has been a solid growth story – in the 13 years through FY 2009, for example, earnings
per share grew 245% (10.0% annually) – so what happened? In short, ADP has been hit recently by two
macroeconomic factors: high unemployment (meaning fewer paychecks being processed) and low
interest rates, which reduce ADP’s earnings from its float.
Float? ADP isn’t an insurance company, so why does it have float? Allow us to explain: as a payroll
processor, ADP collects cash from its customers and then issues paychecks, makes deposits in
retirement accounts, and transfers funds for taxes. All of this happens quickly, but at any given time,
ADP is sitting on more than $18 billion of cash, on which it can earn interest (it appears as a liability on
the balance sheet under “Client funds obligations”, offset by an asset called “Funds held for clients”).
Each dollar that comes in goes out very quickly, but is replaced with another dollar, so this is, in effect,
perpetual (and growing) float.
Of course ADP invests these funds very conservatively – this isn’t long-term float like much of
Berkshire Hathaway’s that can be invested in stocks – so ADP’s earnings from this float are highly
dependent on short-term interest rates. As of December 31st, one-month Treasuries were paying a
microscopic 0.05% vs. 5.05% only 40 months ago on August 1, 2007 (how the world has changed!).
Of course ADP isn’t investing all of its float in one-month Treasuries – it’s laddered such that the
company generated $543 million of revenues in FY 2010 from “Interest on funds held for clients.”
ADP’s float averaged $17.1 billion in FY 2010, so it earned a 3.2% return. Imagine that interest rates
rise 300 basis points over time to more normal (although still low) levels – this would translate into an
extra $540 million in pre-tax profits for ADP, boosting earnings by nearly 30%. In addition, someday
employers in this country will begin to hire again, which will also fuel ADP’s growth. For both of these
reasons, we think ADP’s earnings are depressed right now, making the stock cheaper than it appears.
While we think robust economic growth and a rise in interest rates is unlikely in the near term, when the
economy eventually recovers, ADP should have turbocharged earnings growth. We are prepared to be
patient, collecting a healthy dividend, because we believe the stock is worth at least $60, 30% above
current levels, in even a remotely normal economic environment.
11) Resource America
Resource America rose 69.8% in 2010 thanks to strong results and a recovery in financial stocks.
Interestingly, our analysis of REXI is little changed in the nearly two years since we wrote a chapter
about it in our book, More Mortgage Meltdown: 6 Ways to Profit in These Bad Times, so we’ve posted
this chapter at: www.tilsonfunds.com/REXIMMM.pdf. Here’s an excerpt:
Resource America went public in 1986 as a specialty finance company that bought commercial mortgages
at a discount. It also held some energy assets such as gas wells and pipelines. It built up Fidelity Leasing
and in 2000 sold it to ABN AMRO for $583 million, approximately twice the net assets of the lease
portfolio. a significant premium. Later, REXI IPO’d its energy assets by selling shares of Atlas America
in 2004 and then spun off their remaining shares the next year. In 2005, REXI also created Resource
Capital Corp., a REIT that trades separately under the ticker RSO. Overall, REXI has a very good track
record of accumulating assets on the cheap and selling at good prices, with solid gains for shareholders.
Today, REXI manages assets across a broad range of categories and earns attractive spreads on structured
finance pools. We believe that while some of these pools may experience problems, REXI has modest
liability, which is more than discounted in the stock price. In addition to substantial excess assets
outlined below, we estimate that REXI has earnings power of over $1 per share, though it will not reach
this level in 2009; the company’s guidance is $0.50-$0.70/share. REXI operates in three segments:
Financial Fund Management, which manages various types of asset-backed securities; Real Estate, which
invests in and manages multi-family and commercial real estate; and Commercial Finance, which is
comprised of LEAF, a small equipment leasing business. We believe that the combined value of these
businesses, when added to the value of other investments and what’s on the balance sheet, is multiples of
the current market price. REXI’s upside is very high when the markets eventually recover.
12) Anheuser-Busch Inbev
AB InBev is the world’s largest brewer, managing a portfolio of approximately 200 brands that includes
Budweiser, Bud Light, Michelob, Stella Artois and Beck’s. 13 brands have over $1 billion in sales and
in its top 31 markets, AB InBev is #1 or #2 in 25 of them. We think the beer business is very stable,
with slow growth in most of the world’s largest markets, but with high growth potential in certain
developing markets like China. Comparable businesses in our minds would be Coca Cola and
McDonald’s. This type of stable, dominant business gives us the confidence to project earnings and
cash flows many years into the future, and we expect that we might hold this stock for a long time.
We think AB InBev’s management team is among the finest we’ve ever invested alongside. They are
renowned for being both great operators and also ruthless cost cutters – and there’s a lot of fat to cut in
the recently acquired Anheuser Busch business, which should lead to substantial cost savings (and a
resulting jump in earnings).
We estimate pro forma free cash flow at $5.66/share in 2012. At a 14-16 multiple, that’s $79-$91/share,
38%-59% above 2010’s closing price of $57.09.
We presented AB InBev at the Value Investing Seminar on July 13, 2010:
www.tilsonfunds.com/Julypres.pdf (pages 9-26).
Appendix B: Bill Gross’s October 2010 Letter
William H. Gross | October 2010
Stan Druckenmiller is Leaving
The New Normal has a new set of rules. What once pumped asset prices and favored the
production of paper, as opposed to things, is now in retrograde.
The hard cold reality from Stan Druckenmiller’s “old normal” is that prosperity and
overconsumption was driven by asset inflation that in turn was leverage and interest rate
Investors are faced with 2.5% yielding bonds and stocks staring straight into new normal real
growth rates of 2% or less. There is no 8% there for pension funds. There are no stocks for the
long run at 12% returns.
So the hedgies are in retreat and, in some cases, on the run. Ken Griffin at Citadel is considering cutting
fees, and Stan Druckenmiller at Duquesne/ex-Soros is packing his bags for the golf course. Frustrated at
his inability to replicate the accustomed 30% annualized returns that his business model and expertise
produced over the past several decades, Stan is throwing in the towel. Who’s to blame him? I don’t. I
respect him, not only for his financial wizardry, but his philanthropy which includes not only writing big
checks, but spending lots of time with personal causes such as the Harlem Children’s Zone. And at 57,
he’s certainly learned how to smell more roses, pick more daisies, and replace more divots than yours
truly has at the advancing age of 66. So way to go Stan. Enjoy.
But his departure and Mr. Griffin’s price-cutting are more than personal anecdotes. They are reflective
of a broader trend in the capital markets, one which saw the availability of cheap financing drive asset
prices to unsustainable heights during the dotcom and housing bubble of the past decade, and then
suffered the slings and arrows of a liquidity crisis in 2008 to date. Similarly, liquidity at a discount drove
lots of other successful business models over the past 25 years: housing, commercial real estate,
investment banking, goodness – dare I say, investment management – but for them, its destination is
more likely to be a semi-permanent rest stop than a freeway. The New Normal has a new set of rules.
What once pumped asset prices and favored the production of paper, as opposed to things, is now in
retrograde. Leverage and deregulation are fading from the horizon and their polar opposites are in the
ascendant. Some characterize it in biblical terms – seven fat years to be followed by seven years of lean.
Others like Michael Moore and Oliver Stone describe it in terms of social justice – greed no longer is
good. And the hedgies – well, they just take their ball and go home. What, after all, is the use of
competing if you can’t play by the old rules?
Whoever’s slant or side you choose to take in this transition from the old to the “new” normal, the
unmistakable fact is that future investment returns will be far lower than historical averages. If a levered
Druckenmiller, Soros, or Griffin could deliver double-digit returns in the past, then a less levered hedge
fund community with a lower yielding menu will likely resign themselves to a high single-digit future. If
a “stocks for the long run” Jeremy Siegel grew used to historically “validated” 9 to 10% returns from
stocks prior to writing his bestseller in the late 1990s, then the experience of the last decade should at
least temper his confidence that the “market” will deliver any sort of magical high single-digit return
over the long-term future. And, if bond investors believe that the resplendent and abundant capital gains
of the past 25 years will be duplicated from yield levels of 2 to 3% – well, they just haven’t been to
Japan, have they?
There are all sizes and shapes of “investors” out there who have not correctly visualized the lower return
world of the New Normal. The New York Times just last week described the previous balancing act that
pension funds – both corporate and state-oriented – are now attempting to perform. Their article
describes their predicament as the “illusion of savings,” a condition which features the assumption that
asset returns on their investment portfolios will average 8% over the long-term future. No matter that
returns for the past 10 years have averaged 3%. They remain stuck on the notion that the 25-year history
shown in Chart 1 is the appropriate measure. Sort of a stocks for the long run parody in pension space
one would assume. Yet commonsense would only conclude that a 60/40 allocation of stocks and bonds
would require nearly a 12% return from stocks in order to get there. The last time I checked, the
investment grade bond market yielded only 2.5% and a combination of the two classic asset classes
would require 12% from stocks to hit the magical 8% pool ball. That requires a really long cue stick dear
reader, or what they call a “bridge” in pool hall parlance. Best of luck.
The predicament, of course, is mimicked by all institutions with underfunded liability structures –
insurance companies, Social Security, and perhaps least acknowledged or respected, households. If
a family is expecting to earn a high single-digit return on their 401(k) to fund retirement, or a similar
result from their personal account to pay for college, there will likely not be enough in the piggy bank at
time’s end to pay the bills. If stocks are required to do the heavy lifting because of rather anemic bond
yields, it should be acknowledged that bond yields are rather anemic because of extremely low new
normal expectations for growth and inflation in developed economies. Even the wildest bulls on
Wall Street and worldwide bourses would be hard-pressed to manufacture 12% equity returns from
nominal GDP growth of 2 to 3%. The hard cold reality from Stan Druckenmiller’s “old normal” is
that prosperity and overconsumption was driven by asset inflation that in turn was leverage and
interest rate correlated. With deleveraging the fashion du jour, and yields about as low as they are
going to go, prosperity requires another foundation.
What might that be? Well, let me be the first to acknowledge that the best route to prosperity is the good
old-fashioned route (no, not the dated Paine Webber road map utilizing hoped for paper gains of 12%+)
but good old-fashioned investment in production. If we are to EARN IT – the best way is to utilize
technology and elbow grease to make products that the rest of the world wants to buy. Perhaps we can,
but it would take a long time and an increase in political courage not seen since Ronald Reagan or FDR.
What is more likely is a policy resort to reflation on a multitude of policy fronts: low interest rates
and quantitative easing from the Federal Reserve, near double-digit deficits as a percentage of
GDP from Washington. What the U.S. economy needs to do in order to return to the “old” normal is to
recreate nominal GDP growth of 5%, the majority of which likely comes from inflation. Inflation is the
classic “coin shaving” technique of government since the Roman Empire. In modern parlance, you print
money faster than required, pray that the private sector will spend it to generate investment and
consumption, and then worry about the consequences in a later decade. Ditto for deficits and fiscal
policy. It’s that prayer, however, which the financial markets are now doubting, resembling
circumstances which in part are reminiscent of the lost decades in Japan since the early 1990s. If the
private sector – through undue caution and braking demographic influences –refuses to take the bait, the
reflationary trap will never snap shut.
Investors will likely not know whether the mouse has grabbed for the cheese for several years forward.
In the meantime, they are faced with 2.5% yielding bonds and stocks staring straight into new
normal real growth rates of 2% or less. There is no 8% there for pension funds. There are no
stocks for the long run at 12% returns. And the most likely consequence of stimulative
government policies that strain to get us there will be a declining dollar and a lower standard of
living. Stan Druckenmiller is leaving, and with good reason. A future of low investment returns, and a
heap of trouble for those expecting more, is what lies ahead.
William H. Gross
Appendix C: Excerpt from Jeremy Grantham’s July 2010 Letter
The entire letter is posted at: www.gmo.com/websitecontent/JGLetter_SummerEssays_2Q10.pdf
“Seven Lean Years” Revisited
The idea behind “seven lean years” is that it is unrealistic to expect to overcome the several problems
facing most developed countries, including the U.S., in fewer than several years. The purpose of this
section is to review the negatives that are likely to hamper the global developed economy, especially
from the viewpoint of how much time may be involved.
First, one of the causes of the ﬁnancial crisis was the over-indebtedness of consumers in certain
countries, including the U.S., the U.K., and several European countries. As of today, although they have
stopped increasing consumer debt – which itself is unprecedented and has eaten into consumption – the
total improvement in personal debt levels is still minimal. It would take at least seven years of steady
reduction to reach a more normal level. Anything more rapid than this would make it nearly impossible
for the economy to grow anywhere near its normal rate or, perhaps, at all.
There is in the situation today a nerve-wracking creative tension. At one extreme, massive stimulus
induces government debt to rise to levels that cause a real problem in servicing the debt – interest and
repayment – or at least a crisis of conﬁdence. At the other extreme, a draconian attempt to hold debt
levels while the economy is still fragile runs the risk of causing a severe secondary economic decline.
Deciding which horn of this dilemma to favor will probably prove to be the central economic policy
choice of our time. I am sympathetic to those in power. This is not an easy choice. My guess, though, is
that the best course is less debt reduction now and a longer, slower reduction later. Overdoing it now
may well cause an economic setback for an already tender and vulnerable global economy that might
easily be enough to more than undo all of the beneﬁts of debt reduction. Indeed, with a weaker economy
leading to lower government income, it might sadly cause debt levels to rise after all. This need for time
to cure all ills is one reason why I picked a seven-lean-year recovery over a more normal and rapid one.
The bad news, though, is that in the end, by hook or by crook, debt levels must be lowered at every
level, especially governmental. There is almost no way that this process will be pleasant or quick.
Second, and the most immediately frightening aspect of the seven-lean-year scenario, is that although
the credit crisis was caused by too much credit on too sloppy a basis, the cure was to increase aggregate
debt by ﬂooding economies with government debt. Dangerously excessive ﬁnancial system debt was
moved across, with additions, to become dangerously excessive government debt, with levels of debt to
GDP not seen outside of major wars, and seldom then. Increasingly the “cure” seems more like a stay of
execution. With bank crises, there is the backstop of the central government. For minor countries, the
IMF may be a net help, but for major countries in trouble, the IMF seems outgunned and, if several
major countries have a debt crisis simultaneously, the IMF is clearly irrelevant.
Third, we have lost a series of artiﬁcial stimuli that came out of the steady increases in debt levels and
the related asset bubbles. For example, the artiﬁcial lift to consumers’ attitudes resulting from steadily
rising house prices is unlikely to return soon. In fact, some further price
decline in house prices in the U.S. is probably more than a 50/50 bet, and in the U.K. and Australia is
nearly certain. For sure, that feeling of supreme conﬁdence – counting on the inevitability of further
steady rises in house prices, which was baked into average U.S. opinion by 2006 (including Bernanke’s,
unfortunately) – is long gone. The direct shot in the arm to the economy from the rise in economic
activity from an abnormally high rate of home construction and the services associated with an
abnormally high turnover rate of existing houses (more realtors, etc.) is also a distant memory here. So
the stimulus from rising prices has gone, and stock prices, although they have made a strong recovery
everywhere in the developed world, are still way down from their highs of 10 years ago and, notably in
the U.S., are still overpriced. Both the market and house price declines have also reduced conﬁdence in
the nest eggs that people felt they could count on for retirement as well as a little more spending on the
way there. Now consumers are readjusting to a greater need to save and, perhaps unfortunately, a greater
need to work longer. Unprecedentedly, they are paying down some consumer debt. These changed
attitudes will surely last for years.
Fourth, although the ﬁnancial system has passed its point of maximum stress in the U.S., very bad things
may lie ahead in Europe. And the leverage in the system and the chances of further write-downs (yet
more housing defaults and private equity write-downs, for example) leave banks undercapitalized and
reluctant to lend. Any more shoes dropping here or in Europe, or elsewhere for that matter, will tend to
keep them nervous. The growth in the total U.S. GDP caused by previous rapid increases in the size of
the ﬁnancial sector has also disappeared, and with any luck will stay disappeared, for it was not healthy
growth in my opinion.
Fifth, the runaway costs in the public sector, particularly at the state and city levels, where average
salaries and pensions ran far above private sector equivalents in a mere 15 years (why, that would make
a good report by itself!), have run into a brick wall of reduced taxes. State and other municipalities are
incredibly dependent on real estate taxes, which are down over 30% from falling real estate prices and
defaults, and also on capital gains rates, which have been hit by falling asset prices generally. Their
legal need to stay balanced is leading to painful cost cutting, which in turn puts pressure on an economy
that is coming to the end of much of the stimulus. With many of the artiﬁcial stimuli of the „90s and
2000s gone, their revenues are unlikely to bounce back in one or two years, and a double-dip in the
economy or new asset price declines would move their recovery back further.
Sixth, unemployment is high and will also suffer from the loss of those kickers related to asset bubbles.
The U.S. economy appears to have an oddly hard time producing enough jobs to get ahead of the natural
yearly increases in the workforce. (At least for a while, one long-term economic drag – slowing longer-
term growth of the U.S. labor force – becomes an intermediate-term help in reducing unemployment, but
beyond ﬁve years, it too will work to reduce GDP growth, as it has already done in the last 10 years.)
Needless to say, unemployment works to keep consumer conﬁdence and, hence, corporate willingness to
invest, below normal.
Seventh, another longer-term problem for the global economy is trade imbalances. The U.S. in
particular cannot continue to run large trade imbalances. In a world growing nervous about the quality
of sovereign debt – even that of the U.S. – domestic sovereign debt levels have exploded. The added
complication and threat to the dollar from accumulating foreign debts just adds risk and doubts to the
system. This is similar to the accumulating surpluses of the Chinese.
Imbalances destabilize the system. The trick, though, is to reduce these imbalances so that the process
does not reduce global growth. This necessary rebalancing will not be quick or easy.
Eighth, there is a related but different problem with the euro: incompetent management in Spain,
Greece, Portugal, Ireland, and Italy allowed the local competitiveness of their manufactured goods to
become 20% or more uncompetitive with those of Germany. It was never going to be an easy matter to
head this process off, and doing so would have taken some tough actions with uncomfortable short-term
consequences. But they could see the problem building up like clockwork at about 2% to 3% a year,
year after year. This did not result from the banking crisis, and it was never going to be easy to solve
with a ﬁxed currency. The difﬁculty was implicit in the structure of the euro from the beginning.
Indeed, my friend and former partner, Paul Woolley,1 believed, and let everyone know it, that from day
one this was a fatal ﬂaw nearly certain to bring the euro down under stress. But one might have hoped
for better evasive action or better survival instincts.
Greece in particular has two largely independent problems. First, it has approximately 22% overpriced
labor (complete with 14 months’ salary and retirement in one’s 50s), which can only be cured by
reducing their pay by 22%. This would be tough for any government that does not have an
exceptionally well-established social contract – a commitment from individuals that they have
obligations to help the whole society to prosper or, in this case, muddle through. The Greeks probably
do not have it. Perhaps the U.S. does not either. Would we take being told that ordinary workers would
have to earn 22% less when there are so many other people to blame for our current problems? The
Japanese, in contrast, probably do, but may well have other offsetting disadvantages.
The second problem for the Greeks is that they have accumulated too many government debts relative to
their ability to pay and, as the doubts rise, so do the rates they must pay such that their ability to pay falls
and the doubts rise further. Temporary bailouts are postponements of a necessary restructuring. Should
the system get out of control, there is the problem of the Greek debt that is stuffed into other European
banks. (My colleague, Edward Chancellor, is writing on this topic.) I merely want to make the point that
these twin Greek problems, which affect, to varying intensity, the other PIGS, have become an intrinsic
part of the “seven lean years,” more or less guaranteeing slower than normal GDP growth and a long
Ninth, the general rising levels of sovereign debt and the particular problems facing the euro bloc and
Japan are leading to the systematic loss of conﬁdence in our faith-based currencies. It is becoming a
fragile system that will increasingly limit governments’ choices in terms of dealing with low growth and
Finally, and possibly most important of all, on a long horizon there is a very long-term problem that will
overlap with the seven-year workout and make the period even tougher: widespread over-commitments
to pensions and health beneﬁts, which is covered in the next section.
Paul Woolley started a center for the study of “Capital Market Dysfunctionality” at the London School of Economics.
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