Michael Durante Western Reserve 4Q07 Letter


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Michael Durante Western Reserve 4Q07 Letter

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Michael Durante Western Reserve 4Q07 Letter

  1. 1. Fourth Quarter 2007 December 31, 2007 100 Crescent Court • Suite 400 • Dallas, Texas 75201 YTD Oct-07 Nov-07 Dec-07 4Q07 2007 WRHE Gross 1.2% -8.9% -5.3% -12.7% -14.7% 25.4% WRHE Class A, Net1 0.8% -7.2% -4.3% -10.4% -13.0% 14.8% WRHE Class B, Net1 0.9% -7.5% -4.5% -10.8% -13.4% 15.3% 1 Class A shares are subject to a one year lockup and a 20% performance fee; Class B shares are subject to a three year lockup and a 17% performance fee. Inception to Date “Flight to Simplicity” -- Warren Buffett Dear Partners: Western Reserve Hedged Equity, LP (the “Fund”) posted a difficult year. We saw the excesses in housing and mortgages and stayed well clear since mid 2005. And the Fund performed well in 2006. In 2007, the expected collapse in subprime mortgages unexpectedly reverberated across all credit markets, causing irrational pricing of non mortgage financial assets, sectors and services providers, setting the stage, we believe, for a bull market in financial related stocks not seen in decades. • Subprime has dragged down valuations for most financial assets well below intrinsic value and there are incredible bargains in the carnage • The best investing opportunity in financials in nearly twenty-years is developing • New accounting rules and inefficient synthetic secondary market substitutes may be overstating losses on some asset classes • Risk discounting is over done. As one trader put it, “it’s been a truly terrifying market for the financials…makes the Russian ruble crisis not look so bad.” The year just past ranged from the sublime to the ridiculous. Iowa farmland became more valuable than the Florida coastline and the world’s most prestigious banks became worth less than a rock quarry in New Caledonia. The default insurance premium on many financial firms now price higher than that of Pakistan. Selectively, some of this was deserved, but most of this was irrational and financials under performed the broad stock market en mass and by the widest margin (almost 30%) in the post WWII era, pressuring most service economy sectors. Some patience may be required amid near term economic paralysis over this, but there’s marvelous opportunity in the ubiquity of the purge just the same. (214) 871-6720 Main • (214) 871-6713 Fax info@western-reserve.net
  2. 2. December 31, 2007 We remain committed to bottom-up, fundamental research and believe a market ignoring intrinsic franchise values is an opportunity owing to the abject fear. Current valuations now echo the lowest since the two prior post WWII lows of 1961 and 1990. For smaller capitalization financials, they collapsed to the lowest valuations recorded (the average small cap financial fell over 40% in 2007). While so-called “bottoms” are a process and not an event per se, it is well underway and we are in position to take advantage with sufficient cash to put to work. We suspect Buffett captured it best recently – “flight to simplicity”. The universal purging of financial stocks didn’t make fundamental sense as much as it relieved a ‘brain ache’ to investors not encouraged to figure out who was guilty or innocent in light of the subprime mortgage hot potato being tossed around and these seemingly endless ‘mark-to-market’ accounting-based write-downs by the large investment banking houses, the GSE’s and a few banks here and there. Rating agency Moody’s recently captured the sentiment well - “this is not a credit crisis as much as it is a loss of confidence”. Panic has caused tens of billions in perfectly performing loans across many asset classes to be repriced to highly illiquid, recently invented synthetic secondary market derivatives which represent a fraction of the credit outstanding in the financial system. Most troubling is that these newly created synthetic derivatives were designed for single direction investing – short. By early 2009, we expect write-ups by many a bank forced to arbitrarily write-down performing loan pools caught in the present ‘mark-to-market’ accounting madness. Amid the securitization freeze, financials with well capitalized and solid balance sheets already are putting loans on the books with ROE’s that may exceed 25% or more. The Street is pricing- in a depression and is unwilling to consider the eventual recovery fueled by the powerful combination of multi-decade low valuations, a steepening yield curve, wider credit spreads and high ROE loan production. Many missed the great bank stock bull market of the nineties, when fear and universal under investment in financials last reached this level of despair (1991). M-E-I-T = M=Materials; E=Energy; I=Industrials; T=Cyclical Technology; ex- M-E-I-T = Services, Financials and Consumer Source: Banc of America Securities 2005 2006 2007 92 96 100 104 108 112 Gold@ Indexed S&P 1500 M-E-I-TSectors (639 Companies) S&P 1500 ex- M-E-I-TSectors (861 Companies) 100 Crescent Court • Suite 400 • Dallas, Texas 75201 (214) 871-6720 Main • (214) 871-6713 Fax info@western-reserve.net
  3. 3. December 31, 2007 While earnings fundamentals didn’t suffer across our largely non credit, financial processing universe, the stocks did. Avoiding troubled areas wasn’t good enough and we experienced material multiple contraction previously seen only a few times in the past sixty years. We continue to hunt for asset classes and services providers unaffected by the housing malaise at increasingly bargain bin pricing. We no longer are “accidental contrarians”. We have found values that astonish us. Profitable firms with considerable dividends and excess capital trading well below book value are not hard to find and willing sellers abound. Current short interest across small cap financials is four times the normal as concerns that most credit needs to be written down by material discounts to par value to match the derivatives market proxy for a secondary market. If this were the case, then even these mostly performing loans (>98% of all loans) require yields in excess of 25% to price at ‘fair value’. We think such valuations are ridiculously dire. If the banks were forced to ‘mark-to-market’ all credit against these illiquid derivative proxies, then regulators would have to close down the entire US banking system for capital inadequacy. We’re not buying that as ‘fair market value’. We believe the ‘mark-to-market’ problem is overly influenced by new accounting standards and inefficient derivatives markets, creating a problem multiples of the troubled loans that set-off the panic. “The situation is exacerbated by changes in accounting rules. [Banks] have to mark their portfolios to a market based upon psychological perceptions of the loan’s value. If banks had to do this in prior cycles, none would have survived. And yet, they survived because they don’t lose the money everyone thinks they will lose.” – Richard Pzena, Barron’s 12/31/07 Unexposed financials have been grossly and blindly sold. Patience is the hard part now as emotion/fear has the edge presently. “Sound” financial firms and banks will benefit from the increasingly more aggressive actions taken by the Federal Reserve we see in the coming months and will be more competitive with the securitization market on a very slow heal. Hint: we have added some very strong balance sheets in traditional banking of late long. Subprime mortgage losses are expected to run between $150 and $300 billion. Goldman Sachs seems to have the best feel for subprime on the Street these days and they peg ultimate losses at roughly $240 billion. Citigroup, JP Morgan and Banc of America (neither of which the Fund has been involved with (yet?)) have lost a combined $300 billion in market capitalization alone. We estimate financial stock losses exceed $1.3 trillion or more than thrice the actual worst case expectations for loan losses. Some AAA mortgage bonds now trade around 80c to par, which implies losses will exceed 50%. However, >80% of even subprime loans remain current. 50% loss expectations imply 100% foreclosure and 50% severity (home price decline) or 50% foreclosure and 100% loss on the house. These secondary market “marks” now are mathematically challenged against probable outcome due to the crowded nature of the overwhelming short finance trade. The only point we make is that current risk pricing may be more a function of panic and loss of confidence on the one end and greed for heretofore easy short gains than potential reality at these valuations on the other. Subprime is a mess to be sure, but we have priced in outcomes across multiple asset classes outside subprime that have such low outcome probability that it cannot be ignored by deep value hunters. Outside mortgage banking, the bargains are a plenty. And even 100 Crescent Court • Suite 400 • Dallas, Texas 75201 (214) 871-6720 Main • (214) 871-6713 Fax info@western-reserve.net
  4. 4. December 31, 2007 inside mortgage banking, things are getting interesting. A key catalyst will be getting the bond insurance sector recapitalized and we suspect this will take place relatively quickly. Current speculation is that Buffett’s Berkshire Hathaway is eyeing the group to privatize. Among our top picks are prime mortgage REITs that benefit from Fed action and several derivatives market makers and exchanges benefiting from the panic and heightened volatility. We have a REIT asset manager trading hands at just 3x cash flow or half its peer group and yielding over 7%. We also favor several financial processing firms both on-shore and off-shore. But, it’s the small regional banks with clean balance sheets and loan capacity that are in pole position to help fuel sound growth outside of housing and an absent securitization market for the time being. We are long more traditional banks for the first time in years. And we our monitoring closely the financial firms, such as financial guarantors, mortgage insurers, and other firms squarely in the mortgage mess priced for depression. We suspect some incredible opportunities will present themselves as they shore-up capital. This is not the end of Western civilization. Financial stock funds and distressed debt funds will find themselves like kids in a candy store as we approach the spring-summer. Unwinding four-times the normal short interest in small cap financials could send the sector into orbit, while those forced to actually sell loan pools at these overly depressed secondary market prices will create fortunes for distressed credit players. In 1990, many said it would take ten years to “fix’ the financial system. Such comments are echoed today. What really matters is getting the bad loans circled, written-off and those institutions that need capital infusions to get that done too. This process is well under way already as we see sovereign funds, hedge funds and private equity funds investing in large US financial institutions almost daily. This does parallel 1990 when the Saudis invested in then beleaguered Citicorp. Kuwaiti fund eyes US subprime bargains. Financial Times reports The Kuwait Investment Authority is following its peers in the Middle East in the hope of finding bargain investments in the US in the wake of the subprime mortgage crisis. The $213 bln sovereign wealth fund is particularly interested in opportunities in financial services. "Perhaps we are at the eye of the storm now and are close to the peak of the problem," Bader Al-Sa'ad, head of the KIA, told the Financial Times. "We don't see prices dropping much more." Mr Al-Sa'ad said he intended to speed up decision-making at the KIA to take advantage of the opportunities thrown up by the crisis. "With Citi, the Abu Dhabi Investment Authority had good timing," he said, noting that it took ADIA less than three weeks to seal its late November deal to invest $7.5 bln in convertible securities in Citigroup. "I believe we need to move faster in some of our response time." Peak-to-trough devastation in the financials lasted exactly twelve months (from September 1989 to October 1990). We are getting through the credit crunch/mark-to-market inefficiencies and a 100 Crescent Court • Suite 400 • Dallas, Texas 75201 (214) 871-6720 Main • (214) 871-6713 Fax info@western-reserve.net
  5. 5. December 31, 2007 back-up the truck opportunity in the financials seen every few decades is prepping itself. The demolition in the financials this time around began in February 2007 with the demise of New Century Financial. As a percentage of GDP, this crisis is half the size of the eighties’ credit debacle, barring a major mistake from the Federal Reserve. Certain mortgages ain’t pretty, but 97.5% are still current. Small cap financials are on ‘fire sale’ right now with valuations ranging 15% to 80% of book value and financial technology and processing stocks at 3x to 6x cash flow. The survivors, which will be most of them, will double in value to get back to “cheap”. And large cap financials like JP Morgan and Bank of America et al will rise 50% just to get back to “undervalued” as credit markets mend. We think a steeply sloped yield curve and eventual cessation of write-offs and reserve builds by 2H08 could add even more earnings power than the increasingly pessimistic cuts by Street analysts presently. A recent poll of multiple Street analysts by us suggests the towel has been thrown-in. This is good news. Small caps in general went through a very rough relative bear market in the late nineties. When asked by Barron’s if small caps would ever out perform again, a former mentor of mine replied simply – “yes”. The Barron’s reporter, astonished at the simplicity of his answer inquired “why?” “Greed” was his reply. I’m with Buffett on this one – simplicity. Markets are irrationally despondent and financials are the best value around. ‘Greed’ is the other simple emotion we can think of, while much of the ground on that other emotion has been well covered now… Western Reserve Hedged Equity, LP Cumulative Performance Since Inception (Gross) -20% -16% -12% -8% -4% 0% 4% 8% 12% 16% 20% 24% 28% 32% 36% 40% 44% 48% 52% 56% 60% Western Reserve Gross Western Reserve Net (Class A) SMID Cap Services Composite As for Iowa replacing California and Florida as the most migrated to and valuable state? We’ll just have to see. As one can see above, it’s been a very negative environment for a fund strategy focused just on the services economy. Our comparative services index is down nearly 20% since we launched the Fund. While our returns have been disappointing relative to our longer history in the services space, this is an unprecedented opportunity in an exceptionally out-of-favor space. Interestingly, petrodollars aren’t buying farmland, but they are investing in America’s top 100 Crescent Court • Suite 400 • Dallas, Texas 75201 (214) 871-6720 Main • (214) 871-6713 Fax info@western-reserve.net
  6. 6. December 31, 2007 financial firms. They will lead us out of this downturn and become the next great investment opportunity globally. Regards, Michael P. Durante Managing Partner 100 Crescent Court • Suite 400 • Dallas, Texas 75201 (214) 871-6720 Main • (214) 871-6713 Fax info@western-reserve.net
  7. 7. December 31, 2007 Long Short Total (Gross) Total Class A (Net) 2 Total Class B (Net) 2 Long Short Total (Gross) Total Class A (Net) 2 Total Class B (Net)2 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07 2007 YTD Inception To Date 3 WRHE Gross 3.1% -3.8% -1.8% 1.9% 1.5% -6.2% -3.2% 2.7% 4.1% 1.2% -8.9% -5.3% -14.7% 25.4% WRHE Class A Net 2.3% -3.2% -1.5% 1.4% 1.1% -5.1% -2.6% 2.0% 3.1% 0.8% -7.2% -4.3% -13.0% 14.8% WRHE Class B Net 2.4% -3.3% -1.6% 1.5% 1.1% -5.3% -2.7% 2.1% 3.3% 0.9% -7.5% -4.5% -13.4% 15.3% SMID Cap Services 1.0% -2.0% -1.4% 1.9% 3.3% -1.2% -6.5% 0.9% 2.1% 0.9% -6.2% -10.3% -17.0% -14.6% Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 2006 YTD WRHE Gross 4.7% 2.7% 1.3% 0.7% -2.3% -0.2% -2.6% -0.1% 6.3% 4.2% 2.0% 2.3% 20.3% WRHE Class A Net 3.6% 2.1% 1.0% 0.4% -1.9% -0.3% -2.2% -0.2% 5.0% 3.3% 1.5% 1.7% 15.0% WRHE Class B Net 3.8% 2.1% 1.0% 0.4% -2.0% -0.3% -2.3% -0.2% 5.2% 3.4% 1.6% 1.8% 15.6% SMID Cap Services 4.3% -0.2% 3.1% 1.0% -4.2% -0.8% -3.4% 1.4% 3.5% 3.5% 1.8% -6.1% 3.3% Sector Long Short Gross Net 4% 4% 8% -1% Long Short 0% 0% 0% 0% 38% 27% 1% 7% 8% -5% 59% 46% 0% 0% 0% 0% 13% 3% 17% 10% 13% 6% 19% 8% 7% 1% 8% 6% 0% 4% 4% -4% 1% 1% 2% 0% 1% 0% 1% 1% 12% 5% 17% 7% 53% 31% 84% 22% 1 Freely tradable securities. Immaterial position sizes omitted. 2 Class A shares are subject to a one year lock-up and a 20% performance fee; Class B shares are subject to a three year lock-up and a 17% performance fee. 3 Western Reserve Hedged Equity, LP's inception date is January 1, 2004. Full-Year 2006 Comparative Returns 2 Top 20 Positions Healthcare Services Transaction Processing Cyclical and Industrial Internet Services Consumer Services Quarter Ended December 31, 2007 Performance Average Exposure 1 Trailing Twelve Months (TTM) -15.7% 112% 0.2% Percent of Directional Capital Business Process Outsourcing Performance Ending Exposure 1 -10.4% Portfolio Composition (% of Capital) 31% -10.8% 31% Summary for the Quarter Ended December 31, 2007 Western Reserve Hedged Equity, LP Top 10 Positions -13.7% -10% 0.6% 53% -12.7% 22% 50% -14.7% 162% -13.0% 61% Full Year 2007 Comparative Returns 2 -13.4% 61% Financial Institutions Government Services Technology Services Real Estate Services Financial Services Western Reserve Hedged Equity, LP Cumulative Performance Since Inception (Gross) -20% -16% -12% -8% -4% 0% 4% 8% 12% 16% 20% 24% 28% 32% 36% 40% 44% 48% 52% 56% 60% D ec Feb Apr Jun Aug O ct D ec Feb Apr Jun Aug O ct D ec Feb Apr Jun Aug O ct D ec Feb Apr Jun Aug O ct D ec Western Reserve Gross Western Reserve Net (Class A) SMID Cap Services Composite Please be advised that the past performance of Western Reserve Hedged Equity, LP (the “Fund) is not necessarily indicative of future results. Depending on the timing of a person’s investment in one of the Funds, actual investment returns in the Fund may vary from the returns stated herein. Performance results are estimated, based on both audited and unaudited results, net of management and performance fees and operating expenses. Such performance results assume that a partner invested in the Fund at the inception of the Fund and has not made additional contributions or withdrawals. There is no assurance that at any time the securities held by the Fund will be securities which comprise any of the indices listed above, and the Fund may have substantial cash balances and investments in relatively illiquid securities at any time when compared to the securities comprising a listed index. This report is provided for informational purposes only and is not authorized for use as an offer of sale or a solicitation of an offer to purchase investments in the Fund or any affiliated entity. This report is qualified in its entirety by the more complete information contained in the Fund’s Confidential Private Placement Memorandum and related subscription materials. This report is confidential and may not be reproduced for any purpose. Western Reserve Capital Management, LP serves as the Fund’s investment manager. Its Form ADV Part II and Privacy Policy are available to investors upon request. Historical Monthly Long/Short Exposure 0% 50% 100% 150% Apr-04 Oct-04 Apr-05 Oct-05 Apr-06 Oct-06 Apr-07 Oct-07 Long Short Net WESTERN RESERVE CAPITAL MANAGEMENT, LP 100 Crescent Court • Suite 400 • Dallas, Texas 75201 (214) 871-6720 Main • (214) 871-6713 Fax info@western-reserve.net