Michael Durante Western Reserve 1Q06

First Quarter 2006 April 13, 2006
100 Crescent Court • Suite 400 • Dallas, Texas 75201
YTD
Jan-06 Feb-06 Mar-06 1Q06 2006
WRHE Gross 4.6% 2.6% 1.4% 8.8% 8.8% 32.9%
WRHE Class A, Net1
3.6% 2.0% 1.0% 6.7% 6.7% 22.5%
WRHE Class B, Net1
3.7% 2.1% 1.0% 7.0% 7.0% 23.4%
S&P 500 2.5% 0.0% 1.1% 3.7% 3.7% 16.5%
NASDAQ Composite 4.6% -1.1% 2.6% 6.1% 6.1% 16.9%
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
“Deal or No Deal”
Dear Partners:
For the opening quarter of 2006, Western Reserve Hedged Equity, LP returned 8.8% gross, 6.7%
net (Class A shares) and 7.0% net (Class B shares) vs. the S&P 500 return of 3.6% and the
NASDAQ return of 6.1%. The fund’s net exposure remained consistent at roughly half the
market on a dollar basis and as low as one-third of the more aggressive NASDAQ on a volatility-
adjusted basis. So, it was a good quarter for the fund and particularly strong on a risk adjusted
basis. We continue to see good value and sustained growth in the services areas and escalating
valuation risks in such lower quality sectors as materials and industrials, which are increasingly
‘priced for perfection’. We have yet to see the quality rotation we would expect at this late stage
of a Fed tightening campaign, but the fund is doing well despite this qualitative disconnect and is
well positioned for the rotation.
The action in the market so far this year is noteworthy, so bear with me. The first quarter was a
“flight from safety” and among the most alarming in some time. Low quality, high valuation and
the smallest of market caps led the rally. Stocks priced under $10 whipped the market with an
18% average gain and the highest quintile stocks as measured by P/E and P/Book advanced 21%,
leading everything else save speculation over the new silver ETF. Even the stocks of money
losing companies beat the averages with a stick. We are not amused by this. The risk that
2005’s “junk” stock mania may reach speculative blow-off in 2006 is disquieting because
momentum investing and portfolio manager style drift has become overwhelmingly conspicuous
in our view.
(214) 871-6720 Main • (214) 871-6713 Fax
info@western-reserve.net

April 13, 2006
First Quarter 2006 Stock Returns by Company Quality
S&P Quality Rating YTD Performance
A 3%
A- 3%
B 7%
B- 8%
C 13%
C- 20%
D 42%
Source: Standard & Poor’s, Lehman Brothers and Baseline
First Quarter 2006 Stock Returns by Valuation
P/E Range YTD Performance
<10x 4%
11x-15x 3%
16x-20x 8%
20x-30x 16%
>30x 19%
Losing Money 18%
Source: Standard & Poor’s, Lehman Brothers and Baseline
Stay the course…
We think investors are overpaying for commodity and cyclical stocks, now the higher valuation
groups. While an end to such manic periods is assured, it is difficult to time. The hurricane
economy may be blurring reality and greater clarity should emerge as 2006 proceeds. Our
suspicion is that the clearing of the economic clouds will reveal a slower economy than has been
previously advertised. Many investors may be too long lower quality stocks, as has been the
norm late in recent tightening campaigns. A “quality check” in the market seems inevitable.
The Fed can still snatch victory, but we are prepared to press lower quality shorts as needed to
protect our high quality long positions should risks of a mistake by the Fed mount.
“…low priced and low quality stocks led on a style basis…benefiting from high liquidity, large cap malaise, portfolio
manager style drift and low volatility.”
-- Lehman Brothers April 2006
Western Reserve’s stock selection strategy never drifts. We hunt for fast growing cash cows
because this is where long-term value is created (and held). While challenging, markets this
biased towards low quality do create significant opportunities for qualitative types like us. Real
cash-producing growth can be found at not only reasonable prices, but at a downright steal. We
look for companies that can generate at least 15% organic cash flow growth and whose cash flow
greatly exceeds capital expenditures. This, in broad strokes, is how we define a “good business.”
Silver mining, cement mixing and railroads don’t measure up because they chew up cash.
(214) 871-6720 Main • (214) 871-6713 Fax

April 13, 2006
Although they have been great stocks of late (normal during cyclical euphoria), we have not, and
will not, allocate fund capital to them.
Then… Now…
“Cisco can grow 50% forever” “China is a 50 year growth market”
“Fed’s ‘old economy’ tools don’t affect the ‘new economy’ ” “Flat yield curve doesn’t mean a slow-down”
“I’m a ‘new economy’ analyst” ‘Growth cyclical stocks’
Price to sales (for money losing firms) Enterprise value to Ebitda (for low free cash flow firms)
Venture capital funds white hot LBO funds white hot
Internet funds and technology ETF’s Emerging markets funds and commodity ETF’s
Jim Cramer popular Jim Cramer popular
‘Picks & shovels’ of IT build-out ‘Picks & shovels’ of emerging market build-out
‘Tech start-ups’ Cyclical ‘roll-ups’
Storage software Storage containers
Day trading boom Swing trading boom
Low quality stock leadership Low quality stock leadership
“…we have decided to come off the fence by concluding that our core DCF valuation puts too much emphasis on a
cyclical downturn that is unlikely to materialize… Accordingly, we have switched valuation methodology…”
-- sell-side analyst circa March 2006
“With our most aggressive performance assumption, we don’t believe we could match the value being offered to our
shareholders”
-- CEO of a property REIT being acquired by an LBO firm circa March 2006
Life imitates television…
…or is it that the ‘reality T.V.’ age mirrors human nature? In any case, among the more gripping
debates among the Western Reserve research team these days are the decisions made by the
majority of contestants on the hit television game show – Deal or No Deal. If unfamiliar with
the show, the rules for Deal are refreshingly simple. A contestant eliminates 25 briefcases (each
representing a different amount of cash) over several rounds. After each round, the contestant
must choose to accept a cash offer from the “banker” or to keep going in the hopes of winning $1
million.
What baffles us is that the typical contestant appears either unable or unwilling to calculate the
simple probabilities as the number of unopened cases declines. It reminds us of momentum
investing. The announcement that CNBC would carry re-runs of the show came as no surprise to
us.
If confronted with a limited statistical sample (e.g. less than six cases), an evaluation of the
statistical median-driven “deal” versus the probabilities represented by the number of high cash
cases remaining is not complicated. Nevertheless, most contestants keep pressing rapidly
deteriorating odds, often at the behest of family members, office colleagues and a studio
audience. Many go home with little or no money and most with substantially less than their
highest offer from the “banker” earlier in the game.
(214) 871-6720 Main • (214) 871-6713 Fax

April 13, 2006
We are concerned that investors (as in 1999) are dismissing the probability of a negative cyclical
outcome in favor of the rush to capture short term price momentum in certain parts of the stock
market.
A barbell market is one of investment extremes and most often occurs during major corrective
initiatives (read: unwinding of previous blunders) by the Federal Reserve. Instead of
appropriately discounting risk and reward (much like the Deal contestant above), investors get
caught-up in either greed or the relative performance chase. Normally, the valuation of a given
stock reflects the probability for a statistical outcome based on fundamental variables. The more
predictable the variables, the higher the probability of a particular outcome. In other words, it’s
a discounting mechanism. Only investors don’t always calculate the odds efficiently due to a
range of factors, which most often boil down to two emotions – greed and fear.
Let’s consider lower quality businesses within the context of today’s market. Cyclical stocks are
trading at valuations undiscounted for a future cycle change (commonly referred to as ‘priced-
for-perfection’). Technology stocks in early 2000 were trading along a protracted ‘priced-for-
perfection’ paradigm. The common telltales include style drift among investment managers,
increased retail investor activity, excessive media attention to narrow leadership stocks, and
valuation paradigm shift calls by analysts and strategists. These factors drive new investors to
stock groups or markets with limited capacity. Terms for this mechanical shoe-horning of excess
capital into less liquid coffers are ‘speculative blow-off’ or ‘melt-up’, and the motto often (if not
always) is the same – “it’s different this time”. Emerging markets perhaps are a good example at
present.
China/Internet Parallels
The Internet bubble, of course, was caused by the excess liquidity Greenspan pumped into the
economy to fight off the Asian Crisis and then his obsession over the Y2K bug (that never bit).
The Internet was big of course and will be an important conduit for the rest of our lives. The
seemingly limitless possibility to multiply any and all goods and services across this new
medium was ripe for rabid prospecting by companies and speculation by investors. However,
the revenue opportunity was wildly overrated and the prospectors (the firms that used excess
liquidity to aggressively invest in software, hardware and telecommunications infrastructure to
build out their web strategies) were disappointed by the returns on their investment. When
revenue and thus attractive ROI’s on their new web “presence” didn’t materialize, the manic tech
and telecom spending spree stalled and then cliffed. To be sure, gold speculators in the 1840’s
didn’t find much gold either, but a lot shovels, whiskey and saloon extracurriculars were sold.
We worry that China is similar….Prospectors and governments alike are spending like mad right
now on infrastructure to establish a “presence” in emerging economies.
Clearly, China’s 1.3 billion populace is large, and speculation over the multiplier effect of goods
and services to these folks is not dissimilar to that of the Internet. However, our research into
domestic services firms exposed to Asia continues to reveal that most of the commerce in China
is dominated by western firm prospecting. Like the web, this is a “spend and wait” strategy. For
example, a leading real estate brokerage and services firm (to Asia) we research tells us that as
(214) 871-6720 Main • (214) 871-6713 Fax

April 13, 2006
much as 90% of all class A office leasing activity in Shanghai is from western companies and
not Chinese firms. They also estimate that new car purchases and higher-end dwellings are
being snapped up mostly by interlopers from the west as western firms move personnel over
there to fill the new prospecting offices.
Even a rudimentary study of the Chinese domestic economy supports this concern. The average
Chinese household only makes about $1,200 USD per annum. These potential consumers are
impoverished and are not the belly-up-to-the-bar spenders many portfolio mangers might
believe. Shanghai is bubbling to be sure, but with western dollars, and it may be “hotter” money
than widely discounted. One firm we recently researched remarked that investors need to
“understand that the revenue opportunity is small in China despite the country being enormous.”
That firm is completing its second decade in China.
While this western invasion is positive short term for domestic firms that provide infrastructure
products for the aggressive build-out, we worry about the potential stall-out risk, especially given
valuation extremes afforded “infrastructure” stocks. A professional services firm we research
that has maintained a China “presence” for 12 years tells us that while they have 350 employees
there, they have been challenged to achieve revenue scale. Their revenue per professional in
China runs 25% of their average worldwide. So, after 12 years, China is still not delivering for
them. China will grow and increase in importance over time, but the prospecting may be ahead
of the curve much like it was for the Internet build-out in the late nineties.
One thing the services firms we research cite as problematic to growing commerce in China is
the lack of a banking system and the absence of a rule-of-law legal system, both important
factors that businesses take for granted in capitalistic countries. Western Reserve’s research
team has a long history in banking and finance research. One issue we don’t like is the state of
credit at the four dominant state-owned banks in China. Their loan portfolios are levered to large
loans made to state-owned enterprises (SOE’s). Our review of recent securities filings for
Chinese bank IPO’s indicates that these loans are largely unprofitable. It is clear that the SOE’s
are unable to service the debt. In the U.S., bank regulators call this ‘evergreening’ a loan, and
after the real estate boom and bust of the 1980’s, it is now prohibited for obvious reasons. Yet
evergreening appears to be SOP for SOE’s in China as the government owns both the lender and
the borrower. Cross ownership between Japanese banks and industrial firms offer some
parallels. The Japanese were unwilling for a long time to deal with bad loans built-up in their
boom in the eighties. It was this cross ownership complexity that, in large part, deepened
problems and then prolonged economic stagnation there.
Heavy investing in domestic materials and industrial stocks as well as emerging market funds by
investors, including very aggressive reallocations by retail investors, is directly related to the
prospecting and speculation on China. Narrow “China play” investing is heavily influencing the
markets and fund manager portfolios, and we are not confident that a hiccup is as unlikely as the
prices of these stocks and markets are currently discounting. Our strategy didn’t change during
the Internet bubble, nor has it changed today, and we expect to benefit from the unwinding of
current trends just as our strategy benefited from the unwinding of the tech bubble.
(214) 871-6720 Main • (214) 871-6713 Fax

April 13, 2006
The Banker’s Offer…
On balance, the current stock market is split between groups having momentum and those
lacking it. As a result, valuation as an appropriate discounting mechanism is imbalanced,
thereby providing a great opportunity for a qualitative fundamental investing strategy such as
ours. In an empiric context analogous to 1999-2000, the last six months and the next six months
will likely prove pivotal in confirming why our qualitative approach to investing is superior to
that of the momentum strategies now so dominant in the marketplace. We continue to position
the portfolio to take advantage of these diseconomies.
We remember the Asian crisis, the Russian debt debacle and the Internet bubble. The year is off
to a strong start for the fund, and you may be wondering why I’m writing to you about risks.
This market is transitioning away from easy money across the globe, and the potential travails of
an adjustment period (hopefully nothing quite as dramatic as those above) largely are being
ignored in some parts of the market. Western Reserve’s consistent investment discipline will
benefit from this shift. We are ready.
Fifteen straight rate hikes (soon to be 16) and a valuation paradigm shift for cyclical stocks being
debated by analysts and portfolio managers? Take the deal!
Regards,
Michael P. Durante
Managing Partner
(214) 871-6720 Main • (214) 871-6713 Fax

April 13, 2006
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-06 Feb-06 Mar-06 YTD
WRHE Gross 4.6% 2.6% 1.4% 8.8%
WRHE Class A Net 3.6% 2.0% 1.0% 6.7%
WRHE Class B Net 3.7% 2.1% 1.0% 7.0%
S&P 500 2.5% 0.0% 1.1% 3.7%
NASDAQ 4.6% -1.1% 2.6% 6.1%
Mar-06 Feb-06 Jan-06 Dec-05 Nov-05 Oct-05 Sep-05 Aug-05 Jul-05 Jun-05 May-05 Apr-05 TTM
Inception
To Date3
WRHE Gross 1.4% 2.6% 4.6% 3.3% 0.9% -3.9% -1.9% -5.1% 2.7% 4.0% 1.3% -0.9% 8.7% 32.9%
WRHE Class A Net 1.0% 2.0% 3.6% 2.5% 0.6% -3.2% -1.6% -4.2% 2.1% 3.1% 0.9% -0.8% 5.8% 22.5%
WRHE Class B Net 1.0% 2.1% 3.7% 2.6% 0.6% -3.4% -1.7% -4.3% 2.1% 3.2% 1.0% -0.8% 6.0% 23.4%
S&P 500 1.1% 0.0% 2.5% -0.1% 3.5% -1.8% 0.7% -1.1% 3.6% 0.0% 3.0% -2.0% 9.7% 16.5%
NASDAQ 2.6% -1.1% 4.6% -1.2% 5.3% -1.5% 0.0% -1.5% 6.2% -0.5% 7.6% -3.9% 17.0% 16.9%
Sector Long Short Gross Net
Business Services 10% 4% 14% 6% Alliance Data Long
Consumer 2% 4% 5% -2% eFunds Corp.
Financial Institutions 26% 7% 33% 19% Trammell Crow Co.
Financial Services 24% 6% 30% 18% Americredit Corp.
Healthcare 2% 1% 3% 1% SI International
Industrial 1% 6% 7% -4%
Technology 2% 1% 4% 1%
Technology Services 17% 2% 18% 15% Long Short
Real Estate 13% 2% 15% 10% Top 5 33% 12%
98% 32% 130% 66% 56% 21%
Percent of Capital
Largest Long Positions
Top 10 Positions
Euronet Worldwide
Top 5 Winners YTD
Short
Alliance Data Sirius Satellite
Talx Corporation
CyberSource
Year to Date Comparative Returns
2
Hewitt Assoc.
Trammell Crow Co. Catalina Marketing
Lazard Ltd. First American Corp.
Trailing Twelve Months Comparative Returns
2
Composition by Sector (% of Capital) Key Positions
5.8% 56%
6.0% 56%
-8.9% 41%
8.7% 138%
Trailing Twelve Months (TTM)
Performance Average Exposure1
18.9% 97%
6.7% 66%
7.0% 66%
31 -1.8% 32%
85 8.8% 130%
54 10.7% 98%
March 31, 2006
Positions1
Performance Ending Exposure1
Summary for the Quarter Ended
March 31, 2006
Western Reserve Hedged Equity, LP
Quarter Ended
Western Reserve Hedged Equity, LP
Cumulative Performance Since Inception (Gross)
-9%
-5%
-1%
4%
8%
12%
16%
20%
24%
28%
32%
D
ec
Feb
Apr
Jun
Aug
O
ct
D
ec
Feb
Apr
Jun
Aug
O
ct
D
ec
Feb
Western Reserve
S&P 500
NASDAQ
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.
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.
(214) 871-6720 Main • (214) 871-6713 Fax

Michael Durante Western Reserve 1Q06

Recommended

Recommended

More Related Content

Viewers also liked

Viewers also liked (15)

More from Michael Durante

More from Michael Durante (20)

Recently uploaded

Recently uploaded (20)

Michael Durante Western Reserve 1Q06