- 1. Fourth Quarter 2006 February 14, 2007 100 Crescent Court
Suite 400 Dallas, Texas 75201 YTD Oct-06 Nov-06 Dec-06 4Q06 2006
WRHE Gross 4.2% 2.0% 2.3% 8.7% 20.3% 47.0% WRHE Class A, Net1 3.3%
1.5% 1.7% 6.7% 15.0% 31.7% WRHE Class B, Net1 3.4% 1.6% 1.8% 7.0%
15.6% 33.0% S&P 500 3.2% 1.6% 1.3% 6.2% 13.6% 27.6% NASDAQ
Composite 4.8% 2.7% -0.7% 6.9% 9.5% 20.6% 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 The Five Minute Workout Dear Partners:
Western Reserve Hedged Equity, LP (Fund) returned 20% gross and 16%
net of all fees and expenses for the year ended 2006. For the
fourth quarter, the Fund returned 9% gross and 7% net of all fees
and expenses. Since inception, the Fund is compounding annually at
130% of the S&P 500s return and 160% of NASDAQs return (proxies
for broader market averages) after all fees and expenses, with half
the markets overall exposure. Gross returns are running 175% of the
S&Ps return and 230% of the NASDAQ respectively. We continue to
meet our twice the market for half the risk mantra in measured
time. While 2006 witnessed the beginning of a return to fundamental
reality in some ways, we believe that we still have a long way to
go. The late 2005 through early 2006 speculative blow-off in low
quality and commodity-based stocks has begun to fold, leading
investors to become a tad less infatuated with commodity
speculating. Much like the technology bubble in the last decade,
this decades value stock bubble will take time to fade. As is often
the case after several years of out- performance for an asset class
or style, chasing junk has become habitual for the majority of fund
managers and fund strategies. It strikes us that risk seems to be
escalating towards a potential shakeout in commodity-driven
emerging markets (which could negatively impact most domestic
industrial stocks) sometime between now and about nine months
preceding the opening ceremonies for the 2008 Olympics in Beijing.
Some recently exposed scandals include Chinese banks accounting
practices (we warned about their questionable accounting for
impaired loans in 2006s first quarter letter) and corruption in
Shanghai over questionable funding of opulent commercial real
estate projects. (214) 871-6720 Main (214) 871-6713 Fax
[email protected]
2. February 14, 2007 Such data points suggest that the
inevitable shakeout may come sooner rather than later. If this
shakeout leads to the repatriation of the significant amount of
capital that has recently been shoehorned into illiquid bourses, we
believe we could see a material benefit to high quality domestic
stocks, long ignored by investors amid the industrial economy boom.
Closer to home, our outlook remains the same and our strategy never
changes. For the time being, the Fed has fractured credit
efficiency with a now record-length inverted yield curve, only one
doesnt yet know just how badly fractured. For this type of MRI
scan, it takes time to get back the results and its not unusual for
investors to get punished for overstaying the welcome in low
quality securities while awaiting the diagnosis. So far, the
markets are discounting little or no material consequence as the
consensus is convinced the fallout will be limited to housing and
autos. This could prove too optimistic considering homes and cars
represent the largest CapEx for consumers, who just happen to be
70% of the economy. What is clear from our fundamental research is
that the rising tide that once lifted all ships, rafts, barges and
erstwhile Chinese junks has receded into a lower growth economic
backdrop. While more severe outcomes such as recession may seem
less likely for the moment (impossible to predict), low economic
growth and low inflation are more predictive. And they will not
support old economy leadership ad infinitum. More recent earnings
reports from economically-levered industries clearly bespeak of
faltering organic volumes while cycle-high margins are supported
solely by pricing increases from the trailing commodity run-up.
Unless trends suddenly reverse, volumes and pricing will not
continue to act independently forever. Yet, this is exactly what
the current consensus is convinced will occur. There is a
prevailing belief in the market that the back half of 2007 will
boast accelerated economic strength. While this is often an easy
sale early in a calendar year, we are more skeptical and never
count on the back half thesis for anything. We continue to believe
that although the trend remains at its nadir, the shift towards
growth and quality is slowly emerging as new leadership for stocks.
Being services focused, Western Reserve is the antithesis of
cyclical industry investing. Our performance thus far has been
attained without exposure to commodities or emerging markets. We
leave that to others far better at that type of investing. To be
certain, many have done quite well from what we have observed, yet
we wonder aloud at the risk-adjusted returns over a measured period
of time in strategies heavily levered to commodities. Commodities
have a history of going from boil to broil in a hurry. Five Minutes
To a New You! Arguably, this will be an odd anecdote for a
Quarterly Letter, but my folks were visiting us for Thanksgiving in
November, and per tradition, our whole brood trekked downtown on
Black Friday to lunch at the original Neiman Marcus in Dallas.
While killing time in the gadget area 100 Crescent Court Suite 400
Dallas, Texas 75201 (214) 871-6720 Main (214) 871-6713 Fax
[email protected] 3. February 14, 2007 this year, my father
and I stood staring at the foot of a most curious workout machine.
It had no handlebars, no treadmill, no monitor, no skis, and
frankly, it had no discernible moving parts. The only thing it did
have was a stick to hold onto and a platform upon which to
apparently stand. True to the mandate of the late Messrs Neiman and
Marcus, they werent exactly giving it away either. After of period
of quixotic staring, a salesperson approached us to explain. This
is a revolutionary vibration exerciser, and it will cut your
workout time by 95% he explained. While we arent always the
quickest on the uptake, we caught on reasonably quickly this time.
One simply stands on this thing and it shakes the living snot out
of you. In five minutes (or less we were encouraged to believe),
one can equal what Mr. Universe takes hours a day over years of
hard work to achieve. The tag-line on the machine read achieve
better fitness with minimal effort and reduced risk of injury. And
if all that still sounded suspect to us, Madonna and Gwen Stefani
own one, the salesmen noted confidently. Given the rampant short
cutting (momentum/technical investing) one sees in the market
anymore, Im confident many a fund manager of means owns one of
these immoderately priced vibration exercisers by now. After all,
its consistent with the new paradigm for investing. Why do the
heavy lifting of research when a chart, technical toolbar or simple
algo can do the trick? Stock picks take five minutes (or less) and
so does your workout! As Investors Business Daily (the bible for
chart traders) warns its many followers in every issue Investigate
before you invest. Always check a chart and read a company story on
the Internet. We would have to agree with prejudice. Reading at
least one story about a company on the web before investing
certainly cant hurt. And ostensibly, it can be accomplished quite
efficiently during the five minutes you are standing on your new
vibration exerciser. As they advertise on CNBCs popular show
FastMoney Buy High and Sell Even Higher. The age of no-need-to-
research investing has reached a fevered pitch. At risk is that by
the time you get the research completed, the momentum crowd may
already have moved on to the next thing. Western Reserves research
team does not believe in such an approach to investing. Investors
guided mostly by charts and mechanical means ultimately end up
following just two basic principles: One buys a stock merely
because it has gone up in value; And one sells a stock merely
because it has gone down in value While this contradicts our sense
of sound investing and most likely cannot sustain itself towards
long-term success (our opinion), one certainly cannot argue with
the strategys sheer efficiency and ease of adoptability by aspiring
investors (thus its popularity). 100 Crescent Court Suite 400
Dallas, Texas 75201 (214) 871-6720 Main (214) 871-6713 Fax
[email protected] 4. February 14, 2007 Three Years in the
Rearview Mirror Its been an interesting three years in the stock
market, with a value bubble (industrials and commodities) seeming
to echo the late nineties tech and growth style bubble. Western
Reserve, of course, manages a quality and growth focused investment
partnership, terms contradictory to the recent powerful trends in
stocks, we are saddened to note. So, we are quite pleased with the
Partnerships performance. Since inception, long investments have
compounded at over 72% over three years and close to 25%
annualized. By contrast, short investments (hedge) have cost the
partnership 16% over three years or about 5% annualized despite the
Partnership remaining hedged within our prescribed range. Long
investments on average have outperformed shorts by 2.5x on a dollar
equal basis and 5x overall. That we are not saddened by. Western
Reserve believes the markets are efficient over the long run and
mirror growth in free cash flow (real corporate profits). At the
same time, we also recognize that the stock market can be very
inefficient during shorter time horizons. The challenge for
investors is to recognize inefficiency (mispriced businesses) and
capitalize upon those opportunities while avoiding greed-driven
situations. Extreme and narrow markets like that witnessed in
technology in the late nineties and in commodities during the past
few years skew investor perceptions of risk and reward that are
destined to return to normalcy in time. As in the past, the recent
commodity bubble is a dislocation destined to unwind. The lessons
of the great investors in time have not been revoked. Their
successes boil down to three basic rules of sound and successful
stock-picking: Control the self-defeating emotional tendency that
keeps most investors from beating markets over time buying high and
selling low. Maximize chances at achieving sustainable gains
Minimize odds of suffering irreversible loss While we recognize a
stock will trade on things other than fundamentals, such as
technicals (momentum) and psychology (greed v. fear), we never
stray from our core stock picking discipline: A focus on the
quality of a business model including the degree of recurring
revenue, scale economies and margin defensibility, thereby
maximizing our ability to achieve sustainable returns in individual
stocks while minimizing the odds of suffering an unrecoverable
loss. Our focus on high quality, high recurring-based long
investments allows us to view down periods in the Fund as stored
value. If one identifies good businesses with strong barriers,
permanent loss is of a lower likelihood. Conversely, investing in
cyclical and commoditized industries greatly increases ones odds of
suffering an irreversible loss because they are not good
businesses, and the strategy is rarely defensible while requiring
perfect timing. 100 Crescent Court Suite 400 Dallas, Texas 75201
(214) 871-6720 Main (214) 871-6713 Fax [email protected] 5.
February 14, 2007 Earnings drive stocks over time and little else.
Find recurring growth and one finds sustainable gains. Focus on
secular growing parts of the domestic economy (meaning focus
exclusively on the services sectors of the stock market). Buy at a
discount to fundamentally-driven intrinsic value and short at a
premium, which assuages the emotional tendency to buy high and sell
low. By being valuation-driven in timing entry and exit points, we
minimize our exposure to the errors created by greed and fear in
others. Instead, we use business model strengths and weaknesses
versus valuation to take advantage of the errors of others, which
largely arrive out of their being too short-term oriented and
subject to the tendency to over react to events. Finally,
dislocations at the hand of greed and fear, because they are
emotionally-driven, cannot be arbitraged away. This is the only
consistent anomaly in what are otherwise efficient markets over
time. Western Reserve believes that the trading value of a stock is
determined solely by fundamental analysis over time. By
consistently applying such a disciplined approach, avoiding
greed-driven dislocations (style drift) and capitalizing on
intrinsic value inefficiencies, the Partnership should be able to
exceed market returns under most market conditions short term,
safeguard capital regardless of conditions and greatly exceed
market returns over time. This has proven achievable to us over the
past three years despite having to battle a decidedly feckless
market which has favored low quality over high quality and
shortterm focused trading over long-term investing. A psychology
which has favored corner cutting over research and hard work.
Portfolio Comings and Goings Something(s) New The research team is
very excited about Willden Group (WLDN), a long investment acquired
late in the fourth quarter. WLDN is a great business. They are a
professional services firm which provides outsourced engineering
design and public (a.k.a. municipal) finance advisory services to
local governments, namely counties and smaller cities. Counties and
cities are a terrific government services niche because they are
extraordinarily stable and generally above political friction and
corruption found at the federal and state government levels. And
they receive reams of money from the feds (hoping to get your vote)
to build and repair highly visible infrastructure projects in such
areas as roads, bridges, water systems, sanitation, and storm
management/drainage systems. Recent federal legislation e.g.
earmarked nearly $300 billion for infrastructure spending through
2009 and much of that will be pushed-down to counties and cities to
deploy. State agencies often match the Federal mandates. WLDN
consults on over 3,000 engagements with more than 750 different
local government clients and has over 300 consultants. So, the firm
is quite diversified and the market is both vast and enormously
fragmented of course. They currently operate in just California,
Nevada and Arizona. Growth has compounded at 15%-20% and the
company has been in business for over 30 years. Future growth is
easy to identify. There are fifty states with a few million local
government agencies. WLDN works with just a rounding error of them
at present. The pool of potential clients is why firms that
specialize in local government services grow consistently over
decades. And the privatization of governmental management of
infrastructure is in its infancy. 100 Crescent Court Suite 400
Dallas, Texas 75201 (214) 871-6720 Main (214) 871-6713 Fax
[email protected] 6. February 14, 2007 WLDNs financials are
quite strong - only one down year in sales in the past twenty-seven
and sales historically double every five years. And because the
business is pure fee for services-only, it is neither working
capital nor capital expenditure intensive and thus throws off
tremendous free cash flow. As a result, WLDN produces consistent
and attractive returns on invested capital (ROIC) exceeding 25% and
with almost no leverage. Engineering Services Peer Group Valuation
Analysis 2007E P/E 2008E P/E Michael Baker (BKR) 16x 15x Fluor
Corp. (FLR) 24x 21x Jacobs Engineering (JEC) 23x 20x Shaw Group
(SGR) 22x 20x Washington Group (WGII) 21x 19x URS Corp. (URS) 18x
17x Average 22x 20x Willdan Group (WLDN)* 8x 7x * Excludes net
cash-on-hand per share The stock is under followed as only one
small firm publishes on it. Our cash earnings estimates are 75c to
80c in 2007, >90c in 2008 and $1.10+ in 2009. Excluding almost
$3 in unencumbered cash per share on the balance sheet, the recent
stock price of $9 is actually closer to $6. So, the FCF yield on
2008 is a jaw-dropping 18% (un-levered mind you). Given the double
digit compound growth and low volatility of local government
services businesses, we believe the stock will be revalued closer
to a 5% to 6% free cash flow yield once discovered by the rest of
the Street. As the table above illustrates, WLDNs P/E multiple (FCF
yield turned inside out) is a compelling 70% cheaper than the more
widely followed peer group. This stock simply is not known yet by
many investors. We set an initial 12 month price target of $15
before the $3 in cash. That gets one to $18 or a double. The risk?
Your local town goes out of business multiplied across a few
million towns coast-to-coast. WLDN is a high recurring, low risk
business, sporting strong growth amid a highly fragmented
marketplace and is wildly undervalued. Classic Western Reserve!
Another recent long addition is Clayton Holdings (CLAY), run by the
former CEO of mortgage insurer Radian Group, who has made me lots
of money in the past. With so many pundits down on US housing
formation, we say, Dont be! The US consumer and his dwelling is the
planets best risk-adjusted bet long term. Western Reserve has a
history of investing in the services supporting major secular
growth areas of the economy. Housing formation is among the more
powerful secular trends we water ski behind. While we prefer not to
get involved in the more cyclical aspects of housing long (we do so
short from time to time), there is no question that the management
of mortgage debt in a secular low rate environment is both powerful
and recurring. This country has 80% home ownership, so we have
achieved the holy grail of capitalism and freedom. Eight out of ten
of us own an equity stake in The United States of America, and many
around the world want in on the scarcity, too. This is why our
major cities 100 Crescent Court Suite 400 Dallas, Texas 75201 (214)
871-6720 Main (214) 871-6713 Fax [email protected] 7.
February 14, 2007 are congested, our commutes untenable, private
schools and colleges difficult to matriculate, and our homes keep
rising in value over measured time. The various services
underpinning the massive size and progressive liquidity of
mortgages is a fantastic business. CLAY is a pure services firm
whose clients are large institutional investors and financial
institutions who retain CLAY to provide due diligence and ongoing
risk monitoring of vast pools of domestic mortgages. Bond funds
invest heavily in mortgages as do banks, insurance companies and
pension funds. Trillions of dollars of mortgages are outstanding at
any point in time, and the pool is growing faster than our economy
due to efficiency in the capital markets. In laymens terms, there
are more mortgage products available to more segments of the US
populace every year. This is how we get to 80% home ownership.
Along with the rapid rise in availability and liquidity in
mortgages has come a rapid rise in risks. CLAY specializes in
analytical services to holders of so-called non-conforming
mortgages. The demand is vast and growing. Who better to consult on
non-conforming mortgages than a former mortgage insurance firm CEO?
Thats what scores of institutional investors have concluded and why
CLAYs revenue growth is scaling rapidly despite being a relatively
young company. The heightened concerns surrounding credit quality
in non-conforming mortgages accentuates the market opportunity for
CLAY. Given the specialization of the firm, cash margins run north
of 20% and the return on invested capital (ROIC) exceeds 50%. We
see greater than 30% cash earnings growth in 2007 and at least 25%
in 2008 for the firm. The current price-to-cash earnings multiple
is a low 8x the coming year and closer to 6x for the out year. Our
initial target price is $28 or 10x out year cash earnings. The
recent stock price is $17. The low valuation reflects the
under-the-radar-screen nature of the stock and the fact that the
Street is doing very little homework in the mortgage arena at
present due to generalist portfolio manager top down fear, and in
the case of CLAY bottom up disinformation as to what drives the
business. Alesco Financial (AFN) is a specialty commercial mortgage
REIT which lends money to investment grade commercial banks at the
high yield mezzanine level. The structure AFN specializes in is
very familiar to the research team at Western Reserve Trust
Preferred Securities or TruPS. What makes TruPS a compelling
security for banks to issue is that they offer the borrower dual
use as equity for risk-based capital (regulatory) and non
equity-dilutive debt for GAAP. There are only three firms that
specialize in bank TruPS and each has roughly one-third of the
market. Capital deployment will remain strong for bank TruPS as it
is a cost effective and regulatory safe way to fund growth through
acquisitions in a consolidating banking industry. We estimate that
as much as $12 billion in bank TruPS will be priced over the next
two years, and because AFN has a green field portfolio, organic
origination growth will exceed 30% annually over the next several
years. How AFN works is quite simple. They lend to banks at
interest rates around LIBOR plus 2% to 2.5% (over 50% higher than
Treasuries) and fund at LIBOR plus 0.5% to 0.6% (at like 100
Crescent Court Suite 400 Dallas, Texas 75201 (214) 871-6720 Main
(214) 871-6713 Fax [email protected] 8. February 14, 2007
Treasury). So, the return on assets (ROA) is 1.7% to 2% or superior
to the typical bank. Because bank failures are so infrequent, AFN
can lever the portfolio to produce superior 20% to 25% annual
returns on equity (ROE) or twice the typical bank at relatively no
risk. So, why own fully valued banks when you can own this
structure yielding over 12% on projected forward dividends, growing
at more than twice the rate of the banking industry and ahead of
the banks own equity in risk? We employed this structural play in
REIT TruPS with Taberna Realty Finance (now Rait Financial Trust
(RAS)) in 2005-2006. That investment has doubled so far and still
yields 10% at market as we were conservative in estimating the
growth in that TruPS niche. RAS remains a top 5 long. Something(s)
Old Alliance Data Systems (ADS) As an update to one of our
long-time favorites, ADS 2006 results were amazing and even
exceeded our bullish expectations relative to the rest of the
Street. Sales grew 30% and cash earnings 41% for this leading
manager of loyalty programs for merchants and retailers. The stock
ran 76% last year, in part, aided by scrambling shorts who
consistently misread credit at ADS. We took some profits late in
the year and the position dropped out of the Top 5 for a spell, but
remained a Top 10. However, this February, we took the position
back up to full on a pull-back. In the fourth quarter, ADS
marketing services cash profits exceeded their credit services for
the first time. While we have long argued the Street over
discounted ADS valuation due to the credit business being largely
misidentified and misunderstood, the acceleration in marketing
services growth should result in a higher valuation and assuage
critics who complain that ADS is overly reliant upon credit. ADS
made two important acquisitions in the past year. They now own the
leading traditional marketing data-base provider to merchants -
Abacus Direct and one of the leading on-line direct marketing
data-base firms in Epsilon. These additions round out a now
unparalleled comprehensive suite of multi-channel marketing
services for retailers at both the store locations as well for
their online strategies. This is the key reason why marketing
services now is the largest profit producer at ADS, a line of
business upon which investors should ultimately place a
significantly higher valuation. Additionally, ADS has been over
reserving for redemptions in their air miles rewards program. We
believe this represents substantial withheld profits that can be
released in future periods and currently is not be valued by the
market. The program is now fifteen years old and the total
percentage of air miles issued and subsequently redeemed is roughly
45%. When adjusted for vintage or age of the air mile reward, the
mature redemption rate or what are flat tails to statisticians is
50% to 55% based on a comprehensive study done by Ernst &
Young. Yet since the program launch, ADS has been reserving for 67%
redemptions. These excess air miles never redeemed are pure profit
and of material stored value for ADS. ADS has again set a low
hurdle (our opinion) for 2007 as they have guided the Street to at
least 15% sales growth and 20% cash earnings growth. We believe
both figures will be 100 Crescent Court Suite 400 Dallas, Texas
75201 (214) 871-6720 Main (214) 871-6713 Fax
[email protected] 9. February 14, 2007 exceeded. At just 17x
our 2007E of fully taxed-effected cash earnings, the stock remains
quite cheap for this kind recurring growth and visibility. The
multiple of actual operating cash earnings (ADS has a tax advantage
in the way air mile rewards are treated for GAAP versus tax) is a
compelling 10x. Too low! We see ADS hitting $85-$88 in the next
twelve months or 22x fully-taxed effected cash earnings for 2008 of
$4.00-$4.10. The recent stock price was $60-$61. Capital One (COF)
To further eliminate the temptation to time this stock as sentiment
ebbs and flows, last summer we purchased January 2008 LEAPS when
the stock touched $69 (recently $83). As an update, the bank
mergers are all closed now; credit is as diversified and solid as
it has ever been; and the stock trades like its going out of
business at 8x. The valuation is comical relative to the junk we
see trading at 30% to 50% higher in financial services. COF is so
misunderstood and viciously maligned by even the most sophisticated
investors that a Barrons Roundtable portfolio manager bragged in
print that he sold his NorthFork Bank shares because he had learned
that 33% of COFs loans were Alt-A (non-conforming) mortgages. What
he failed to see was that 33% of NorthForks loans were Alt-A
mortgages (not COF). Apparently, this was news to the seller as he
blamed COF for holding the very non-conforming mortgage loans he
previously was long in his NorthFork stake. Further, Northfork/COF
sells most of their nonconforming mortgages at the time of
origination. As I often have joked with colleagues over the years
(I have been long COF almost nonstop since 1994), COF has been
accused of many things, including both Kennedy assassinations.
1,500% earnings growth since going public in 1994, no multiple
expansion since 1994, no down years ever; and
