Monthly Client Update - January 2009

Our montly returns are being audited right now. I believe our number to be accurate. That being said I will be published the official number as soon as completed - hopefully any day.

The letter is a collection of my thoughts on the outlook for 2009. The economic deterioration is moving at a break neck pace so I thought it important to outline where we stand.


February 3, 2009


Dear Investors,

This is our first communication of 2009 and it comes on the heels of our best month since inception. The fund returned 16% in January - a good start to the year. Performance was driven by our Health Care exposure. In January, the Pfizer–Wyeth mega merger illustrated that merger and acquisition activity was not dead but was just hiding in the Health Care sector. Also, one of our biotechnology companies finalized a lucrative partnership deal. This helped move the stock up 281%. We are anticipating another positive event with the company’s Phase III readout this month. Stay tuned!!!!

40,000 FOOT VIEW

In our December commentary we discussed how we are becoming constructive on the equity markets for 2009. I want to elaborate on our position. Regarding 2009, our prior view was that both interest rate cuts and pending fiscal stimulus would “…be felt in the economy in 2009 and help stabilize both the global economy and equity markets.”

This has changed somewhat. It is clear now that monetary stimulus has not worked. Central banks either have cut rates close to zero or are in the process of doing so. History tells us that recessions are inventory crises solved by monetary policy. Cutting interest rates lowers borrowing costs and induces spending, and the economy begins to recover. To be perfectly clear, we are not seeing this at all. Banks continue to tighten lending standards and hoard cash (to repair their own leveraged balance sheets) while consumers have stopped spending on anything non-essential (most likely due to the fear surrounding the ever rising unemployment rate). Our current economic situation is a balance sheet issue in which Western-world economies accumulated debt at an astounding rate over the past two decades. This is the deflationary unwinding process.

We have established three principles, not only to live by, but to invest by as well:

1) deleveraging will become the new leveraging (households really do prefer less debt)
2) in order to deleverage and pay down debt we will continue to liquidate assets
3) personal savings rates will drift upward toward the long run average of 8%

This will not happen over night. Time is the only antidote. Simply put, excess in one direction always leads to excess in the other direction.

To muddy the water, the global banking system is in the process of being nationalized (at least to some degree). Banks such as the Royal Bank of Scotland, Lloyds TSB, Bank of America and Citigroup all have varying degrees of state ownership. This process is nowhere near over. Global fiscal stimulus will certainly help. However, it will only serve as a plug figure as personal investment and consumption fall off a cliff for many years.

WHERE THE RISKS LIE

Our investment approach is to focus on companies exposed to near term catalysts within five core sectors. Given current global circumstances, we are not investing in the financial sector until it is clear what role governments will play in the restructuring process. To be frank, I would have better odds in Las Vegas at the blackjack table than investing in the financial sector. TARP has indeed become a TRAP for investors. The restructuring that needs to happen will be in the form of capacity reduction. Financial institutions will either merge or fail to help reduce excess capacity. In this environment M&A premiums will be eroded and equity returns will focus on ever shrinking earnings. The competition for deposits and loans will be fierce, driving down bank earnings until the sector is rationalized. This has not happen yet and as such we wait.

We also fear that a worldwide recovery in the latter part of 2009 is priced for perfection in the markets. We see risk here - especially in China. This is an uncertain time and we feel it prudent to take a wait and see approach with the recovery. The reason for this is that if growth does not emerge, there is a high probability we will be looking at protectionism and trade wars. We have already seen the new U.S. administration making noise over currency manipulation of the Chinese renminbi. We feel this is just the beginning and we will be hearing more and more rhetoric sooner rather than later.

STRANGE BEDFELLOWS – FROM CONSOLIDATION TO PROTECTIONISM

Throughout history we note that bubbles build overcapacity and that consolidation is natural once the bubble bursts. One of the interesting points about this credit bubble is that it was global in nature, crossing borders and industries. Consolidation is not looked upon favorably in recessions. It tends to cross economics and move into politics as unemployment increases as firms merge, improve economies of scale or go bankrupt. Politicians tend to fight back via protectionist measures and support industries that should cease to exist. Decisions are not rational. The U.S. domestic auto industry is a perfect example.

For investment purposes it is important not to lose site that protectionism serves to keep excess capacity in the system, and limits corporate pricing power. In fact, I have yet to find a period in which inflation moves higher when excess capacity remains in the economy. We continue to monitor capacity utilization and the output gap as a gauge of slack in the global economy. At this point there is no reason to be excited. This is why we have cooled to the “reflationary” global growth trade. The outcome looks inevitable. Deflation is here to stay.


HEALTH CARE IS EXCITING!

To expand on our Health Care theme, there were 89 acquisitions worth $92.6 billion in 2008. It bears saying that Health Care has nothing to do with global growth, Chinese GDP or rising commodity prices. It has to do with people getting sick, which is recession-proof. However the sector is not completely immune to a major financial crisis. The lack of liquidity and limited availability of credit have become major constraints to the industry – lowering potential M&A opportunities, partnerships, and corporate financing for many biotechnology companies. Large pharmaceutical companies have become much more selective where they spend their war-chest.

After analyzing trends in Health Care M&A, we have concluded that the buyers are looking to buy companies with co-marketed products. This helps eliminate both execution risk and competitive response while potentially addressing the need to add late-stage drugs to their pipelines. The proposed acquisitions of Genentech by its partner Roche and ImClone by its partner Bristol-Myers Squibb are examples of this trend. We see this as an important theme for 2009 and have highlighted four macro factors that help support this view:

1) pharmaceutical companies have become de facto marketing companies (remember those Cialis adds where the guy is throwing the football through a moving tire – brilliant)
2) drug development has stalled in the past decade leading to insufficient pipelines
3) a large number of blockbuster drugs (> $1 billion in sales) come off patent between 2010 and 2013 – this revenue needs to be replaced
4) large pharmaceutical companies are in good financial position with approximately 8% of their market cap in cash




As a closing note on the Health Care space, we present M&A data relating premiums to deal size. Statistically 95% of all mergers between 1998 - 2009 involved companies with a market capitalization of less the $5 billion. The average premium of these deals was 45%. The remaining 5% of acquisitions were above $5 billion but captured a lower premium (25%)! We continue to build a basket of health care names that are differentiated by targeted disease, capitalization and stage of development.

INTO THE BLOGOSPHERE!

We have become much more cautious on the global economy moving forward. Deflationary headwinds continue to be felt and will be difficult to eliminate in the near to medium term. The portfolio is positioned to benefit from this environment. We continue to focus on stock-specific outcomes that are independent of the market. If we are wrong on the direction of the market our portfolio will follow the market higher as a “rising tide floats all boats”. But for now, caution is the word of the day.

January was our second consecutive positive month. While we are pleased with these results these are only a few steps in a long journey. I will be trying to write more often and to facilitate this have started a blog: http://www.epicfailures.blogspot.com/. I’m trying to post between two and three entries per week. This will give candid insight as to my thoughts on the world in which we live and invest. Let us know if you have any questions.