"Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it” Warren Buffett      "We believe that according the name 'investors' to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a 'romantic" Warren Buffet      The fund has been up and running for four months now and we certainly picked a very volatile time to launch. Pair wise correlation in June reached levels last seen in 1987 (see graph below) as volatility caused by macro uncertainty caused investors to sell stocks indiscriminately. We further more believe High Frequency Trading (HFT) which are run by computer programs employed by hedge funds, which currently accounts for between 50%-70% of volume, has further increased this volatility and was the reason for the flash crash of May 6 where the Dow dropped 998 points in 10 min before rising 600 points before finally closing down 350.    As mentioned in previous mails this recovery has been led by lower quality companies that are both operationally and financially geared with poor prospects. Many of these were of the verge of bankruptcy a year ago yet have outperformed quality for 14 months, the 3rd longest cycle since 1987. How long it will persist we cannot forecast but I think its safe to assume the trend is long in the tooth.    The trifecta of volatility, high correlation and low quality outperforming is not a great environment for bottom up stock picking to outperform in the short term but does provide us with some wonderful opportunities to set the stage for significant outperformance over the next few years as we are able to buy quality companies with bright prospects at the same or even cheaper valuations than the market which in itself is cheap (see table below).    When rationality returns and the market once again shows a preference for stable earnings with good prospects we should be duly rewarded even if multiples do not expand. With our bias for quality and concentration we should benefit disproportionately when this happens.

     

Below is a table that illustrates the difference in yield between the earnings yield on the Dow and high grade corporate bond yields at every market bottom since 1932. The average difference at market bottoms since 1932 is -2.8%, we are currently sitting at approximately -4.3%. The earnings yield of the market as a whole is 9.6% when adjusted for the $100 of cash embedded in the SP500 its over 10%. If companies can grow at 5%, which they will be able to do without having to reinvest earnings since there is so much spare capacity, investors will receive mid double digit returns p.a. even if multiples did not expand.    Our portfolio of assets are far cheaper than the market overall with better growth prospects and I expect our returns to be 20%+ p.a next couple of years. It amazes me that one can obtain such a large spread by owning a growing coupon relative to lending a fixed one. How long the anomaly will persist is beyond our ability to forecast but that it will eventually normalise is a certainty, as it always has in the past.    Attached is our latest letter for your perusal where we speak in greater detail as to why we have such a constructive view currently.    

             

Fountainhead  Partners  Letter  No.  2  July  2010    Market  Commentary    I will begin with three quotes that speak to the current situation. Two are by Ben Graham, the father of value investing, as at times like this I always dust off the Intelligent Investor to remind myself of the principles that successful investing are based on. “The Chinese use two brush strokes to write the word 'crisis'. One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger-but recognize the opportunity.” John  F  Kennedy “Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble... to give way to hope, fear and greed.” Ben Graham “The individual investor should act consistently as an investor and not as a speculator. This means that he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money's worth for his purchase.” Ben  Graham      

             

 

   

         

The  fund  was  launched  approximately  three  months  ago  and  while  the  returns  have  underperformed  the  broader  market  we  are  more  excited  now  than  we  were  late  2008/early  2009.  Given  the  concentrated  nature  of  the  fund  together  with  its  bottom  up  methodology,  the  fund  will  often  lag  the  market  in  the  short  term  to  achieve  its  long-­‐term  goal  of  creating  value.          Cast  your  mind  back  to  the  late  2008/early  2009  time  period.  (Refresher  below)    

The  Fannie  Mae  and  Freddie  Mac  were  both  placed  in  conservatorship  in  September  2008.  The  two  entities  guarantee  or  hold  mortgage-­‐backed  securities,  mortgages  and  other  debt  with  a  Notional  value  of  more  than  $5  trillion.  

   Merrill  Lynch  was  acquired  by  Bank  of  America  in  September  2008  for  a  mere  $50  billion.  ($29  a  share  vs.  peak  of  $98,  after  the  share  price  had  sunk  as  low  as  $17)  

   Scottish  banking  group  HBOS  agreed  on  17  September  2008  to  an  emergency  acquisition  by  its  UK  rival  Lloyds  TSB,  after  a  major  decline  in  HBOS's  share  price  stemming  from  growing  fears  about  its  exposure  to  British  and  American  mortgage  back  securities.  The  UK  government  made  this  takeover  possible  by  agreeing  to  waive  its  competition  rules.  

         Lehman  Brothers  declared  bankruptcy  on  15  September  2008,  after  the  Secretary  of  the  Treasury  Henry  Paulson,  citing  moral  hazard,  refused  to  bail  it  out.  

 AIG  received  an  $85  billion  emergency  loan  in  September  2008  from  the  Federal  Reserve,  which  AIG  is  expected  to  repay  by  gradually  selling  off  its  assets.  In  exchange,  the  federal  government  acquired  a  79.9%  equity  stake  in  AIG.      Washington  Mutual  (WaMu)  was  seized  in  September  2008  by  the  USA  Office  of  Thrift  Supervision  (OTS).  Most  of  WaMu's  untroubled  assets  were  to  be  sold  to  J.P.  Morgan  Chase.  

   In  November  2008,  the  U.S.  government  announced  it  was  purchasing  $27  billion  of  preferred  stock  in  Citigroup,  a  USA  bank  with  over  $2  trillion  in  assets,  and  warrants  on  4.5%  of  its  common  stock.  The  preferred  stock  carries  an  8%  dividend.  This  purchase  follows  an  earlier  purchase  of  $25  billion  of  the  same  preferred  stock  using  Troubled  Asset  Relief  Program  (TARP)  funds.    

At  the  time  there  was  large  uncertainty  whether  the  worlds  financial  system  would  totally  collapse  and  send  the  global  economy  back  into  the  Stone  Age.    As  a  result  the  market  was  extremely  volatile  and  we  witnessed  several  of  the  largest  points  moves  on  the  Dow  in  either  direction  during  that  period.  

Largest daily point losses Rank Date Close Net Change % Change

1 2008-09-29 10,365.45 -777.68 -6.98 2 2008-10-15 8,577.91 -733.08 -7.87 3 2001-09-17 8,920.70 -684.81 -7.13 4 2008-12-01 8,149.09 -679.95 -7.70 5 2008-10-09 8,579.19 -678.91 -7.33

 

Largest daily point gains Rank Date Close Net Change % Change

1 2008-10-13 9,387.61 +936.42 +11.08 2 2008-10-28 9,065.12 +889.35 +10.88 3 2008-11-13 8,835.25 +552.59 +6.67 4 2000-03-16 10,630.60 +499.19 +4.93 5 2009-03-23 7,775.86 +497.48 +6.84

 The  two  recessions  of  the  new  millennium  coupled  with  earlier  losses  in  the  dotcom  crash  explains  what  we  see  as  irrational  behaviour  of  investors  today.    With  equities  in  developed  markets  having  produced  negative  returns  over  the  past  ten  years  together  with  large  volatility,  investors  have  started  to  ignore  this  asset  class  as  a  form  of  wealth  creation.    The  strongest  performing  assets  classes  over  the  past  10  years  continue  to  receive  fund  inflows  as  investors  believe  that  returns  made  from  these  asset  classes  will  be  repeated  in  the  next  several  years.      Investors  are  simply  ignoring  fundamentals  and  continuing  to  commit  funds  into  what  has  worked  the  last  10  years  -­‐  in  no  particular  order,  bonds,  gold,  cash  and  emerging  market  equities.    With  bond  yields  on  the  10  year  US  treasuries  sitting  at  below  3%  we  believe  with  great  certainty  that  investors  will  receive  negative  returns  in  the  years  ahead,  yet  currently  9  of  the  top  10  funds  receiving  inflows  are  bond  funds.  PIMCO  received  the  most  inflows  out  of  any  firm,  despite  Bill  Gross  clearly  stating  he  thinks,  “Bonds  have  had  their  best  days”.  Interestingly  PIMCO  opened  an  equity  fund  for  the  first  time  since  the  80’s,  days  after  this  comment.  This  statement  comes  after  the  record  inflows  that  bond  funds  have  received  during  2009,  which  amounted  to  $375bn  and  equates  to  more  than  the  inflows  for  the  preceding  5  years  combined.        

 

What  is  even  stranger  is  that  bonds  and  gold  are  rallying  simultaneously.  One  would  be  bullish  on  gold  if  the  expectation  was  for  an  inflationary  environment  and  bullish  on  bonds  if  one  was  expecting  deflation.  The  only  explanation  is  that  investors  are  basing  their  decision  on  where  to  invest  their  funds  on  past  performance  and  not  fundamentals.  

 Lastly  emerging  markets  continue  to  perform  well  as  investors  use  past  performance  as  a  basis  for  investing.  Although  Fountainhead  has  several  excellent  emerging  market  companies  on  our  radar  screen,  only  two  currently  pass  our  valuation  criteria.      

Fund  Position    Developed  market  equities  and  especially  US  companies  offer  significant  value  and  are  as  cheap  as  they  have  been  at  anytime  in  the  past  50  years  (see  graph  below).  A  bottom  up  value  approach  is  crucial  to  indentify  this  value  and  is  the  reason  why  89%  of  the  fund  has  been  invested  in  well  established  large  cap  quality  stocks  in  the  US.  

 Source:  Legg  Mason    

   

Once  again  I  reiterate  to  partners  that  most  of  these  companies  are  actually  global  companies  with  US  listing,  but  due  to  the  negativity  surrounding  equity  investing  in  the  US,  one  can  buy  these  stocks  at  fantastic  prices.    One  has  far  more  visibility  today  than  what  one  had  in  2008/early  2009,  yet  many  of  these  stocks  trade  at  very  similar  prices  to  what  we  saw  the  during  the  worst  part  of  the  crisis.  This  increases  our  belief  for  the  return  potential  of  the  portfolio.  All  the  companies,  whether  from  balance  sheet  perspective  or  from  the  large  amount  of  costs  that  they  have  managed  to  save,  are  far  superior  to  the  position  they  were  in  during  the  crisis.    All  these  companies  are  trading  on  high  double  digit  free  cash  flow  yields  or  owners  earnings  as  Warren  Buffet  refers  to  it,  based  depressed  earnings  and  are  therefore  likely  to  grow  significantly  the  next  few  years  with  well  capitalized  balance  sheets,  Mr  Market  however  is  not  paying  any  attention  to  fundamentals  at  the  moment.  Even  if  the  global  economy  remains  stagnant  for  the  foreseeable  future  these  stocks  will  still  provide  excellent  returns,  all  that  is  required  is  patience.  If  the  global  economy  surprises  on  the  upside  the  returns  will  be  even  better  

     

The  table  below  that  we  got  from  Legg  Masson  is  pretty  powerful        

                         

 It  shows  the  real  value  of  $1  invested  over  a  207  year  period  in  different  asset  classes.  Despite  equities  outperforming  bonds  by  a  factor  of  427  over  the  last  200  years  the  value  that  has  been  destroyed  in  equities  over  the  past  10  years  has  resulted  in  equities  largely  being  ignored  by  investors  today.    As  long  term  investors  we  are  delighted  by  this  negativity,  not  only  because  we  can  purchase  these  companies  at  exceptionally  discounted  prices  but  also  due  to  the  value  creating  activities  of  several  of  our  management  teams  by  using  free  cash  flow  to  buyback  and  retire  a  significant  percentage  of  their  outstanding  shares,  thereby  creating  enormous  value  creation  that  will  accrue  to  the  portfolio  once  the  fundamentals  of  our  portfolio  holdings  starts  to  be  recognized  and  starts  reflecting  in  the  share  prices.    Due  to  the  continuous  inflows  that  we  are  receiving  in  the  fund  we  are  able  to  buy  more  of  these  businesses  at  ever  more  discounted  prices  to  provide  further  value  to  the  fund.    Most  investors  incorrectly  associate  short  term  volatility  with  risk,  which  creates  an  opportunity  to  acquire  great  companies  using  our  fundamental,  unemotional  process.  Mr  Market  today  is  providing  investors  whom  are  willing  to  do  the  same  a  wonderful  opportunity  to  create  value  and  wealth.    With  the  portfolio  trading  at  close  to  0.3  P/V  the  fund  is  extremely  well  placed  to  produce  significant  returns  over  the  next  few  years.  As  per  Ben  Graham’s  quote  on  the  first  page,  we  are  obtaining  significantly  more  than  our  money’s  worth  for  each  incremental  dollar  invested  either  

via  inflows  invested  by  us  or  via  the  action  of  the  management  teams  of  our  investee  companies  via  buybacks.      We  have  attached  two  reports  for  interested  readers,  the  first  by  Legg  Masson  covering  the  topic  of  sideways  markets  that  occur  if  macro  data  tends  to  be  weak  and  non  directional  as  we  had  in  the  mid  70’s  till  early  eighties  (SP500  was  at  the  same  level  in  1982  as  it  was  in  1975,  a  period  when  stock  pickers  such  as  Buffett  and  Ruane  produced  average  annual  returns  of  31%  and  28%  respectively).  You  will  find  some  of  the  material  very  interesting,  especially  in  an  environment  where  long  term  value  investing  is  being  ignored  as  an  investment  principle.  Also  included  is  Legg  Masons  Bill  Miller,  July  2010  comment      I  will  end  of  with  a  excerpt  from  this  report      “It  is  almost  tautology  in  capital  markets  that  the  best  investments  are  those  with  the  worst  previous  returns,  where  expectations  are  low,  demand  is  down,  and  prospects  appear  at  best  highly  uncertain.  In  1980  bonds  had  been  through  a  30  year  bear  market  relative  to  stocks,  inflation  was  soaring,  yields  were  at  historic  highs,  yet  expected  to  go  higher,  and  a  long  bull  market  in  bonds  was  at  hand.  The  idea  that  US  interest  rates  would  be  near  all  time  lows  30  years  later  would  have  been  dismissed  as  ludicrous.  The  situation  is  now  reversed,  with  stocks  having  underperformed  bonds  for  decades.    The  point  here  is  simple:  US  large  capitalization  stocks  present  a  once  in  a  lifetime  opportunity  to  buy  the  best  quality  companies  in  the  world  at  bargain  prices.  The  last  time  they  were  this  cheap  relative  to  bonds  was  1951.  I  was  1  year  old  then,  but  did  not  have  sufficient  sentience  or  capital  to  invest”.    BM    I  will  conclude  with  a  quote  by  Warren  Buffet  that  sums  up  how  we  feel  at  present.  He  said  this  when  he  began  actively  buying  stocks  again  in  the  mid  70’s.    "Look  At  All  Those  Beautiful,  Scantily  Clad  Girls  Out  There!"  WB      As  always  if  you  have  any  questions  do  not  hesitate  to  contact  me.    Yours  in  Value    Fountainhead  Partners    July  2010