2012 Annual Letter to Investors

Our portfolio gained 16.41% in 2012. Here are our returns since 2009ⁱ:

	Return	S&P1	Difference	HFRX2	Difference
2009	50.92%	26.46%	24.46%	13.40%	37.52%
2010	18.83%	15.06%	3.77%	5.19%	13.64%
2011	2.28%	2.05%	0.23%	-8.88%	11.16%
2012	16.41%	16.00%	0.41%	3.51%	12.90%
CAGR3	17.06%	14.56%	2.50%	2.99%	14.07%

And here is how $100,000 would have compounded versus those two benchmarks if it was invested at the end of 2008:

Compared to the hedge fund universe at large (HFRX), we have done well. But compared with the S&P, we have done just okay.

As erstwhile Buffett lieutenant David Sokol once said, I am pleased but not satisfied. With the exception of 2009, our investments have tracked the S&P 500 very closely. In fact, one might draw the conclusion that I am “index hugging”. To value investors, including myself, that is a pejorative. So while I am pleased we have not had a down year (yet) and I am pleased we have outperformed the S&P (if only by a slim margin these past few years), I am not satisfied. My goal is to outperform by a bigger margin.

***

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¹This is the total return of the S&P 500, including if dividends were reinvested.
²The specific index here is the HFRX Global Hedge Fund Index, widely used index to praise or pan hedge funds in the press.
³CAGR = Compound Annual Growth Rate. Note that our 17.06% return is actually an IRR (explained in footnote 4) from 2009-2012 rather than a simple CAGR, which would have been a more inflated 20.88%.

No Bids On The TSLF

In a day of flash bang news items (Mark-to-market rule changes, G20 coverage, Yadda yadda), here's a quiet little piece that very few people saw:

Dealers submit no bids in $25 billion TSLF auction

This is a very important indicator of the recovering health of the financial markets. The TSLF was setup to swap trash-for-cash, essentially, when banks were suffering from a frozen winter in the credit and repo markets. According to Tony Crescenzi, the initial bid/cover ratio at its launch was near 2 to 1 as banks hit it up like a man hitting up a water fountain in the desert. Today? zero.

Liquidity is flowing again. And with the newly defanged mark-to-market rules, banks are now free to earn their way out of trouble. Bank of America CEO Ken Lewis is on the record saying his company has a normalized $30 billion in earnings power, translating to $5/share. Simple arithmetic implies a $50/share value given a normal 10x earnings multiple. Of course, take what any CEO tells you with large helpings of salt and Tabasco sauce, but it's without question that surviving bank stocks will be multi-baggers in the intermediate future.

I have owned Goldman Sachs for several months now, averaging down to about a $70 cost basis that has paid off handsomely since. I am now looking seriously at Bank of America, as I think it is clear 1.) it will not be allowed to fail, 2.) it is unlikely to be nationalized given its earnings power combined with PPIP and forbearance in the form of relaxed M2M.

Sometimes, it's just that easy. Shelve the righteousness and take what you can get. Be steadfast during the rocky day-to-day volatility.

Those of the more cautious persuasion should take a look at any of its deeply discounted preferreds. Many of them are more than 50% discounted from par, and yield a ridiculous 15%+.