Eagle Capital Management provides a quarterly report for Q1 2010. While the S&P 500 gained 5.39% for the quarter, Eagle's performance was impacted by avoiding cyclical stocks that drove the market. Eagle believes the current economic recovery is short-term and focused on companies positioned for slow growth. Specifically, Eagle did not invest in banks, which rose significantly, instead relying on individual stock picking. Eagle is concerned banks' value depends too much on interest rates, which the Fed controls, and sees risks to the current low rate environment from limited demand for bonds and potential inflation. One of Eagle's investments, Kraft Foods, fell after an acquisition but Eagle analyzed the combined company and believes execution of synergies
Eagle Capital Management provides a quarterly report for Q1 2010. While the S&P 500 gained 5.39% for the quarter, Eagle's performance was impacted by avoiding cyclical stocks that drove the market. Eagle believes the current economic recovery is short-term and focused on companies positioned for slow growth. Specifically, Eagle did not invest in banks, which rose significantly, instead relying on individual stock picking. Eagle is concerned banks' value depends too much on interest rates, which the Fed controls, and sees risks to the current low rate environment from limited demand for bonds and potential inflation. One of Eagle's investments, Kraft Foods, fell after an acquisition but Eagle analyzed the combined company and believes execution of synergies
Eagle Capital Management provides a quarterly report for Q1 2010. While the S&P 500 gained 5.39% for the quarter, Eagle's performance was impacted by avoiding cyclical stocks that drove the market. Eagle believes the current economic recovery is short-term and focused on companies positioned for slow growth. Specifically, Eagle did not invest in banks, which rose significantly, instead relying on individual stock picking. Eagle is concerned banks' value depends too much on interest rates, which the Fed controls, and sees risks to the current low rate environment from limited demand for bonds and potential inflation. One of Eagle's investments, Kraft Foods, fell after an acquisition but Eagle analyzed the combined company and believes execution of synergies
The first quarters 5.39% gain for the S&P 500 marked a 55-week move of 77% from the March 2009 lows. This is one of the longest rallies without a 10% correction in history; all three comparable rallies were in the secular bear period of the 1930s. We were pleased that we performed as well as we did, given the strength of cyclical stocks, which we had avoided. Expense cuts and inventory rebuilding are fuelling a short-term profit recovery, but GDP growth is likely to slow as these effects wane. Unprecedented government spending and Federal Reserve liquidity must be cut back at some point, and consumers will be constrained by debts for a long time. Many observers have focused on the sharp earnings rebound in the near quarters, while we have concentrated on companies that are poised to do best in a slow-growth economy over the next five years. In a quarter when bank shares rose four times faster than the rest of the market, Eagle owned none; we depended on individual stock-picking to keep up with this liquidity-driven rocket. We may lag for a time if banks continue their run, so it is appropriate to explain why we have not made that commitment with your money. Our reluctance is not a product of any certainty that banks are overvalued. Many banks appear cheap on "normalized" earnings, and some have attractive franchises. Were we to run a hedge fund, we would not be short. But we are concerned that the current value of banks seems especially dependent on and vulnerable to future interest rates. Our historical returns have derived from getting a research advantage in estimating a companys prospects and value, not betting on the shape of the yield curve. There is widespread faith that the Federal Reserve has firm control over interest rates and that Ben Bernanke has the tools necessary to keep short rates low and long rates moderate. This curve, if it holds, provides apparently free money to banks that borrow short and lend long, while it drives investor money into risky assets, including bank loan collateral and bank shares themselves. The idea is that a US "output gap" prevents inflation, permitting the Fed to keep short rates near current levels, while a global savings glut ensures adequate demand for longer-term debt at real rates of 2%. This view could turn out to be correct, but the market seems more certain than we are.
April 2010
Eagle Capital Management, LLC
There are two key risks in the medium term to the current shape of the yield curve and along with it - the health of fragile banks. First is the limited supply of buyers for 10-year US government bonds at an interest rate of only 4%. China may need its trillion dollars for its own stimulus program. Japan's savings rate is now approaching zero. US consumers have barely raised their savings. Nearly every nation is aging, and as more people retire, savings are tapped faster than they accumulate. Second is the potential for inflation if the dollar is debased and commodity prices rise from emerging markets demand. Already China buys more oil from Saudi Arabia than the US does. Asias infrastructure build-out and domestic consumption will raise demand for building materials and all kinds of food inputs. The Chinese currency will appreciate at some point. When it does, imports will cost the US more and Chinese buying power will rise proportionately. As we press China to revalue their currency, we might keep in mind that it will be tougher to bid against them when they do (be careful what you wish for). Meanwhile, skilled labor is not in infinite supply in the US or globally. Wages in China have been rising for years, and even the US has three million jobs unfilled because we lack the skills to fill them. That could lead to stagflation, which occurs when money grows in the face of supply constraints. Our shopping malls may be empty and 15% of Americans may not have jobs, but that doesn't mean the cost of oil, food, and certain skilled labor can't move up sharply if monetary policy is too loose. Theory aside, we have seen this story before. We highly recommend Michael Lewiss new book, The Big Short, in which one of our good friends, Charlie Ledley, figures prominently. Working from a friends back-yard shed, Charlie and his partner managed to build one of the best track records in a brutal, competitive industry. Their key advantage was and remains an understanding that the market repeatedly underestimates the odds of unlikely events. As they researched one of their greatest trades - a 2007 bet against mortgage CDOs, Charlie tried to understand why none of the Wall Street experts were making the same bet. "Things will never get so bad that CDOs will go bad," Charlie was told repeatedly. Lewis writes that Charlie and his partner didn't know for sure that sub-prime loans would default in sufficient numbers to cause the CDOs to collapse. All they knew was that Deutsche Bank didn't know either, and neither did anybody else." When we think about risk, we do not think about the risk that we underperform some benchmark temporarily. We think about risk as the possible permanent loss of your capital. There is a chance our bearish vision of higher interest rates, stalling growth and inflation wont play out, or that it will not happen within the next year or two that comprise most investors' time horizon. But we do not predicate our investments on a specific economic premise. We think about a wide range of possible outcomes and try to be sure that we can be safe in all of them, prosperous in enough of them. Some call this probabilistic thinking, but it is really just dynamic common sense.
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April 2010
Eagle Capital Management, LLC
Fortunately we have opportunities that do not require a strong macroeconomic view. One recent investment we have made is Kraft Foods. Kraft shares fell in January of this year after the company announced its acquisition of Cadbury, a global confectionary company with a strong footprint in Europe and emerging markets. We had previously studied Cadbury and liked its position. We built up our understanding of Kraft, spending time with the CEO in our offices and speaking with current and previous executives and mid-level employees at Kraft, Cadbury, their competitors and retail buyers in the US, Europe and Asia. We modeled the combined companies product by product, adding up the value of the pieces into a global whole. As we reviewed each business, we concluded that - with a large emerging markets presence, efficient scale in Europe, and product dominance in each geographic area Krafts new management team should be able to cut costs, ramp up growth and leverage its free cash flow, raising earnings per share and its low multiple. There is of course a risk that we are mistaken in our analysis. We may be wrong about Kraft's execution, about the future of private label products in chocolate and gum, about the power of retailers in emerging markets, etc. But these are all calculated risks, and they can be balanced against the price we are paying and the returns we can earn even in a bad scenario. Unlike certain bank stocks we have tried to analyze recently, there is almost no macroeconomic development that could bankrupt Kraft or force a recapitalization. If we are wrong about CEO Irene Rosenfeld and her ability to revitalize the company, the business we bought should still earn a depressed cash-on-cash return of 8%. That is not an aspirational target, but as a bad-case scenario it gives us comfort. That said, we arrive each morning ready to re-examine our ideas and consider new facts. Many smart investors have invested in banks this year, generally to their profit, and we are always grateful for your contrary opinions. If you have any questions or would like to discuss anything we are doing, please call Terry Shea, John Johnson, John Holman, Anne Maffei, Boykin Curry or Ravenel Curry at 212293-4040.