whitney tilson photoFrom Whitney Tilson:

September 1, 2011

Dear Partner,

Our fund declined 13.7% in August vs. -5.4% for the S&P 500, -4.0% for the Dow and -6.4% for the Nasdaq. Year to date, it’s down 22.1% vs. -1.8% for the S&P 500, +2.1% for the Dow and -2.2% for the Nasdaq.

On the long side, our portfolio got clobbered across the board despite generally good company-specific news regarding our major holdings (discussed below). Amidst a tumultuous month in the markets, investors dumped stocks that were even slightly illiquid, or that are valued primarily on future, rather than current, profits – both traits that characterize many positions in our fund. One of our biggest advantages is being willing and able to look out 2-3 years when most investors are looking out 2-3 months (or, in many cases, 2-3 microseconds), but this hurt us last month. Thus, big-cap stalwarts with strong cash flows and balance sheets like Berkshire Hathaway (-1.6%), Microsoft (-2.9%), AB InBev (-4.0%), and Kraft (+1.9%) held up relatively well, but the rest of our portfolio didn’t as more than a dozen of our major holdings suffered double-digit declines: Grupo Prisa B (-28.0%), Resource America (-23.3%), Citigroup (-19.0%), General Growth Properties (-18.9%), Iridium warrants (-17.6%), Seagate (-16.6%), Winn Dixie (-14.1%), J.C. Penney (-13.4%), BP (-13.3%), CIT Group (-13.0%), dELiA*s (-11.5%), Sears Canada (-11.1%), and Howard Hughes (-10.5%).

Our short book performed well, led by declines in Corinthian Colleges (-47.1%), Boyd Gaming (-28.5%), ReachLocal (-20.0%), Lennar (-16.9%), ITT Educational Services (-15.8%), MBIA

(-15.7%), First Solar (-15.4%), OpenTable (-13.9%), SuccessFactors (-13.5%), Salesforce.com

(-11.0%), and Lululemon Athletica (-9.6%).

Our View of Market Opportunities 

In our view, the turmoil of the past month has created the best bargains we’ve seen in the market since the chaos and panic of late 2008 and early 2009. Of course stocks aren’t anywhere as cheap now as they were then, but the risks aren’t nearly as great either (we think many people didn’t realize or have forgotten how close we were then to a worldwide Great Depression), so on a risk-adjusted basis we think our portfolio is as attractive now as it was then.

While we have great confidence in the eventual outcome, we can’t make any short-term forecasts. We thought the stocks we owned were very cheap a month ago, but that didn’t stop them from falling quite a bit further – and this could continue. Catching falling knives sometimes results in cuts.

So, then, you might ask, why don’t we stop holding onto falling knives, sell much of what we own, and wait for more clarity, strength, confidence, etc. to return to the market? Oaktree’s

Howard Marks answers this question in his latest book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor (which we highly recommend). He writes:

Common threads run through the best investments I’ve witnessed. They’re usually contrarian, challenging and uncomfortable. Whenever the debt market collapses, for example, most people say, ?We’re not going to try to catch a falling knife; it’s too dangerous.? They usually add, ?We’re going to wait until the dust settles and uncertainty is resolved.?

The one thing I’m sure of is that by the time the knife has stopped falling, the dust has settled and the uncertainty has been resolved, there’ll be no great bargains left. Thus a hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron.

It’s our job as contrarians to catch falling knives, hopefully with care and skill. That’s why the concept of intrinsic value is so important. If we hold a view of value that enables us to buy when everyone else is selling – and if our view turns out to be right – that’s the route to the greatest rewards earned with the least risk.

Changes to the Portfolio 

We took advantage of the market volatility last month to make a number of changes in our portfolio. Specifically, we:

  • Reduced risk by taking down both our gross long and short exposures such that we are now 117% long and 40% short (77% net long).
  • Eliminated any position in which we didn’t have enormous conviction. In particular, with only a few exceptions, for long positions smaller than 3% we either bought more or, in most cases, sold entirely. With regret (because we think they’re cheap and will do well), we sold CIT Group, General Growth Properties, Winn Dixie, Kraft, BP and Fairfax Financial, among others.
  • We only made a few changes to our short book, most notably covering MBIA (what an wild and profitable ride that has been over nearly a decade!) and Simon Properties (which was a hedge against our long position in GGP).
  • For investments with similar risk-reward profiles, we chose our favorite and sold the other. Specifically, we added to Citigroup and exited CIT Group, sold Seagate to buy Western Digital, and trimmed Microsoft to buy Dell (discussed below).
  • We took advantage of the carnage among financial stocks and initiated new positions in Goldman Sachs and a tiny position in Bank of America (after Buffett invested), plus added to our positions in Berkshire Hathaway, Citigroup and Wells Fargo. We think investors are lumping imperiled European financials in with U.S. financials, which are in much better shape (though still facing real headwinds to be sure).

The net result of these changes, we believe, is lower risk, less clutter (both in our portfolio and in our minds), some great new positions, and tremendous upside thanks to a portfolio much more focused on our best ideas.

Annus horribilis 

It has now been exactly a year since our performance has taken a nosedive – we’re down 23.3%. We feel terrible about it and obviously wish we’d done some things differently, but we are not at all discouraged or worried, as we’ve been through this before: if you look at our performance table at the end of this letter, you will see that we’ve lost more money, much faster, on two other occasions: we were down 27.4% in eight months from June 2002 – January 2003, and down 32.8% in five months from October 2008 – February 2009. In both of these cases, by playing a strong hand and buying more of our favorite stocks as they plunged, we made back all of the losses (and then some) remarkably quickly: in only nine months in 2002-03 and a mere seven months in 2008-09. We could not be more confident that we will rebound strongly from these latest losses as well.

An obvious difference, of course, is that in the previous two declines, the market was tumbling as well, whereas over the past year, the market is up 18.5%. Thus, while our absolute decline isn’t as large, our relative performance is far worse. This is due to three factors, which we’ve discussed in previous letters: first, we made a few mistakes, such as being short Netflix; second, in a far greater number of stocks, we invested too early (though we are confident that we’ll be proven right); and finally, our macro calls have been completely wrong.

Regarding the latter, it’s been very frustrating to accurately predict the primary causes of the current market turmoil –the weak U.S. economy characterized by persistently high unemployment and a feeble housing market, plus the sovereign debt crisis in Europe – but to have done

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