110104 Tilson - t2 Annual Letter

7/31/2019 110104 Tilson - t2 Annual Letter

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The GM Building, 767 Fifth Avenue, 18th Floor, New York, NY 10153

Whitney R. Tilson and Glenn H. Tongue phone: 212 386 7160

Managing Partners fax: 240 368 0299

www.T2PartnersLLC.com

January 4, 2011

Dear Partner,

We hope you had wonderful holidays and wish you a happy new year!

In each of our annual letters we seek to frankly assess our performance, reiterate our core investmentphilosophy, and share our latest thinking about various matters. In addition, we discuss our 12 largestlong positions so you can better understand how we invest, what we own and why, and why we have somuch confidence in our funds future prospects.

Our fund had a solid year, though due to a lethargic last four months we ended the year trailing the S&P

500 for only the third time in our 12-year history (all three times, our underperformance was in singledigits):

December 4th Quarter Full Year

TotalSince

Inception

AnnualizedSince

Inception

T2 Accredited Fund - gross 0.3% -4.0% 12.9% 260.8% 11.3%

T2 Accredited Fund - net 0.3% -3. 3% 10.3% 184.9% 9.1%

S&P 500 6.7% 10.8% 15.1% 26.5% 2.0%

Dow 5.3% 8.0% 14.1% 65.7% 4.3%

NASDAQ 6.3% 12.2% 17.8% 24.8% 1.9%Past performance is not indicative of future results. Please refer to the disclosure section at the end of this letter. The T2 Accredited Fundwas launched on 1/1/99. Gains and losses among private placements are only reflected in the returns since inception.

This chart shows our performance since inception:

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Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

(%)

T2 Accredited Fund S&P 500


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Overview of 2010

We had four huge winners in 2010, each accounting for more than four percentage points of return (indescending order of contribution): General Growth Properties, our biggest winner for the second year ina row, which emerged from bankruptcy as two companies; Berkshire Hathaway, thanks to our big betearly in the year that the stock would be added to the S&P 500; Liberty Acquisition Corp. warrants,which skyrocketed when the merger with Grupo Prisa was consummated; and BP, in which we correctlyanticipated that the company would weather the Gulf of Mexico crisis.

We had no losers of note on the long sidethe biggest was Winn-Dixie, which fell 28.5% and cost us0.6% of performancebut we took quite a beating on the short side. Among the most costly shorts,each costing us more than 1% of performance, were Netflix, MBIA, DineEquity, and LululemonAthletica. We short both to make money and protect our portfolio from a market downdraft, but in 2010we only succeeded in the latter, as we discuss further below.

Our first priority is always capital preservation, so we are usually playing defense, even if this means wesometimes trail the market when its ripping upward. On rare occasions, however, in periods like late2008 and early 2009, the market offers enough opportunities that we can go on offense and practice get-

rich-quickly investing. We wish we were in such a period today, but dont believe we are. Instead, weare in a time ofunusual uncertainty (to quote Ben Bernanke), yet the market is complacent, so wethink its prudent to be quite defensive, both by maintaining a robust short book and also, on the longside, by focusing on big-cap, blue-chip stocks with strong market positions, cash flows and balancesheets.

Performance ObjectivesIn every year-end letter we repeat our performance objectives, which have been the same since ourfunds inception (no changing the rules in the middle of the race): Our primary goal is to earn you acompound annual return of at least 15%, measured over a minimum of a 3-5 year horizon.

We arrived at that objective by assuming the overall stock market is likely to compound at 5-10%annually over the foreseeable future, and then adding 5-10 percentage points for the value we seek toadd, which reflects our secondary objective of beating the S&P 500 by 5-10 percentage points annuallyover shorter time periods. While a 15% compounded annual return might not sound very exciting, itwould quadruple your investment over the next 10 years, while 7-8% annuallyabout what we expectfrom the overall marketwould only double your money.

Since inception 12 years ago, we have not met our 15% objective, thanks in part to one of the worstperiods ever for stocks. We have, however, outperformed the S&P 500 by 7.1 percentage points peryear, near the midpoint of our 5-10 percentage point goal. There are few funds that have beaten themarket by this margin over the past dozen years, but nevertheless we are not satisfied with our

performance and aim to improve it.

Performance Assessment

In light of our objectives, wed give ourselves a B for the year. To understand why we give ourselves agood grade, despite neither earning a 15% return nor beating the market, one must understand how weapproach managing our fund. We do not trade rapidly in an attempt to get rich quickly; rather, we arecontent to get rich slowly while investing conservatively, with a primary focus on capital preservation.


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As evidence of this, consider the four months in 2010 when the S&P 500 (with dividends reinvested)declined: January (-3.6%), May (-8.0%), June (-5.2), and August (-4.5%). During these months, theS&P 500 declined 19.7% in totalbut our fund was down a mere 1.3%. During the other eight monthswhen the market rose, our fund did okay, gaining 11.8%, but this trailed the markets 43.3% return.

In summary, we earned a double-digit return while simultaneously being positioned very defensively,which is satisfactory to us.

Why We Missed the QE2 RallyThe fact that our house didnt burn down doesnt mean that we regret having bought insurance.However, with the benefit of hindsight (which is always 20/20), we bought too much insurance. As aresult, we went from crushing the market over the first eight months of 2010 to ending the year trailingit. The market is really quite remarkable in its ability to keep you humble. Just when youre feelingreally smart, it tends to come along and kick you in the shins, which is what happened to us during thelast four months of the year.

As we discussed in recent monthly letters, our underperformance wasnt due to bad stock picking even

on the short side, wed argue that in most cases we made investments that have moved against ustemporarily, not permanentlybut rather due to completely misreading the short-term impact of theFeds second round of quantitative easing (so-called QE2). We interpreted the Feds move asvalidating our assessment that the economy continued to suffer from many areas of weakness, mostnotably a terrible housing market and persistently high unemployment, and questioned whether QE2would achieve its objectivesboth of which made us cautious about the market. As a result, wecontinued to position our portfolio somewhat defensively, which turned out to be precisely wrong as themarket jumped 20.6% in the last four months of the year. The gains were driven by the frothiest, mostspeculative stocks, which are precisely the ones we tend to be short, so our profits on the long side wereoffset by losses on the short side such that we missed this big rally.

The market surge was driven by two factors: fundamentals and froth. Regarding the former, whileunemployment remains a vexing problem, corporate earnings have been strong and the overall economyis showing some signs of life. That said, the data remains mixed and we still think the muddlethrough scenario we outline below remains the most likely outcome over the next 2-7 years: weakGDP growth (1-3%), unemployment remaining high (7-9%), and continued government deficits. Underthis scenario, the stock market would likely compound at 3-6%.

A bigger driver of the markets upward surge, we believe, is froth: the expectation (followed by theimplementation) of QE2 triggered a dont fight the Fed burst of optimism across the market and, inparticular, a speculative orgy among the most popular momentum stocks, which ripped upwards,irrespective of valuation. It is nothing short of mind-boggling that a mere two years after utter panic and

paralysis in the market, animal spirits have returned and reckless risk-taking is occurring in many areasof both the debt and equity markets. We think this will end badly and we will not participate. AsBuffett once wrote: We have no idea how long the excesses will last, nor do we know what will changethe attitudes of the government, lender and buyer that fuel them. But we know that the less prudencewith which others conduct their affairs, the greater the prudence with which we should conduct our ownaffairs.


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Nobody likes being left out while a big party is going onbut sometimes thats the price a prudentinvestor must pay for long-term outperformance, so its important to put four months of sidewaysperformance in the context of the results our fund has delivered over time.

Thoughts on Shorting

Our long portfolio (discussed at length in Appendix A) performed beautifully in 2010, but we incurredsignificant losses in our short portfolio for the second consecutive year, so wed like to discuss it further.

The first question to address is why do it at all? Shorting is an awful business, for 11 reasons wehighlighted in the chapter on shorting from our book, More Mortgage Meltdown: 6 Ways to Profit inThese Bad Times (see:www.tilsonfunds.com/ShortingMMM.pdf). Yet we still do it for reasons weoutlined in the January 2006 edition ofValue Investor Insight. Heres an excerpt:

Given the long-term upward trend in equity prices and frequent bouts of excessive investor optimismMarkets can remain irrational longer than you can remain solvent, John Maynard Keynes once warned

one might ask why make bearish bets at all. This question is particularly relevant to us given the moneyweve lost in this area over the past couple of years.

After carefully studying our experience, were not swearing off negative bets for two main reasons: First,we still think we can make money on them. In addition, they remain a great tool for hedging againstrisk

[In addition,] 1) It reduces risk, defined as the permanent loss of capital; 2) In the event of a majorcorrection, it will provide us with substantial cash to invest at bargain prices, thereby enhancing returns;and 3) It allows us to remain invested in certain stocks we otherwise might sell prematurely, which alsoshould enhance returns.

All of these reasons were on display during the market crash from late 2007 through early 2009. Ourshort book not only protected us from huge losses during the decline, but also allowed us to investaggressively at the bottom, so it materially contributed our returns during the rebound.

Of course, in a perfect world, we would only be short just before major market declines, but were notgood enough market timers to do that. In truth, we hope to break even on our short book when themarket is going up, in which our good company and industry analysis offsets the general rising tide ofthe market, and make a lot of money when the market is tumbling.

Our favorite shorts generally involve one or more of the following characteristics: outright frauds (ourvery favorite), industries in decline or facing major headwinds, lousy or faddish business models, badbalance sheets, and incompetent, excessively promotional and/or crooked management. In general, weprefer to short businesses with these traits, even when their stocks trade a seemingly low valuationmultiples, rather than shorting the stocks of good businesses with strong managements, even at high

valuations. Sometimes, however, the valuations become so extreme that we will short the latter, butgenerally only when we believe there is a catalyst that will impact the company and cause the stock tofall.

Our Current Short Book

Given the recent losses in our short book, are we ready to issue a mea culpa, cover the shorts that havehurt us the most, and get on board the momentum bandwagon? In a word, no (though we carefully
http://www.tilsonfunds.com/ShortingMMM.pdfhttp://www.tilsonfunds.com/ShortingMMM.pdfhttp://www.tilsonfunds.com/ShortingMMM.pdfhttp://www.tilsonfunds.com/ShortingMMM.pdf


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manage risk, in part through position sizing, so weve trimmed some of our short positions and/orconverted them to put options).

Weve carefully analyzed our entire portfolio, especially the stocks on which weve lost money in ourshort book, looking for a position we wouldnt hold if we were reconstructing our portfolio from scratchand cant find a single one. We dont hold losing positions in a desperate and irrational attempt to tryto make back what weve lost. The price at which we initially established a position, the amount of ourlosses to date, and whether we will ever make back these losses are completely irrelevant to our decisionto hold a position today.

Our 10 largest short positions going into 2011 reflect the different types of opportunities we find on theshort side (in alphabetical order): AIG, homebuilders (various plus an ETF), InterOil, ITT EducationalServices (and other for-profit education companies), Lender Processing Services, Lululemon Athletica,MBIA, Netflix, Salesforce.com, and St. Joe.

We believe our short book represents a win-win right now: it should provide excellent protection in theevent of a general market downturn, but even if this doesnt occur we still think well make money on it.In fact, well go so far as to say that, after the recent burst of froth, foolishness and speculation, we think

our short book is the most attractive its ever been, with the exception of early 2008.

Speaking of which, it might interest you to know that the last time we suffered such big losses in ourshort book and felt like covering everything was in late 2007. But after evaluating each position at thattime, we werent willing to cover things like MBIA, Ambac and Lehman Brothers around $70, or AlliedCapital and Farmer Mac around $30and thank goodness we didnt!

How We Manage Positions That Move Against Us

Since we rarely buy a stock at the very bottom or short one at the very top, having a position moveagainst us, at least initially, is a common occurrence. When this happens, we reevaluate our analysisand investment thesis and make one of three decisions: add to the position, do nothing, or trim/exit.

Making the right decision here is criticalits often more important than the initial investment decisionand theres no easy answer or rule of thumb. (In our experience, wed guess that we add to a position40% of the time, do nothing 40% of the time, and sell/exit 20% the time.)

Its often a hard decision, both for fundamental and emotional reasons. Regarding the former, the factthat a stocks price has become more attractive doesnt necessarily mean its a better investment. Astock typically moves because something has happened to the company, industry or world, so thechange in the fundamentals must be weighed against the change in the share price.

The emotional side can be even more difficult. Numerous studies of investor behavior show that oncean investor has a position in a stock, there are tremendous biases to seek confirming information, ignore

disconfirming information, and not admit a mistake. We dont claim to be immune from theseemotions, but weve studied them extensively and do our best to block them out. One of the simplesttechniques we use is to ask ourselves, If our portfolio were 100% cash and we were investing fromscratch, would we establish this position and, if so, how big would it be?

While we always keep open minds, look for contrary opinions, and are willing to admit mistakes, we arealso very stubborn when were convinced were right. To quote Ben Graham, we view the market asour servant, not our guide, so we are unperturbed when one of our positions moves against us. As value


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investors, we make money by betting against the consensus viewby deviating from the herdand, ofcourse, being right more often than wrong. Its hard enough to be right on the fundamentals andthenalso get the timing exactly right as well, so we find that were often early but our experience is that weare usually rewarded for our patience and willingness to endure short-term, mark-to-market pain.

Netflix and Why We Sometimes Go Public With Our Analyses

Netflix was our biggest loser in 2010, so its a good case study of what we do when a position movesagainst us. First, to manage risk we trimmed our short position as the stock rose and replaced part of itwith put options, so that we can only lose the amount we paid for the option (vs. shorting, where lossesare potentially unlimited).

Then, we wrote up our investment thesis in great detail and, after sharing it first with our investors,published it (seehttp://seekingalpha.com/article/242320-whitney-tilson-why-we-re-short-netflix). Thisis unusual for a number of reasons: most hedge funds maintain a low profile in general and certainlydont speak or write in detail about any particular stocks. And to the extent they do, they certainly donttalk about short positions and/or stocks in which theyve lost a lot of money.

So why did we take this unusual step? Its not for marketing or ego reasons, nor is it an attempt to move

stock prices so we can exit at a better pricewe are value investors, not traders, and harbor no illusionsabout our ability to move markets. Rather, it helps us make money, in four primary ways:

1) It helps clarify our thinking to put our investment thesis in writing, especially on complex andcontroversial positions. For example, on June 11th we published an 11-page analysis(www.tilsonfunds.com/BP.pdf) of why we were buying BPs stock amidst the panic at that time(it was then at $33.97 and closed the year at $44.17).

2) When it is widely known that we have a position in a particular stock, we often hear from otherinvestors who share valuable information or analyses.

3) Invariably, some people have the polar opposite view of a particular stock and, in sharing it withus, they can help us identify things we might have missed in our analysis. If information oranalyses exist that would cause us to change our view, we want to hear about it!

4) When we share our ideas, it creates reciprocity and others share their best ideas with us.In the case of Netflix, we think its particularly healthy to disclose and fully analyze our mistakes(although in this case we are not yet conceding that weve made a mistake in our analysis, but weobviously made a mistake in terms of timing our entry into the position).

Our analysis of Netflix generated much more attention than we anticipated, which resulted in dozens of

emails with great feedback, both agreeing and disagreeing with us, which is what wed hoped for. Themost interesting feedback, which we hadnt expected, was from the CEO of Netflix, Reed Hastings, whoemailed us in a friendly way, saying he had no problem with short sellers, but disagreed with ouranalysis and published an open letter telling us why we shouldnt be short his stock(http://seekingalpha.com/article/242653-netflix-ceo-reed-hastings-responds-to-whitney-tilson-cover-your-short-position-now). He made some good points and it helped us learn more about him and hiscompanyand we appreciated his friendly tone (other CEOs should take note that, if one is going torespond to a short seller, this is the best way to do it). He sure makes it tough to be short his stock
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hes been a great CEO and how do you not like a guy who served in the Peace Corps for two years inSwaziland?

As we made clear in our letter, we think highly of Netflix, just not its valuationand as value investors,price matters a lot. If we were to summarize the main deficiency in Hastingss letter and nearly all ofthe bullish-on-Netflix emails weve received, its that theres no discussion of valuation. They wouldread the same if the stock were trading at 15x earnings or 75x earningsbut from our point of view, that5x valuation gap is the difference between a great long and a great short.

A final step we took was to ask our friends who are Netflix subscribers to fill out a short online survey(seewww.surveymonkey.com/s/N9ZLZVS) to tell us about their experience with the company, inparticular its new streaming service. To date, over 380 people have filled out the survey. Were stillanalyzing the results, but can say that the most important insight so far is that Netflix subscribers appearto like the streaming service more than we expected, despite the weak content library, viewing it as agood value because of Netflixs low, all-you-can-watch monthly price.

With Netflix, as with all of our investments, long and short, were always testing our investment thesisby collecting and analyzing new information and viewpoints. If we conclude that our thesis is weaker

than we thought (or flat out wrong), we quickly adjust our portfolio accordingly.

Market OverviewWe hesitate to share our big-picture views because one might come to the mistaken conclusion thatweve abandoned our bottoms-up stock picking and industry analysis that has been (and always will be)the core of what we do. But the biggest lesson for us over the past two years is that our estimates ofintrinsic value, which are generally rooted in estima tes of future cash flows, arent worth much if theeconomy and/or financial system fall apart. Thus, we build our portfolio from the bottom up, based oncompany- and industry-specific analysis (which we discuss in depth in Appendix A), but whendetermining overall portfolio positioning we do factor in our macro outlook and adjust our portfolioaccordingly.

Our net long exposure has ranged over the past two years from a low of 20% in early 2010 (90% long,70% short) to 90% in early March 2009 (120% long, 30% short), and today we are closer to the moreconservative end of that spectrum at 40% net long (100% long, 60% short).

We dont know for sure what the future holds for the U.S. economy and stock market, but overall weremain cautious. Our best guess is that the economy will face significant headwinds for a number ofyears, mostly due to the aftershocks of the bursting of the greatest asset bubble in history. The majorconcerns we have include:

Interest rates have risen materially, despite QE2s primary aim to lowerinterest rates. 10-year Treasuries rose from 2.47% at the end of August to 3.38% at the end of year (a 37%increase), and 30-year Treasuries rose from 3.52% to 4.43% (a 26% increase);

The jump in interest rates largely reflects growing optimism about an economic recovery, butalso creates a headwind for the housing market, which was already feeble and on governmentlife support. The housing market has worsened recently, with sales and prices weakening;

The economy has failed to produce enough jobs to keep up with the growth of the jobmarket, resulting in unemployment rising from 9.6% to 9.8% in recent months;
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Corporate profits have been strong, but this is mainly due to cost cutting, not robust demand,so further profit gains may prove elusive, especially if commodity prices continue to surge;

American consumers, who account for 70% of GDP, are under enormous pressure due tosevere job losses and hours being cut back, the collapse in housing prices, and the need todeleverage after decades of excessive consumption and declining savings;

Continued high levels of fiscal and monetary stimulus combined with unaffordable pensionand healthcare promises made to millions of people will lead to large deficits and enormousbudgetary pressures on governments at all levels;

The European sovereign debt crisis reared its ugly head once again, requiring a bailout ofIreland and raising fresh concerns not only about Portugal and Greece, but also Spain, Italyand Belgium; and

Last but not least, South Korea (the worlds 15th-largest economy) was shelled by NorthKorea, the worlds most unstable, unpredictable and dangerous regime, dramatically raisingtensions in one of the most volatile areas of the world.

In light of these factors, we believe that we are in uncharted waters and there is a very wide range ofpossible outcomes over the next 2-7 years. Broadly speaking, they fall into three scenarios:

1) A V-shaped economic recovery with strong GDP growth (3-5%), a falling unemployment rate,and reduced government deficits. Under this scenario, the stock market would likely compoundat 7-10%.

2) A muddle-through economy with weak GDP growth (1-3%), unemployment remaining high(7-9%), and continued government deficits. Under this scenario, the stock market would likelycompound at 3-6%.

3) A double- (and triple-, and quadruple-) dip recession where periods of growth are followed byperiods of contraction, with no overall GDP growth, unemployment around 10% (with the actual

level higher due to people giving up looking for work), and large deficits as the government triesto stimulate the economy (but with little impact). Under this scenario, which looks like whatJapan has gone through for more than two decades, the stock market would be flat to down.

Both as investors and as Americans, were of course hoping for the V-shaped economic recovery, butthink that the muddle-through scenario is most likely. Weak GDP growth is not a catastropheit wasonly a short while ago that we were facing the very real possibility of Armageddon, the chance of whichhas receded materially, thank goodnessbut it will likely keep a lid on corporate profit growth and thestock market.

The stock market, however, as we discuss below, is now priced for the V-shaped scenario, as if the seas

are calm and the skies are clear. Hence, we are positioning our portfolio more conservatively, trimmingsome of our longs, adding to our short book, and increasingly shifting our long portfolio into big-cap,strong-balance-sheet, dominant-market-position blue chips like AB InBev, ADP, Berkshire Hathaway,Kraft and Microsoft, as well as shorter-duration, special situation investments like General GrowthProperties, BP, and Grupo Prisa (all discussed in Appendix A).

For further background on the risks that exist, weve attached insightful letters by two wise investors,Bill Gross and Jeremy Grantham. Heres an excerpt from Grosss letter (see Appendix B):


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Investors are faced with 2.5% yielding bonds and stocks staring straight into new normal real growth ratesof 2% or less. There is no 8% there for pension funds. There are no stocks for the long run at 12% returns.

And heres the opening paragraph of the excerpt from Granthams letter (see Appendix C):

The idea behind seven lean years is that it is unrealistic to expect to overcome the several problems

facing most developed countries, including the U.S., in fewer than several years. The purpose of thissection is to review the negatives that are likely to hamper the global developed economy, especially fromthe viewpoint of how much time may be involved.

Here are Granthams 10 negatives that are likely to hamper the global developed economy and lead toseven lean years:

1. Over-indebtedness of consumers in certain countries, including the U.S., the U.K., and severalEuropean countries

2. Dangerously excessive financial system debt was moved across, with additions, to becomedangerously excessive government debt

3. We have lost a series of artificial stimuli that came out of the steady increases in debt levels andthe related asset bubbles4. Very bad things may lie ahead in Europe, and banks in general are undercapitalized and reluctant

to lend5. Runaway costs in the public sector, particularly at the state and city levels, have run into a brick

wall of reduced taxes6. Unemployment is high and will also suffer from the loss of those kickers related to asset bubbles7. Trade imbalances and the explosion of domestic sovereign debt levels8. Incompetent management in Spain, Greece, Portugal, Ireland, and Italy allowed the local

competitiveness of their manufactured goods to become 20% or more uncompetitive with thoseof Germany

9.

The general rising levels of sovereign debt and the particular problems facing the euro bloc andJapan are leading to the systematic loss of confidence in our faith-based currencies10.Widespread over-commitments to pensions and health benefits

We would underscore #9 and note that while the current focus is on Europe, we think Japan (with a GDPthat is 3x larger than Spain and Portugal combined) could be a wild card. Its ratio of sovereign debt toGDP, at 225%, is nearly double that of Greece, Italy or Ireland, and as Japans economy continues tostagnate while its population ages, the situation looks to worsen rapidly. Low interest rates and theability to fund deficits entirely with domestic savings have allowed Japan to put off the day ofreckoning, but both of these factors are changing. The possibility of a sovereign debt crisis in Japanreminds us of what Alexis de Tocqueville once said: Events can move from the impossible to the

inevitable without ever stopping at the probable.

Market ValuationIf stocks were as cheap as they were in March 2009, we wouldnt let our macro concerns deter us frombuying aggressively, but theyre not, as the markets have rallied substantially from the lows of early2009. To see how expensive stocks in general have become, consider this chart, which tracks the P/Emultiple of the S&P 500 based on inflation-adjusted average earnings over the past 10 years (wereskeptical of valuation methodologies that use estimates of future earnings, which are usually far toooptimistic). One can see that the S&P 500, at 22.7x, is trading at a 39% premium above its 130-year


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average of 16.3x, which reinforces our view that while we dont think stocks are extremely expensive,theyre far from cheap.

Source: Stock Market Data Used in Irrational Exuberance Princeton University Press, 2000, 2005, updated, Robert J.

Shiller.

Deliberate Practice and Review

We recently read an excellent book, Talent Is Overrated: WhatReally Separates World-Class Performersfrom Everybody Else, by Fortune magazines Geoff Colvin. In it, he argues convincingly that world-class performers in a wide range of areasfrom sports, to music, to academia and, yes, to investingarent born with innate supernatural gifts, but rather become great through a series of specific steps,most importantly, a lot of hard work and deliberate practice. This excerpt really resonated with us,because its exactly what we try to do to become better investors over time:

The best performers observe themselves closely. They are in effect able to step outside themselves,monitor what is happening in their own minds, and ask how its going. Researchers call this

metacognitionknowledge about your own knowledge, thinking about your own thinking. Topperformers do this much more systematically than others do; its an established part of their routine.

Metacognition is important because situations change as they play out. Apart from its role in findingopportunities for practice, it plays a valuable part in helping top performers adapt to changingconditions[A]n excellent businessperson can pause mentally and observe his or her own mental

processes as if from the outside:Am I being hijacked by my emotions? Do I need a different strategyhere? What should it be?

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Long-term P/Eaverage: 16.3x

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After the work.

Practice activities are worthless without useful feedback about the results

Excellent performers judge themselves differently from the way other people do. Theyre morespecific, just as they are when they set goals and strategies. Average performers are content to tellthemselves that they did great or poorly or okay. The best performers judge themselves against a standardthats relevant for what theyre trying to achieve. Sometimes they compare their performance with their

ownpersonal best; sometimes they compare with the performance of competitors theyre facing or expectto face; sometimes they compare with the best known performance by anyone in the field

If you were pushing yourself appropriately and have evaluated yourself rigorously, then you will haveidentified errors that you made. A critical part of self-evaluation is deciding what caused those errors.Average performers believe their errors were caused by factors outside their control: My opponent gotlucky; the task was too hard; I just dont have the natural ability for this. Top performers, by contrast,believe they are responsible for their errors. Note that this is not just a difference of personality orattitude. Recall that the best performers have set highly specific, technique-based goals and strategies forthemselves; they have though through exactly how they intent to achieve what they want. So whensomething doesnt work, they can relate the failure to specific elements of their performance that ma yhave misfired

Since excellent performers go through a sharply different process from the beginning, they can makegood guesses about how to adapt. That is, their ideas for how to perform better next time are likely toworkThey approach the job with more specific goals and strategies, since their previous experience wasessentially a test of specific goals and strategies; and theyre more likely to believe in their own efficacybecause their detailed analysis is more effective than the vague, unfocused analysis of averageperformers. Thus their own effectiveness help give them the crucial motivation to press on, powering aself-reinforcing cycle.

Discussion of Our 12 Largest Long Positions

In Appendix A, we discuss our 12 largest long positions across all three hedge funds we manage, whichare (in descending order of size, as of 12/31/10):

Position 2010 Performance*1) Grupo Prisa (PRIS & PRIS.B) 153.6%**2) Microsoft -8.4%3) Berkshire Hathaway 21.4%4) BP -23.8%*5) General Growth Properties 81.0%6) CIT Group 70.6%7) Kraft stock/warrants 15.9%8) Seagate Technology -17.4%9) Iridium stock/warrants 2.7%/-11.8%

10) Automatic Data Processing 8.1%11) Resource America 69.8%12) AB InBev 9.7%

* Certain positions were acquired during 2010, such that the 2010 performance does not reflect our actual gains or losses.For example, BP was one of our most profitable investments in 2010 because we bought it after the stock had collapsed.** 153.6% was the gain in Liberty Acquisition Holdings Corp. warrants from the beginning of the year ($0.69) to the mergerwith Grupo Prisa ($1.75).


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Quarterly Conference CallWe will be hosting our Q4 conference call from 12:00-1:30pm EST on Tuesday, January 11th. The call-in number is (712) 432-1601 and the access code is 1023274#. As always, we will make a recording ofthe call available to you shortly afterward.

New Redemption Option

Effective immediately, we are making a second redemption option available to all existing and newinvestors. The current redemption option permits limited partners to withdraw all (or any fraction) oftheir investment once a year, on the anniversary date of the first investment, with 45 days notice.

Some (primarily institutional) investors need quarterly liquidity to match their own redemption policies,so to accommodate this, were now offering a second redemption option that allows limited partners towithdraw of their investment each quarter, with 45 days notice. Note that this option is in place of,not in addition to the current redemption option.

Existing investors dont need to do anything they will continue to be able to make full redemptionsonce a yearunless they wish to change to the new redemption option, in which case they shouldcontact Kelli Alires at (212) 386-7160 [email protected]. All new investors going

forward will need to select one of the options.

ConclusionWe want to acknowledge and thank Damien Smith, who has been an outstanding analyst for us fornearly eight years, Kelli Alires, who does a fabulous job as office manager, and Joe DeJulius, anotheroutstanding analyst who joined us this year. Joe started his business career in the Fixed Income Divisionof Lehman Brothers, was a senior executive with two international tech/consulting companies, and wasan analyst at Quilcap Management, an equity long/short hedge fund. He has a BS degree in Engineeringfrom the U.S. Military Academy at West Point and an MBA in Finance from Columbia BusinessSchool.

Thank you for your continued confidence in us and the fund. As always, we welcome your commentsso please dont hesitate to call us at (212) 386-7160.

Sincerely yours,

Whitney Tilson and Glenn Tongue
mailto:[email protected]:[email protected]:[email protected]:[email protected]


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Appendix A: 12 Largest Long Positions

Notes: The stocks are listed in descending order of size as of 12/31/10.

1) Grupo Prisa (formerly Liberty Acquisition Holdings)

It would be hard to find something more off the beaten path than Liberty Acquisition Holdings Corp., a

Special Purpose Acquisition Company (SPAC) that recently merged with Grupo Prisa (PRIS andPRIS.B), a Spanish media conglomerate with a good business but a bad balance sheet. This transactionwas ideal for both parties: Liberty deployed its cash at an attractive valuation while Prisa reduced andrestructured its debt burden.

Our positions in Liberty stock and warrantsone of our biggest winners in 2010converted to cashand stock in Prisa, which we continue to hold because we think the underlying business, with a new,stronger balance sheet, will do well. In the near term, however, the stock could be volatile because thedistribution of shares will initially be to unnatural shareholders (the original SPAC shareholders). Overtime, however, we expect that the stock will migrate to intrinsic value.

We presented our analysis of Prisa and its value at the Value Investing Congress on October 13, 2010:www.tilsonfunds.com/Octpres.pdf(pages 32-46).

Heres a Wall St. Journal article from November about the deal, with the key part highlighted:

Liberty Turns Leader of the SPAC

The Wall Street JournalHeard on the StreetNovember 1, 2010By JOHN JANNARONE

Some blank checks are tough to cash.

Special-purpose-acquisition companies became popular in the boom, raising cash through initial publicofferings that could be invested in virtually any business. The catch is that SPAC investments requireapproval from shareholders, who became skittish in the crunch. Of the $17.1 billion raised by the 50 largestSPACs since 2000, some $5.8 billion was returned to shareholders minus expenses, according to Dealogic.And among SPACs that managed to make investments, shares in the companies they bought generally havefared poorly.

But not all SPACs have cracked. Liberty Acquisition Holdings, the largest of the group with a $1 billion IPOin 2007, has proposed a deal giving investors a stake in struggling Spanish media firm Prisa. The deal lookslikely to get approval because Liberty shares trade at $10.50, 6% higher than the $9.87 cash liquidation value

of the trust. In contrast, most other SPACs traded at a discount even after announcing a deal because manyshareholders planned to vote deals down and take cash.

Setting aside the complex deal structure, the investment makes sense for simpler reasons. First, the deal helpssolve Prisas key problem: financial distress. Having binged on acquisitions, net debt reached 7.6 timesearnings before interest, taxes, depreciation and amortization at the end of 2009, says Citigroups ThomasSinglehurst. Assuming the deal goes through and Prisa continues to reduce leverage, net debt will be just 3.5times Ebitda at the end of next year, he says.
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And because the family controlling Prisa faces heavy dilution, Liberty investors get a reasonable price withsome downside protection. Each Liberty share will convert to a mix of cash, Prisa shares, and convertiblePrisa bonds. Discounting the value of the convertibles dividend at 10%, Liberty investors essentially payfive times Mr. Singlehursts expected 2011 earnings for their Prisa shares. That is far lower than

multiples above 10 times for many media companies.

Admittedly, Spains economy remains troubled. But, for local advertising, the worst may be past. Ad

spending for both television and newspapers fell 23% in 2009, says media-buying firmZenithOptimedia. The fall is much less this year, and spending is forecast at roughly flat in 2011. Prisa

owns the leading Spanish newspaper and broadcast-TV channel, which may win share at the expense ofsmaller competitors if the market stays soft.

But Libertys potential success isnt a ray of hope for SPACs in general. Even those run by well-knowninvestors like Nelson Peltz, have failed to get deals done. Prisa may prove an exception because itscontrolling shareholders know they need Libertys cash to set the company free.

2) Microsoft

Microsoft reported spectacular earnings in late October, handily beating analysts estimates, yet thestockhas barely moved so wed added to our position.

Adjusting for the deferral of Windows 7 revenues last year, Microsoft reported revenue, EPS, bookings,and operating cash flow growth of 13%, 19%, 24%, and 34%, respectively. The companys results werestrong across the board, riding a wave driven by its three main profit drivers, Windows, Office, andServer & Tools.

Capital allocation was excellent, as Microsoft has (so far anyway) avoided doing what so many otherlarge, cash-rich companies are doing, making a big, overpriced acquisition, and has instead wiselyramped up returning cash to shareholders: $5.5 billion last quarter via $1.1 billion of dividends (thestock currently yields 2.3%) plus $4.4 billion of share repurchases (up 3x year-over-year, leading to thediluted share count falling 3.2%). At this rate, the company will retire nearly 8% of its outstanding

shares in the next year.

The stock closed the year at $27.91 and the company has $3.85 of net cash ($4.91 if one includesEquity and other investments), so the stock, net of cash, is at $24.06. Trailing earnings are$2.32/share, so thats a P/E multiple of10.4x. Thats insanely low for a company with Microsoftscharacteristics: dominant and stable market shares across various products, 81% gross margins, 33% netmargins, an infinite return on capital, prodigious cash flows, and one of the strongest balance sheets inthe world.

The consensus view is that Microsoft is an incompetent, lumbering dinosaur, declining rapidly towardthe dustbin of history. Newspapers, check printers and paging companies, look out! The problem with

this view is that there is no evidence for it. Despite endless predictions over the past decade of howApple or Linux or Google Apps are going to erode Microsofts dominance in its key product categories,the companys market shares are stable or rising. Revenues and profits, rather than falling, are risingsharply.

Yet analysts persist in ignoring the overwhelming evidence of Microsofts powerful new product cycleand are projecting flat revenues and EPS down 8.1% for the current quarter (ending December 2010),and flat earnings for the remaining three quarters of the 2011 fiscal year. In light of such low


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expectations, we believe Microsoft will continue to handily beat estimates over the next year, withearnings growth in the mid-teens. This, combined with likely multiple expansion, should result in thestock appreciating to at least the mid-$30s range with a year.

We presented Microsoft at the Value Investing Seminar on July 13, 2010:www.tilsonfunds.com/Julypres.pdf(pages 27-35).

3) Berkshire Hathaway

Under Warren Buffetts direction, Berkshires performance has been nothing short of remarkable overthe past two years. His disciplined capital retention looked overly conservative for many years, butwhen the crisis hit there were few buyers and waves of panicked sellers, so he was able to deploy tens ofbillions of dollars in some terrific businesses, on highly favorable terms. Thus, ironically, whileBerkshires stock is down 15.0% since the beginning of 2008 (-31.8% in 2008, up 2.7% in 2009, and up21.4% in 2010), the companys intrinsic value has risen markedly, which we believe makes it anexceptional bargain today.

While the stock was up 21.4% in 2010, we made a much higher return by correctly anticipating thatBerkshire, once it completed the acquisition of Burlington Northern, would replace BNI in the S&P 100

and 500 indices. We estimated that index funds would have to buy approximately $38 billion worth ofBerkshire stock, which would cause the price to jump, so we significantly increased our positionandwere quickly rewarded when the stock popped 15.5% in January.

We have posted a detailed slide presentation of our analysis of Berkshire at:www.tilsonfunds.com/BRK.pdf. Page 14 highlights the impact of the Burlington Northern acquisition:Berkshires investments per share only declined slightly from the end of 2009 to the end of 2010, despitepaying nearly $11 billion in cash as part of the acquisition, yet Berkshires operating earnings haveincreased hugely, driving our estimate of intrinsic value to $160,000/A share, a 33% premium to theyear-end price of $120,450.

4) BPThe overall story ofBPs Gulf of Mexico disaster is well known, so we wont repeat it here. As aninvestment, there are two stories, reflecting two quite different investment opportunities.

The first was in June at the depths of the crisis, when the stock hit a 14-year low amidst hysteria that thecompany might have to file for bankruptcy. We started buying BPs stock in early June around $37 andbought all the way down to its late-June low of $26.75 (including some call options near the low). Ouraverage cost at that time was around $29.

Our investment thesis, which we released publicly (see our June 19th article in Barrons at:http://online.barrons.com/article/SB50001424052970203296004575308800681560686.htmland our full

analysis at:www.tilsonfunds.com/BP.pdf), rested on the following beliefs: the well would be cappedsooner than most investors expected; the environmental damage would be less than feared; the clean-upcosts, fines and legal liabilities would be at the low end of estimates; and the company had the assets andcash flows to meet all eventualities. In less than two months, our investment thesis was almost entirelyvalidatedmost importantly, the well was cappedand the stock soared nearly 50%.

At that point, many investors seemed to think that the easy money had been made (there was nothingeasy about it!) and sold, leading to the stock dropping from $43 to under $35 in less than three weeks in
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August. This presented a very different risk-reward equation than only two months earlier. Of coursethe stock wasnt as cheap, but the tail risk of bankruptcy was gone (given that the well was capped), BPhad reported strong Q2 operating results, and had raised $7 billion by selling some non-core assets toApache for a fantastic price of 2x book value and 42x cash flow. Thus, we concluded that the stock, ona risk-adjusted basis, was even more attractive than it was in June so we bought a lot more. This, too,has worked well as the stock has risen to $44.17 at year-end thanks to the company reporting solid Q3earnings, strengthening its balance sheet, selling additional assets, and announcing that it will reinstatethe dividend next quarter. At its current price, the stock trades at 8.1x estimated 2010 earnings(excluding the Gulf spill costs) and 7.3x 2011 estimates, which we believe is far too cheap, both on arelative and absolute basis.

We presented BP at the Value Investing Congress on October 13, 2010:www.tilsonfunds.com/Octpres.pdf(pages 19-31).

5) General Growth Properties

General Growth Properties was our biggest winner for the second year in a row. After successfullyshorting the stock from the $40s to near zero, we flipped around and purchased it in early 2009, initiallyat under $1, when we realized that there might be some recovery for the equity even though the

company had filed for bankruptcy. We thought the upside potential was $20, but we kept it a smallposition at the time, reflecting the high risk that the equity could be worthless.

As the best-case scenario played out month after month, we let the position continue to grow because,like BP, the risk-reward equation kept getting more favorable, yet the stock price wasnt keeping up, soit remained cheapand was becoming safer and safer as the credit crisis eased, allowing GGP torefinance its debt and progress quickly through bankruptcy.

It wasnt always a smooth ride, however. In December 2009, a hedge fund named Hovde Capital, whichwas short the stock, published three bearish analyses that knocked the stock down. We concluded thatHovdes analyses were flawed and rebutted them in three published articles (see:

www.tilsonfunds.com/GGP.pdf). We ended up profiting from this volatility by adding to our position attemporarily distressed prices.

GGP exited bankruptcy on November 9th in the form of two companies: GGP, which will operate strictlyas a mall operator, and Howard Hughes Corp., a real-estate development company. We have trimmedthe positions, but continue to own both.

We presented GGP at the Boys & Girls Harbor investment conference on February 3, 2010:www.tilsonfunds.com/Harbor.pdf(pages 14-19).

6) CIT Group

Founded in 1908 to provide financing for horse-drawn carriages, CIT Group is a major player inlending to small and mid-sized businesses, in particular in specialized areas such as asset-basedlending to retail suppliers, transportation leasing and equipment finance. In November 2009,CIT filed for bankruptcy, crushed under the weight of increasing loan defaults, ill-timed foraysinto non-core areas such as student lending and subprime residential mortgages, and an inabilityto tap credit markets to finance its day-to-day operations. Shareholders were wiped out,including $2.3 billion in U.S. taxpayer money that the federal government had invested in thecompany a year before.
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By the time it emerged from its prepackaged reorganization in December, CIT had shed $10.5billion in debt, shrunk its asset base, and was touting a new and improved back-to-basicsbusiness plan.

Under new Chairman and CEO John Thain, CIT is refocusing on its core strengths in lending tosmaller businesses across a wide variety of commercial and industrial sectors. The lack ofcompetition for such business today from banks should allow CIT to not only take share, but todo so at attractive rates and without compromising on credit quality. The company certainly hasthe liquidity to lend should it choose to, with a post-bankruptcy balance sheet that sports $11.2billion in cash.

One key challenge to investing in any distressed lending institution like CIT is gaining comfortthat the asset values on the books reflect reality. As of September 30, CIT reported tangiblebook value of $42.20 per share, which we believe will prove reliable given that management hadevery incentive coming out of the bankruptcy process to write down or write off problem loansas much as possible and start off with a clean slate.

The companys primary challenge today is its cost of financing. Its net revenue spread is lowdue to CITs very high cost of financing, but we believe the company will be able to lower itsborrowing costs by refinancing existing high-cost obligations, using cash to buy back debt, andgenerating increased low-cost deposits from its bank subsidiary.

If CIT can capture the financing-cost savings we believe are possible, we think the companycould earn around $5 per share. At a 12-14x multiple we think is reasonable, that translates into$60 to $70 per share, a 27%-49% premium to the year-end price of $47.10. Even moreintriguing is the possibility that a healthy bank might acquire CIT, attracted by the enormousearnings leverage available in applying the acquiringbanks much lower borrowing costs toCITs business model.

7) Kraft

Like many of our other top holdings, Kraft is a high-quality business trading at a historically lowvaluation. In addition, we believe the 2010 Cadbury acquisition will provide substantial upside.

Kraft is the world's 2nd largest food company, and owns some of the best-known brands of snack foods,beverages, cheeses, meat products and grocery items. With the acquisition of Cadbury, the companyadds not only branded confectionery items, including gums and chocolates, but also a world-classdistribution capability that is complementary to Krafts existing distribution.

The stock currently trades at a market multiple, but we believe Kraft should trade at a premium given

the stable, high-margin characteristics of its branded portfolio. In addition, Kraft has the opportunityover the next few years to materially improve its margins to industry norms and significantly reducecosts due to synergies with Cadbury.

We believe Kraft can earn around $3.00 per share within two years, which should result in a stock priceapproximately 50% above current levels.

Pershing Square Capital Management did an excellent presentation on Kraft on February 3, 2010, which


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is posted at:www.tilsonfunds.com/Kraft.pdf

8) Seagate Technologies

Seagate is a leading manufacturer of hard disk drive storage devices (HDDs.) The industry hasexperienced significant consolidation over the last decade, resulting in three major players. Seagatesmarket share is approximately 30%.

Consensus thinking for many years is that this is a cyclical, rapidly dying industry, and that Solid StateDrives (SDDs) will soon replace HDDs in the majority of applications. Our variant perception is thatthe medium-term viability of hard disk storage is quite strong, given that HDDs have a roughly 10:1 costadvantage over SSDs. We expect that a substantial cost advantage will be sustained for some time.

In the meantime, Seagate is a powerful free cash generator. In FY 2010 (ending 7/2/10), the companyhad $1.6 billion of net income and generated $1.9 billion of operating cash flow vs. cap ex of only $639million. The resulting in $1.3 billion of free cash flow allowed Seagate to buy back $584 million ofstock and increase its cash hoard by $836 million.

The historical cyclicality of the business has been reduced thanks to the flexible nature of the

manufacturing process and industry consolidation. Gross and operating margins in FY 2010 were 28%and 15%, respectively, vs. 23% and 9%, respectively in 2006.

The company has allocated its capital sensibly over time, and has retired 17% of its stock in the pastthree years. Continued buybacks should contribute to a materially higher valuation of the company overtime.

If we are correct that Seagates business isnt in rapid decline, then its stock is one of the cheapest in ourportfolio, trading at a mere 4.8x trailing earnings and 2.8x enterprise value/EBITDA.

9) Iridium

Iridium operates a constellation of low-earth orbiting satellites that provide worldwide real-time dataand voice capabilities over 100% of the earth. The company delivers secure mission-criticalcommunications services to and from areas where landlines and terrestrial-based wireless services areeither unavailable or unreliable. It is one of two major players in the Global Satellite Communicationsindustry.

The company has a tumultuous history. Originally a division of Motorola, Iridium spent $5 billionlaunching satellites in the late 1990s, but filed for bankruptcy in 1999 with only 50,000 customers due totoo much debt and clunky phones that didnt work inside buildings. Since then, however, Iridium hasthrived. It is growing very rapidly and is taking market share from its competitors.

The company went public in late September, 2009 by merging with a Special Purpose AcquisitionCompany (SPAC) and has been weak since then, despite recently reporting strong results.

We continue to believe that this is an excellent company and that the stock is extremely undervalued.Comparable businesses are trading at 10x EV/EBITDA, while Iridium, which is growing significantlyfaster than and taking share from its competitors, trades at under 4x EBITDA. Finally, we areencouraged by the recent large insider purchases by both the CEO and Chairman of the company.
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We presented Iridium at the Boys & Girls Harbor investment conference on February 3, 2010:www.tilsonfunds.com/Harbor.pdf(pages 20-31 and 41-66).

10) ADP

We recently added another high-quality blue-chip stock to our portfolio, Automatic Data Processing.ADPs core business is payroll processing and we believe that it is one of the worlds great companies.It is more than four times the size of its nearest competitor and there are very high switching costs for itscustomers, so ADP has fabulous 20% operating margins and unlevered returns on equity in the mid-20%range. It is such a pillar of financial strength that it is one of only four companies left that still have thehighest AAA credit rating (we also happen to own the other three, Microsoft, Exxon Mobil and Johnson& Johnson, though only the former in any size). Finally, ADP has excellent management and is veryshareholder friendly, returning cash to shareholders via a healthy 3.1% dividend and share repurchases(17% of shares have been retired in the past five years).

So whats not to like? Two things: 1) Growth has disappeared (EPS in FY 2010, which ended on June30th, declined 9% from the previous year, and the company only expects 1-3% revenue and EPS growthin FY 2011); and 2) The stock doesnt appear particularly cheap, trading at 19.3x trailing EPS, based on2010s closing price of $46.28.

ADP historically has been a solid growth storyin the 13 years through FY 2009, for example, earningsper share grew 245% (10.0% annually)so what happened? In short, ADP has been hit recently by twomacroeconomic factors: high unemployment (meaning fewer paychecks being processed) and lowinterest rates, which reduce ADPs earnings from its float.

Float? ADP isnt an insurance company, so why does it have float? Allow us to explain: as a payrollprocessor, ADP collects cash from its customers and then issues paychecks, makes deposits inretirement accounts, and transfers funds for taxes. All of this happens quickly, but at any given time,ADP is sitting on more than $18 billion of cash, on which it can earn interest (it appears as a liability onthe balance sheet under Client funds obligations, offset by an asset called Funds held for clients).

Each dollar that comes in goes out very quickly, but is replaced with another dollar, so this is, in effect,perpetual (and growing) float.

Of course ADP invests these funds very conservativelythis isnt long-term float like much ofBerkshire Hathaways that can be invested in stocksso ADPs earnings from this float are highlydependent on short-term interest rates. As of December 31st, one-month Treasuries were paying amicroscopic 0.05% vs. 5.05% only 40 months ago on August 1, 2007 (how the world has changed!).

Of course ADP isnt investing all of its float in one-month Treasuriesits laddered such that thecompany generated $543 million of revenues in FY 2010 from Interest on funds held for clients.ADPs float averaged $17.1 billion in FY 2010, so it earned a 3.2% return. Imagine that interest rates

rise 300 basis points over time to more normal (although still low) levelsthis would translate into anextra $540 million in pre-tax profits for ADP, boosting earnings by nearly 30%. In addition, somedayemployers in this country will begin to hire again, which will also fuel ADPs growth. For both of thesereasons, we think ADPs earnings are depressed right now, making the stock cheaper than it appears.

While we think robust economic growth and a rise in interest rates is unlikely in the near term, when theeconomy eventually recovers, ADP should have turbocharged earnings growth. We are prepared to be
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Appendix B: Bill Grosss October 2010 Letter

Investment OutlookWilliam H. Gross | October 2010www.pimco.com/Pages/StanDruckenmillerisLeaving.aspx

Stan Druckenmiller is Leaving

The New Normal has a new set of rules. What once pumped asset prices and favored theproduction of paper, as opposed to things, is now in retrograde.

The hard cold reality from Stan Druckenmillers old normal is that prosperity andoverconsumption was driven by asset inflation that in turn was leverage and interest rate

correlated.

Investors are faced with 2.5% yielding bonds and stocks staring straight into new normal realgrowth rates of 2% or less. There is no 8% there for pension funds. There are no stocks for the

long run at 12% returns.

So the hedgies are in retreat and, in some cases, on the run. Ken Griffin at Citadel is considering cuttingfees, and Stan Druckenmiller at Duquesne/ex-Soros is packing his bags for the golf course. Frustrated athis inability to replicate the accustomed 30% annualized returns that his business model and expertiseproduced over the past several decades, Stan is throwing in the towel. Whos to blame him? I dont. Irespect him, not only for his financial wizardry, but his philanthropy which includes not only writing bigchecks, but spending lots of time with personal causes such as the Harlem Childrens Zone. And at 57,hes certainly learned how to smell more roses, pick more daisies, and replace more divots than yourstruly has at the advancing age of 66. So way to go Stan. Enjoy.

But his departure and Mr. Griffins price-cutting are more than personal anecdotes. They are reflectiveof a broader trend in the capital markets, one which saw the availability of cheap financing drive asset

prices to unsustainable heights during the dotcom and housing bubble of the past decade, and thensuffered the slings and arrows of a liquidity crisis in 2008 to date. Similarly, liquidity at a discount drovelots of other successful business models over the past 25 years: housing, commercial real estate,investment banking, goodnessdare I say, investment managementbut for them, its destination ismore likely to be a semi-permanent rest stop than a freeway. The New Normal has a new set of rules.What once pumped asset prices and favored the production of paper, as opposed to things, is now inretrograde. Leverage and deregulation are fading from the horizon and their polar opposites are in theascendant. Some characterize it in biblical termsseven fat years to be followed by seven years of lean.Others like Michael Moore and Oliver Stone describe it in terms of social justicegreed no longer isgood. And the hedgieswell, they just take their ball and go home. What, after all, is the use ofcompeting if you cant play by the old rules?

Whoevers slant or side you choose to take in this transition from the old to the new normal, theunmistakable fact is that future investment returns will be far lower than historical averages. If a leveredDruckenmiller, Soros, or Griffin could deliver double-digit returns in the past, then a less levered hedgefund community with a lower yielding menu will likely resign themselves to a high single-digit future. Ifa stocks for the long run Jeremy Siegel grew used to historically validated 9 to 10% returns fromstocks prior to writing his bestseller in the late 1990s, then the experience of the last decade should atleast temper his confidence that the market will deliver any sort of magical high single-digit returnover the long-term future. And, if bond investors believe that the resplendent and abundant capital gains
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of the past 25 years will be duplicated from yield levels of 2 to 3%well, they just havent been toJapan, have they?

There are all sizes and shapes ofinvestors out there who have not correctly visualized the lower returnworld of the New Normal. The New York Times just last week described the previous balancing act thatpension fundsboth corporate and state-orientedare now attempting to perform. Their articledescribes their predicament as the illusion of savings, a condition which features the assumption thatasset returns on their investment portfolios will average 8% over the long-term future. No matter thatreturns for the past 10 years have averaged 3%. They remain stuck on the notion that the 25-year historyshown in Chart 1 is the appropriate measure. Sort of a stocks for the long run parody in pension spaceone would assume. Yet commonsense would only conclude that a 60/40 allocation of stocks and bondswould require nearly a 12% return from stocks in order to get there. The last time I checked, theinvestment grade bond market yielded only 2.5% and a combination of the two classic asset classeswould require 12% from stocks to hit the magical 8% pool ball. That requires a really long cue stick dearreader, or what they call a bridge in pool hall parlance. Best of luck.

The predicament, of course, is mimicked by all institutions with underfunded liability structures

insurance companies, Social Security, and perhaps least acknowledged or respected, households. Ifa family is expecting to earn a high single-digit return on their 401(k) to fund retirement, or a similarresult from their personal account to pay for college, there will likely not be enough in the piggy bank attimes end to pay the bills. If stocks are required to do the heavy lifting because of rather anemic bondyields, it should be acknowledged that bond yields are rather anemic because of extremely low new

normal expectations for growth and inflation in developed economies. Even the wildest bulls onWall Street and worldwide bourses would be hard-pressed to manufacture 12% equity returns fromnominal GDP growth of 2 to 3%. The hard cold reality from Stan Druckenmillers old normal isthat prosperity and overconsumption was driven by asset inflation that in turn was leverage and

interest rate correlated. With deleveraging the fashion du jour, and yields about as low as they are

going to go, prosperity requires another foundation.


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What might that be? Well, let me be the first to acknowledge that the best route to prosperity is the goodold-fashioned route (no, not the dated Paine Webber road map utilizing hoped for paper gains of 12%+)but good old-fashioned investment in production. If we are to EARN ITthe best way is to utilizetechnology and elbow grease to make products that the rest of the world wants to buy. Perhaps we can,but it would take a long time and an increase in political courage not seen since Ronald Reagan or FDR.

What is more likely is a policy resort to reflation on a multitude of policy fronts: low interest rates

and quantitative easing from the Federal Reserve, near double-digit deficits as a percentage of

GDP from Washington. What the U.S. economy needs to do in order to return to the old normal is torecreate nominal GDP growth of 5%, the majority of which likely comes from inflation. Inflation is theclassic coin shaving technique of government since the Roman Empire. In modern parlance, you printmoney faster than required, pray that the private sector will spend it to generate investment andconsumption, and then worry about the consequences in a later decade. Ditto for deficits and fiscalpolicy. Its that prayer, however, which the financial markets are now doubting, resemblingcircumstances which in part are reminiscent of the lost decades in Japan since the early 1990s. If theprivate sectorthrough undue caution and braking demographic influencesrefuses to take the bait, thereflationary trap will never snap shut.

Investors will likely not know whether the mouse has grabbed for the cheese for several years forward.In the meantime, they are faced with 2.5% yielding bonds and stocks staring straight into new

normal real growth rates of 2% or less. There is no 8% there for pension funds. There are no

stocks for the long run at 12% returns. And the most likely consequence of stimulative

government policies that strain to get us there will be a declining dollar and a lower standard of

living. Stan Druckenmiller is leaving, and with good reason. A future of low investment returns, and aheap of trouble for those expecting more, is what lies ahead.

William H. GrossManaging Director


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Appendix C: Excerpt from Jeremy Granthams July 2010 Letter

The entire letter is posted at:www.gmo.com/websitecontent/JGLetter_SummerEssays_2Q10.pdf

Seven Lean Years Revisited

The idea behind seven lean years is that it is unrealistic to expect to overcome the several problemsfacing most developed countries, including the U.S., in fewer than several years. The purpose of thissection is to review the negatives that are likely to hamper the global developed economy, especiallyfrom the viewpoint of how much time may be involved.

First, one of the causes of the financial crisis was the over-indebtedness of consumers in certaincountries, including the U.S., the U.K., and several European countries. As of today, although they havestopped increasing consumer debtwhich itself is unprecedented and has eaten into consumptionthetotal improvement in personal debt levels is still minimal. It would take at least seven years of steadyreduction to reach a more normal level. Anything more rapid than this would make it nearly impossiblefor the economy to grow anywhere near its normal rate or, perhaps, at all.

There is in the situation today a nerve-wracking creative tension. At one extreme, massive stimulusinduces government debt to rise to levels that cause a real problem in servicing the debtinterest andrepaymentor at least a crisis of confidence. At the other extreme, a draconian attempt to hold debtlevels while the economy is still fragile runs the risk of causing a severe secondary economic decline.Deciding which horn of this dilemma to favor will probably prove to be the central economic policychoice of our time. I am sympathetic to those in power. This is not an easy choice. My guess, though, isthat the best course is less debt reduction now and a longer, slower reduction later. Overdoing it nowmay well cause an economic setback for an already tender and vulnerable global economy that mighteasily be enough to more than undo all of the benefits of debt reduction. Indeed, with a weaker economyleading to lower government income, it might sadly cause debt levels to rise after all. This need for time

to cure all ills is one reason why I picked a seven-lean-year recovery over a more normal and rapid one.The bad news, though, is that in the end, by hook or by crook, debt levels must be lowered at everylevel, especially governmental. There is almost no way that this process will be pleasant or quick.

Second, and the most immediately frightening aspect of the seven-lean-year scenario, is that althoughthe credit crisis was caused by too much credit on too sloppy a basis, the cure was to increase aggregatedebt by flooding economies with government debt. Dangerously excessive financial system debt wasmoved across, with additions, to become dangerously excessive government debt, with levels of debt toGDP not seen outside of major wars, and seldom then. Increasingly the cure seems more like a stay ofexecution. With bank crises, there is the backstop of the central government. For minor countries, theIMF may be a net help, but for major countries in trouble, the IMF seems outgunned and, if several

major countries have a debt crisis simultaneously, the IMF is clearly irrelevant.

Third, we have lost a series of artificial stimuli that came out of the steady increases in debt levels andthe related asset bubbles. For example, the artificial lift to consumers attitudes resulting from steadilyrising house prices is unlikely to return soon. In fact, some further price
http://www.gmo.com/websitecontent/JGLetter_SummerEssays_2Q10.pdfhttp://www.gmo.com/websitecontent/JGLetter_SummerEssays_2Q10.pdfhttp://www.gmo.com/websitecontent/JGLetter_SummerEssays_2Q10.pdfhttp://www.gmo.com/websitecontent/JGLetter_SummerEssays_2Q10.pdf


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decline in house prices in the U.S. is probably more than a 50/50 bet, and in the U.K. and Australia isnearly certain. For sure, that feeling of supreme confidence counting on the inevitability of furthersteady rises in house prices, which was baked into average U.S. opinion by 2006 (including Bernankes,unfortunately)is long gone. The direct shot in the arm to the economy from the rise in economicactivity from an abnormally high rate of home construction and the services associated with anabnormally high turnover rate of existing houses (more realtors, etc.) is also a distant memory here. Sothe stimulus from rising prices has gone, and stock prices, although they have made a strong recoveryeverywhere in the developed world, are still way down from their highs of 10 years ago and, notably inthe U.S., are still overpriced. Both the market and house price declines have also reduced confidence inthe nest eggs that people felt they could count on for retirement as well as a little more spending on theway there. Now consumers are readjusting to a greater need to save and, perhaps unfortunately, a greaterneed to work longer. Unprecedentedly, they are paying down some consumer debt. These changedattitudes will surely last for years.

Fourth, although the financial system has passed its point of maximum stress in the U.S., very bad thingsmay lie ahead in Europe. And the leverage in the system and the chances of further write-downs (yetmore housing defaults and private equity write-downs, for example) leave banks undercapitalized andreluctant to lend. Any more shoes dropping here or in Europe, or elsewhere for that matter, will tend to

keep them nervous. The growth in the total U.S. GDP caused by previous rapid increases in the size ofthe financial sector has also disappeared, and with any luck will stay disappeared, for it was not healthygrowth in my opinion.

Fifth, the runaway costs in the public sector, particularly at the state and city levels, where averagesalaries and pensions ran far above private sector equivalents in a mere 15 years (why, that would makea good report by itself!), have run into a brick wall of reduced taxes. State and other municipalities areincredibly dependent on real estate taxes, which are down over 30% from falling real estate prices anddefaults, and also on capital gains rates, which have been hit by falling asset prices generally. Theirlegal need to stay balanced is leading to painful cost cutting, which in turn puts pressure on an economythat is coming to the end of much of the stimulus. With many of the artificial stimuli of the 90s and

2000s gone, their revenues are unlikely to bounce back in one or two years, and a double-dip in theeconomy or new asset price declines would move their recovery back further.

Sixth, unemployment is high and will also suffer from the loss of those kickers related to asset bubbles.The U.S. economy appears to have an oddly hard time producing enough jobs to get ahead of the naturalyearly increases in the workforce. (At least for a while, one long-term economic dragslowing longer-term growth of the U.S. labor forcebecomes an intermediate-term help in reducing unemployment, butbeyond five years, it too will work to reduce GDP growth, as it has already done in the last 10 years.)Needless to say, unemployment works to keep consumer confidence and, hence, corporate willingness toinvest, below normal.

Seventh, another longer-term problem for the global economy is trade imbalances. The U.S. inparticular cannot continue to run large trade imbalances. In a world growing nervous about the qualityof sovereign debteven that of the U.S.domestic sovereign debt levels have exploded. The addedcomplication and threat to the dollar from accumulating foreign debts just adds risk and doubts to thesystem. This is similar to the accumulating surpluses of the Chinese.


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Imbalances destabilize the system. The trick, though, is to reduce these imbalances so that the processdoes not reduce global growth. This necessary rebalancing will not be quick or easy.

Eighth, there is a related but different problem with the euro: incompetent management in Spain,Greece, Portugal, Ireland, and Italy allowed the local competitiveness of their manufactured goods tobecome 20% or more uncompetitive with those of Germany. It was never going to be an easy matter tohead this process off, and doing so would have taken some tough actions with uncomfortable short-termconsequences. But they could see the problem building up like clockwork at about 2% to 3% a year,year after year. This did not result from the banking crisis, and it was never going to be easy to solvewith a fixed currency. The difficulty was implicit in the structure of the euro from the beginning.Indeed, my friend and former partner, Paul Woolley,1 believed, and let everyone know it, that from dayone this was a fatal flaw nearly certain to bring the euro down under stress. But one might have hopedfor better evasive action or better survival instincts.

Greece in particular has two largely independent problems. First, it has approximately 22% overpricedlabor (complete with 14 months salary and retirement in ones 50s), which can only be cured byreducing their pay by 22%. This would be tough for any government that does not have anexceptionally well-established social contracta commitment from individuals that they have

obligations to help the whole society to prosper or, in this case, muddle through. The Greeks probablydo not have it. Perhaps the U.S. does not either. Would we take being told that ordinary workers wouldhave to earn 22% less when there are so many other people to blame for our current problems? TheJapanese, in contrast, probably do, but may well have other offsetting disadvantages.

The second problem for the Greeks is that they have accumulated too many government debts relative totheir ability to pay and, as the doubts rise, so do the rates they must pay such that their ability to pay fallsand the doubts rise further. Temporary bailouts are postponements of a necessary restructuring. Shouldthe system get out of control, there is the problem of the Greek debt that is stuffed into other Europeanbanks. (My colleague, Edward Chancellor, is writing on this topic.) I merely want to make the point thatthese twin Greek problems, which affect, to varying intensity, the other PIGS, have become an intrinsic

part of the seven lean years, more or less guaranteeing slower than normal GDP growth and a longworkout period.

Ninth, the general rising levels of sovereign debt and the particular problems facing the euro bloc andJapan are leading to the systematic loss of confidence in our faith -based currencies. It is becoming afragile system that will increasingly limit governments choices in terms of dealing with low growth andexcessive credit.

Finally, and possibly most important of all, on a long horizon there is a very long-term problem that willoverlap with the seven-year workout and make the period even tougher: widespread over-commitmentsto pensions and health benefits, which is covered in the next section.

1Paul Woolley started a center for the study of Capital Market Dysfunctionality at the London School of Economics.


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T2 Accredited Fund, LP (the Fund) commenced operations on January 1, 1999. The Fundsinvestment objective is to achieve long-term after-tax capital appreciation commensurate with moderaterisk, primarily by investing with a long-term perspective in a concentrated portfolio of U.S. stocks. Incarrying out the Partnerships investment objective, the Investment Manager, T2 Partners Management,LLC, seeks to buy stocks at a steep discount to intrinsic value such that there is low risk of capital lossand significant upside potential. The primary focus of the Investment Manager is on the long-termfortunes of the companies in the Partnerships portfolio or which are otherwise followed by theInvestment Manager, relative to the prices of their stocks.

There is no assurance that any securities discussed herein will remain in Funds portfolio at the time youreceive this report or that securities sold have not been repurchased. The securities discussed may notrepresent the Funds entire portfolio and in the aggregate may represent only a small percentage of anaccounts portfolio holdings. It should not be assumed that any of the securities transactions, holdingsor sectors discussed were or will prove to be profitable, or that the investment recommendations ordecisions we make in the future will be profitable or will equal the investment performance of thesecurities discussed herein. All recommendations within the preceding 12 months or applicable periodare available upon request.

Performance results shown are for the T2 Accredited Fund, LP and are presented gross and net ofincentive fees. Gross returns reflect the deduction of management fees, brokerage commissions,administrative expenses, and other operating expenses of the Fund. Gross returns will be reduced byaccrued performance allocation or incentive fees, if any. Gross and net performance includes thereinvestment of all dividends, interest, and capital gains. Performance for the most recent month is anestimate.

The fee schedule for the Investment Manager includes a 1.5% annual management fee and a 20%incentive fee allocation. For periods prior to June 1, 2004, the Investment Managers fee scheduleincluded a 1% annual management fee and a 20% incentive fee allocation, subject to a 10% hurdlerate. In practice, the incentive fee is earned on an annual, not monthly, basis or upon a withdrawal

from the Fund. Because some investors may have different fee arrangements and depending on thetiming of a specific investment, net performance for an individual investor may vary from the netperformance as stated herein.

The return of the S&P 500 and other indices are included in the presentation. The volatility of theseindices may be materially different from the volatility in the Fund. In addition, the Funds holdingsdiffer significantly from the securities that comprise the indices. The indices have not been selected torepresent appropriate benchmarks to compare an investors performance, but rather are disclosed toallow for comparison of the investors performance to that of certain well-known and widely recognizedindices. You cannot invest directly in these indices.

Past results are no guarantee of future results and no representation is made that an investor will or islikely to achieve results similar to those shown. All investments involve risk including the loss ofprincipal. This document is confidential and may not be distributed without the consent of theInvestment Manager and does not constitute an offer to sell or the solicitation of an offer to purchase anysecurity or investment product. Any such offer or solicitation may only be made by means of deliveryof an approved confidential offering memorandum.

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