East Coast Asset Management on Competitive Advantage: Quarterly Letter

East Coast Asset Management's quarterly letters have become one of our favorites for insight and timeless advice on the topic of compounding as well as variant perception. This time around, Christopher Begg focuses on competitive advantage and the ability of businesses to first become 'local champions'.

Begg writes that, "high quality businesses that can raise prices and whose products have localized advantages with a growing emerging market consumer will thrive." This point is exemplified by Warren Buffett & Berkshire Hathaway, whose latest purchase of Lubrizol was seemingly based on pricing power.

The main gist of the letter is that solid investments are found in businesses with solid competitive advantages that allow them to do something their competitors cannot.

East Coast's letter also goes on to quote Steve Mandel of Lone Pine Capital who said, "Our ability to identify businesses that have the market opportunity, product distinction, competitive advantage and management skill to grow earnings and cash flow for longer than is factored into consensus expectations has distinguished our investment effort over the years."

Lastly, Begg gives an example of misclassifying an investment in Cisco Systems (CSCO) and how he has learned from the mistake. Investors never stop learning and this is the perfect example of why many successful investors critically focus on competitive advantage.

Embedded below is East Coast Asset Management's latest letter:



You can download a .pdf copy here.

Begg has also accepted a position as an Adjunct Professor at Columbia Business School and will be teaching Security Analysis this summer. For more great insight from this firm, check out East Coast on gaining an investment edge.

What We're Reading ~ 4/8/11

Thoughts on Ackman's latest activist holding: ALEX [Value Plays]

Notes from the Harvard Business School turnaround conference [DDI]

Jeff Gundlach breaks down a multi-asset portfolio [Prag Cap]

Margin in Trading [Stone Street Advisors]

Carl Icahn calls Blockbuster the worst investment ever made [Fast Company]

Bill Ackman's letter to Howard Hughes (HHC) shareholders [ValuePlays]

Google (GOOG): The freight train that is Android [Above the Crowd]

Mutual funds employing hedge-fund like strategies [USAToday]

Top 10 dying industries [WSJ]

Career tips from Goldman Sachs [Business Insider]

Oaktree Capital's Howard Marks Speaking at the Value Investing Congress

Readers of the site should be familiar with Oaktree Capital's Howard Marks as we've posted his commentary numerous times and found it very insightful. Now you can hear his latest thoughts on the markets and his favorite investment ideas as he will be speaking on May 3rd & 4th in Pasadena, California. Learn more about the Value Investing Congress.

Marks is a contrarian and founded Oaktree in 1995 and now manages over $80 billion. He has a new book coming out entitled The Most Important Thing: Uncommon Sense for the Thoughtful Investor and everyone attending the event will receive a free copy.

Additionally, Guy Gottfriend will be presenting. He is the founder of Rational Investment Group and has generated net returns of 40% per annum since launching in 2009 while holding 25% of assets in cash.

Here's the full list of speakers at the event:

- Howard Marks, Oaktree Capital
- Jeffrey Ubben, ValueAct Capital
- Steven Romick, First Pacific Advisors
- David Nierenberg, The D3 Family Funds
- Rahul Saraogi, Atyant Capital (India)
- Michael Kao, Akanthos Capital Management
- Ori Eyal, Emerging Value Capital Management
- Kian Ghazi, Hawkshaw Capital Management
- Guy Gottfried, Relational Investment Group
- Whitney Tilson & Glenn Tongue, T2 Partners

Here's a rare chance to get the latest market thoughts and investment ideas from hedge fund managers. It's also a great chance to network and talk stocks with other analysts and portfolio managers attending the event. Click here to register for the Value Investing Congress.

Michael Steinhardt on Differences Between Past & Current Hedge Funds

Michael Steinhardt founded Steinhardt Partners in 1967 and generated 24% average annual returns over a 28 year period. He was one of the true pioneers in the industry and he recently sat down with CNBC for an interview.

The former titan talked about his time as a hedge fund manager, saying "When I was doing it, it was an elite phenomenon. Now it ain't an elite business anymore." Steinhardt is now the chairman of ETF firm, WisdomTree.

Hedge Fund Differences: Then & Now

Performance: He notes that the main difference between hedge funds then and now is the goal of performance. He targeted (and achieved) outsized returns, while many funds today are happy cranking out "only" 12-14% gains.

Assets Under Management (AUM): Steinhardt also slipped in his signature phrase of 'diseconomies of scale,' referring to the fact that as assets under management (AUM) grew, true outperformance was harder to achieve. He chastised modern hedge funds as asset gathering behemoths with goals of making money from the assets (management fee) rather than making money from performance.

Impact of Fund Size on Returns: This is a big talking point amongst investors, especially as of late it seems. The classic example, of course, is John Paulson. His hedge fund Paulson & Co catapulted to fame with his stellar returns shorting subprime. As his AUM has swelled, investors have raised concern and Paulson addressed his fund size in his year-end letter.

Maverick Capital's hedge fund founder Lee Ainslie also wrote a quarterly letter to refute the notion that large fund size negatively impacts a manager's ability to generate returns.

Steinhardt's point (and it's a good one), is that regardless of whether or not these funds generate performance, the funds are still making money due to the management fee on a sizable chunk of assets.

Hedge Fund Herding: The hedge fund legend also points out that so many managers are using similar strategies these days, whereas he was one of the few employing them in his time. This is yet another topic that high profile funds have been forced to address via investor letters. Viking Global's Andreas Halvorsen wrote about hedge fund herding here (scroll down in the post).

In short, Steinhardt raises some valid points about how hedge funds have slightly strayed from their original incarnation. The reason? Money, of course.

He's not alone in his concern, either. After all, so many prominent funds wouldn't have to address such issues had they not seen continuous signs of concern from their investors.

You can watch Steinhardt's interview below where he also gives his macro outlook and oddly enough goes on a tirade against Warren Buffett (email readers come to the site to watch):



In the video, Steinhardt also briefly mentions that he remains short 2 year Treasuries. You can also read his past thoughts on why he thinks treasuries are foolish.

T2 Partners Attributes Poor Performance to Contrarianism

Whitney Tilson and Glenn Tongue's hedge fund T2 Partners sent out a monthly update to investors and they reveal performance of -4.3% in March and -3.1% for the year. This trails the S&P 500, which is up 5.9% in 2011. More interesting than the performance figures, though, is the the notion of deviating from the herd and its subsequent effect on that performance.

T2 writes that, "a bigger reason for our underperformance, especially last month, is our investment strategy, which is rooted in deviating from the crowd with contrarian bets. It's the only way to outperform the market over the long term, but it also carries with it the risk - indeed, the certainty - that there will be periods during which one underperforms the market."

Obsession With Short-Term Performance

This is worth pointing out because Wall Street and investors are seemingly always fixated on short-term performance. In part, this is one of the reasons that Shumway Capital Partners returned outside investor capital (among many other reasons). In his letter, Chris Shumway noted that returning outsider money would allow him to focus on long-term positioning that he has been so successful with.

When investors place monthly expectations on a manager, rather than yearly ones, the manager is pressured to attain short-term performance and it compromises their core investment strategy.

Value Versus Global Macro Managers

To illustrate this point, we turn to a comparison between value-based investors and global macro traders. If a macro manager sees a mountain top (gains from a potential trade), he will go after it. However, if he encounters a valley (temporary loss of capital) on the way to the mountain top, he will pivot and trade around that position to eliminate near-term risk or even profit from the decline by temporarily shorting.

A value-based manager, on the other hand, will continue to hold their long position and ride out the valley (decline) in order to get to the mountain top (gain). Their deeply rooted stance makes them more prone to near-term underperformance.

T2's Letter

In the recent past, T2 Partners has blamed poor performance on their short positions. Yet despite covering their short of Netflix (NFLX), they puzzlingly held onto other valuation shorts like Opentable (OPEN) and Lululemon (LULU), but that's a whole 'nother conversation.

Now they are attributing poor performance to contrarianism. Some will undoubtedly say this is just excuse after excuse and wonder what the fund will blame next. Putting that aside, T2 does underline a prescient point worth extracting: sometimes it's painful to be contrarian.

In the letter, T2 goes on to highlight that, "it's easy to deviate from the crowd, of course, but it's much harder to be right - and even harder to be right on the timing."

If a value investor can stomach the near-term anguish (and assuming their thesis is proven correct), they'll make it to that mountain top eventually. T2 gives an example of this with their investment in Iridium (IRDM). While they think the stock is a triple in 3-5 years, they have to hang on through the bumpy ride in the near-term as last month the stock was down 15.1% and the warrants dropped 24.1%.

T2's run of poor performance continues and you can read their take on the situation embedded below in their investor letter (email readers need to come to the site to view it):



For more on that particular stock, head to T2's analysis of Iridium.

Hedge Fund Third Point Reduces Net Long Exposure: Latest Positioning

Dan Loeb's hedge fund firm Third Point LLC has released its March performance and exposure report. Third Point returned 0.9% in March and is up 8.6% year to date versus 5.9% for the S&P 500. Third Point's Offshore Fund now has an annualized return of 19%.

Latest Exposure Levels

Third Point is net long equities to the tune of 42.2%. This is a decrease of 14%, down from last month's 56.2% net long exposure. As various crises (risk) around the world escalated, Third Point has ratcheted their exposure down. In Loeb's year-end letter, he voiced that he was concerned about the consensus bullish view.

Third Point's largest net exposure is in energy, basic materials, and consumer. In credit, Third Point is 17.1% net long asset backed securities (RMBS & CMBS exposure), 11.5% net long distressed, 6.1% net long performing and -5.1% short government securities. Their credit allocations are largely unchanged from last month.

Third Point's Top Positions:

1. Gold
2. Delphi Corp
3. Chrysler
4. El Paso Corp (EP)
5. NXP Semiconductor (NXPI) ~ multiple securities held

In February, we highlighted how Loeb started El Paso as a new position and it remains one of their top holdings. This month, their exposure to NXP Semiconductor (NXPI) replaces LyondellBasell (LYB) as their fifth largest position.

NXPI is a prime player in the NFC (near field communications) space that seems to be sweeping the mobile industry as interest in mobile payments heats up. The company recently priced a secondary offering at $30 per share and has been doing a roadshow to drum up investor interest. This offering significantly helps liquidity in the stock and should allow larger hedge funds to accumulate positions.

Top Winners & Losers for Third Point

We get a glimpse at some of Third Point's other positions with their top winners from the month, including: CVR Energy (CVI), Short A, Statoil Fuel & Retail ASA (SFR), Aveta, and Health Net (HNET). Their top losing positions for the month include Potash (POT), PHH Corp (multiple securities held), Inmarsat, ProSieben (multiple securities held), and El Paso.

To see analysis of Loeb's portfolio and the investment thesis behind some of his picks, check out our Hedge Fund Wisdom newsletter.