“MOUNT EVEREST” Valquest’s May 2013 Update to Partnersvalcap.com/letters-reports/Everest-May-2013-Update-to-Partners.pdf · remained flat, its 6-year rate of decline that we

Valquest Capital Management, LLC 720 5th Avenue, 10th Fl. New York, NY 10019

Tel/Fax 212.981.4909 [email protected] www.valcap.com

“MOUNT EVEREST”

Valquest’s May 2013 Update to Partners

Metaphorically speaking, we might say the market has scaled the summit of “Mount Everest,” hence the title of this Update. This is not to imply the proverbial “top” has been reached, since, to paraphrase Humphrey Bogart in “Casablanca,” we’ll always have the moon and outer space (and of course Paris). We think we are at a very timely juncture to share with you our present view “from the summit,” and to bring you up to date on our performance, as well as strategies we’ve been implementing and why. Beginning with the generational lows and investment opportunities that we wrote about and capitalized upon in the aftermath of the 2008 market meltdown, Valquest’s various letters have put forward our long-term vision for the equities marketplace, building the case over the years that a confluence of many favorable factors were evolving that were thoroughly laid out in Valquest’s Third Quarter 2012 Letter (our “Magnum Opus”) where we posited “a more expansive and positive view and alternative outlook that investors have not bought into nor considered seriously for a decade – a Renaissance for Equities.” While most pundits and analysts last September were citing “end of the world” scenarios and expecting a major sell-off, our Magnum Opus called for no more than a garden variety 10% correction, to be followed by a move to new highs that would herald the Renaissance. Since the stock market’s 9% correction and November bottom, it has been delivering and rocketing to new all-time highs. With the market now beginning to experience our “Renaissance” scenario, it is now important to take a fresh look and review the various metrics and historical data that are guiding our investing and risk management processes.

PERFORMANCE:

At this writing, Valquest’s preliminary year to date returns after fees are 17.96%, as compared with 15.70% for the S&P 500, 18.30% for the Russell 2000 Small Cap Index, and 9.85% for the HFRX Equity Hedge/Fundamental Value Index. While having had a taste of the equities Renaissance we posited, we have nonetheless been measuredly reducing our conservative net long exposure to the market (from 70% earlier in the year to below 60% currently) by both harvesting gains and incrementing hedges to defend against a short-term reversal that may result from the stock market’s recent parabolic run, as our indicators below are suggesting. We do remain bullish, particularly over the market’s longer-term prospects, and are pleased that we could achieve our excellent returns to date with a little more than half the exposure of the S&P 500 and Russell 2000 indexes. I attribute this to the outstanding performance of our many Winning Footprint companies, a number of which remain at historically low valuations and with further significant upside potential. They are indicative of the strong horsepower we have under the hood.

Valquest Partners, LP

Hedged Deep Value Investing

for Superior Long-Term Gains



PERSPECTIVE:

Some of the factors we continue to monitor include the following:

SENTIMENT

While the market’s fundamentals are not suggesting a top, our indicators are giving us enough

reasons for caution in the short-term and we’ve been reducing our exposures. We have said previously that our sentiment barometers serve as valuable tools in anticipating what may lie ahead, especially when they point to extremes in negative or positive psychology, as one will eventually give way to the other. Acknowledging some supportive aspects of sentiment, the market has withstood “stress tests” in the form of the Cyprus banking crisis, the Boston bombings, the rout in gold, the falsely attributed AP report of an attack on the White House, and “flash crashes” at the stock level. It took the body blows and moved defiantly higher. We are mindful that markets often undergo a self-correcting process after reaching a key level in their climb, and it isn’t unusual for them to then test support levels below, similar to a mountaineer falling no lower than the length of rope secured by the “piton” (the small metal spike referred to as “protection” or “pro” in mountain climbing) they have hammered into the rock. The markets also have a history of overshooting, which we call “the lunatic fringe.” While sentiment may not be at lunatic fringe levels quite yet, our barometers have moved further along their trajectories since the Third Quarter Letter, which is concerning us at the moment. We have high conviction with our companies being able to deliver fundamentally, but unless we are in those with valuations materially below the market and with turnaround/fundamental improvement prospects above the market, we are lightening up in the short-term. From the market’s current levels, we are concerned that even a minor reversal can still cause a lot of volatility in less liquid names. Of most concern is the current position of our Breadth Chart (see charts section at the end of the Update) which is at a potentially ominous point where we could see volatility and corrections. We had previously argued that although the parabolic move to all-time high breadth readings appeared ominous, it was supported by the build-up in strong fundamental corporate momentum, as well as the comparatively higher growth rates of smaller companies returning from abandonment. Thus we argued that there remained room for them to grow into their multiples. Regarding the more recent valuation data for small caps, we cite a May 9th article from Barron’s that noted “at a 16.4x forward PE multiple at the end of April (above the long-term average of 15.4 times), the Russell 2000 has admittedly lost its

valuation appeal. But the index doesn't look too expensive yet either as the forward multiple remains

below its post-2009 forward P/E highs of 17 times and higher. Current earnings estimates suggest the

Russell 2000 won't hit that valuation pressure point until the index hits the 990-1,025 area. Small-cap

valuations are slightly above average relative to large caps currently.” With the Russell already having reached 1008 at this writing, and with breadth now even higher than at the last writing, we are more alert to a correction in breadth developing. Despite the valuations of our smaller Winning Footprint companies being close to their life-of-company lows compared to those cited above, breadth corrections can see bids disappear and take illiquid stocks down in a heartbeat. Like breadth, the 21-day Arms Index, another volume indicator that utilizes advance/decline data, is at levels suggesting stocks are getting near-term overbought, which increases the potential for a correction. However, with respect to the longer-term picture, volume trends otherwise remain supportive. For example, the ratio of upside to downside volume has been persistently favoring the upside since June of



last year, providing some fuel for the S&P 500’s strong advance. While daily trading volume itself has remained flat, its 6-year rate of decline that we cited in our January 2012 Update as having bottomed has continued rising (if perhaps modestly) above its inflection point for almost two years. The number of NYSE stocks making new daily highs versus new daily lows has also been increasing since its last major inflection point in August 2011. Per our Cycle of Market Emotions Chart, and with the S&P 500 now trading above 1680, its current trailing PE multiple of 18x still remains below the levels reached at the bull market tops in 2000 (44x) and 2007 (27x). As alluded to above, large cap valuations are relatively lower than small caps, and we are willing to give the S&P 500 a little more latitude as far as the PE multiple. Standard & Poor’s December 31st (seven months away) forecast of earnings approaching $110.53 would suggest that the market is only trading at 14x the earnings estimate. Between 12x to 18x is considered fair valuation, and above 20x is reaching overvaluation. Therefore, we are more concerned about a correction developing not because of the index’s PE multiple, but because of its parabolic rise. Looking at our Volatility Index (VIX) Chart (a gauge of investor fear versus complacency that moves opposite to the S&P 500) we had noted last September that the VIX reached its most complacent reading in five years, hitting a low of 13.30 on August 17th. You may recall that many pundits were ringing alarm bells, concerned that the low readings were announcing the end of the bull run. While we did not dismiss this possibility, we also pointed out that “historically speaking, the VIX can remain at low levels for a long period, as it did between 1994 to 1996, and 2004 to 2006.” That it could get lower was consistent with our view that the S&P 500 was not overvalued, and it has in fact gotten as low as 11.05, averaging in the 12-13 range. We are less concerned with small point moves up or down in the VIX, but are watching its current position closely, and actually making an upside bet on the VIX to hedge our portfolio against a possible replay of its fourth quarter move above 20. All told, our indicators are suggesting there is the potential for a short-term correction. We are content to sell some of our big winners to those intrepid momentum guys who wish to extrapolate the market higher, or to the fundamental analysts whose conviction moves up with the price of the stock. Markets can have sudden and severe setbacks. It’s frustrating that we hedge against them, but better that, than being caught swimming without our shorts when the tide that lifts all boats goes back out. EARNINGS Corporate earnings continue to support our Renaissance scenario. More than 75% of S&P 500 companies beat or met analyst estimates in Q4-2012. This was a big change in expectations from last September, when Standard & Poor’s analysts ratcheted down estimates to $101.47 in light of headline risk, slower cash growth, and higher commodity prices. As we stated then, either side of $100 would be good for Valquest. It was rewarding for us when the actual number for full year 2012 came in at $104. Here we are in the middle of 2013 and Standard & Poor’s has now raised the current year’s earnings estimate to $110.53. We are cognizant of analyst commentaries regarding Q1-2013 earnings reporting that have noted the slower growth in revenues, despite most companies continuing to beat on the earnings side, and we remain optimistic about the prospects for our low valuation Valquest Winning Footprint companies even if full year S&P 500 earnings come in somewhat lower than $110.53.



ECONOMY

GDP growth has been slow, though stable enough to support the individual company turnarounds

in Valquest’s portfolio. After a dismal 0.4% growth rate in Q4-2012, GDP growth in Q1-2013 improved to 2.5%. This improvement is in accord with comments by economist Ed Hyman earlier in the year that stocks and the economy “will do better than most people believe” in the first quarter. He pointed out that there have been an unprecedented 312 stimulative easings over the last 16 months by central banks around the world since the 2008 meltdown. “That, probably as much as anything, has helped financial markets do better.” The combination of the economy improving and monetary policy “set at max” with zero returns from safe assets explains why the markets have done well. With the return on cash basically zero, “ there’s no choice but to invest in risk.” Even Nouriel Roubini has been sounding a more optimistic note about the market being able to run higher over the next two years – as long as the Fed continues its aggressive stimulus strategy. He noted in recent comments that the U.S. is still undergoing “extremely mediocre economic growth,” with the Federal Reserve fueling much of that growth with a heavy dose of money supply into the economy. Like Ed Hyman, Mr. Roubini believes that the concerted move by the world’s central banks to provide easy access to money via aggressive monetary policy is what’s helping to drive the current buying in the stock market. “In the short-term, it’s great for assets.” Even so, he says there is a gap between the real economy and financial markets, and that Fed-induced growth will “ultimately prove unsustainable.” It is nevertheless encouraging for our Renaissance scenario that two economists we highly respect (and who rarely agree on the markets and economy) are apparently in agreement on the market’s potential, even if being driven by stimulus. I’m sure that embedded within their optimistic view of the stock market is another key economic metric showing signs of strength, the housing market. Valquest knows this anecdotally from the strong performance of our homebuilder stocks, bought at their life-of-company lows, and at a time when many were saying they’re never coming back. The latest (and more scientific) data available show the Case-Shiller Home Price Index climbed 9.3% in February from the same month in 2012, the biggest gain since mid-2006. Yet another significant fact is Fannie Mae’s recent announcement that it would make a $59.4 billion payment to the Treasury Department in June, after reporting a record quarterly profit driven by rising home prices and declining delinquencies. With this payment, Fannie Mae will have repaid the Treasury a total of $95 billion towards the $117.1 billion of capital infusions it had received. Combined with a $7 billion dividend payment from Freddie Mac (which will have paid down $36 billion on its debt) we now have some clear signs of growing housing market stability. With both stock prices and home prices rising, we are perhaps seeing a “wealth effect” taking shape. According to a new Gallup poll, 26% of American consumers surveyed said they are spending more money than they used to. Figures released by the U.S. Department of Commerce also showed an increase in consumer spending this April, as motor vehicle spending rose 8.8%, and retail sales by 3.6%, compared to April 2012. This wealth effect has a multiplier effect, and as we like to say, nothing exceeds like excess.



THE DEAL LANDSCAPE

The M&A cycle that began in 2009 is still moving forward though currently not as robust as we

had projected. We believe it will improve, but for the moment the rate of announced deals has slowed. Last year the larger deals were somewhat absent as Corporate America poured money into share repurchases in the companies they know best (their own) and where earnings and shareholders would benefit, while middle-market deals were doing their best in years. Thus far this year, middle-market deals have slowed, while values of announced transactions by big companies only appear higher owing to a few high-priced deals. The deal pipeline still remains clogged by lingering economic uncertainties. A recent Ernst & Young survey found that while corporate executives are seeing improvements in the economy, they are still keeping a somewhat restrained hand on acquisition activity. “Executives are continuing to wait for a sustained recovery before engaging in M&A." In speaking with numerous company managements and investment bankers, Valquest’s own deal intelligence reveals that although the Cyprus banking crisis was a stress test that didn’t produce a heart attack in the stock market, the crisis reverberated around the world causing palpitations among corporate managements, putting expansion plans and a number of M&A transactions on hold, backing up the deal pipeline temporarily. As M&A activity recovers from the Cyprus shock, Valquest believes we should see a strong resumption of cross-border mergers & acquisitions, which had reached their best level last year since the 2008 financial markets meltdown, and accounted for 37% of all global deal activity. According to a report released in April by the global law firm Baker & McKenzie, nearly half of all senior executives surveyed expect their company's appetite for cross-border M&A to increase over the next two years. Companies based in high-growth market countries also reported targeting a wider range of jurisdictions to advance their growth strategies, and will continue to expand beyond the BRICS countries (Brazil, Russia, India, China and South Africa) to include other high-growth markets. "Outbound M&A activity is shifting and

we are seeing a greater number of deals involving high-growth market countries," said the head of Baker & McKenzie's Global M&A Practice. "It's not just Western companies on the buy side anymore. Both

developed and emerging market companies are chasing acquisition opportunities in new markets such as

Indonesia, Turkey, and Vietnam, and the frontier markets that lie beyond.” As U.S. corporations look to beef up their share in attractive emerging markets (and some of the beat up developed ones in Europe), and foreign corporations seek to increase their share of quality U.S. assets, we may well be witnessing what we might call “Geographic Monopoly,” like the old board game where the objective is to buy up as many assets as you can before the other player. Also beneficially, global private equity-backed merger and acquisition activity accounted for 22% of worldwide M&A during the first quarter and doubled compared to 2012 levels. This was in line with the expectations outlined in Valquest’s Magnum Opus on the need for buyout funds to “use or lose” their investible cash. As noted above, while large corporations may not have been in a hurry to transact external deals, they appear to be in a hurry to buy their own stock (“internal takeovers”). Last year, S&P 500 companies made $398.9 billion in share repurchases, and this year buyback programs are running at nearly double that pace according to some estimates. The peak in corporate share buybacks was reached back in 2007, when companies bought $589.1 billion worth of stock. If buybacks in 2013 are in fact double last year’s rate, then they would already be exceeding the 2007 record.



We expected and have seen a proliferation of announced Dutch auction tender offers being used to effect share repurchases, including some of our own Winning Footprint companies among them. There is an incentive for companies to borrow and/or use their free cash flow to finance stock buybacks via Dutch tenders, and we are predicting this trend will continue to grow.



OUTLOOK:

We believe our long-term outlook for a “Renaissance for Equities” remains intact, and its

fundamental underpinnings are getting stronger. The Perspectives section provided the reasons why we think a correction may develop in the near-term, though unless we see other evidence, we do not believe that it will derail the still evolving “kinder, gentler and more inviting marketplace for equities.” Below, we give our reasons for why we believe the “Renaissance” can continue, and look at some historical precedents that parallel the market’s current performance to consider where we may be headed from here. To cite some of the factors we think will continue to underpin the equities Renaissance in the long-term:

1. More traditional investors are returning: While not yet stampeding in, investors have been walking in and are just getting around to buying those “productive U.S. corporate assets” that we always talk about (not tulips and not even gold). Equities have been regaining some of their lost luster among many investors who all but abandoned them in exchange for the “return free risk” of Treasury bonds and increasingly lower yielding corporate bonds. The current earnings yield on the S&P 500 is now an inviting 5.5%, versus the below 5% yields on junk bonds, which are at all-time lows and not worth the inherent risk. High yield is now just yield, but junk is still junk. Some tangible evidence that retail investors are returning comes from TrimTabs Investment Research, which reported that U.S. equity mutual funds and ETFs received $52.0 billion in the first quarter, the biggest quarterly inflow since the first quarter of 2004. Globally, equity mutual funds and ETFs took in $65.7 billion in the first quarter, the fifth consecutive quarterly inflow and the highest quarterly inflow since the first quarter of 2006. While perhaps not quite the “Great Rotation,” it is a strong sign that the massive outflow of investment from equity funds has abated. Also, according to data from Interactive Brokers Group (which largely serves retail customers) daily average revenue trades, considered a crucial measure in the industry, grew by 17% on a year-over-year basis. Also trending upward was the figure for customer equity at the end of the month, which stood at $36.4 billion, some 25% higher than at the end of April 2012. Ending customer credit balances also advanced to $22.6 billion, or 20% higher, than the year-ago figure. With other data showing that only 52% of Americans own stocks – the lowest percentage since 1989, there is certainly a lot more room for retail investor funds still on the sidelines to return to equities. 2. Global consumerism is creating opportunities that will further support corporate growth: The funds now trickling into the stock market from retail investors may well be a reflection of the improving consumer spending trends we cited earlier. With consumer spending representing 70% of GDP, we never want to underestimate the consumer’s desire to spend, nor the fact that consumerism is growing globally and will accelerate as people in emerging nations can now see the proverbial carrot on their smart phones and are able to get their education on their tablets (e.g., KahnAcademy.com, over 200 Harvard Online Classes, etc.). As one of our highly lauded portfolio companies doing business around the globe just stated in their March 31, 2013 10Q Report: “Asian economies continue to present more resilient fundamentals than other parts of the World. The

significant potential from the rapid growth in the urban population and increasing household

disposable incomes provide opportunities for profitable expansion across the region.”



Besides Asia, Mexico, Turkey and South Africa are among the emerging markets cited in a research paper forecasting potential consumer spending growth of between 7.7% and 15.2% per year from 2013 to 2016. Also supporting this global consumer spending trend is the accelerating economic recovery in Japan, where it has been reported that the world’s third largest economy grew at a robust annualized pace of 3.5% in the first quarter, driven by higher household consumption and exports, a sign that the aggressive policies of Prime Minister Shinzo Abe to restore the Japanese economy are gaining some traction. All told, the world at large is creating more and more consumers who want a better life and will want to consume more and more. This will result in the rapid growth of global customers, which will benefit Corporate America. 3. The stock market rise is supported by measurable and improving fundamentals: Fed Chairman Ben Bernanke summed this up well in his May 21st testimony before Congress when he said: “Corporate bonds and stock prices are not inconsistent with fundamentals.” As evidence, we earlier cited the still attractive stock market valuations that suggest equities are growing into reasonable and sustainable multiples. The Fed Chairman’s comments also indicate that the “Bernanke put” is still keeping a floor under the market, as he is still humming Michael Jackson’s hit song “Don’t Stop ‘Til You Get Enough.”

In hindsight, the “stress tests” mentioned in the Sentiment section, while not causing a cardiac arrest in the market still served to chase the weak holders out. Such events remain a fact of life even in our kinder, gentler and more inviting marketplace. The stock market’s parabolic rise since its November low has aroused the uber bears to growl ever more loudly that this will all end badly. Despite all the nouveau opera aficionados anxiously waiting to hear a very buxom lady wearing a winged helmet sing a high pitched, shattering note, there’s no telling how many acts this opera will have, given such benefactors as Ben Bernanke and Shinzo Abe, among others. It is also our view that periodic corrections can and will occur within the context of a still and longer-term unfolding equities Renaissance, and in fact may be healthy in relieving overbought conditions, and creating opportunities to buy the value that the market will create for us. As Yogi Berra said, “Prediction is very hard, especially about the future.” Currently, the S&P 500’s 25-week advance to new all-time highs without a correction of more than 5% is its third best performance ever. Market history shows periods when parabolic moves lasted longer than most people expected and the corrections that ensued were not necessarily severe. For example, from December 1984 to July 1985, the S&P 500 advanced 28 weeks, before reversing in an 8.5% correction lasting 10 weeks. The longest advance without a correction of 5% or more occurred between November 1994-June 1996. An 80-week advance, it was followed by an 11% correction lasting 7 weeks. There have been other corrections that were more severe, but proved to be only temporary setbacks ahead of another run to new all-time highs. These include the 22-week, 21% decline of May-October 2011 (during the period of the U.S. debt downgrade), the 8-week, 22% decline of July-October 1998 (in reaction to the then global financial crisis that caught up Long Term Capital Management), and the 12-week, 20% decline of July-October 1990 (incorporating the period of the Kuwait Invasion by Iraq). Describing some of the market’s volatility in our August 2011 Update we cited remarks by Dr. Marc Faber that “we have never had before so many up days with volumes of 9 to 1 and down days with volumes of 9 to 1. On down days, the downward volume is 9 times the upward volume, and on up days



vice versa. This is most unusual.” Dr. Faber makes a key observation in citing the case for parabolic volume moves in either direction. After all, what’s good for the bear should be good for the bull too. With momentum currently ruling the day (and with apologies to Sir Isaac Newton) we cite “Grotell’s Law” which states: “an object in motion stays in motion – until momentum traders start losing money on the trade.” When that inflection point may come is difficult to say, given the different market dynamics playing out today than at other times in the past when the likely outcomes were easier to see. Over the years, when Valquest spotted docile cubs (baby bears) that would grow up into dangerous grizzlies and we were “bearish,” we never hesitated to tell it like it is, as when we made a strong call for a major downturn in 2000 of the S&P 500 from what we called “Indexicide (death by indexation)” whereby investor preoccupation with large over-owned companies touted by sell-side analysts and having a high rate of short-term momentum was reversing and at the same time capital was freeing up and flowing to small and mid-cap value stocks; in 2006 when we sold short Fannie Mae and the home builders as most people were saying “real estate prices only go up”; and yet again in 2007, when we took our largest short position ever and warned of the “bubbles within bubbles that could only end with the largest Federal bailout ever.” We called it “a time of ‘risk-on’ on steroids; the crowd clamored for more stocks and new derivative products on the expectation that ‘The BRICS’ – Brazil, Russia, India, China and South

Africa – would lift the consumption of manufactured goods, commodity and equities prices.”

Although some measures of sentiment are now arguably frothier than before the 9% correction that took place through November 2012, and we cannot predict how long the market’s parabolic run since then will continue, the above cited historical examples recognize that the current froth is nowhere near the levels that, based on our analysis of current fundamentals and sentiment, would warrant a clarion call to sell. Even so, our defense against what may only be a short-term setback is prudent yet does not deter us from our longer-term outlook, and we currently see no material reason to change our case for a more realized Renaissance for Equities, as we deal with the temporary interruptions that are bound to occur along the way.



THE VALQUEST OPPORTUNITY:

Even more significant than the opportunities existing in our current portfolio, and its alignment

for performance within the still-evolving investment environment we’ve discussed, the real

Valquest opportunity is its differentiated investment process. This overarching process encompasses our Winning Footprint stock selection methodology, our sentiment and fundamental driven analytics, and our risk management tactics whereby we actively modulate our long/short exposures as market conditions dictate. For more than 20 years we have adhered to this process, which is repeatable and has delivered Valquest’s historical outperformance in up, down and sideways markets. We appreciate rising tides and takeovers, however, our performance is not dependent upon them. We do not chase yield, inflated assets, concepts, markets or stocks to get our returns. Instead, Valquest’s Winning Footprint process of stock selection itself is the mechanism at the core of our historical outperformance; it is the antithesis of chasing, particularly with respect to the first attribute of our selection process. For Valquest to designate a company as having the “Winning Footprint” it is required that they have these 3 attributes in tandem: the first is that their stock price be down 50-75 percent from their highs and trading with an embedded “negative expectational discount.” Secondly, there needs to be a turnaround in place that we can easily benchmark. Thirdly, they must have asset transfer values being undervalued by the market that could attract a strategic or economic acquirer willing to pay a premium to acquire those assets. To give you an example of our investment process at work, the companies below represent just some of the horsepower we have under the hood, though more significantly, they illustrate the characteristics shared by the many companies that have come through Valquest’s Winning Footprint stock selection process over the fund’s history. These five were mentioned in our Magnum Opus, and the charts display their performances to date. We have increased our ownership in some of these companies, and have added new ones to the portfolio. We continue to monitor and grow our bullpen through Valquest’s cumulative and ongoing independent research, whereby we meet with hundreds of companies each year to build our knowledge base and uncover those meeting our Winning Footprint selection criteria for potential inclusion in the portfolio.

Some of Valquest’s “Under the Hood” 2012 Investments for Future Profits (Updated)

Performance Since Q3-2012 to Date Performance Since Q3-2012 to Date Performance Since Q3-2012 to Date



Performance Since Q3-2012 to Date Performance Since Q3-2012 to Date

Along with their Winning Footprint attributes, other characteristics of the companies in Valquest’s portfolio include 2-4 percent yields, fortress balance sheets and strong cash flows, exciting new products coming to market, and meaningful stock repurchase programs. As discussed earlier, Standard & Poor’s forward earnings outlook, together with economic conditions remaining generally stable, an improving M&A landscape and an historic rise in the number and dollar volume of share buybacks and Dutch tenders all bode well for our companies as they turn around from being laggards to leaders, and potentially becoming part of the list of the 23 Valquest portfolio companies that have received takeover bids since 2009. As further examples of the process, we take a moment to update you on where we are with our three “black & blue chips,” Microsoft, General Electric and Yahoo, which we bought when those chips were down and at historically low valuations. All three displayed the same negative expectational discount in their share prices and the transformational attributes that we look for in our Winning Footprint stock selection. Although initially and throughout their seesaw move up they hurt our performance, another core component of our investing discipline is to exercise patience with our holdings when they are turning around and their fundamentals and intrinsic value are on the rise. This is based on Valquest’s “slow frequency algorithm” of O+T= P (Opportunity + Time = Performance). It is quite in contrast to the High Frequency Trading crowd, for whom valuations are irrelevant, and who are now beginning to slow down. In the past couple of years since we bought our black & blue chips, they went from being discarded and unloved laggards, until attracting the attention of value investors, and then later GARP investors (i.e., Growth at a Reasonable Price) to now once again becoming market darlings and leaders. The five Winning Footprint companies mentioned above, also bought at historically low valuations, still have more to go in their progress from laggard to leader like these three, though we expect that in time their charts will show a similar performance:



Valquest’s “Black & Blue Chips” Now Market Leaders

Performance Since Q3-2012 to Date Performance Since Q3-2012 to Date Performance Since Q3-2012 to Date

As our Renaissance scenario has been unfolding, we have been seeing many investors chasing the discarded stocks Valquest bought at or near their life-of-company lows that are now selling at 3 and 4 times our cost. We are content, as I said earlier, to sell some of our big winners to the momentum players who want to extrapolate their prices higher. Many of us grew up playing musical chairs, and most investors have been reminded of that game over the past ten years. As contrarians, by definition we try not to get caught up with the music while running around in circles. We keep our eyes on some of the others running around in “La-la Do-Re-Mi Land,” as well as the disc jockey. This prevents us from ending up without a chair, when and if the music stops. Risk is the price paid for opportunity, and we have been taking measured steps to lower it. Valquest was practicing “Tapering” long before the Federal Reserve coined the term to describe their gradual withdrawal of stimulus. We have been tapering down by harvesting gains and reducing into strength our positions in the three “black & blue chips” and in some of our other holdings that have moved materially higher. At the same time, we have been incrementing our hedges. Summing up, we are prepared for both a market moonshot from Everest, or more likely, a retreat followed by a slower climb to the summit, as accomplished this week by record-breaking 80-year-old Yuichiro Miura, who has reached it twice before, and who also (not unlike our market) has undergone four heart surgeries since 2007!! Should the market continue its trajectory higher in the near term, then we expect stocks with technical momentum will lead and ultimately enhance the value of our Winning Footprint companies, which tend to march to the beat of their own drummer as they turnaround and/or get acquired. Even with a small percentage correction, the higher market multiples overall compared to the far lower valuation levels of Valquest’s Winning Footprint companies (our value arbitrage) will make them ever more compelling. Should a more substantial correction come, we want to be there with cash to seize upon it as an opportunity to buy what we want at better prices. However it all ultimately plays out, Valquest’s complete investment process – our style, stock selection, tactics, diversification, risk management and exposure limits will keep us safe. Whenever we have erred, it has usually been for being early in the short term, but not for being late getting in, or getting out. In our inimitable fashion, we will be reviewing any new data, rethinking our strategy, and keeping you updated.



In closing, I am pleased to be able to share with you my “comfort and joy” over Valquest’s most recent accomplishments, and our outlook for the road ahead. As always, you have my gratitude for your trust in me to successfully navigate this dynamically moving market, and prudently manage your investment. Respectfully submitted,

Michael Grotell







Documents

“MOUNT EVEREST” Valquest’s May 2013 Update to Partnersvalcap.com/letters-reports/Everest-May-2013-Update-to-Partners.pdf · remained flat, its 6-year rate of decline that we