Third Point - Third Quarter Letter (2010)

8/8/2019 Third Point - Third Quarter Letter (2010)

1/8


2/8

2

A bacterium found in the arsenicfilled waters of a Californian lake is poised tooverturn scientists' understanding of the biochemistry of living organisms. Themicrobe seems to be able to replace phosphorus with arsenic in some of its basiccellular processes suggesting the possibility of a biochemistry very different fromthe one we know, which could be used by organisms in past or present extremeenvironments on Earth, or even on other planets.3

When we are reminded that even factual stories about the building blocks of molecular life aresubject to revision, what weight should we rightly put on the prevailing narratives of economicscience, particularly those that are rapidly evolving to justify this eventful period we are living in of bubbles and busts and unprecedented government interventions? Indeed, I cannot think of afield that lends itself better to storytelling: stitching together facts with conjecture, theory,history, legend, psychology, and fancy graphs all ridden with personal biases in an attempt to makesense of a complex and sometimes inexplicable world, than the dismal science of Economics.Notwithstanding the fact that it came off as a staged infomercial rather than a serious interview,Fed Chairman Ben Bernanke's recent 60 Minutes segment with Scott Pelley serves as a powerfulcase study of personal storytelling and steering a historical narrative. This format allowedChairman Bernanke to tell his story which seemed, improbably enough, intended tosimultaneously frighten and reassure. His narrative arc posits that the global economy would havecollapsed and unemployment would have exceeded levels of the Great Depression had the Fed notintervened to rescue the financial system. Having set the stage for how we were saved from globalfinancial Armageddon once before and therefore ought to trust the Feds intervention blindly again,Chairman Bernankes next chapter states that the Feds latest $600 billion market intervention willalleviate our seemingly intractable high levels of unemployment, which otherwise would continueindefinitely.So we have learned his story and his conclusion that without the Fed engaging in a carry trade ofsignificant proportions to lower longterm rates heading into 2011, we would be headed for years

of persistent unemployment and stagnation. Chairman Bernanke pointedly addressed the concernsof naysayers, scolding those who propagate the myth that the Fed is simply printing money. Heclaimed that the money supply will not be affected by these and future purchases. Perhaps hedidnt want to strain the minds of the 60 Minutes audience, but Pelley did not ask the obviousquestion where then does the money come from? Is it loose change the Fed keeps around for arainy day, perhaps stashed in a cookie jar in the Federal Reserve kitchen, or stuffed under themattress in the Chairmans bedroom?The real source of the funds for QE2 are bank balances kept on reserve at the Fed whichotherwise would be invested in short term instruments, and a little known program with theTreasury called the Supplementary Financing Program. The Fed is effectively borrowing short termmoney and investing in long dated securities (with an average maturity of 56 years and nearly one

3 Alla Katsnelson, Arseniceating Microbe May Redefine Chemistry of Life, Nature Magazine 2 December 2010:http://www.nature.com/news/2010/101202/full/news.2010.645.html.


3/8

3

third of purchases in maturities between 730 years).4 This strategy, when employed by the privatesector, is called a carry trade because the practitioner of the strategy earns the carry (ordifferential) between the lower shortterm interest rates at which she borrows and the higher,longer term rates that she earns. These transactions should also be known as carry tradesbecause when they go wrong, i.e. when longer term rates increase and the price of those bondsdecline sharply in value, the practitioner is carried out (as in on a stretcher).

Chairman Bernankes story serves to establish his stature as an insightful regulator whose prudentintervention prevented a global meltdown. The only problem with his narrative is that itcontradicts certain facts and our own experience like the Fed's admitted inability to see the crisiscoming or to regulate effectively the banks under its purview. Psychologists call the process ofrationalizing two incompatible or conflicting beliefs or observations "cognitive dissonance":

Cognitive dissonance [is] the hard wired psychological mechanism that creates selfjustification and protects our certainties, selfesteem, and tribal affiliations . . . themost harmful consequences of selfjustification . . . exacerbates prejudice andcorruption, distorts memory [and] turns professional confidence into arrogance. . . .5

When asked by Pelley if there was anything he wishes he had done differently since the crisisbegan, the Chairman replies with a faint smirk: "Well, I wish I'd been omniscient and seen the crisiscoming, the way you asked me about, I didn't. But it was a very, very difficult situation. And theFederal Reserve responded very aggressively, very proactively.6

Next, Pelley asks the Chairman: "How did the Fed miss the looming financial crisis?" Recall,Bernanke had just made a statement that implied only omniscient people could have seen the crisiscoming, but he responds that "there were large portions of the financial system that were notadequately covered by the regulatory oversight,"7 such as Lehman Brothers and AIG. I can onlyassume that Pelley was so mesmerized by Chairman Bernankes answer that he neglected to askhim about the other 90% of the financial system which the Fed didregulate and which also fell to

shreds. Adding to Chairman Bernanke's discomfort must be memories of his prior economicforecasts, such as this one made March 28, 2007 in prepared testimony to Congress' Joint EconomicCommittee. "At this juncture . . . the impact on the broader economy and financial markets of theproblems in the subprime markets seems likely to be contained."

What was most striking in the interview was Chairman Bernankes devotion to the righteousness ofhis narrative at a time when every actor in the financial system still ought to be asking how thingswent so terribly wrong. The desire to create a story that emancipates one from blame andpromises future forecasting precision must be incredibly powerful for any public servant chargedwith the awesome responsibilities of the Fed Chairman. Yet it is precisely these sorts of leaders

4 See the Federal Reserve Bank of New Yorks website: http://www.newyorkfed.org/markets/lttreas_faq.html

5 Elliot Aronson and Carol Tavris, Mistakes Were Made (But Not By Me) (New York: Harcourt Inc, 2007) 10.6http://www.cbsnews.com/stories/2010/12/03/60minutes/main7114229_page4.shtml?tag=contentMain;contentBody7 Ibid.


4/8

4

who should be the most attuned to understanding the dangers of believing too much in the storieswe tell ourselves, and instead be willing to search out facts and admit wrongdoing.8

One more consideration in analyzing our own and others stories are the experiences that shapeone's views and biases. Some researchers have argued that these experiences are so fundamentalthat they affect our judgment on a neurological level.

The brain changes continually as a result of our experiences. Experiences produce physicalchanges in the brain either through new neural connections or through the generation ofnew neurons . . . This creates different convictions, habits, values and character.9

The President, before the recent national elections theorized the following: "Part of the reason thatour politics seems so tough right now, and facts and science and argument does not seem to bewinning the day all the time, is because were hardwired not to always think clearly when werescared, and the country is scared. In an apparently spectacular display of cognitive dissonance(the electorate's disaffection for the Democratic Party and his own belief in these rejected policies),the President's statement raised an interesting question, not about the electorate's "hardwiring,"

but that of his own and his administration's. In particular, is this administration with no knownparticipation in the free enterprise system, with no experience in innovation, management of anenterprise or risk taking capable at a neurological level of understanding the basic drivers of theentrepreneur or manager, or how to spur economic growth? Based on the President's lambastingof the opposing party following the recent tax rate negotiations with charges of "hostage taking,"this seems to be a reasonable question to ask.

How does all of this apply to Third Point? From an investors point of view, our challenge is notonly to keep up with rapidly unfolding events around the world, but also to keep our perspectivefresh and differentiated from that of our competitors.10 As securities analysts we are truth seekersand problem solvers. We must satisfy ourselves with determining ranges of outcomes andpotential scenarios rather than searching for, and ultimately fabricating, absolute truths. The only

thing we are 100% confident in is that we are fallible, we dont have all the answers, and we willmake some mistakes. However, if we are honest with ourselves and our colleagues, remain

8As if forming an accurate story wasnt hard enough, in todays world the velocity of information and the amount ofnoise is deafening and may lead to confusion and a heightened sense of anxiety. Former National Security Advisor andgeostrategist Zbigniew Brzezinski wrote:

Recognition of the notable acceleration in the velocity of our history and uncertainty of its trajectory isthe necessary departure for my argument. History has not ended but become compressed. Whereas inthe past, historical epochs stood out in relatively sharp relief, and one could thus have a defined senseof historical progression, history today entails sharp discontinuities that collide with each other,condense our sense of perspective, and confuse our historical perceptions.In other words we live in a world today that is in fact very different from the one which we have begun

to comprehend, and by the time our comprehension has caught up with the new reality, the world islikely to be even more drastically different in ways that today seem unthinkable.8 {ZbigniewBrzezinski, Out of Control (New York: Touchstone, 1993) ix.}

Brzezinski makes an insightful point about the nature of our stories today. In effect, he is saying that once we have begunto comprehend the world around us, what we understand is no longer relevant. What makes Professor Brzezinskiscomment even more profound was that he wrote this in 1993, before the advent of the internet and the rise of China.9 Peter Bevelin, Seeking Wisdom: From Darwin to Munger (New York: PCA Publications, 2007).10 I recommend three other books that provide insight when thinking these issues: Geoff Colvins Talent is Overrated;Michael Mauboussins Think Twice; and Josh Waitzkins The Art of Learning.


5/8

5

attentive to our own biases and deceptions, focus on process, attempt to understand why we erred,and engage in deliberate practice and selfobservation to improve our decision making ability, wewill not only minimize our errors, but also ultimately become better people and better investors.That is our story.

ThirdQuarter2010ResultsSet forth below are our results through September 30, 2010 and a brief discussion of selectedpositions that impacted the portfolio during the quarter.

Third PointOffshore Fund S&P 500 CS Event Driven

2010 Third Quarter 8.3% 11.3% 4.4%

2010 YTD Performance 19.2% 3.9% 6.3%

Annualized Return SinceInception

18.2% 5.1% 9.6%

The top winners for the quarter were Lyondell, Chrysler, Anadarko, CIT, and Delphi. The top losersfor the quarter were Short A, Asset Backed Security A, NXP Semiconductor, Citadel Broadcastingand SemCrude.Assets under management at September 30th, 2010 were $3.6 billion.Performance for the quarter was derived from nearly all asset classes and sectors, with creditstrategies and long/short equity contributing almost equal gains.SelectPortfolioPositionsAnadarkoAnadarko Petroleum Corporation is one of the largest independent oil and gas explorationcompanies in the world. Anadarko was invited by BP in late 2009 to be a minority nonoperatingpartner in the development of Mississippi Canyon block 252, better known as the Macondo Well.Pursuant to their Joint Operating Agreement (JOA), Anadarko accepted liability for all damages,

costs and claims related to activities under the JOA in proportion to its 25% economic interest inthe well, except in the event liability results from the gross negligence or willful misconduct by theoperator, BP. Subsequent to the explosion of the Deepwater Horizon platform and the discovery ofoil leaking from the Macondo well into the Gulf of Mexico, Anadarkos share price declined from~$73 preincident to a low of $35, while spreads on the companys debt securities (which carriedinvestment grade ratings preincident) increased from ~100 bps to nearly 700 bps.The decline in the value of the securities was precipitated by 1) uncertainty over the magnitude ofthe total claims, cleanup costs, and fines related to the spill, as well as Anadarkos share of the


6/8

6

liabilities, 2) uncertainty over the timing of the payments related to the spill (and concerns aboutliquidity), 3) concerns over the potential impairment of Anadarkos Gulf of Mexico assets in thewake of the drilling moratorium, and 4) forced selling by investment grade bond holders afterMoodys downgraded the bonds to junk.We initiated a position in the debt securities in June and July of 2010 at yields to maturity of 8 to

9.5%, expecting allin returns via interest and capital appreciation of 20 to 30% based on the viewthat the market overreacted to the impact of the spill and potential liabilities. We believed thatinvestors were ignoring the long duration of the cash outflows related to spill liabilities (NPV effect)as well as the tax deductibility of those expenses. Our analysis suggested that the worstcaseliability figures for BP included punitive damages and criminal fines that Anadarko would not berequired to share in any scenario, and Anadarko will likely not have to pay its 25% share of theliabilities due to a finding of gross negligence on the part of BP or, more plausibly, a settlement withBP (a scenario with potent political tailwinds). Finally, we knew the Companys intentis to be aninvestment grade company, and so regardless of the ultimate liability, the Company would takeactions (equity raises, asset sales, Capex reductions) to reattain investment grade status.Since our investment, the majority of the securities related to the Macondo tragedy haveappreciated significantly, including Anadarkos bonds. Our analysis was correct and in hindsight,investors could have generated similar returns by investing in anything Macondorelated (e.g.RIG, BP and Anadarko equities). However, Anadarko bonds offered similar upside to theaforementioned equity securities but with effectively zero downside in the event that either ourthesis on the severity of the spill was incorrect or there was a material decline in oil and/or naturalgas prices, and so we delivered excellent riskadjusted returns.NXP SemiconductorsIn August, we participated in the IPO of NXP Semiconductors NV, a leading semiconductormanufacturer emerging from a 2006 LBO led by KKR, Silver Lake, Bain and Apax. We had

successfully participated in the NXP story via its distressed debt in late 2009, and were preparedfor the IPO, which came at a very attractive valuation of roughly 5.5x estimated 2011 EPS. Thecompany is in the final stages of completing a substantial operational and capital structurerestructuring, which is driving strong free cash flow, rapid deleveraging and attractive newopportunities like a leadership position (>50% market share) in Near Field Communications, a fastemerging mobile payment technology being adopted by Google Android, Nokia and Blackberry.Despite a strong recent run in the shares, limited familiarity and misconceptions leave it trading ata 50% discount to peer P/E and FCF multiples and lagging the performance of other comparablylevered, postLBO IPOs such as Sensata and Avago. As NXPs growth, profitability and cash flowattributes (it will generate close to $3 in 2011 FCF) become better understood, we see substantialupside in the name.

ProSiebenProSieben is one of Europes largest media operators, with an attractive 40% share of the Germanfreetoair television market. This investment fits one of our favorite framework profiles asituation with a confusing capital and ownership structure, and a distressed valuation exacerbatedby equity investors who misunderstood the credit story and credit investors who ignored theequity angle.


7/8

7

Third Point began accumulating a stake in the companys preference shares almost a year ago whenthey traded at


8/8

8

We presented our Quarterly Performance Review and Business Update via webcast and conferencecall on October 20th, 2010. Thank you to all who participated either live or by accessing the replay.Please contact Investor Relations if you would like a copy of the slides that accompanied thepresentationReminder:InvestorYearinReviewandDueDiligencePresentationsOur annual Investor Day will be held on Wednesday, January 19th 2011. We are introducingsomething new this year in the interest of increasing transparency. On the 19 th, we will hold a DueDiligence Presentation beginning in the late morning and continuing through a light lunch at theNew York Athletic Club, at which our COO, CFO and CAO will cover key issues in Finance,Operations, Technology and Compliance. Our traditional evening presentation will reviewperformance in 2010, and provide our outlook for 2011. The evening presentation will be held atthe Museum of Modern Art, and will be followed by a reception. You will receive your invitationsthis week.Please feel free to contact us with questions or thoughts.

Sincerely,

Daniel S. Loeb_____________________The performance data presented represents that of Third Point Offshore Fund Ltd. All P&L or performance results are

based on the net asset value of feepaying investors only and are presented net of management fees, brokeragecommissions, administrative expenses, and accrued performance allocation, if any, and include the reinvestment of alldividends, interest, and capital gains. The performance above represents fundlevel returns, and is not an estimate of anyspecific investors actual performance, which may be materially different from such performance depending on numerousfactors. All performance results are estimates and should not be regarded as final until audited financial statements areissued.While the performances of the Funds have been compared here with the performance of a wellknown and widelyrecognized index, the index has not been selected to represent an appropriate benchmark for the Funds whose holdings,performance and volatility may differ significantly from the securities that comprise the index. Investors cannot investdirectly in an index (although one can invest in an index fund designed to closely track such index).Past performance is not necessarily indicative of future results. All information provided herein is for informationalpurposes only and should not be deemed as a recommendation to buy or sell securities. All investments involve riskincluding the loss of principal. This transmission is confidential and may not be redistributed without the express written

consent of Third Point LLC and does not constitute an offer to sell or the solicitation of an offer to purchase any securityor investment product. Any such offer or solicitation may only be made by means of delivery of an approved confidentialoffering memorandum.Information provided herein, or otherwise provided with respect to a potential investment in the Funds, may constitutenonpublic information regarding Third Point Offshore Investors Limited, a feeder fund listed on the London StockExchange, and accordingly dealing or trading in the shares of that fund on the basis of such information may violatesecurities laws in the United Kingdom and elsewhere._____________________

Documents

Third Point - Third Quarter Letter (2010)