2007 CHUONG LETTER TO PARTNERS

The 2007 year was an extremely volatile one with stomach churning peaks and heart stopping troughs. As exciting as this ride appeared to be, the partnership spent most of the time on the sidelines. Instead of trying to hit moving targets we decided to shoot sitting ducks.

The partnership added to our position in K-Swiss. Our K-Swiss holdings are likely to increase in the near future. Our combined holdings in K-Swiss, Fossil and Berkshire Hathaway now account for almost half the value of the entire fund. The partnership strongly believes in the benefits of hyper-concentration in a small number of high quality and well-understood businesses.

"The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it." - Warren Buffett

This past year also marked the year that Luxottica, the $16B Italian eyewear giant, came to an agreement with Jim Jannard, founder and CEO of Oakley, to purchase Oakley for $2.1B in cash. After this transaction is completed, virtually our entire portfolio will be embodied by 4 companies – Fossil, K-Swiss, Berkshire Hathaway, and The Buckle.

GENETICALLY GIFTED

“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” – Warren Buffett

A few years ago my wife decided that she wanted to run a marathon. In support of this, the both of us joined the Running Room and began a regular training regimen. Five years prior to her decision I had been running for 30 minutes, 3 times a day at my local gym. Natalie, on the other hand, didn’t run on a regular basis.

After running with my wife for a few weeks it was clear that there was a difference in genetic potential. The long and short of it is that, after a few months at the Running Room I was still doing 30-60 minute runs and Natalie had completed a marathon in Rome, Italy for the Canadian Diabetes Association.

This is a prime example of how different genetics results in wide ranges of performance. The same is true in the business world. There are businesses that are built to make money with far less effort and at a faster pace than others. The partnership seeks to find these genetically gifted businesses, to buy them at a reasonable price, and to hold them for extremely long periods of time.

The partnership seeks to purchase companies with the following characteristics (with associated running analogies):

Business characteristic	Running analogy
Market capitalization of $500M to $1B	Young
10 years of available public information	Predictable
Increasing revenue, net income and shareholder equity	Consistently faster run times
High profit margins and returns on equity	Resilience to injury and environmental challenges
Positive cash flow	Never gets tired
Low capital expenditures	Doesn’t need to train often
No debt	Doesn’t need performance enhancing drugs
High insider ownership	Self-driven and passionate

Our governing principles outline the space or circle of competence that we have decided to invest in. In addition to purchasing genetically gifted companies and holding them for a decade or two, we will sometimes engage in asset plays.

An example of an asset play would be our purchase of Berkshire Hathaway class B shares in 2000 when the price fell from $80,000 (BRKA) to $45,000 (BRKA) and the balance sheet for Berkshire Hathaway showed $40,000 per share of marketable securities thus pricing the insurance businesses for free. This fortuitous purchase came at a time when Berkshire Hathaway was being shunned for internet stocks, paying out for a number of hurricanes, and trying to digest their acquisition of General Re.

DIVERSIFICATION

"We think diversification, as practiced generally, makes very little sense for anyone who knows what they're doing. Diversification serves as protection against ignorance.” - Warren Buffett

I have been questioned most often by how I feel about the inherent risk of investing in a small number of businesses; to be so concentrated when virtually all mutual funds are hyper-diversified. Conventional wisdom suggests that one’s portfolio is protected against large declines in value since one stock’s decrease in price will likely be offset by another’s increase. I can only offer that I do not understand the stated benefit of investing in a large number of investments.

There are three major problems that I find with investing in a large number of companies. First, the converse is also true; that one stock’s increase in price will likely be offset by another’s decrease. You can’t have one side of a coin without the other. Since this mitigating effect will always be present, it becomes apparently clear that the return of a hyper-diversified fund will approach the average.

Second, stock indices such as the S&P500, Nasdaq or Dow, which contain thousands of stocks, are extremely well diversified. Nonetheless this diversification did not prevent them from collapsing in 1974, 1987 and 2002.

Third, as the number of stocks in a portfolio increases, each added business represents an increase in overall risk. It is less likely that one will understand 100 businesses as well as only two or three.

“We believe that almost all really good investment records will involve relatively little diversification. The basic idea that it was hard to find good investments and that you wanted to be in good investments, and therefore, you’d just find a few of them that you knew a lot about and concentrate on those seemed to me such an obviously good idea. And indeed, it’s proven to be an obviously good idea. Yet 98% of the investing world doesn’t follow it. That’s been good for us.” – Charlie Munger

EARNING YIELD

 

It goes without saying that investing in a stock (business) is riskier than investing in a GIC or government-issue bond. The odds of bankruptcy are greater with a public company than it is with the government. For this reason, it is important to compare the yields of stocks versus an asset that offers a risk-free rate of return to ensure that you are being properly compensated for taking on the additional risk of investing in stock.

 

The earnings yield on a stock is net income divided by price paid. If you paid $100 for a pinball business that generated $10 per year, it has an earnings yield of 10%. This is the inverse of the price-to-earnings or P/E ratio.

At the time of this writing, Ontario savings bonds (www.ontariosavingsbonds.com) are offering a 5-year “step-up” bond that starts at 4% in year 1, 4.2% in year 2, 4.4% in year 3, 4.6% in year 4 and ends at 4.95% in year 5. This is summarized below:

 

 

 

To rationalize an investment in a stock, one must be sure that the company can produce a yield (now and in the future) that is significantly higher than a government bond. Otherwise, there is no reason to assume the extra risk.

 

Let us look at Fossil Watches (FOSL), which holds a 50% market share of the domestic watch market in North America. Let us assume that the stock was purchased in 1998 for $10 per share. In that particular year, the earnings were a little over $0.40 per share, resulting in a 4% yield. In this example, in the first year, owning a share of fossil is equivalent to owning the provincial savings bond.

 

What happens when a business produces consistently increasing earnings? The following summarizes Fossil’s earnings from 1998 to 2007:

 

1998	1999	2000	2001	2002	2003	2004	2005	2006	2007
$0.44	$0.69	$0.76	$0.62	$0.81	$0.93	$1.22	1.07	$1.13	$1.51

 

Observe how, based on a $10 purchase, the earnings yield changes as Fossil stock is held in the portfolio for an extended period of time:

 

1998	1999	2000	2001	2002	2003	2004	2005	2006	2007
4.4%	6.9%	7.6%	6.2%	8.1%	9.3%	12.2%	10.7%	11.3%	15.1%

 

It is not a coincidence that, as the yields and earnings almost quadrupled from 4% to 15% and $0.40 per share to $1.5 per share respectively that the price also quadrupled from $10 per share in 1998 to $42 per share in 2007. Share price, over long periods of time, will always move in lock-step with profit.

 

Assuming that Fossil’s earnings quadruple in the next 9-year period to $6 per share, a person who bought the stock for $10 in 1998 (held for 18 years), would be happily earning a 60% yield on his original investment and the price would be somewhere around $160 per share.

 

This makes it painfully clear that overpaying for a company would significantly impact the yield one would receive from owning the stock. If one paid $20 instead of $10 per share, the yields would have been cut in half and thus a poor candidate for investment compared to the government bond. Conversely, if one was skilled enough to pay $5 per share, the yields would double.

 

However, even if one was to have paid $20, by holding (and never selling) a company that has consistently increasing earnings, one would still do significantly better than investing in an OSB.

 

In conclusion, it is extremely important to 1) purchase at a low price and 2) purchase only businesses that have consistently increasing profits.

 

DISCUSSION

 

Company	% of Portfolio
Cash Fossil	51.2% 18.5%
K-Swiss	16.6%
Berkshire Hathaway	9.2%
The Buckle	4.1%
General Employment	0.3%
Oakley*	0.0%*

*Luxottica Group completed its $2.1B cash purchase of Oakley on November 14, 2007.

 

Our cash balance increased dramatically as more individuals joined the partnership at the end of the year. We increased our position in K-Swiss.

 

Here is a brief look at the relative sizes of the companies in the portfolio:

 

Company	Size ($)
Berkshire Hathaway	207.3B
Fossil	2.3B
Oakley*	2.0B*
The Buckle	1.2B
K-Swiss	660.3M
General Employment	8.7M

The following are brief discussions surrounding the businesses in the portfolio. They are not discussed in any particular order.

 

Fossil

 

In 2007 Fossil cleaned up their balance sheet. Although 2006 was a modest year, 2007 showed an 18% increase in sales and almost a doubling of net income.

 

In 2004 Fossil’s net income reached a peak of $90M. Overconfident in their ability to increase revenue, the company aggressively bloated their inventory in preparation for the 2005 Christmas season. This was probably one of the best ways to invite disaster. As we all now know, the company wasn’t able to hit its sales target. Excess inventory had to be marked down and the company’s profits plummeted to $78M in 2005.

 

The company wrote down inventory through in 2006 and profits remained stagnant at $77M in 2006. At this point in time, many analysts had a sell order on Fossil. To compound problems, NASDAQ issued a notice threatening to suspend the company’s stock from trading if Fossil didn’t get its filings up to date. At the time, the company was investigating concerns about improper pricing of past stock options.

 

The option issue was cleared up and the turnaround proceeded faster than we expected. We were rewarded in 2007 as profits in the trailing twelve months hit $105M and the stock price nearly doubled from $22.40 in January to $40 at the end of 2007.

 

We are happy that inventory levels have remained relatively flat at the company for 2007 and that there is still no debt on the balance sheet.

 

This year also marked the announcement of a partnership between Fossil and Burberry that will have the company creating and selling Burberry watches and accessories through 2012.

 

We continue to hold Fossil as long as its brand continues to translate into strong financial results.

 

K-Swiss

 

Shares of the company collapsed in 2007 from $31.50 in January to $18 at the end of the year. The price may go lower.

 

Domestic sales dropped 36% while international sales grew 7% as reported in the company’s Q3 report. In light of these results the company cut its 2007 sales and profit targets.

 

The brand has become stale and irrelevant. To correct this, the company recently announced that Toth Brand Imaging will be the new advertising agency of record. K-Swiss’s ad account was previously handled by New York-based Gale Group.

 

Unlike Fossil, K-Swiss did not self-inflict itself with an inventory problem. The $620M company shows inventory at $60M since 2004, with no debt and over $280M in cash.

The company is effectively priced at $340M with annual profit of approximately $60M. This represents a 17% yield.

 

We continue to believe that companies such as Fossil and K-Swiss should only increase inventory levels in lock step with achieved revenue targets and not anticipated revenue targets; to do otherwise, places the business at significant risk. This risk was made all-too clear to us in 2005 when Fossil boosted its inventory in anticipation of a fast-selling Christmas season that never materialized. We are very satisfied that K-Swiss has not fallen into this trap.

 

The challenge that K-Swiss faces is a deteriorating domestic market for its products. Time will tell whether Steve Nichols and his team will be able to weather this storm.

 

The partnership significantly increased its stake in the company in 2007. Partners should recognize that our returns in 2007 were significantly hampered due to this decision. Partners should also know that there is a strong possibility that we will continue to add to our stake in K-Swiss if the price falls.

 

We anticipate the turnaround at K-Swiss to recover no earlier than 2009. Results in 2008 should be similar to 2007. We plant seeds now in order to reap a harvest later.

 

Berkshire Hathaway

 

Our class B shares of Berkshire Hathaway increased from $3500 in January to $4500 by the end of the year.

 

In 2007, Berkshire Hathaway made a number of transactions. First, the company purchased 20% of Burlington Northern railway (but discharged shares in Norfolk Southern and Union Pacific). Second, Berkshire booked a profit of $3.5B on the sale of Petrochina stock after holding for 4 years. Third, at the end of the year, Buffett came to an agreement with Chicago’s Pritzker family to purchase a 60% stake in conglomerate Marmon Group with the remainder to be bought over the next 6 years. This brings the total number of employees directly working for Berkshire Hathaway to almost 240,000.

 

Potentially one of the biggest transactions of the year was indeed saved for last. Although the company owns a wide variety of businesses, Berkshire’s primary vehicle for growth remains in insurance. During the sub-prime turmoil of 2007, the company is launching a New York-based bond insurance company.

 

Most individuals are aware that municipal, state and the U.S. governments issue bonds to help fund everything from roads and bridges to the military and environmental protection. Governments recognize that it is cheaper to borrow from the masses than from financial institutions. In order to sell their bonds, the government must seek insurance from companies such as MBIA and Ambac to show the public that their money is safe. In return, these government bonds inherit the triple-A rating of the insurer behind them.

 

During the real estate boom, insurers such as MBIA and Ambac saw significantly more profit in insuring mortgages, especially sub-prime mortgages, and began to stray dangerously from their safe, bond-insuring ways. As the sub-prime mortgage market collapsed, many bond insurers began to write-down billions of dollars and place their coveted triple-A ratings in risk. More importantly, the loss of standing has jeopardized these companies’s relationship with the government – their primary and most stable customer.

 

At a time when MBIA and Ambac most needed infusion of capital from insuring government bonds Warren Buffett decided to step in a create a bond insurer. This company promised never to stray from bond insurance, held tens of billions of dollars and has a rock-solid triple-A rating. Needless to say, this move may signal the demise of many bond insurers across the country.

 

Berkshire Hathaway has a market capitalization of $217B. To give context to this number, the next largest company in our portfolio is Fossil at $2B. Logically there appears to be more room to grow at Fossil than at Berkshire Hathaway, but CEO Warren Buffett continues to show us that elephants can still dance.

 

Due to the size of the company, we feel that Berkshire Hathaway’s future growth is limited and consider it to be a proxy for cash. Berkshire Hathaway remains an extremely healthy and profitable business. It is unlikely that we will ever sell our stake in Berkshire Hathaway. We will, however, consider this business a good buy at 1x book.

 

The Buckle

 

The Buckle is in the simple business of re-selling branded denim, clothing and accessories to consumers, including their own exclusive brand, BKE.

 

The company performed fabulously in 2007 with sales for the 43 week period ended December 1^st, 2007 increasing 18% to $472.3M. Comparable store sales increased 11.5%. This $670M company is expected to earn a little over $60M in 2007.

 

We consider the Buckle to be a very conservative modestly-growing retailer and will continue to keep it in the portfolio as long as Daniel Hirschfeld is at the helm and the company’s fundamentals remain sound.

 

Oakley

 

In 2007 Jim Jannard sold Oakley to eyewear giant Luxottica for $2.1B. The deal closed on November 14^th, 2007. Mr. Jannard’s majority holding translated to a one-time disposition of $1.3B. Congratulations to everybody who made Oakley a success. The partnership enjoyed a very profitable relationship with Oakley.

 

Closing

 

Looking into 2008 many people are forecasting a recession in the U.S. economy and a weakening of the USD. These may indeed occur, but I am out of my depth to predict them. I am confident that we hold an extremely resilient collection of businesses that will continue to perform well into the next decade and if a recession does hit, we have the reserves to take full advantage of that event.

 

There is concern of consequences from the fallout of the subprime mortgage market, namely, a decline in consumer spending. This will affect companies that derive the majority of their revenues from the domestic market, such as The Buckle, however the remaining businesses have significant contributions from international markets that may be able to offset any consumer weakness in the U.S. Only time will tell how it all plays out.

 

To give some idea of how I feel about the prices of our holdings I will introduce a new rating system for our holdings and assign either an “over valued”, “fair value” or “under valued” weight to them so that partners, along with our weighting in these companies, can assess how we will perform going forward.

 

Portfolio	Assessment
Fossil	Over valued
K-Swiss	Fair value
Berkshire Hathaway	Over valued
The Buckle	Over valued
Oakley*	Over valued

If this table causes you distress, please keep in mind that most stocks will be considered over valued the vast majority of the time. If everything was fair valued or under valued we would be buying everything under the sun and our portfolio’s returns would mirror the index.