Q2 Performance

Q2 was a rough period for equities. Across the board equities got hammered by double-digit declines. The S&P500 was down almost 12%, Dow Jones was down 10%, and the Russell 200o was down 10%. I could not do much better. The portfolio was down 19%, giving back all the gains of Q1.

Although the portfolio is down in Q2, I wouldn’t read much into the short-term performance. As of August 4th, the portfolio has gained back all the ‘loss’ from YTD and then some. A concentrated portfolio of small caps is bound to fluctuate on a quarter-by-quarter basis. Although I believe the holdings have tremendous upside and I think the results from the second half of 2010 should result in substantial out-performance over the major indicies.

The holdings:

Caraco Pharma: The company is on track for return of manufacturing in second half of FY11. The company has hired back 50-100 employees. The Q1 results were exceptional, although I don’t expect similar top-line results going forward. The company was cash flow positive in the quarter and I don’t expect the company to burn cash until they restart manufacturing. The investment thesis is intact.

General Growth Properties: The company is on track for a Fall ’10 return from Chapter 11. I believe the emerged GGP has great upside potential in short-term and long-term. I’m very intrigued by the SpinCo (formerly named GGO). I believe the shares could be in a sell-off right out of the spin-off. It could create an intriguing buying opportunity.

WellCare: I believe the company has finally put all the legal issues behind it. The management team can now get back on focusing of the operations of the company and growing the company. I think the company will now be an ideal candidate for a buyout.

Ternium: The management team has made the company even stronger coming out of the credit crisis. The company has been growing and I believe their plans for a plant in Brazil could have a huge impact on the cash flow.

Harvest Natural Resources: I believe the company is geared for a strong second half of 2010 and 2011. The company could have a huge increase in NAV based on the results from their US properties and Indonesia.

KVH Industries: The company had an exceptionally strong Q2. The company should hit 1,000 sales for their TracPhone v7 in Q3. I believe there is plenty of growth for the TracPhone v7 in 2011 and the strong recurring revenue will make the market realize the true value of the company.

Heckmann Corp: Management has mentioned they plan to start work on major pipeline work in second half of 2010. I believe the company will be working with some of the big players in the Marcellus shale area. It might take a few years for this idea to play out but I believe this company is the only player in the water pipeline area.

ATP Oil & Gas: The company had a tough Q2. Our performance was drastically hit by ATPG’s share price decline. The GOM disaster dropped the shares by more than 50%. Although the uncertainty created by the GOM disaster has delayed the production increases for ATPG, I believe the future cash flow have been delayed a few months. I doubled-down on the ATPG shares as it became clear the government wouldn’t make decisions that would drastically impact the company’s value.

Cano Petroleum: This is another company where the drop in the share prices impacted our Q2 performance. The company’s merger with Reseca was called off. The shares dropped off over 50%. The company has hired 2 i-banks to help the company find another buy. I believe these company should be able to find a buyer and investment thesis is still in play.

Palladon Ventures: After Q2 closed, the company announced they have shipped iron ore to the Richmond port for final shipment to China. I believe the company is on track to start major production/shipment to its Chinese customer. The company will likely do dilution to raise capital.

I ended Q2 with little cash, about 4%.

Market Analysis

In some respect, 2010 is turning out to be a worst year for consumer than 2009. In July 2010, consumer bankruptcies grew 10% compared to prior year. Also, the number of consumer bankruptcies in 2010 is expected to be highest in the last five years. Now that the the unemployment benefits have been scaled back, the impact on unemployed individuals will be severe. Individuals that were counting on the unemployment checks to pay for rent and living expenses will soon find themselves having to sacrifice on essential needs. In the most recent Dean Food conference call, the CEO mentioned:

Yes, I’ll give you what is an anecdote. But it is one of the things frankly, that I am somewhat worried about. And that is if you go back and you look at our fluid milk volumes several quarters ago, and you track them on a weekly basis, we used to see, as you would expect, was a truly stable category with complete household penetration. You used to see very flat volumes week to week, right? So very little change in average daily sales.

We’re now seeing a different pattern. And that pattern is at the beginning of the month, we’re seeing sales rise above the trend line. And by the time that you get to the end of the month, sales are down in what are meaningful percentages for a category like this, that’s flat, it has been for 30 years. So you’re seeing inter-month volume volatility, or a volume pattern emerging. And the only conclusion, I think, you can draw from that is there are people who are big consumers in this category, they’re just running out of money, starting at the end of the month.

And you’ll recall, during the month of June and in part of July, the Congress stalemated over extending unemployment benefits for a large number of people. We saw that in our business in soft volumes. So that’s really my concern about the category is that there are still a very large number of households in the U.S. who are very constrained in terms of disposable income, and they’re cutting back wherever they can. And they’re not cutting back just one category, they’re trimming around the edges everywhere. And we see soft category volumes.

I believe as the government realizes that they can’t keep propping up the economy, the true picture of the economy will become clear. I believe the consumer is still in a tough situation. The consumer will still take a while before they can significantly impact the growth in the US GDP. I believe we are in a business cycle with strong odds of zero or very low growth rates. In such an anemic growth environment, I believe it will be exceptionally important to be patient and pick the right companies to invest in.

Finding Ideas

“If it’s in the papers, it’s in the price. The market does reflect the available information, as the professors tell us. But just as the funhouse mirrors don’t always accurately reflect your weight, the markets don’t always accurately reflect that information. Usually they are too pessimistic when it is bad, and too optimistic when it is good.”
— Bill Miller

In the current market I don’t see many opportunities for companies that could do well in a zero to negative growth GDP environment. The most interesting opportunities that I’ve seen involve forced sellers. The companies on my radar have a small float and big stakeholders are forced to sell. The companies are selling at very cheap valuations and with little regard to their underlying business fundamentals. In one case the company has a business model that is counter-cyclical, the company actually creates more cash flow in zero to negative growth environments. There are a few small cap growth companies with clean balance sheets and product lines that should do well in slow growth environment.

I see the portfolio increasing its cash holding in the second half of 2010 and most of 2011. I believe the current global economic situation will create many opportunities for patient investors. I will hold onto the cash, waiting for these opportunities.