Our 2009 Performance Review

by: North Fork Investors

We are pleased with our portfolio's performance in our inaugural year, although we are sure most investors feel the same after the tremendous market appreciation since mid-March. We began in February with $100,000 of equity and ended the year at $132,329 (or an increase of 32.33%). This lagged the S&P 500 slightly (which returned 34.86% for the same period), but we achieved this substantial increase with far less risk to our portfolio than a fully-invested index during a period of great uncertainty. At most, we were 54% invested in the market, with the remainder in cash. We also invested (or sold cash-secured puts) in stable, positive cash flow companies with business models generally able to withstand the horrific economic environment. Note that our internal rate of return on our invested portfolio (our long investments, plus the entire amount of cash required upon exercise of any of our naked puts) for the year was 79.69%.

Holding a large cash balance won't necessarily be our investment model going forward - it was a result of our slow, diligent moves into the market as we found bargains. In hindsight, we should have gone "all in" when we started in February 2009, but we're confident our more cautious approach will serve us well going forward. In 2010 we will look to slowly build our portfolio of investments, until we are closer to 75-100% fully invested. Assuming the market continues to appreciate, we'll also look to build a portfolio of shorts of troubled businesses. Below is a brief summary of our current holdings, and the positions we exited in 2009.

Current Holdings:

Greenlight Capital Re, Ltd. (NASDAQ:GLRE)

Our first investment was Greenlight Capital Re, Ltd., which we purchased on February 13 for $12.90 per share. In Greenlight we saw the opportunity to piggy-back on the performance of one of the better long-short equity hedge funds, while participating in the compound growth that profitable reinsurance underwriting combined with strong investment returns can generate over time (and no corporate level tax!), all at a purchase price below tangible equity per share. We're pleased with the performance of both the stock and the business thus far. The underwriting team has been hard at work this year, expanding unearned and earned premiums over the previous year (leveraging their balance sheet with zero-cost leverage), and the hedge-fund investments had a stellar year (David Einhorn and his team generated returns of 32.1% for the year). As such, the company has recouped all previous investment losses in 2008 and then some, and the market has taken note. The stock is now trading at what we believe is a fair premium to book value (1.2x-1.3x). Our investment thesis has not changed, and we look forward to holding the stock indefinitely as we believe the company is built around a great business model and management team, and believe that the stock warrants a premium to book value. Going forward, we believe that reinsurance pricing will "harden" as economic growth accelerates, and that Greenlight is well positioned to capture an increase in business and pricing.

Linn Energy, LLC (LINE)

Linn Energy has had a very interesting year. The company's second quarter results were far lower than expected due to extremely low prices for oil and natural gas. Since that point, however, the energy market has rallied along with the entire stock market and Linn has disproportionably participated in these gains. We continue to hold as our initial investment thesis is intact - Linn is a highly hedged company with solid, sustainable cash flows which support the quarterly distribution and ongoing oil/gas property development. We note that Linn management made some excellent decisions over the prior year to put itself in an enviable market position. They successfully completed an equity offering in order to pay down debt, reducing unnecessary risk in an uncertain market, they completed an acquisition of an oil and natural gas field at a favorable price, and the company has seamlessly completed an upper management transition - former COO Mark Elliis was appointed as a successor CEO to founder Michael Linn. Nevertheless, the market's valuation of Linn has expanded quite a bit over the last year, and we are currently reviewing whether or not the fundamentals warrant continued investment.

China Nepstar Chain Drugstore Ltd. (NYSE:NPD)

Similar to WSP Holdings (discussed below) China Nepstar, an operator of small chain drug stores in China, is a stock we were initially attracted to because of (a) a large cash balance due to a recent IPO at a much higher price, and (b) long term growth potential. We purchased a small position in Nepstar at $3.86 per share in February, received a regular dividend of $.35 per share in May and then a large $1.50 per share special dividend in December. As such, we've already recouped a substantial amount of our initial investment. But notwithstanding these large dividends, Nepstar's stock price has also increased substantially, reaching a high near $7.50 per share in late November. When we purchased the stock, we calculated an enterprise value (market cap less excess cash) of roughly $59M, and an EV/EBITDA ratio of around 2.5x. Now that the company has far less cash (because of the dividends) and because the stock price has increased, the company's enterprise value has risen dramatically (roughly around $300M as of today's date). But Nepstar really doesn't make much money - its still in its growth phase - so the stock now carries a lofty EV/EBITDA multiple. Feeling that the stock's price had become a bit inflated, we sold calls in November struck at $7.50 per share which expire in March. NPD has since come down in price substantially to around $6.00 per share, a more appropriate price (albeit still inflated in our opinion). While we do think the company has the ability to become a market leader in the chain-pharmacy space as the Chinese marketplace continues to develop and modernize, we find the stock's current valuation less than compelling. While we had hoped to hold the stock for a long period of time, we're currently evaluating whether continued investment makes sense.

Ark Restaurants Corp. (NASDAQ:ARKR)

In October we purchased a full position in Ark Restaurants Corp, a micro-cap operator of unique restaurants and fast-food concepts in touristy locations (New York, Las Vegas, etc). While we are sure that Ark's stock will not follow the same path as a high-flying tech stock like Adobe, we are excited about the company's consistent cash generation and measured, debt-free growth. Ark's restaurants have performed solidly in a down market, and management has demonstrated a forward-looking and prudent perspective - they've kept headcount up and avoided layoffs at the expense of short term profit while generating long-term goodwill with employees. They also operate the company with a debt-free balance sheet and focused on maintaining a conservative cash position, cutting the dividend in early 2009 (which drove the price of the stock very low) and then reinstating the dividend at a lower rate later in the year. Over the short-term we are excited about the performance of the company's new restaurant at Columbus Circle, Robert @ MAD which has gotten favorable reviews so far. Over the long-term we look forward to an increase in sales at the company's restaurants in Las Vegas and New York as the economy turns. If the company can come close to generating 2006 and 2007 type profit figures at some point over the medium term, we think the investment will be very much worth the wait. In the meantime, we will collect roughly a 7% dividend.

PetMed Express, Inc. (NASDAQ:PETS)

As a recent position, most of our thoughts can be summed up in our January 18th post here. We are excited about owning a market leader in this space, and applaud the company's recently released quarterly results. This is a well managed, scalable, high ROIC business with serious tailwinds. Given its prospects (80% of pet meds are sold by vets for marked up prices), we find its mid-teens earnings multiple more than reasonable.

Additional 2010 Investments

Note that so far in 2010 we (i) sold puts on Microsoft Corporation (NASDAQ:MSFT) and (ii) purchased a 1/2 position in Yum Brands, Inc. (NYSE:YUM) while also selling additional puts on YUM.

Closed Positions:

WSP Holdings Ltd. (NYSE:WH)

In May we purchased a small position in WSP Holdings, Ltd., a Chinese steel pipe manufacturer, at $3.48 per share. Like China Nepstar, we were initially attracted to the stock because of its historical earnings growth combined with a very large cash balance which was a result of an IPO the year before at a much higher price. This turned out to be a very interesting investment, one which we admittedly could have been smarter about. Soon after our investment, the Company announced a special dividend of $.45 per share, and the market responded favorable (irrationally excited you could say - the company was distributing to shareholders a very large portion of its safety-value cash balance). The stock was quickly driven to the mid 6's. Having collected the special dividend, and participating in this large price appreciation, we should have sold and moved on.

We continued to hold believing that the company's pricing power compared to the large steel companies in the industrialized world would lead it to consistent growth. Time will tell over the long term, but in the short term other macro and political factors began to take a toll on the company's business. The company is now facing large tariffs in the North American market, downward pricing pressure resulting from a glut of supply in the Asian markets, and general declining demand. In addition, due to rapid expansion and facility construction, the company's short term debt ballooned. In November we sold our shares of $3.60 per share, feeling that there was far too much uncertainty facing WSP's business to justify continued investment. Including the special dividend, our IRR on this investment was 32.94%.

Adobe Systems, Inc. (NASDAQ:ADBE)

In February, we purchased 230 shares of Adobe Systems, Inc. at $17.37 per share, while simultaneously selling puts (hoping to purchase more shares at an even lower price). We subsequently bought back the puts after they declined in price, and sold a second set of later-dated puts at a higher price, again hoping to leg into more adobe shares at prices lower than the market was willing to offer. This second set of puts again expired worthless as Adobe's stock price crept upwards. What we thought of as prudence at the time, we now see as greed. We should have purchased a full position in the high-teens when we had the chance. We think the opportunities the market was offering up in Feb/March of 2009 in blue chip technology names are unlikely to return for years, if ever.

Adobe is a cash-generating machine with a number of incredibly valuable software franchises, and terrific growth potential in its website development platform (Flash). At the time Adobe was trading at around 6.7x free cash flow, a silly multiple for such a strong business. Using conservative growth assumptions and a high cost of capital, we were modeling Adobe's intrinsic value at around 50% higher than its current price. As could be expected, Adobe quickly rebounded to levels we thought were much closer to fair value. In July we decided to sell two January 34 calls to collect additional premium. These calls were eventually exercised, and we sold 200 of our Adobe shares for an effective price of $36.50, less commissions. We then sold our remaining odd lot and have moved on. This of course isn't to suggest that we don't like the company or its prospects - we think they are great. We just think we can find better bargains elsewhere. All in, this investment generated a whole dollar profit of $4,348.18, on an initial investment of $4,010.05, which represents an investment IRR of 135.21%.

Other Put Sales

In 2009, we also sold cash-secured puts on Nike, Inc. (NYSE:NKE) and Gamestop Corp. (NYSE:GME) attempting to enter positions in these stocks at lower than market prices. Each set of puts was repurchased after a substantial decline in premium for a profit. We'd love the opportunity to purchase Nike at a price we thinks makes sense at some point in the future, but feel differently towards Gamestop after further analysis.