2010 Q1 Eagle Commentary

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Eagle Capital Management, LLC
FIRST QUARTER 2010
The first quarter’s 5.39% gain for the S&P 500 marked a 55-week move of 77% from the
March 2009 lows. This is one of the longest rallies without a 10% correction in history; all
three comparable rallies were in the secular bear period of the 1930s. We were pleased
that we performed as well as we did, given the strength of cyclical stocks, which we had
avoided.
Expense cuts and inventory rebuilding are fuelling a short-term profit recovery, but GDP
growth is likely to slow as these effects wane. Unprecedented government spending and
Federal Reserve liquidity must be cut back at some point, and consumers will be
constrained by debts for a long time.
Many observers have focused on the sharp earnings rebound in the near quarters, while we
have concentrated on companies that are poised to do best in a slow-growth economy over
the next five years.
In a quarter when bank shares rose four times faster than the rest of the market, Eagle
owned none; we depended on individual stock-picking to keep up with this liquidity-driven
rocket.
We may lag for a time if banks continue their run, so it is appropriate to explain why we
have not made that commitment with your money.
Our reluctance is not a product of any certainty that banks are overvalued. Many banks
appear cheap on "normalized" earnings, and some have attractive franchises. Were we to
run a hedge fund, we would not be short.
But we are concerned that the current value of banks seems especially dependent on – and
vulnerable to – future interest rates. Our historical returns have derived from getting a
research advantage in estimating a company’s prospects and value, not betting on the shape
of the yield curve.
There is widespread faith that the Federal Reserve has firm control over interest rates and
that Ben Bernanke has the tools necessary to keep short rates low and long rates moderate.
This curve, if it holds, provides apparently free money to banks that borrow short and lend
long, while it drives investor money into risky assets, including bank loan collateral and
bank shares themselves. The idea is that a US "output gap" prevents inflation, permitting
the Fed to keep short rates near current levels, while a global savings glut ensures adequate
demand for longer-term debt at real rates of 2%.
This view could turn out to be correct, but the market seems more certain than we are.

April 2010

Eagle Capital Management, LLC
There are two key risks in the medium term to the current shape of the yield curve and along with it - the health of fragile banks.
First is the limited supply of buyers for 10-year US government bonds at an interest rate of
only 4%. China may need its trillion dollars for its own stimulus program. Japan's savings
rate is now approaching zero. US consumers have barely raised their savings. Nearly every
nation is aging, and as more people retire, savings are tapped faster than they accumulate.
Second is the potential for inflation if the dollar is debased and commodity prices rise from
emerging markets demand. Already China buys more oil from Saudi Arabia than the US
does. Asia’s infrastructure build-out and domestic consumption will raise demand for
building materials and all kinds of food inputs. The Chinese currency will appreciate at
some point. When it does, imports will cost the US more and Chinese buying power will
rise proportionately. As we press China to revalue their currency, we might keep in mind
that it will be tougher to bid against them when they do (be careful what you wish for).
Meanwhile, skilled labor is not in infinite supply in the US or globally. Wages in China
have been rising for years, and even the US has three million jobs unfilled because we lack
the skills to fill them. That could lead to stagflation, which occurs when money grows in the
face of supply constraints. Our shopping malls may be empty and 15% of Americans may
not have jobs, but that doesn't mean the cost of oil, food, and certain skilled labor can't
move up sharply if monetary policy is too loose. Theory aside, we have seen this story
before.
We highly recommend Michael Lewis’s new book, The Big Short, in which one of our good
friends, Charlie Ledley, figures prominently. Working from a friend’s back-yard shed,
Charlie and his partner managed to build one of the best track records in a brutal,
competitive industry. Their key advantage was and remains an understanding that the
market repeatedly underestimates the odds of unlikely events. As they researched one of
their greatest trades - a 2007 bet against mortgage CDOs, Charlie tried to understand why
none of the Wall Street experts were making the same bet. "Things will never get so bad
that CDOs will go bad," Charlie was told repeatedly. Lewis writes that Charlie and his
partner “didn't know for sure that sub-prime loans would default in sufficient numbers to
cause the CDOs to collapse. All they knew was that Deutsche Bank didn't know either, and
neither did anybody else."
When we think about risk, we do not think about the risk that we underperform some
benchmark temporarily. We think about risk as the possible permanent loss of your capital.
There is a chance our bearish vision of higher interest rates, stalling growth and inflation
won’t play out, or that it will not happen within the next year or two that comprise most
investors' time horizon. But we do not predicate our investments on a specific economic
premise. We think about a wide range of possible outcomes and try to be sure that we can
be safe in all of them, prosperous in enough of them. Some call this probabilistic thinking,
but it is really just dynamic common sense.

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April 2010

Eagle Capital Management, LLC
Fortunately we have opportunities that do not require a strong macroeconomic view. One
recent investment we have made is Kraft Foods. Kraft shares fell in January of this year
after the company announced its acquisition of Cadbury, a global confectionary company
with a strong footprint in Europe and emerging markets. We had previously studied
Cadbury and liked its position. We built up our understanding of Kraft, spending time with
the CEO in our offices and speaking with current and previous executives and mid-level
employees at Kraft, Cadbury, their competitors and retail buyers in the US, Europe and
Asia. We modeled the combined companies product by product, adding up the value of the
pieces into a global whole.
As we reviewed each business, we concluded that - with a large emerging markets
presence, efficient scale in Europe, and product dominance in each geographic area Kraft’s new management team should be able to cut costs, ramp up growth and leverage its
free cash flow, raising earnings per share and its low multiple.
There is of course a risk that we are mistaken in our analysis. We may be wrong about
Kraft's execution, about the future of private label products in chocolate and gum, about the
power of retailers in emerging markets, etc. But these are all calculated risks, and they can
be balanced against the price we are paying and the returns we can earn even in a bad
scenario. Unlike certain bank stocks we have tried to analyze recently, there is almost no
macroeconomic development that could bankrupt Kraft or force a recapitalization. If we are
wrong about CEO Irene Rosenfeld and her ability to revitalize the company, the business
we bought should still earn a depressed cash-on-cash return of 8%. That is not an
aspirational target, but as a bad-case scenario it gives us comfort.
That said, we arrive each morning ready to re-examine our ideas and consider new facts.
Many smart investors have invested in banks this year, generally to their profit, and we are
always grateful for your contrary opinions.
If you have any questions or would like to discuss anything we are doing, please call Terry
Shea, John Johnson, John Holman, Anne Maffei, Boykin Curry or Ravenel Curry at 212293-4040.

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April 2010

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