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Eminence Capital Q1 Letter 2010

Eminence Capital Q1 Letter 2010

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Published by marketfolly.com

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Published by: marketfolly.com on May 06, 2010
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 May 4, 2010Dear Limited Partner:Eminence Partners advanced 1.7% gross and net
in the first quarter 2010. The first quarter andthe month of April in particular have been a struggle for us. Cheap money and signs of life inthe domestic economy have combined with a stock market environment where tradingmomentum seems obsessed with current data points vs. long term value. This has led to anaccelerated widening in the performance and valuations between low quality vs. high quality,small capitalization vs. large capitalization and cyclical vs. consistent growth. As “investors”,our portfolio is generally positioned opposite these recent trends as we seek value and quality onthe long side and low quality and over-valued on the short side.We have been less surprised with the strength of the recovery and first quarter earnings than wehave been with the market’s reaction to those data points. The stock market has becomeenamored with companies that “beat and raise” near term earnings expectations regardless of valuation or long term business prospects. We have been of the belief that many low quality,small capitalization and cyclical businesses are more than fully priced for several years’ worth of very strong earnings growth, an outcome we don’t think is likely based on both structural issuesmuting economic growth and structural issues facing numerous businesses that fit those criteria.It has been quite a bifurcated market recently where stocks that only meet expectations or slightly temper expectations are being sold regardless of valuation, business quality or their longterm prospects while companies that beat estimates and raise guidance are going up withoutregard to valuation, business quality or long term earnings sustainability. Experience has taughtus that markets like these are not sustainable, but we respect that predicting when it will end or how far it will carry is difficult.Below we present our 3 and 5 year CAGR in addition to the respective inception to date performance information:
 2010 CAGR
Q13 yearreturns5 yearreturnsSince inception(January 1999)
Eminence Partners gross
1.7% 6.3% 9.5% 18.7%Eminence Partners net
1.7% 4.8% 7.5% 15.1%
S&P 500
5.4% (4.2%) 1.9% 1.3%Russell 2000
8.9% (4.0%) 3.4% 5.7%Avg. US Stock Fund
6.2% (3.9%) 2.3% 2.7%
 Note: Past performance is not indicative of future results
See last page for all note descriptions
65 East 55
Street, 25
New York, New York 10022Telephone: 212-418-2100
Facsimile: 212-418-2150
Q13 yearreturnsSince inception(July 2005)
Eminence Leveraged Long Alpha gross
2.6% 1.9% 6.8%Eminence Leveraged Long Alpha net
2.6% 0.8% 5.0%
S&P 500
5.4% (4.2%) 1.7%Russell 2000
8.9% (4.0%) 2.6%Avg. US Stock Fund
6.2% (3.9%) 1.9%
 Note: Past performance is not indicative of future results
See last page for all note descriptions
Performance Review
Our average long position did fine in the first quarter, advancing about 7% which is above all theindices except the small cap index. Our average short position, on the other hand, advanced between 9% and 10%, generating negative alpha to both the market and our longs.
Contribution to Return
 Average Eminence Partners Q1 Exposure
Long Investments
10.2% 151%
Short Investments
(8.0%) 85%
Management Fees & Operating Expenses
 Portfolio Return & Avg. Net Exposure
1.7% 66% Average Eminence Leveraged Long Alpha Q1 Exposure
Long Investments
15.2% 226%
Short Investments
(12.0%) 127%
Management Fees & Operating Expenses
 Portfolio Return & Avg. Net Exposure
 2.6% 99%
(Figures may not add due to rounding)
See last page for all note descriptions.
Winners on the long side (and their respective contribution) included Nintendo (90bps), Hasbro(60bps), Carnival (60bps), US Bancorp (50bps) and Ross Stores (50bps). No long position hurtthe fund by more than 20bps.The short side unfortunately had only a handful of winners and an abundance of losers. Our  biggest losses outside of indices were a printing company, an aerospace and defense company,an apparel manufacturer and a media distribution company.
Portfolio Update
Throughout the first quarter, gross exposure averaged 235%, net exposure averaged 66% netlong and our long / short ratio averaged 1.8x. Currently, gross exposure is 260%, net exposure is60% net long and our long / short ratio is 1.6x. We have used the strength in the market in Q1and April to reduce longs that have less favorable risk / rewards and add to or initiate short positions in low quality companies that seem priced for more than perfection.
 Increasingly, we have been positioning the portfolio for an eventual rotation to higher quality,larger capitalization and more defensive growth companies. The intrinsic value gap between businesses with these characteristics and those with the opposite is increasingly wide. Thestrength of near term business conditions has caused the market to buy the cyclical, lower qualitycompanies that get a bigger bang from this strength without regard for valuation. As first quarter earnings seasons comes to a close we are hopeful that the lack of catalysts will cause investors toshift from “beat and raise” to “what is it worth?”We have been cognizant that the broad advance in stocks combined with the decline in our equity in April has caused an increase to gross exposure. We plan to manage gross exposurelimits at or near current levels. Further, we continue to manage position sizes on the short sidesuch that no stock specific short position exceeds 2% of capital.Since our last letter, we added new long positions in Aon, Coca-Cola Enterprises, Raytheon,Monsanto, TD Ameritrade, Research in Motion, Avon Products, Dollar Tree Stores, AmericanEagle Outfitters and Beckman Coulter. We added to existing long positions in JP Morgan,Google, Charles Schwab and Fidelity National Information Services.We exited long positions in Nestle, General Mills and Northrup Grumman and reduced positionsizes in Nintendo, Hasbro, Abbott, Carnival, Ross Stores, CSX and Reed Elsevier.Aon is the largest commercial insurance broker in the world with global operations in over 40countries. Commercial insurance brokers help corporate clients manage risk and obtain fai pricing amongst a wide market of insurers in areas such as workers comp, property and generalliability insurance. Aon is a high quality business that generates a high return on equity, produces strong and consistent cash flow and requires little capital to grow. Aon’s stock priceand its earnings have been under pressure as the commercial insurance market has been goingthrough a period of declining, or “soft” pricing for the past few years. There are a number of factors contributing to this including the lack of catastrophic events and the global economicdownturn. This soft market impairs both the dollar amount of commissions earned and thenumber of transactions. The current low interest rate environment has also hurt the industry asthe brokers derive short term investment income on cash they hold on behalf of their clients.Aon has been executing a series of restructuring programs to help streamline their business and bring margins to best in class under the leadership of CEO Greg Case. Greg was a partner atMcKinsey and is known throughout the industry as one of the brightest minds in the business.Despite a difficult industry backdrop, Greg has been delivering on the improvements to Aon’s business. The combination of continued execution by management including increased sharerepurchases, an eventual “harder” pricing cycle, rising short term yields and the recent lift of the ban of contingent commissions all provide tremendous upside for Aon’s earnings. We purchasedAon for 10x normalized earnings and believe we could see 50% upside in the stock over the next2 years.Coca Cola Enterprises (CCE) owns the rights to bottle and distribute Coca Cola (KO) productsand other non alcoholic beverages in a number of US markets as well as several Europeancountries. In late February, the company and KO announced a transaction whereby KO would buy the US bottling assets from CCE. Following the closing of this transaction in Q4, CCEshareholders will receive a $10 dividend and maintain an investment in the European bottlingassets.

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