November 3, 2008Dear Pershing Square Investor:The Pershing Square funds’ outperformed the major market indexes for the third quarter of 2008and for the year to date as set forth below:
1
For the QuarterYear to DateJuly 1 - September 30January 1 - September 30Since Inception
Pershing Square, L.P.
01/01/04 - 09/30/08Gross Return1.0%3.5%312.1%Net of All Fees0.5%1.9%204.0%
Pershing Square II, L.P.
01/01/05 - 09/30/08Gross Return2.5%5.2%186.8%Net of All Fees1.7%3.2%127.8%
Pershing Square International, Ltd.
01/01/05 - 09/30/08Gross Return1.0%4.1%158.6%Net of All Fees0.5%2.4%108.9%
Indexes (including dividend reinvestment)
01/01/04 - 09/30/08S&P 500 Index-8.4%-19.3%14.7%NASDAQ Composite Index-8.6%-20.6%8.1%Russell 1000 Index-9.3%-19.5%16.5%Dow Jones Industrial Average-3.7%-16.6%15.8%
Recent Events
These are extraordinary times particularly for active participants in the capital markets. While Ido not normally choose to write about macro and regulatory events, I thought it would be usefulfor you to understand how we think about recent events and their impact on our portfolio.We are currently witnessing the greatest deleveraging event in history. What began as a creditbubble bursting has now spread to the equity markets as banks, investment banks, hedge funds,structured products, mutual funds, pension funds, endowments and other leveraged andunleveraged market participants have been forced to liquidate assets by their counterparties,leverage providers, redeeming clients, and as a result of downgrades, other debts or othercommitments that need to be funded.
1
Past performance is not necessarily indicative of future results. Please see the additional disclaimers and notes to performance results at the endof this letter.
2 These actions have led to forced and indiscriminate selling in security markets around the world,which in turn has caused other investors to panic or simply to sell, to get out of the way of otherforced sellers.As a fund which is generally substantially more long than short, we have also suffered largemark-to-market declines in our long investments. Year to date, however, our performance hassubstantially exceeded that of the broader equity markets, which at this writing have seen a morethan 34% decline. Our outperformance is largely due to large gains on our investments in LongsDrugs and Wachovia Corporation as well as profits on our credit default swap and other shortexposures. Our market losses have been further mitigated because we operate unleveraged andhave substantial cash balances. Currently, we have cash and near-cash (Longs Drugs andWachovia/Wells Fargo long/short) equal to approximately 39% of our capital.When, you might ask, will the selling end? While I don’t proclaim to be a marketprognosticator, I will make a few observations. Unlike the deleveraging that takes place whenbanks and other financial institutions sell assets to meet regulatory requirements, which istypically a longer term process, the forced deleveraging that is now taking place in the equitymarkets is being implemented largely by the prime brokerage firms and margin accountmanagers at broker dealers around the world. Prime brokers are not known to be laggardly intheir approach to liquidating an account that no longer meets margin requirements. This is likelyto be even more true in the current environment. As such, it may be reasonable to conclude thatthe forced liquidation that is now taking place may not be a prolonged process.Security prices around the world have come down tremendously. In the larger capitalizationU.S. markets, which are the focus of our strategy, the reductions have been substantial. As of themarket close on October 31
st
, the S&P 500 is down 34.0%, year to date, and down by 37.5%from its high on October 31, 2007; and this is after last week’s rally in which the S&P 500 rosemore than 12% from the lows. Unlike the bear market of 1973 and 1974, in which stocksdeclined by 45% from the highs, this bear market was not preceded by the “Nifty 50” bubble inwhich large capitalization growth stocks traded at extraordinary valuations. While valuationswere not cheap one year ago, in a long-term historical context, the market as a whole(particularly if one were to exclude financials) was not particularly expensive either.As such, in today’s market, we are finding extraordinary bargains, the kinds of opportunities thatare normally associated with market bottoms. While there are still weak and poorly capitalizedbusinesses that are likely still overvalued, the high quality, well-capitalized, larger capitalizationbusinesses which are the focus of our strategy look very cheap to us.While this means that now is likely to be a much better time to be a buyer rather than a seller, itdoes not mean that the market will not continue to decline, even substantially, from currentlevels, particularly in the short term. In fact, because of tax-loss selling over the next 60 or sodays, there will likely be additional selling pressure. At some point, however, the forced sellingwill come to an end. Large amounts of cash are sitting on the sidelines waiting to be deployedwhen investors feel the coast is clear. In the event the market were to start to rise again, it wouldnot be a surprise to see institutional, retail, and hedge fund investors rapidly deploy capital so asnot to miss a, perhaps, explosive market rally.
3 What does this all mean for Pershing Square? Despite the fact that we occasionally have anopinion, we spend little time trying to outguess market prognosticators about the short-termfuture of the markets or the economy for the purpose of deciding whether or not to invest. Sincewe believe that short-term market and economic prognostication is largely a fool’s errand, weinvest according to a strategy that makes the need to rely on short-term market or economicassessments largely irrelevant.Our strategy is to seek to identify businesses and occasionally collections of assets which trade inthe public markets for which we can predict with a high degree of confidence their future cashflows – not precisely, but within a reasonable band of outcomes. We seek to identify companieswhich offer a high degree of predictability in their businesses and are relatively immune toextrinsic factors like fluctuations in commodity prices, interest rates, and the economic cycle.Often, we are not capable of predicting a business’ earnings power over an extended period of time. These investments typically end up in the “Don’t Know” pile.Because we cannot predict the economic cycles with precision, we look for businesses which arecapitalized to withstand difficult economic times or even the normal ups and downs of anybusiness. If we can find such a business and it trades at a deep discount to our estimate of fairvalue, we have found a potential investment for the portfolio. Next we look for the factors thathave led to the business’ undervaluation, and judge – based on our assessment of the company’sgovernance structure, management team, ownership, and other factors – whether we caneffectuate change in order to unlock value. When the price is right, the business is high quality,the management is excellent, and there are no changes to be made, we are willing to make apassive investment.Our assessment of the short-term supply and demand for securities plays almost no role in ourdetermining whether to invest capital, long or short. If we believed that it was possible toaccurately predict short-term market or individual stock price movements and we had thecapability to do so ourselves, we might have a different approach. Below I quote Warren Buffettin his 1994 Letter to shareholders where he perhaps says it best:
We will continue to ignore political and economic forecasts, which are an expensive distraction for manyinvestors and businessmen. Thirty years ago, no one could have foreseen the huge expansion of theVietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of theSoviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8%and 17.4%.But, surprise - none of these blockbuster events made the slightest dent in Ben Graham's investmentprinciples. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices.Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro eventwere at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these norto profit from them. If we can identify businesses similar to those we have purchased in the past, externalsurprises will have little effect on our long-term results…
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Pershing Square Q3 2008 Investor Letter
From DealBook: The letter sent to investors by William Ackman of Pershing Square Capital. The hedge fund details its investments in A.I.G., Wachovia and others.
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