July 19, 2010

Dear Partners:

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Comparison of $1 Million Investment
(as of 6/30/10)
$11,000,000 $10,000,000 $9,000,000 $8,000,000 $7,000,000 $6,000,000 $5,000,000 $4,000,000 $3,000,000 $2,000,000 $1,000,000 $1989 1991 1993 1995 1997 1999 2001 2003 2005
Massey SP 500 LT T-Bond NASDAQ CPI

AltaRock’s performance during the first six months of 2010 was poor in comparison to the broader market: we were down 15% while the S&P 500 was down 7%. We don’t ordinarily place much significance on short-term numbers and this time is no different. Our strategy is to buy a select group of excellent businesses when they are cheap, and wait patiently as they compound our money at superior rates over the long term. This strategy tends to generate short-term stretches of both superior and substandard returns. Over longer periods we believe we will continue to meaningfully outperform the market and the vast majority of our peers.

Long-term Results

Our updated long-term results are as follows:

Since July 1989 (my inception as a manager of other people’s money), we have grown partner net worth 813% versus 409% for the S&P 500. This equates to a compound annual growth rate of 11.1%, 305 basis points better than the 8.1% generated by the S&P 500. $1 million invested with

AltaRock Partners, LLC 100 Cummings Center, Suite 435 - P, Beverly, MA 01915 Telephone: 978-922-7701 Facsimile: 978-922-7708

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2007 2009

us July 1, 1989 is now worth $9.13 million versus $5.09 million had one invested in the S&P 500. 1 Since 1999 (the final year of the great stock market bubble) we have grown partner net worth by 54% as compared to a 15% loss for the S&P 500. This equates to a compound annual growth rate of 4.2%, 570 basis points better than the market’s -1.5%. $1 million invested with us over this time is now worth $1.54 million versus $849,000 had one invested in the S&P 500.1 Since the inception of the AltaRock Fund on April 3, 2002 we have grown partner net worth 47% as compared to a 7% gain for the S&P 500. This equates to a compound annual growth rate of 4.8%, 404 basis points better than the market’s 0.8%. $1 million invested with us over this time is now worth $1.47 million versus $1.07 million had one invested in the S&P 500.1 All of the above was accomplished in spite of having approximately 30% (on average) of our capital tied up in low returning cash equivalents. This was a big mistake that we estimate cost us about 400 basis points of annual return over the last twenty one years. We continue to slowly get less dumb.

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The Current Environment

In addition to the high levels of government debt and even larger off balance sheet liabilities (i.e. entitlements) resulting from decades of poor political leadership, the developed world now must also deal with the aftermath of a large credit induced inflation. These problems will not go away quickly. Politicians and central bankers will continue to face tough, unpopular choices in the years ahead. While we would have preferred that they did their job in the first place to prevent the rapid and harmful creation of credit by banks/investment banks, we believe that the central bankers and politicians have performed quite well in dealing with the messy downside of their prior lack of prudence. They have demonstrated a willingness and ability to coordinate and print money in order to avert a panicked liquidation of the banking sector. We believe this removes the possibility of a deflationary spiral like the US experienced during the Great Depression. We also believe that while the economy and the financial intermediary function will survive, securities markets are likely to remain choppy for a while as large amounts of bad debt are digested, and as people, companies and governments get used to the idea that they are not as well off as they thought they were.
Past performance is not necessarily indicative of future results. All investment programs have the potential for loss and profit. Comparisons to the S&P 500 Index are for informational purposes only. Massey returns from 7/1/89 - 7/31/95 are as co-manager of the Eureka Fund, from 8/1/95 - 4/2/02 as sole manager of Massey Capital Management and from 4/3/02 to the present as sole manager of the AltaRock Fund.


This letter presented to you by MarketFolly.com

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The AltaRock Conglomerate

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Warren Buffett regards these words from his former boss and mentor, Ben Graham, as the nine most important words ever written about investing: “Investing is most intelligent when it is most businesslike.” Indeed! Stocks are not just quotes on a screen that randomly bounce up and down, they are, in fact, certificates of ownership in real businesses. Successful investing involves getting to know the true nature of a business and becoming so comfortable with its characteristics and valuation that you would happily buy the entire company at today’s price with the intention of holding it for many years, if not forever. It is in that light that we have taken to calling our portfolio The AltaRock Conglomerate (“TAC”). Below we provide you with some look-through information on the businesses that we own today: Seven Subs: While The AltaRock Conglomerate is currently made up of seven subsidiaries, our top five make up 84% of our invested capital and 94% of our earnings on a look-through basis. Sustainable Competitive Advantage: Each of our companies is not only a leader in its field, but has fostered a truly enviable position within the economy through some combination of economies-of-scale, network-effects, and strong branding. We assign every company we are thinking about owning a 10-year and 30year sustainable competitive advantage (“SCA”) rating on a scale of 1-10. To give you a feeling for our scale: a “10” is a perfect monopoly that will never be regulated; think of the government’s ability to tax. As Dudley Moore

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In consideration of the above, we spend a lot of time thinking about how much, if any, cash we should hold. While cash currently pays us nothing, it does provide us with the potentially valuable option of snapping up bargains that may emerge in the months and years ahead. We find ourselves equally convinced to hold more or less cash as we focus alternatively on the potentially poor macroeconomic environment on the one hand, and the cheap prices of the very high quality companies we currently own on the other hand. When the market is declining, cash always feels great, but to the extent that we can find excellent long-term investments in superior businesses, we don’t want to forgo them. A bargain in a great company is our holy grail; to ignore it in the hopes of even better deals in the future seems foolish to us. After all, we can never really know if a better bargain will appear in the future, but we do know with near certainty that a great business purchased today at a bargain price will compound our wealth at healthy rates over the long term and with very little risk of loss.

We do not hand out grades light-heartedly. Understanding the durability of a business’ competitive advantages is the most critical part of our investment process. Endless hours of thought and study go into determining exactly what (if any) advantages a company possesses and whether we have overwhelming conviction that these advantages will be sustained many years into the future. On a weighted average basis, The AltaRock Conglomerate possesses a 10year and 30-year SCA rating of 8.3 and 7.4, respectively. These are very healthy ratings considering that on our self-imposed scale a “9” is about as good as it gets. If you are wondering why our 30-year SCA rating is lower than our 10-year, it’s because very few businesses deserve a higher 30-year rating than their 10-year. Even monopolies, not done in by regulation, will eventually succumb to the wheels of innovation.

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It is important to note, however, that a slow or far-off deterioration of a very strong competitive position will not hurt the investor, provided he has paid a reasonable price. Consider Warren Buffett’s 1973 purchase of Washington Post, a position he still owns today. Like most major city newspapers, The Washington Post enjoyed an almost monopolistic position for many decades. Today, however, its competitive advantages have been destroyed by the ever advancing Internet. Despite the loss of its former advantages and a nearly 60% decline in its stock price since 2004, Washington Post has still been one of Warren’s best investments ever. From 1973 through June 2010, he has earned 16% per year, or 630 basis points better than the S&P 500. That is a phenomenal return to earn over 37 years. It’s also a powerful illustration of why we’ve chosen to copy the investment strategy that made Warren Buffett and Charlie Munger so rich. Strong Profitability: As you would expect, companies with durable franchises tend to have above average profit margins. Taken together, The AltaRock Conglomerate enjoys an exceptional 33% operating margin. This compares to the S&P 500’s long-term average of just over 6%. Shareholder Friendly Management: Since we are minority investors, it’s imperative that we partner with managers that we can trust to equitably share the wealth with us when they have run out of safe, high-return projects to invest in. We have great confidence that all of our managers will continue to

My wife and daughter, of course, being the two exceptions to this rule!


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discovered in the movie “10”, the perfect woman 2 does not exist; neither does the perfect business. A “5” is a company with no advantages over its wouldbe competitors. At best, this kind of business is worth nothing more than its net asset value since it will merely earn back its cost of capital over time. Anything less than a “5” is unlikely to survive due to issues of obsolescence or a weak financial position.

act in our interests based upon their longstanding, demonstrated performance. We Sell Necessities: Almost all of our earnings come from the sale of products and services that are necessities. While the purchase of some of our products may be deferred for a time, we don’t believe they can be put off indefinitely. A testament to this is the performance of our businesses during the 2007-2009 recession, the worst since the Great Depression. Only two of our seven businesses experienced a decline in sales during this two-year period and in both cases the decline was less than 2%. At the TAC holding company level, our revenues were actually up 24% during the recession, or 13% if we exclude one smaller subsidiary that experienced incredible and unsustainably high growth. Our profit growth during the recession was even more impressive. While we did have one subsidiary suffer a 36% decline in profits from 2007 to 2009, taken together, TAC’s profits were up 73% over this two-year period, or 56% if we exclude that same smaller, rapidly-growing subsidiary. Global Diversity: The AltaRock Conglomerate is a truly global powerhouse with revenues derived from almost every nation on earth. Currently 60%, 15% and 25% of our profits are earned in North America, Europe, and emerging markets, respectively. Although we expect our North American revenues and profits to grow at a healthy pace over time, we also expect them to decline as a percentage of our total. This is because we should continue to enjoy two favorable tailwinds outside of North America: 1) Three of our key subsidiaries should continue to gain significant market share overseas due to significant, durable advantages they possess over their competitors. 2) There are many populous nations in which we operate that are still far behind the USA in GDP per capita, but they are clearly catching up, and we see no reason why their progress will not continue. An additional reason why we like our global diversity has to do with potential currency/inflation risks associated with the developed world’s high indebtedness. It is interesting and perhaps quite relevant to note that from 1938 to 1985 the value of the British pound declined by nearly 80% relative to the US Dollar. This means that all things being equal, British citizens who invested in the US over this 47-year period enjoyed a 350 basis point tailwind to their annual investment performance from currency alone! Postwar Great Britain may prove an apt analog for the developed economies of today (Europe, Japan and America), while today’s developing nations are perhaps reminiscent of the younger, pro-business, less-indebted United States of long ago. Strong Balance Sheet: We have a very strong balance sheet. Our debt equates to only 2% of our current equity market capitalization. Five of our seven subs have no debt at all, with net cash equaling 9%, 10%, 20%, 28%, and 37% of their individual equity market capitalization. Strong balance

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sheets provide our managers with both defensive safety, and the offensive flexibility to make opportunistic purchases of the company’s own shares, or strategic acquisitions that could accelerate value creation for us as owners. Strong Free Cash Flow: Every one of our current subsidiaries is producing free cash flow equal to its net earnings. It is the unusual, yet highly desirable business that can grow faster than GDP without having to invest additional capital. We are fortunate to own four such businesses and we believe they are meaningfully undervalued right now. Our other three subsidiaries also produce oodles of cash, but for the more mundane reason that they are now relatively mature.

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Good Growth: Before assessing the value of any potential subsidiary, we study every important aspect of its business. Eventually, toward the end of our analysis, we forecast revenues, earnings, and cash flow for the subsequent ten and thirty-year period. Our current expectation is that TAC’s free cash flow will grow at approximately 7.3%, and 4.7% over the next ten and thirty years, respectively. We believe our growth rate expectations are on the conservative side of reasonable. Cheap Valuation: The AltaRock Conglomerate currently sells for 13.6x and 12.5x 2010 and 2011 net earnings, respectively. Since, in our case, net earnings equates to free cash flow, our effective cash flow yield will be 7.7% over the next twelve months. Incidentally, our estimates are more conservative than Wall Street’s, so our realized cash flow yield may, in fact, be a bit higher, if the more optimistic consensus view proves correct. Current Long-Term Return Expectations: As with any investment, our expected return comes down to what we paid compared to the cash flow we will receive over time. As a simple rule of thumb, you can add together the free cash flow yield and the expected long-term growth rate to approximate your expected rate-of-return. In our case, if you add our 7.7% free cash flow yield to our expected 10-year growth rate of 7.3%, you will arrive at an expected return of 15.0% per year over the coming decade. Our actual expected return is 15.3%, as the rule of thumb in this case slightly understates the true math. Some Historical Context: To put our growth, valuation, and return expectations for the AltaRock Conglomerate into some useful context, consider that from 1952 to today the S&P 500 has returned 10.1% (on a nominal basis). This return can be dissected into its two components: cash flow yield (dividends) of 3.4%, and growth (earnings per share growth rate) of 6.7%. Since inflation averaged 4.0% over this nearly 58 year period, the real growth rate was 2.7%, virtually identical to real GDP growth. Real returns to investors were 6.1% (10.1% nominal return less the 4.0% rate of inflation). The 58 years before 1952 were not meaningfully different despite a currency crisis, the Great Depression and two world wars.

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Our businesses will be affected by the overall pace of economic growth, and over the next ten years this is the variable in which we have the least amount of confidence. Over twenty and thirty years, however, we have much higher conviction that economic growth will continue to track along its historical path. We direct you to the chart below that shows real GDP growth per capita for every decade since 1900. The long-term growth rate (+1.8%) is both undeniable and seemingly unstoppable. It is driven by innovation, investment, and the encouraging resiliency of the free market enterprise system. The biggest outlier on the chart, of course, is the Great Depression decade when the US experienced a negative 0.6% growth rate. (Note: real GDP growth is about 1% higher than the real per capita GDP growth rate due to population growth)

One way to think about a potential worst case scenario for AltaRock is as follows: Let’s assume that global GDP is flat or even down over the next ten years – an outcome similar to the Great Depression. What would that mean for us?

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As compared to the historical returns on the S&P 500, AltaRock, today, starts out in a very strong position with a current yield that is 430 basis points higher, 7.7% vs. 3.4%. We also expect our earnings to grow much faster than both, GDP and the S&P 500. Importantly, our growth estimates do not incorporate much, if any inflation, so our 15.3% return expectation is largely a real number.

2) To the extent that our managers do what they are supposed to do and what we expect them to do, which is to use our cash-rich balance sheets and large, recurring cash flows to repurchase shares at depressed prices, we might enjoy an upside bias to that 8% cash flow yield. Stock repurchases allow us to defer taxes, a highly valuable attribute, and to the extent that they are done at significant discounts to intrinsic value, they add even more value. 3) We have great conviction that our businesses will grow meaningfully faster than global GDP, so even if GDP is flattish, we should still enjoy a few extra percentage points of annual return over and above our free cash flow yields.

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4) To the extent that the downside scenario is more extreme, our strong balance sheets, durable competitive advantages, and stable businesses might allow our managers to purchase entire businesses at very cheap prices, which could also add to our eventual return profile. 5) To the extent that governments continue to debase currencies as they have done throughout history, our ownership of solid businesses will surely protect the purchasing power of our wealth. The same cannot be said of today’s fixed income markets, which very much remind us of the post World War II era. Back then the US Government kept a lid on both short and long term rates for a long time in a highly successful effort to inflate away the value of its large war debts. Bond investors, who had done exceedingly well in the preceding twenty years, lost money for the next forty, after considering the impact of inflation. While long-dated Treasuries may do well for a bit longer, if deflation persists or if the Federal Reserve is successful in controlling the long end of the yield curve, over a multi-year period we believe they are almost certainly a loser.

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1) All things being equal, it means we would at least earn our free cash flow yield of about 8%. This is about 500 basis points better than the current yield on 10-year Treasuries and about 600 basis points better than the current dividend yield on the S&P 500. While this would be a disappointing outcome, we still would double our net worth during a period in which most investors will have done much worse.

In Conclusion Nobody, including us, knows the short or intermediate-term direction of the economy, interest rates, the stock market, or individual stock prices. This is a constant. And while we share the general unease many have about the macroeconomic environment, we really feel quite confident that AltaRock’s excellent subsidiaries, talented and trustworthy managers, and cheap valuation will provide us with both enormous safety and powerful wealth generation over the long term. In fact, barring an exceptional rally in our positions over the next twelve days, we believe this is a good time to be adding to your long-term investment in AltaRock. Thank you for the trust you’ve placed in us. We work very hard to continually earn it. Thank you also for your long-term focus, which is a definite key to our success. Please feel free to call us at 978-922-7701 with any questions, comments or investment ideas. To the extent that you would like to introduce like-minded friends or associates to us, we would be thrilled to speak with them and/or mail them relevant materials.

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Sincerely yours, Mark T. Massey, CFA

We hope you are enjoying a wonderful, relaxing summer and we look forward to updating you on AltaRock’s progress early in the New Year.

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