07 Mar 2011 Sound Shore - 2010 Annual Report ( Portfolio )
Indeed two of our best contributors for 2010, Smith International and Genzyme, were acquisition targets. Oil services provider Smith, which gained 62% after agreeing to be acquired by Schlumberger, was a position we started in 2009 when it was trading below norms on earnings and cash flow and at book value. Our research concluded that Smith’s new senior management team and its industry leading positions in drill bits and fluids appeared poised to produce better than consensus earnings through 2012. Schlumberger, the global leader in oil service, apparently came to the same conclusion and purchased the company to bolster its presence in resurgent North American energy markets. We sold our Smith shares as the stock achieved our target valuation in the first quarter.

Meanwhile, drug developer Genzyme, which we profiled in last year’s annual letter, attracted interest from several potential suitors due to its unrivalled rare-disorder product pipeline and attractive valuation. Genzyme hit our screens in early 2009 when the stock had dropped to an all time low valuation of less than 13 times earnings and under 10 times cash flow following a contamination issue at one of its manufacturing facilities, a not uncommon occurrence in biotechnology. Our review of the company’s pipeline indicated sum-of-the-drugs revenue and earnings growth that was well above sell-side analysts’ expectations that were fixated on the near-term impact of restoring its idle facility. After our initial third quarter 2009 investment, we used the stocks’ subsequent volatility to add to our position so that when, in July 2010, pharma giant Sanofi-Aventis announced its acquisition interest, Genzyme was our biggest holding. Although a transaction had not occurred as of year-end, we sold our shares in the fourth quarter after the stock had achieved our target valuation.

Citigroup was another strong 2010 performer as it outdistanced the lagging financial sector. We built our position in Citi during the latter part of 2009 when the shares were selling for a significant discount to tangible book value and were also depressed by a poorly executed partial sale of the U.S. Treasury’s holdings. In addition to its compelling valuation, we believed Citi’s strong consumer bank, low relative mortgage exposure, and prospectively over-reserved balance sheet could drive better than forecast earnings. During 2010, Citi outperformed as financial results and the complete U.S. government exit from its shares were both ahead of schedule.

On the takeaway side, Apollo Group and Exelon were among our biggest detractors. Apollo, the leading for-profit education company, was lower due to concerns about federal rule changes regarding funding eligibility at its schools. Apollo, valued at less than 10 times 2011 consensus earnings, is likely to emerge a winner in the changing industry environment as it is the only for-profit school system already meeting proposed new requirements for gainful employment. Meanwhile, power generator Exelon declined due to lower natural gas prices and slower than expected demand recoveries in its Midwest and mid-Atlantic markets. Typically, Exelon’s best in class nuclear electric fleet commands a significant valuation premium per megawatt versus coal and natural gas, but due to the severity of the recent economic cycle that premium has all but disappeared. Our view is that management’s efforts to add capacity and cut costs has the potential to yield better than expected earnings power in the next 12-24 months and, following that, differentiated pricing of its unique portfolio of power assets should recur.

Sound Shore’s bottom-up, fundamental research process should be well positioned for the current market environment. Following the big cyclical snap-back from March 2009 to April 2010, company-specific drivers of stock performance appear to have regained relevance which we believe could continue in 2011. Meanwhile, even with S&P 500 earnings poised to set an all-time high in 2011, stocks are almost 20% below the peak levels achieved in 2007 and 2000. The large flow of funds away from stocks and into bonds during the past 24 months has helped to keep equity valuations reasonable to attractive. As well, we are optimistic about our holdings which we estimate have above average earnings growth prospects but, at year-end were valued at 11.7 times 2011 consensus earnings versus 13.6 times for the S&P 500.