PSH-Annual-Report

Annual Report Year Ended December 31, 2014we could short credits on which we expected toprofit as the market eventually reassessed theircreditworthiness, when credit events took place, orwhen stocks and bonds generally declined invalue. These were ideal hedges, as the best andleast costly hedge is one which you wouldpurchase as a standalone investment withoutregard to its hedging benefits, but one which alsois likely to increase in value dramatically at times ofmarket stress.We have been unable to identify large singlename,standalone CDS investments since 2009.This is largely due to the rapid improvement incorporate creditworthiness over the last [six] years.Asymmetry in Hedging and InvestingSince the inception of the funds, we havepurchased options which offer asymmetric payoffsin the event of the occurrence of low-probabilitycatastrophic or otherwise unanticipated negativeevents. These events could include largemovements in interest rates, currencies, or otherasset prices that we believe may occur duringperiods of market stress. Most of the options thatwe have purchased that fit this description havehistorically expired worthless. You have not noticedthese losses because the size of thesecommitments has been immaterial.We have committed capital to these investmentsbecause of the potential hedging benefits theyoffer, and also, in certain cases, because webelieve the pricing of the instruments understatesthe expected value of the payoff event. For each ofthese investments, the payoffs have historicallybeen zero or nominal unless there is a largemovement in the underlying instrument, which isonly likely to occur during periods of extraordinarymarket stress. As such, they are not likely toprotect the funds from other than very large marketdeclines, and even then there is no guarantee thatthey will serve their desired function.We have also made asymmetric investments whichare not for hedging purposes but which also offerlarge payoffs on relatively modest commitments ofcapital where we similarly believe that the markethas mispriced the probability of a positive outcome.In some cases, as with GGP, we were able to buycommon stock for less than a dollar per sharebecause the probability of a recovery forshareholders was correctly perceived to be deminimis, but where our active intervention couldmeaningfully tilt the probability of a successfuloutcome in our favor.The Impact of Macro Factors on Our InvestmentSelectionDespite the fact that we occasionally have anopinion, we spend little time trying to outguessmarket prognosticators about the short-term futureof the markets or the economy for the purpose ofdeciding whether or not to invest. Since we believethat short-term market and economicprognostication is largely a fool’s errand, we investaccording to a strategy that makes the need to relyon short-term market or economic assessmentslargely irrelevant.Our strategy is to seek to identify businesses andoccasionally collections of assets which trade inthe public markets for which we can predict with ahigh degree of confidence their future cash flows –not precisely, but within a reasonable band ofoutcomes. We seek to identify companies whichoffer a high degree of predictability in theirbusinesses and are relatively immune to extrinsicfactors like fluctuations in commodity prices,interest rates, and the economic cycle. Often, weare not capable of predicting a business’ earningspower over an extended period of time. Theseinvestments typically end up in the “Don’t Know”pile.Because we cannot predict the economic cycleswith precision, we look for businesses which arecapitalized to withstand difficult economic times oreven the normal ups and downs of any business. Ifwe can find such a business and it trades at adeep discount to our estimate of fair value, wehave found a potential investment for the portfolio.Next we look for the factors that have led to thebusiness’ undervaluation, and judge – based onour assessment of the company’s governancestructure, management team, ownership, and otherfactors – whether we can effectuate change inorder to unlock value. When the price is right, thebusiness is high quality, the management isexcellent, and there are no changes to be made,we are willing to make a passive investment.Our assessment of the short-term supply anddemand for securities plays almost no role in ourdetermining whether to invest capital, long or short.If we believed that it was possible to accuratelypredict short-term market or individual stock pricemovements and we had the capability to do soourselves, we might have a different approach.Over the past [11] years, we have profited notbecause of our predictive powers concerningmacro events, but rather because of our ability toPERSHING SQUARE HOLDINGS, LTD. 21