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David Rolfe Wedgewood Partners Fourth Quarter Letter to Investors

January 29, 2013 | About:
Holly LaFon

Holly LaFon

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Review and Outlook During the 4th quarter of 2012, our Composite declined -.01%. We (barely) outperformed our benchmark, the Russell 1000 Growth Index (-1.32%), as well as the Standard & Poor's 500 Index (-.38%). For the year, we are quite pleased to report that our Composite gain of +21.6% outperformed both the Russell 1000 Growth Index (+15.3%) and the Standard & Poor's 500 Index (+16.0%).

Our leading 4th quarter performance contributors were Cummins (+18.1%), Varian Medical Systems (+16.4%) and Charles Schwab (+12.8%). Our top lagging performers were Apple (-19.9%), Express Scripts (-13.8%) and National Oilwell Varco (-14.5%). For the year, our top performance contributors were Gilead Sciences (+79.4%) Apple (+32.6%) and Visa (+50.5%). Our top lagging performers were Expeditor's International (-2.0%), Varian Medical Systems (+4.6%) and Schlumberger (+3.0%).

We were relatively busy during the recent quarter. We bought Priceline and Monster Beverages. We trimmed our positions in Google and Visa. We added to existing holdings in Apple. Over the course of 2012 we added just two others, Charles Schwab in January and Coach in July.

2012 began as most years do on Wall Street – brimming with optimism. Economists expectations of GDP growth started at 3.5% and fell steadily throughout the year to stallspeed growth just 1.5%. Wall Street analysts (hard to find a more consistently exuberant bunch of folks on the planet) began the year expecting earnings growth of 12% and steadily fell throughout the year to a piddling 1%. Indeed, while there was plenty of classic hand wringing, "wall-of-worrying" news and events throughout the year (recession fears, European debt crisis fears, recession fears in China, plunging consumer confidence), the stock market (Standard & Poor's 500 Index) climbed that wall and posted a very solid gain of +16%. Yet, to the chagrin and angst of most portfolio and fund managers 2012 will go in the books as year most would rather forget. Just as 2011 was a tough year for active managers, 2012 was more of the same. According to Goldman Sachs, 49% of Large Cap Growth outperformed their respective benchmarks. Only 35% of Large Cap Core did the same. Large Cap Value fund managers brought up the rear with only 20% outperforming their benchmark in 2012. Not to be outdone, 88% of hedge funds underperformed their benchmarks too.

Despite all of the noise that investors had to filter through in 2012, individual stock returns were quite orderly when it came to corporate earnings growth expectations. Mr. Market was unusually kind to those stocks that the biggest increases in earnings expectations – and woe to the stocks with the largest decreases in earnings expectations. If we had to hazard our best prospective forecast for 2013, we are wont to believe that changes in earnings expectations may have an even greater impact than in 2012. Our reasoning behind this is pretty straightforward. Corporate America has been "lean and mean" for quite a few years now. That's the good news. The bad news is that Corporate America has little room to get leaner. Even seemingly small changes in corporate margins can have an out-sized effect on earnings. Corporate margins peaked at 10.3% in the fourth quarter of 2011. The have "only" dropped to 9.7% by the third quarter of 2012. This relatively small decline significantly accounts for the concomitant flattening in earnings growth over the past twelve months. Unfortunately, 9.7% is still quite high by historical measures. In our view, "earnings cliffs" are more problematic for the broad stock market than either "fiscal cliffs" or "debt ceiling cliffs."

John and Jane Q. Investor have been beyond fed up with of the stock market. Surviving the dot.com bubble-bust was one thing, but suffering through the housing-credit bubble was simply too much to bear. Investors have made their mind up to get out of the stock market, period. So, despite double-digit returns in the stock market, 2012 will set a record for equity mutual fund redemptions. Net equity fund outflows are expected to reach -$160 billion. The former record for redemptions was set last year at -$148 billion. Since 2007, investors have redeemed nearly $630 billion in equity mutual funds.

Conversely, over the last twelve years, net cash inflows into bond funds are approximately $1.5 trillion. Maybe bonds do have more fun? (Note to contrarian self: As this Letter is being written we get the news that the most recent weekly inflows into equity mutual posted their second biggest week ever at $22 billion – just in the nick of time in a bull market entering its fifth year.)

Our view of the current investing environment is largely unchanged from our thoughts over the past year. The Great Bull Market of 2009-2012 marched on, but with increasing head winds from a weaker macro environment, non-stop lowering of said earnings expectations and increasing angst on the political front (elections, fiscal cliff, debt ceiling, etc.). While such "macro-driven" markets have seemed to become the norm over the past few years, and to the frustration of most investors, our focused approach to investing need only be fed by a few exceptional opportunities to move the needle in our portfolio. That said, we do share (unfortunately) the ever-growing consensus view that major moves in the stock market will continue to be driven as much by D.C. legislative proposals, debates, brinksmanship, fights (ad nauseam), rather than the usual mix of corporate earnings and changes in both interest rates and economic growth. The new, new normal of politics is the direct relationship between the ever-growing margin of victory at both the congressional districts and state level that is proportional to the growing political divide. Said another way, our political divisions throughout the country are manifested in the very hard-Left and hard-Right politicians We-The-People elect and send to D.C. In addition, while the advent of daily politically-centric cable and TV shows, magnified through the amplifier of innumerable raucous politically-centric internet websites and blogs may seem that our country's two-party system has become completely unhinged, even a cursory reading of history shows that most of the current political spit and vigor is old hat. This marvelous country of ours was founded on a debate and argument. We Americans do love this participation sport!

Federal Reserve policy will continue to take center stage. Beyond the academic discussion of the systemic change in the proper role of the price signaling of interest rates in a normally functioning economy, given the fact that the Fed is "loudly" purchasing $85 billion of bonds every month is it any wonder that the bond bull market has made bond bears truly extinct. Since the beginning of 2009, the world's six largest central banks have collectively issued six trillion dollars' worth of IOUs in a herculean attempt to offset private sector deleveraging. According to David Rosenberg of Gluskin Sheff, before the onset of the Fed's Quantitative Easings, the change in the Fed's balance sheet had a long-held 20% correlation with the S&P 500. Yet, since 2009 that correlation has spiked to an astonishing 85% - eclipsing the historical relationship between stocks and corporate earnings. Who would have ever thought that bonds are purchased (speculated?) for capital appreciation and stocks are now purchased for income?

So, what's an investor to do? Our best answer is to stay laser-focused on those industries and companies least affected by the legislative whims of D.C. and be prepared to take advantage of those sure to come events of politically driven market volatility. Indeed, our last three purchases (Coach, Priceline and Monster Beverages) are instructive on this point. These three terrific companies share a key profitability attribute that the vast majority of companies (public or private) could only dream of – the ability to generate returns on assets consistently above 25%-30%. Utilizing the Morningstar stock screener, we screened the 1,515 domestic companies with a market cap of greater than $5 billion that generated a return on assets of at least 20% found only 19 companies. Your Fund owns six of these beauties – Apple, Coach, Monster Beverage, Priceline and Verisk Analytics. To think that Mr. Market served up three of these companies in a single year – wonderful! The lesson? Focus on best-of-breed companies, not worst-of-breed politicians.

As we enter 2013, we find our portfolio of companies with growth expectations and profitability metrics meaningfully higher (about 45-50%) than the Standard & Poor's 500 Index, yet our portfolio is valued near par with the same. As we often remark, we like such odds.

Philosophy and Process

For over 20 years and across several macroeconomic cycles - including a technology/telecom bubble and a credit/housing bubble, Wedgewood Partners has managed risk and pursued reward by thinking and acting like successful business owners, which means that we are particularly concerned about whether or not we are going to lose money on an investment and we look forward to being rewarded by the long-term appreciation of equity relative to underlying the appreciation of business fundamentals.

Of course, this "business owner" approach seems like common sense, partly because so many managers claim to invest this way. Their frantic portfolio turnover tells another tale entirely. However, we think we are unique because noticeably absent from our approach of focusing on business ownership is any attempt to manage the volatility of the underlying securities - which is not to say that we ignore the prices of stocks. Instead, we do not believe that short-term fluctuations of market prices are very good at discounting the long-term trajectory of business fundamentals, so we do not attempt to characterize, much less manage, risk with this framework. Indeed, we welcome shortterm volatility in stock prices for the ample opportunities Mr. Market throws our way.

In lieu of managing volatility, which often requires wide diversification, we choose to manage only our best ideas. Given that we are a long-only strategy, the primary way that our portfolio positions will add value is if they appreciate, which is in-line with what we think a business owner would expect. For example, our focused approach of owning less than two dozen holdings, yields a portfolio where, as of 12/31/2012, every position is overweight, relative to the weightings in the Russell 1000® Growth Index, and most positions by several hundred basis points. Conviction trumps needless overdiversification.

That is contrast to owning underweight positions, which, for a long-only portfolio, primarily add alpha when they depreciate, which begs: if the holdings mostly add value when they depreciate, why own them at all? There are several reasons for this, but the most normative answer has something to do with managing volatility and very little to do with thinking and behaving like a business owner. As we have oft remarked over the years, temperament, not I.Q., is the most propitious attribute of successful investors.

In executing our philosophy, we employ a rigorous but thoughtful, bottom-up research process, where we typically manage to uncover fewer than two dozen uniquely profitable, financially stable, growth businesses that are trading at attractive prices. Sustainably higher profitability, relative to competitors, is a particularly important feature of the companies in our portfolio. We think higher profitability is evidence that a company is able to keep competitive threats (i.e. the pressure for a dollar of profits) - at bay. When determining the sustainability of this profitability, we not only analyze and consider rivals as a threat, but also suppliers, customers, substitutes and potential rivals; they all exert pressure on a company's profit and loss statement and/or capital base. So we think that it is critical that our companies exhibit and maintain a compelling "competitive advantage," or unique attribute that can sustainably keep those threats in check.

For example, Apple has a return on invested capital profile that is consistently superior (by orders of magnitude) to the vast majority of its competitors. So we ask ourselves if that level of profitability sustainable and if it is, what, specifically, drives that sustainability. According to our research, Apple has long been the superlative vertically integrated seller of consumer electronics, particularly computers, smartphones and tablets. By "vertically integrated" we mean that Apple designs, manufactures and integrates the hardware and software for all of its devices. This approach contrasts with competitors that either design hardware or outsource software (e.g. Samsung) or design and license software, while outsourcing hardware (e.g. Microsoft). It would not surprise us if both Samsung and Microsoft knew that Apple's vertical integration was the driving engine behind its profitability. So why not just copy it? As we have found, a company like Microsoft is competitively positioned in such a way that would make it extremely risky for them to overhaul the way they currently do business.

Consider, if Microsoft decided to mimic Apple's vertical integration, then the original equipment manufacturers (OEM) that equip their hardware with Windows would no longer be supplier partners, and instead convert to direct rivals. While the OEM and Microsoft would still be competing for a dollar of profitability, it would be a vastly different dynamic that could potentially jeopardize Microsoft's vitally important supply chain. That is the potential risk that we believe Microsoft would face in order to mimic Apple and we think that is an unlikely scenario. In fact, so desperate, in our view, that Microsoft has become of late by entirely missing the paradigm shift of the mobile internet (and the significant threat it poses to their business model) that their current strategy with their Surface tablet strategy is positioned as a direct competitor with many of their key OEM partners. Redmond, we have a problem! Of course, there are several companies that Apple competes with for a dollar of profitability, not just Microsoft, but this is an important exercise that is part of our process to uncover competitively advantaged businesses.

Company Commentaries

During the quarter, the Fund outperformed the benchmark, in part due to positive performance from Charles Schwab, Priceline.com and Monster Beverage. Performance detractors included National Oilwell Varco and Apple.

We think Charles Schwab continues to exhibit a low cost advantage relative to competitors in the financial services industry, with non-interest expenses as a percentage of total client assets of 0.19%, as of the first three quarters of 2012, according to management. This has led to pre-tax profit margins in excess of 30%, which is a multiple of some of the most well established wealth management platforms in the world. We think that this abnormally low expense rate emanates from Schwab's focus on leveraging its information technology infrastructure. In contrast, we think too many of Schwab's rivals rely on more expensive and less efficient human capital to gather assets. The stock continues to trade at a historically low price to book ratio, though that is somewhat offset by a higher forward price to earnings ratio. We think both valuation metrics are somewhat misleading in this historically low interest rate environment and in the event of a rising interest rates, the Company's earnings would likely expand at a very rapid rate, primarily due to money market fund fee waiver relief. So we continue to believe Charles Schwab represents an excellent balance between business quality and valuation.

Priceline.com was added to the Fund during the 4th quarter and after a multi-month decline from the stock's all-time high. Priceline.com is an online travel agency made up of a several of online properties such as TravelJigsaw, Agoda and, of course, Priceline.com, but generates the vast majority of its profitability from its internationallyfocused, hotel booking site, Booking.com. We think that Priceline.com has been able to generate superior ROIC, relative to its peer group, because of its rapidly increasing scale in the international hotel industry, which is a highly fragmented market. Rather than face the daunting task of advertising across several different languages, cultural preferences and mediums, over 200,000 of these international hotels have turned to Booking.com to list inventory.

In turn, this inventory consolidation has made Booking.com much more relevant to more international travelers, with the site hosting over 30 million unique visitors per month, a multiple of the site's closest rivals, as we estimate. This traffic has built up over the years, particularly as the Company has aggressively reinvested in a formidable search engine optimization program, particularly with Google, and boasts that a relevant search term by a customer almost always places Booking.com ads at the top of Google searches. Priceline.com's online advertising budget routinely exceeds 25% of gross profits and in the most recent 12 months they spent over $1 billion, most of it on search engine optimization, so this visibility is expensive but very few competitors have the resources and scale to achieve it.

We think Priceline.com's opportunity for double-digit growth is robust, as they have tapped into only a fraction of worldwide hotel supply and demand. Also with its ample financial strength, the Company recently purchased Kayak, a travel-focused search engine that drove over 10% of Priceline.com's traffic during the past 12 months, at a cost of a little more than 5% ($1.8bn) of Priceline.com's market capitalization.

However, the Fund also has a sizable position in Google, so Priceline.com introduces competitive overlap risk, but we think it is minimal. For instance, if we assume Priceline.com's entire online marketing budgets were allocated to Google; it would amount to less than 3% of Google's trailing 12-month operating profit. So while the two Companies are competing for the same dollar of profitability, we see it as an acceptable level of risk, given the vast potential of their respective businesses.

We also added Monster Beverage Corp. to the Fund during the quarter. For over 20 years, prior to a name change in January 2012, the Company was known as Hansen Natural Corp, with roots tracing back to the 1930's. Currently, Monster Beverage primarily manufactures beverages that compete in the alternative beverage industry, with a particular focus on the energy drink category.

Branding and innovation are both extremely important elements to Monster's consistently superior ROIC generation, relative to a competitive field that includes offerings from such branding masters as Coca-Cola and PepsiCo. Monster's early entrance into the US energy drink market in the mid 1990's coincided with its rival Red Bull's entrance. The latter was the first energy drink to reach critical mass on an international scale but, importantly, implanted the idea of beverage functionality into the minds of consumers around the world. This functionality continues to be a defining element for this category and typically includes twice as much caffeine per ounce relative to conventional carbonated soft drinks (CSDs), in addition to supplements such as taurine and B-group vitamins. This energy boost continues to command a handsome premium on a per-ounce basis, relative to CSDs, as an 8.3 ounce can of Red Bull retails for around the equivalent of 35 cents per ounce, while Monster Energy is about half of that and CSDs closer to about 5 cents per ounce.

Now, we recognize that competing on pricing alone is a very poor long-term strategy, however, Monster Energy's large discount to Red Bull dates back, effectively, to the Brand's inception, circa 1997, when Monster's management recognized the enormous pricing power that Red Bull exhibited relative to CSDs. However, instead of offering a similar tall and slim 8.3 ounce form factor, Monster chose to offer a much larger and more ostentatious 16 ounce can, but for the same price as an 8.3 ounce Red Bull - effectively 50% cheaper. Monster Energy's new form-factor and discount was instrumental for driving visibility as the Brand quickly gained critical mass at the expense of (and passive abetment from) a more established rival. Over the past 10 years, Monster Beverage has sold more than 8 billion cans of Monster Energy, at the same time, several rivals, that include PepsiCo and Coca-Cola, have mimicked Monster's larger form factor and pricing strategy, but with unit sale results that are a small fraction.

Monster's form-factor and pricing strategy were pioneering elements to the energy drink category, however, the Company continues to meticulously curate the Monster Energy brand by exclusively focusing on unconventional marketing mediums and innovative offerings. For instance, through the first 11 months of 2012, new products drove almost one-third of Monster's US unit growth. The Company recently launched a noncarbonated, low-carb, energy drink line, Monster Rehab, that includes tea-based and noncitrus flavors, and has quickly become one of the Company's most successful products, we estimate generating almost 10% of US gross revenues during 2011, after launching in February of the same year. Further, Monster's brand awareness is cultivated through non-traditional mediums, with, we estimate, less that 10% of the Company's marketing budget dedicated to conventional mediums such as radio, television, newspaper and online. Most of the Company's marketing focus is on audiences of unconventional and emerging sports such as motocross, BMX racing, snowboarding, skiing, Formula 1 and Professional Bull Riders. This is in contrast to many of Monster's rivals that typically apply more conventional methods to their marketing efforts.

We think that there is ample room for growth as the Company's sales represent less than 25% of the US energy drink market, yet Monster recently became the market share leader in the US, in terms of units sold. Outside of the US, there is a very large, untapped market where in many countries. Currently, about 20% of Monster's gross sales are generated outside of the US. Despite having populated international countries for an average of about 3 years, Monster has already generated unit sales that are a quarter of Red Bull's, while Red Bull has over 20 years experience in international markets. We think Monster's rapid market share take is a testament to the international portability of the Brand and the market's ability and willingness to support two large players, many years into the future.

When it comes to the global oil service business National Oilwell Varco is truly a jackof- all-trades. Over the many decades the Company has been uniquely successful through countless mergers and acquisitions by both vertically and horizontally integrating their plethora of products and services. Indeed, the Company has been so successful in offering a global one-stop-shop that their well-known industry sobriquet is "No Other Vender." The Company traces its roots to its founding in antebellum Houston in 1841. The Company's two main predecessors, Oilwell Supply and National Supply were founded in 1862 and 1893, respectively. Varco took its formal name in 1915 from three key partners – Edgar Vuilleumiere, Walter Abegg and Baldwin Reinhold. Fastforwarding into the 20th century finds Oilwell Supply acquired by U.S. Steel in 1930 and in 1958 Armco Steel merged with National Supply. In 1987, National Supply merged with USS Oilwell to become National Oilwell. The Company finally took its current name and form when in 2005 National Oilwell and Varco merged to become National Oilwell Varco.

The Company's current, and enduring competitive advantage must be credited to the singular foresight and vision of CEO Pete Miller. Miller began his career at the Company in 1996, and was named CEO in 2001. Miller foresaw that the oil service business was woefully wedded in the past philosophy of custom drilling rigs and related custom repair parts and services. His revolutionary view was that manifold advances in oil well productivity and efficiency could be achieved via standardization. Furthermore, the first-mover advantage of the company which could lead the consolidation of this fragmented industry would be uniquely positioned – potentially reaping the benefits of less severe boom-bust orders, capturing a greater percentage of contract bill-of-goods and a concomitant stream of annuity-like service and repair part revenues. Miller and team thus began an orchestrated 15-year string of +300 deals – including nearly $6 billion over the past 18 months alone. Keystone Miller acquisitions include the $2.4 billion acquisition of Varco in 2005 and the $7.4 billion purchase of Grant Prideco in 2007.

Fast forward to late 2012, the Company stands astride the global oil services industry like no other. Leveraging over 800 worldwide manufacturing, sales and service centers, National Oilwell Varco is a global leader in providing major mechanical components and integrated solutions for both land and offshore drilling rigs. Post-Macondo, the Company's integration of deep-sea rig technology, with the magnified emphasis of safety, has put the Company in a class by itself. In addition, with a growing panoply of 139 brands, which include complete land drilling and well servicing rigs, tubular inspection and internal tubular coatings, drill string equipment, extensive lifting and handling equipment, and a broad offering of downhole drilling motors, bits and tools, as well as supply chain services through though the Company's network of distribution service centers, all located near major drilling and production activity, it is literally impossible to drill or operate an oil well or rig without calling Houston. The tale of the standardization-consolidation tape underscores Miller's vision. Little more than ten years ago the Company could only scratch out middling single-digit pre-tax operating margins. Over the past few years the Company has consistently generated pre-tax operating margins of around 19%-20%. The Company has also cut their financial leverage by 25% over the past decade. Returns on equity and invested capital have doubled has well.

The stock was essentially flat in 2012 reflecting the continued decline in North America in both oil and gas rig count. U.S. rig count has doubled since the mid-2009 bottom, plus (according to CFO Clay Williams) an "unprecedented surge" in U.S. oil production has created a "new parsimoniousness…sweeping through the North American oil complex." Rig counts are down over 168 since the beginning of 2012. Due to an over-supplied market and "fierce" price competition the Company's new North American rig orders have ground to a halt.

A notable bright spot in North America is the Company's omnipresent in the booming shale industry – which continues to be a unique American success story. The EIA recently reported that due to the surge in U.S. energy production (led by North Dakota and Texas) net oil imports in 2012 would account for little more than 40% of U.S. oil consumption – the lowest dependence in foreign oil since 1992. The oil production in Texas has doubled over the past three years and has reached a level of output last recorded in 1987. Not to be outdone, Pennsylvania's natural gas production has quadrupled since just 2009. A renaissance is emerging in the cost-competiveness in U.S. manufacturing due to the "flipping of the energy equation" with abundant and cheap natural gas. Credit such cutting edge technology such as expanded horizontal drilling and hydraulic fracturing. National Oilwell Varco is a leader in both technologies. (On a related note: Berkshire Hathaway owned Burlington Northern railroad expects to boost daily crude-oil shipments in 2013 by 40% to 700,000 barrels – in large part from Bakken shale. In addition, Union Tank Car Company – which is owned by Chicago-based Marmon; which in turn is 60% owned by Berkshire – is scrambling to increase their +80,000 fleet of leased tank cars).

However, outside of the gloom in North America, the Company has reported extensive customer activity in nearly every corner of the globe. Key international markets include Argentina, Kuwait, Algeria, Saudi Arabia, Brazil, Oman, Iraq and Indonesia. The Company has increased its investments in Eastern Europe, Russia, Africa and Latin America. The sweet spot for the Company continues to be deepwater offshore. New technologies are driving the fleet growth of next generation large deepwater rigs. Once again, from CFO Williams, "Shipyards are underemployed, hungry, and aggressive on pricing. Deepwater day rates are high and rising. Capital is available and cheap. Construction time is shortening, and execution risk is approaching zero, at least for our customers. Importantly, this situation has been stable for eight-plus quarters, and our deepwater drilling contractor customers seem to be exhibiting a growing confidence with what we hope is a new era."

We remain cognizant that the oil 'bidness is not for the faint of heart – for both companies and investors. We also continue to be of the opinion that the best business models in this industry are the best-in-technology-class service companies. We believe we own two of the very best in both National Oilwell Varco and Schlumberger. That said, when it comes to the shares of such companies, we continue to give wide berth in swings of valuation in our purchase and sales – particularly our purchases. While the valuation of the Company shares are, in our opinion, not demanding at current prices, we require a larger margin of safety to increase our current holdings.

Miller will be retiring in 2013. In our opinion, the Company is in good hands with a depth and breath of seasoned executives. Company veteran CFO Clay Williams will take the reigns as the new COO. Miller's legacy and culture is firmly ensconced at the Company. Fittingly, Morningstar named Miller as their CEO of the year. As homage to Rockefeller's Standard Oil, Miller's last act as CEO should be the renaming of National Oilwell Varco to Standard Oilwell.

2012 was the year that Apple was "out-sized." In our 24/7/365 world of non-stop information flow, 2012 was a bandwidth firehouse when it came to Apple. The vitriol between Apple "fan-boys," who believe that the Company can do no wrong and Apple "haters," who believe that the Company's best days are behind them, reached a new high (low?); even the firing of a top executive quickly led to rumored plotlines and intrigue worthy of Shakespeare. More than previous years, it seemed that anything and everything associated with Apple was out-sized, which included the Company's early year earnings "beats" and its late year earnings "misses," the stock's early year gain and its late year decline, as well as the Company's product successes (iPhone and iPad mini) and perceived product failures (iOS Maps). The naysayers are absolutely sure that Steve Jobs would have never released such a flawed product as iOS Maps. Furthermore, Steve Jobs was absolutely convinced that a smaller version of the iPad would be a flawed product. Well.

The learning curve of iOS Maps has not been as steep as initially believed, and the iPad mini is such a success that the Company is feverously ramping up supply production to meet out-sized demand. But even for Apple bulls like ourselves must admit and recognize that the "expectations bar" is higher for the Company than literally any of their competitors. Early versions of Mobile Me, iCloud and, yes, iOS Maps have not been "insanely-great" – not even close. So while we agree that Apple is far from blemish free, we do ardently disagree with the knee-jerk verdict that the Company, post-Steve Jobs, must be irrevocably on a path similar to Polaroid's decline and demise post-Edwin Land. The opposing view/question will the Company's future be more similar to the growth and prosperity of Disney post-Walt Disney? In our view, Apple circa-2012, it is far too soon to tell. But both tales are worthy of our study and conjecture.

So, if we can pull ourselves out of the gravitational pull of all-things-Apple, we will try to summarize our views and opinions on both Apple the company and Apple the stock. In our opinion, Apple-the-company continues to operate at a level that is quite unique (and envy) in the annals Corporate America. The Company exited fiscal 2011 (September) with a revenue base of $108 billion – up 66% over 2010; and an earnings base of $26 billion – up 85% over 2010. So, despite all of the strum und drang during 2012, Apple generated revenue, earnings and earnings per share growth of 44%, 61% and 59%, respectively. 2012 return on invested capital at +42% speaks to the Company's unrivaled competitive position. Even after spending billions on capital expenditures, the Company still generated $41 billion in free cash flow – an increase of 38%. The 1st National Bank of Cupertino is now sitting on Ft. Knox-like pile of liquid assets of more than $120 billion. Assuming just single-digit growth rates in the Company's free cash flow generation will put Apple's cash-liquidity hoard in excess of $200 billion by mid-2014. How big is $200 billion? The current market caps of both Google and Microsoft are approximately $225 billion.

Driving this stellar performance, in our opinion, was no more than "business-as-usual" for the Company. The global expansion of the Company's Mac and iOS ecosystem of products (iPhone, iPad and iPod Touch), services, iCloud and the App Store - intertwined with their +390 industry leading stores – continued to facilitate the growth of new customers, as well has the repeat purchase of tens of millions of loyal Apple customers. Indeed, this uniquely competitively advantaged asset of Apple – backboned with +700,000 Apps, +400 million iOS users and +200 million iCloud users – was the driving force of the sale of over 200 million iOS devices in 2012. Not to be out done by the success of iOS, the Company's Mac franchise continues to grow at multiples of PC growth. In fact, given that +80% of Mac unit sales are laptops – and with the launch of the App Store on Mac OS, plus the ubiquity of the iTunes Store on Macs – the line between Macs and iOS devices has become intentionally blurred.

China will be the short list of focus for the Company in 2013 – and beyond. As recently as 2009, China accounted for about $770 million in sales. In fiscal 2012, China generated $22.8 billion for the Company. Apple currently has eleven stores in China – six were opened just last year. Per capita, Apple only has one store per every 216 million people in China. The Company expects to significantly exceed its initial goal of 25 Apple stores in the future. The Company also has a network of over 2,000 authorized offline specialty retailers. In terms of context, there are over 3,700 KFC restaurants in 700 cities across China; Starbucks has more than 570 locations in China. According to McKinsey Insights China report on "Understanding China's Love for Luxury," the luxury market in China is projected to reach $27 billion by 2015 – or as much as 20% of the global luxury market. The iPhone is a unique status symbol in China, particularly among youths. Indeed, the average smartphone user in China is 22 to 24 years old, compared to 35 to 40 years of age in the U.S. China could well be the Company's largest market in little more than three years.

The Company exits 2012 with a complete product refresh – the oldest hardware product in Apple's portfolio is a mere 5 months old. Apple-the-stock has been on a roller coaster ride for all of 2012. At the stock's 2012 peak the shares were up 74% - and finished 2012 -28% off of the mid-September highs. During the Company's winter of discontent, consensus expectations for fiscal 2013 have fallen over the past few months and are now just 10% greater than the $44 per share the Company earned in 2012. The steep decline in the Company's expected 2013 growth rate embedded in current earnings expectations is far too dire in our opinion. In addition, with the stock currently at $520, the market implied revenue growth at current prices infers a deleterious decline in the Company's competitive position. But if in fact consensus expectations do come to pass, the stock is currently valued at little more than 10X 2013 earnings. In our view, the stock possesses an asymmetric risk/reward profile worthy to be the Fund's largest holding.

On behalf of Wedgewood Partners we thank you for your confidence and continued interest. We hope these Letters give you some added insight into our portfolio strategy and process. As always, please do not hesitate to contact us if you have any questions or comments about anything we have written in our Letters.

Sincerely,

David A. Rolfe, CFA

Chief Investment Officer

Dana L. Webb, CFA

Senior Portfolio Manager

Michael X. Quigley, CFA

Portfolio Manager

The information and statistical data contained herein have been obtained from sources, which we believe to be reliable, but in no way are warranted by us to accuracy or completeness. We do not undertake to advise you as to any change in figures or our views. This is not a solicitation of any order to buy or sell. We, our affiliates and any officer, director or stockholder or any member of their families, may have a position in and may from time to time purchase or sell any of the above mentioned or related securities. Past results are no guarantee of future results.

This report includes candid statements and observations regarding investment strategies, individual securities, and economic and market conditions; however, there is no guarantee that these statements, opinions or forecasts will prove to be correct. These comments may also include the expression of opinions that are speculative in nature and should not be relied on as statements of fact.

Wedgewood Partners is committed to communicating with our investment partners as candidly as possible because we believe our investors benefit from understanding our investment philosophy and approach. Our views and opinions include "forward-looking statements" which may or may not be accurate over the long term. Forward-looking statements can be identified by words like "believe," "expect," "anticipate," or similar expressions. You should not place undue reliance on forward-looking statements, which are current as of the date of this report. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events or otherwise. While we believe we have a reasonable basis for our appraisals and we have confidence in our opinions, actual results may differ materially from those we anticipate.

The information provided in this material should not be considered a recommendation to buy, sell or hold any particular security.


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