Almost Time To Be Greedy Another Month, another handful of crises Greece, US, Italy, Spain.

The Aspiring Analyst Vol. 1 Iss. 7 theaspiringanalyst@gmail.com

It appears Buttonwood1 summarizes it best: Governments of the rich world have painted themselves into a corner with their fiscal and monetary stimuli that does nothing to solve the underlying problems of an overextended credit cycle. By not allowing economies to go into recession, governments will one day create a recession so great that the Great Depression would look like a stroll in the park by comparison. This months newsletter will be relatively short, as we are in the midst of quarterly reporting, but we feel its important to speak out on a couple of topics. So here goes.

Jason Chen The Aspiring Analyst

The Economist, retrieved August 6, 2011: http://www.economist.com/node/21524886

Almost Time To Be Greedy Where To Begin?

The Aspiring Analyst Vol. 1 Iss. 7 theaspiringanalyst@gmail.com

In an eventful month filled with macro-economic events, it is hard to find a starting place. Where should we begin our discussions? How about the breaking news that the S&P has finally downgraded the United States credit rating to AA+? http://www.zerohedge.com/news/sp-downgrades-us-aa-outlook-negative-full-text

Good for the people at S&P, at least they are showing some backbone and independence (although this will likely lead roil global markets next week). Unlike the other two international rating agencies such as Fitch and Moodys, S&P actually followed through on the much deserved downgrade of United States credit rating. We have reproduced S&Ps rationale (and highlighted relevant sections) below: We lowered our long-term rating on the U.S. because we believe that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process. We also believe that the fiscal consolidation plan that Congress and the Administration agreed to this week falls short of the amount that we believe is necessary to stabilize the general government debt burden by the middle of the decade. Our lowering of the rating was prompted by our view on the rising public debt burden and our perception of greater policymaking uncertainty, consistent with our criteria (see "Sovereign Government Rating Methodology and Assumptions," June 30, 2011, especially Paragraphs 36-41). Nevertheless, we view the U.S. federal government's other economic, external, and monetary credit attributes, which form the basis for the sovereign rating, as broadly unchanged. We have taken the ratings off CreditWatch because the Aug. 2 passage of the Budget Control Act Amendment of 2011 has removed any perceived immediate threat of payment default posed by delays to raising the government's debt ceiling. In addition, we believe that the act provides sufficient clarity to allow us to evaluate the likely course of U.S. fiscal policy for the next few years. The political brinksmanship of recent months highlights what we see as America's governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy. Despite this year's wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge, and, as we see it, the resulting agreement fell well short of the comprehensive fiscal consolidation program that some proponents had envisaged until quite recently. Republicans and Democrats have only been able to agree to relatively modest savings on discretionary spending while delegating to the Select Committee decisions on more comprehensive measures. It appears that for now, new revenues have dropped down on the menu of policy options. In addition, the plan envisions only minor policy changes on Medicare and little change in other entitlements, the containment of which we and most other independent observers regard as key to long-term fiscal sustainability. 2

Almost Time To Be Greedy

The Aspiring Analyst Vol. 1 Iss. 7 theaspiringanalyst@gmail.com

Our opinion is that elected officials remain wary of tackling the structural issues required to effectively address the rising U.S. public debt burden in a manner consistent with a 'AAA' rating and with 'AAA' rated sovereign peers (see Sovereign Government Rating Methodology and Assumptions," June 30, 2011, especially Paragraphs 36-41). In our view, the difficulty in framing a consensus on fiscal policy weakens the government's ability to manage public finances and diverts attention from the debate over how to achieve more balanced and dynamic economic growth in an era of fiscal stringency and private-sector deleveraging (ibid). A new political consensus might (or might not) emerge after the 2012 elections, but we believe that by then, the government debt burden will likely be higher, the needed medium-term fiscal adjustment potentially greater, and the inflection point on the U.S. population's demographics and other age-related spending drivers closer at hand (see "Global Aging 2011: In The U.S., Going Gray Will Likely Cost Even More Green, Now," June 21, 2011). Need we say more? Yes, we do. $2.4 Trillion Is A Drop In The Bucket The main problem with the US is the massive amounts of entitlements that have been promised to its citizens but have yet to be funded. Sure, the debt ceiling increase2 voted in by the US Congress on Tuesday may have reduced future deficits by $2.4 Trillion (ignoring the fact that the actual agreement punts the task of actually finding the areas to cut to future Congressmen and that the CBO calculates the deal only reduces the deficit by only $2.1 Trillion3), but the figure just pale in comparison to the $64 Trillion that have been promised but not yet funded. We think Bill Gross has written one of the most succinct pieces on this issue. We highly encourage everyone to read it: http://www.pimco.com/EN/Insights/Pages/Kings-of-the-Wild-Frontier.aspx

There is absolutely nothing different between the US government and its $64 Trillion in unfunded liabilities and GM/Chrysler and their Billions in unfunded health plans and pensions. Eventually, the piper needs to be paid. Every Week... It certainly seems like every week, another crisis erupts in Europe. Not long after the EU agreed on the second 159 Billion Greek Bailout4 (with European politicians claiming that the debt crisis would be contained5), we now have a fresh crisis with Spanish and Italian debt requiring ECB intervention6. When

Bloomberg, retrieved August 5, 2011: http://www.bloomberg.com/news/2011-08-02/senate-votes-today-on-u-sdebt-compromise-amid-doubts-over-impact-of-plan.html 3 CBO, retrieved August 5, 2011: http://www.cbo.gov/ftpdocs/123xx/doc12357/BudgetControlActAug1.pdf 4 The Telegraph, retrieved August 5, 2011: http://www.telegraph.co.uk/finance/financialcrisis/8653634/Greece-todefault-as-eurozone-agrees-159bn-bailout.html 5 The Telegraph, retrieved August 5, 2011: http://www.telegraph.co.uk/finance/financialcrisis/8652781/Eurozoneleaders-to-give-rescue-fund-power-to-stop-contagion-spreading-in-indebted-nations.html

Almost Time To Be Greedy

The Aspiring Analyst Vol. 1 Iss. 7 theaspiringanalyst@gmail.com

will central bankers and politicians realize that the problem in Europe is not liquidity (which can be solved by central bankers buying up debt) but solvency (which can only be solved by a slow and painful deleveraging phase)? The longer these band-aid solutions drag on, the longer the real problems fester and the worse the eventual outcome will be. How Come No One Makes A Big Fuss When Japan Does It? What also caught our attention this week was news that both Switzerlands and Japans governments intervened in the currency markets to artificially weaken their currencies to maintain competitiveness7. Our question is, how come no one, especially the US, makes a big fuss when it is Japan or Switzerland artificially increasing their exporters competitiveness, yet all hell breaks loose when its China doing it? Just a thought. Was He Just Lucky? This week, we also came across an article stating that John Paulson, of subprime CDS fame, is down 21% for the year in his flagship Advantage Plus fund, before the epic collapse of the last few days8. This begs the question, was he just in the right place at the right time to have plucked the subprime bubble? Investors who have piled into Paulsons funds the last few years (taking John Paulson from a middling merger-arb specialist into multi-strategy asset management behemoth) have no one to blame but themselves for the losses they have sustained while investing with Paulson. Once again, past performance is not indicative of future results. If the manager running our merger-arb allocation wanted to bet the house on subprime CDS, we should consider withdrawing our money, not giving him more. Portfolio Performance: 2012 Has Been Ugly
Portfolio* S&P/TSX** S&P500** -15.3% -35.0% -38.5% 2008 15.2% 1.4% 1.6% 2009 29.4% 14.4% 12.8% 2010 -8.8% -9.5% -4.6% YTD 2011 * Portfolio Returns are calculated as compounded monthly returns with inflows counted as end of period flows, i.e., a $10,000 portfolio with a $1,000 intra-period inflow and $500 increase in value will show a monthly return of 5.0% ($500 return on beginning of period $10,000). ** Index returns are calculated as simple differences between end-of-year index levels without accounting for dividends.

Finally, we turn to yours truly. Results for the past few months have been abysmal. If we were investing your money, you should demand a refund. Having just marked our books prior to writing this newsletter, we are down 8.8% for the year, vs. 9.5% for the TSX and 4.6% for the S&P500 (MTD, we are

Bloomberg, retrieved August 5, 2011: http://www.bloomberg.com/news/2011-08-05/europe-struggles-to-tamecrisis-as-ecb-bond-buying-fails-to-halt-contagion.html 7 Bloomberg, retrieved August 6, 2011:http://www.bloomberg.com/news/2011-08-04/japan-follows-switzerlandin-intervening-to-stem-currency-s-appreciation.html 8 Financial Post, August 6, 2011: http://business.financialpost.com/2011/08/04/another-rough-month-forpaulsons-hedge-funds/

Almost Time To Be Greedy

The Aspiring Analyst Vol. 1 Iss. 7 theaspiringanalyst@gmail.com

down 3.6% vs. 6.0% for the TSX and 6.5% for the S&P). This is clearly an unacceptable level of performance given our portfolio has been at or above 40% cash for most of 2011. We have made a number of costly investments (at least on an MTM basis) in 2011, including: Ram Power (RPG-TSX; we no longer hold any position in the stock), as discussed previously we suffered terrible timing in our RPG investment Cline Mining (CMK-TSX; we currently own shares of Cline); we continue to believe that a 3 MM tpa metalurgical coal producer with ~$100 cash cost should be worth somewhere in the vicinity of $1.0 BB (assuming $200 met coal price, operating CF / ton should be ~$100, or annual cash flows of $200 - $300 MM, applying a 4x 5x valuation multiple gives ~$1.0 BB), or $5 / sh. The snag at Cline has been a slower than expected production ramp, compounded by a weakened global economic picture. On the positive side, the company continues to explore an expansion in the mine to 6 MM tpa, which should boost value above $6 / sh. Investors with a stomach for volatility should consider Cline. Bank of America (BAC-NYSE; we own shares and call options on Bank of America); our sum of parts analysis values BAC at between $20 - $25 / sh, assuming the US economy normalizes in a reasonable time frame. The problem at BAC has been legacy claims from the GSEs, compounded by a weak US economy. We increased our investment in BAC after we saw the Companys investor day presentation highlighting pre-tax earnings power of $35 BB - $40 BB per year, or $2.15 to $2.509 (note, the presentation is no longer available as originally presented). Assuming analysts are correct in their estimates (consensus estimate for BAC in 2013 is EPS of $1.90) and assuming the stock trades at 10.0x forward earnings (historically, BAC trades between 7x to 13x forward earnings), we should come out slightly ahead in our overall position. Our one worry right now is whether BAC has to take a larger than expected charge for mortgage repurchase costs10 and whether these costs will force the company to issue cheap equity and dilute the potential upside for current shareholders. Time will tell whether we are correct on BAC.

Almost Time To Be Greedy While the current market volatility is troubling to many market watchers, we are actually quite delighted that market dislocations appear to be forming which will allow us to capitalize on undervalued securities. We will end this months newsletter with one chart and one quote from our favourite investor, Warren Buffett: Investors should try to be fearful when others are greedy and greedy when others are fearful. - Warren Buffett, Berkshire Hathaways 2004 Chairmans Letter

Wall Street Journal, retrieved August 6, 2011: http://blogs.wsj.com/deals/2011/03/09/bank-of-america-investorday-five-takeaways/ 10 Bloomberg, retrieved August 6, 2011: http://www.bloomberg.com/news/2011-08-04/bank-of-america-seesclaims-rising-from-fannie-mae-for-mortgage-buybacks.html

Almost Time To Be Greedy

The Aspiring Analyst Vol. 1 Iss. 7 theaspiringanalyst@gmail.com

Figure 1: Investor Sentiment. Source: Pragmatic Capitalism.

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