The Aspiring Analyst Vol. 1 Iss.

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2010 Review And 2011 Outlook theaspiringanalyst@gmail.com

Dear readers, this is the inaugural copy of The Aspiring Analyst – the title summarizes the purpose of this
letter and my motivation for writing. I am an aspiring analyst (associate) at a Toronto sell-side boutique
(not owned by the big 6 Canadian banks). Through these periodic letters, I hope to provide analysis and
ideas that you may find useful in forming your own investment decisions. In the process, I hope to
improve my investment analysis skills.

First, a little introduction on my background: I began dabbling in investments early in my undergraduate

days and witnessed both the boom and bust of the great technology bubble. I then proceeded to lose a
shirt day-trading on Bollinger oscillators and other technical patterns in between my engineering
degrees. At Stanford, where I received a master’s of engineering degree, I took an introductory finance
course taught by Professor Anat Admati that literally opened my eyes to the world of finance. I learned
about CAPM and Modigliani and Miller and I was hooked.

To further my education, I enrolled in the CFA program (I have since completed all 3 levels and am
accruing the necessary work experience to use the designation) and found a job at a Canadian bank in
their technology department, implementing trading systems for Credit Derivatives (before CDSs gained
infamy). I also worked briefly on a Capital Structure Arbitrage trading desk (finding arbitrage
opportunities between credit and equity derivatives) for the bank before going to the Rotman School of
Management for an MBA. In between my work and my MBA, I lost a second shirt looking for arbitrage
opportunities (I seem to have a knack for losing money while waiting to start school).

At Rotman, I had the pleasure of studying under Professor Eric Kirzner in his Value Investing course and
got to meet Warren Buffett, which was the highlight of my MBA studies. Witnessing the boom and bust
of the tech bubble and experiencing disappointing personal results from technical and arbitrage trading,
I find myself gravitating towards the value investing philosophy of Benjamin Graham and Chris Dodd.

I am not soliciting for the management of your investments nor seeking to provide investment advice. I
merely wish to present my views of investing and how I manage my personal portfolio. If you wish to be
added (or removed) from the distribution list, please send an email to theaspiringanalyst@gmail.com.
Comments and questions are always welcome. Disclaimers and disclosures can be found at the end of
this letter.

Yours sincerely,

Jason Chen
The Aspiring Analyst

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2010 Review And 2011 Outlook theaspiringanalyst@gmail.com

The Year That Was...

As we step into the New Year, we find it useful to reflect back on the year that was. When we began
2010, our major fear was that the U.S. and possibly the world would fall into a double-dip recession as
government stimulus programs (such as the U.S. First Time Homebuyer Tax Credit) around the world
wore off. We believed the U.S. consumer was over-leveraged, and in the process of de-leveraging,
would negatively affect consumer spending. This would crimp export growth in emerging countries such
as China. We believed in a world of artificially low interest rates and with the threat of deflation,
investments providing safe and sustainable yields will become in-demand and sought after. We thought
natural gas prices will make a comeback after a dismal 2009 as demand normalizes and low prices curtail
further investments in exploration and development. Most of our forecasts for 2010 were wrong.

We did not expect the flash crash in May, nor the European Union sovereign debt crisis. We did not
expect the record credit expansion in China (7.5 Trillion Yuan), nor the worldwide surge in commodity
prices as exporters raced to satisfy China’s voracious appetite. If you had told us at the beginning of
2010 that the U.S. economy would require a second round of quantitative easing by the Federal Reserve
and yet the S&P500 would rally 13% Y/Y, we would have asked what you were smoking.

However, we believe being wrong after carefully analysis is far superior to being right for the wrong
reasons. Our 2010 experience reminds us that history never plays out as we expected, and we would
caution the reader against anyone who would claim otherwise.

Portfolio Performance
Portfolio* S&P/TSX** S&P500**
2008 -15.3% -35.0% -38.5%
2009 15.2% 30.7% 23.5%
2010 29.4% 14.4% 12.8%
* 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.

In 2010, our long-only equity portfolio provided satisfactory returns of 29.4%, mostly on the back of our
investment positioning heading into 2010. We also capitalized on several unique stories during the year.
Our notable successes of 2010 include:

• Income Securities - one of the few investment themes that we got right in 2010 was that in a
low-interest rate world facing the threat of deflation, investments with high and sustainable
yields would become in-demand. Based on this analysis, we started looking for high-yielding
equities in late 2009 and throughout 2010 with sustainable yields. Characteristics we looked for
was a non-cyclical base business with expanding earnings and cash flow and a conservative
payout ratio to support a high yield. For example, one such security that we added to our
portfolio in late 2009 was Northland Power Income Fund (NPI.un-TSX; we sold NPI towards the
end of 2010 due to price appreciation). Northland Power is one of the largest Canadian
independent power producers (IPP) with generation capabilities in thermal, wind, hydro and
solar power. When we first added Northland, it was paying an annualized $1.08 distribution and

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yielding approximately 10% with a strong development pipeline and a payout ratio just under
100%. Over the next several quarters, investors began to realize the stability in Northland’s
operating results and development potential and gradually bid the yield down to 7%.

At that point, we decided to exit our position because we became concerned about Northland’s
payout ratio, which had been consistently been over 100% throughout 2010. Management even
publicly stated in its Q3 MD&A Outlook that cash distributions were expected to exceed
distributable cash until H2/2013, yet management intends to aggressively pay out distributions,
maintaining its $1.08 distribution post conversion to an income-tax paying corporation in early
2011. In effect, the company will run-down its cash balance and increase leverage if necessary
to maintain its current level of distributions/dividends. This went against our personal rules on
capital preservation and safety, hence we decided to sell.

• IC Potash (ICP-TSXV, still in our portfolio) was introduced to us by the Special Sits / Agriculture
analyst at our firm. While mining companies are not within our area of expertise, what
interested us about IC Potash was its niche market and cheap valuation to potential value.

ICP is a development stage mining company targeting the niche agriculture market for Sulphate
of Potash (SOP, aka Potassium Sulphate) fertilizers. SOP’s main difference from traditional
Muriate of Potash (MOP, aka Potassium Chloride) fertilizers is the absence of chloride, which
can become toxic to crops at high concentrations. SOP also dissolves more slowly than MOP and
hence is a better fertilizer in areas with heavy rainfall. In the 5 MM ton global market for SOP,
approximately 25% of global production is produced by primary producers who have access to
low-cost feedstock such as natural lake brines that can be evaporated to precipitate out SOP.
Over 50% of production is supplied by secondary (marginal) producers who must first purchase
MOP and then react it with sulphur-based chemicals to create SOP. Due to the nature of SOP
production – with more than half of the market being marginal producers who must use MOP as
a feedstock, combined with the benefits of using SOP over MOP, SOP is generally priced at a
premium to MOP.

ICP intends to become a primary producer of SOP by mining polyhalite (a mixture of potassium,
magnesium and calcium sulphates) from its Ochoa project in New Mexico as a feedstock to
produce SOP. In ICP’s proposed process, Polyhalite is mined, pulverized, heated and dissolved in
water to create high-concentration potassium sulphate brines that will then be solar evaporated
to produce SOP. Although the full process has not commercially tested, the individual steps are
based on proven technologies and reputable third parties have confirmed the production
process. If ICP is successful in achieving commercial production of SOP through its polyhalite
process, it will become one of the lowest cost primary producers of the premium SOP fertilizer.

While it is difficult to value such an early stage development opportunity, with a market cap of
less than $40 MM at the time of our investment versus a project NPV north of $1 BB (based on
published NI43-101 reports), we believe the risk-reward was very compelling. Note, this is a
‘speculative bet’ and not a pure ‘investment’, in the sense that there is a significant risk of

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capital loss (we will spend some time in the future discussing our distinction between a
speculative bet versus an investment).

• At the beginning of October, as the world debated the anticipated size of the U.S. Federal
Reserve’s QE2 program, we recognized that the price of gold and gold related equities would
rally significantly from the fear of the Fed ‘printing money’. At the same time, we saw that the
shares of Canadian gold miner, Allied Nevada Gold Corp. (ANV-TSX, no longer in portfolio) was
selling at abnormally depressed levels relative to the price of gold and its peers. We developed a
small call option position (readers are cautioned to carefully understand the risks involved in
option trading strategies) to benefit from the perceived mispricing of the equity. Within a
matter of days after the Fed announced its $600 BB QE2 program, the underlying stock price
corrected itself and we were able to realize a significant return on our initial investment.

And to make sure we remain humble, here are our top 3 mistakes of 2010:

• One of our biggest mistakes of 2010 was also related to the Allied Nevada trade mentioned
above. While we correctly anticipated the rally in gold and gold-related equities, we were caught
off-guard by the size and strength of the rally. As the value of our options continued to rise, we
panicked and sold off the position far earlier than originally planned, ultimately realizing a
return far less than if we had held onto the position. This example shows that fortitude to hold
onto a trade, especially in good times, is critical to long-term investment success. Given the
confidence we had in our analysis of both the equity and the macro environment, we should
have maintained the position.
• We are always on the lookout for arbitrage opportunities, and we thought we had found one in
Crown Gold Corp. (CWM-TSXV, still in our portfolio), which is a micro cap gold exploration
company with interests in Ontario and Nevada. The main reason why we liked CWM was
because CWM has a 20% working interest in Trelawney Mining Corp.’s (TRR-TSXV) Chester
project (CWM exchanged 80% interest in the Chester and Yeo projects for a 50% option on the
Benneweis project, all in the Timmins area of Ontario) where recent exploration success has
allowed TRR to raise C$57 MM in capital and valued TRR in excess of C$250 MM. Our thinking
was, if TRR was worth C$250 MM mostly because of Chester, then a 20% interest in Chester
should be worth C$40 - $50 MM. CWM was (and is still) valued at less than $10 MM.

The fallacy of our reasoning, we’ve come to realize, is that the valuation of Chester is not
something tangible. It requires continued exploration and development by TRR. CWM equity is
really a call option on the Chester project – either Chester becomes a viable gold mine (with
economically recoverable resources) and our call options will be in the money, or it doesn’t and
our call options will be worthless. We thought we had spotted an arbitrage opportunity
(ensuring safety of principal with a satisfactory return), but in fact, it was a speculative bet
(although one we still like).

• With our natural gas view, we had decided to take positions in several Western Canadian oil and
gas companies that were trading at depressed levels because of their heavy weighting to natural

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gas. One such company was Iteration Energy, which was acquired in 2010 by Storm Ventures
(and the combined entity is now known as Chinook Energy, CKE-TSX, still in our portfolio). While
it was great that our thesis was proven correct in this case – Iteration was taken out at a
premium to our investment, our big mistake was misreading the management circular (or in our
case, not bothering to read it carefully enough). The announced deal was that each share of
Iteration would receive either 0.5631 SVI (Storm Ventures Inc., the acquisition vehicle which
converted into CKE shares) shares or cash consideration of C$1.83, or a combination of cash and
common shares of SVI. We elected to take the default option, which was receiving shares of SVI,
to delay capital gains taxes.

However, instead of getting C$1.83 worth of Chinook shares, we ended up C$1.41 worth. How?
Because the transaction gave each Chinook share an implied valuation of C$3.25. However, on
the first day of trading, Chinook shares closed C$2.50. Even shareholders who elected to receive
shares and cash (C$1.05 + 0.24 share) got at most C$1.65 for their shares of Iteration. In
retrospect, we should have taken the all cash offer and ran. How the investment bankers could
have mispriced the transaction by 30% ($3.25 vs. $2.50) and why the exchange ratio was not
adjusted is beyond our understanding.

We will endeavour to be more careful the next time a takeover circular comes our way.

2011 Macro Outlook

We have read many investment forecasts for 2011, and we would not attempt to make our own
predictions. On the whole, Wall Street economists appear to be ‘bullish’ while a minority such as David
Rosenberg appear to be ‘bearish’. Perhaps both sides are simply talking up their books. Nonetheless, we
are siding with the bearish camp heading into 2011 for the following reasons:

1. Markets appear overbought

Equities have been on a tear since the fall, and investor confidence is near all-time highs.
When everyone is bullish and have already bought equities, who is left to buy some more?
Note in the following figure, we are currently above sentiment levels in May 2010 and
December 2008.

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Source 1: www.pragcap.com

2. China is in a bubble

For those who haven’t seen the scale and extent of the Chinese real estate investment
bubble, please go to: http://www.businessinsider.com/pictures-chinese-ghost-cities-2010-
12#.

GDP = C + I + G + (X-M). By fuelling real estate investments through cheap credit, China has
been able to maintain its 10% GDP growth rate. But at what cost? Who thinks building an
empty city of Inner Mongolia (Ordos) is productive besides boosting GDP through
investments? Put it this way, total Chinese loans outstanding grew by about 7.5T Yuan in
2010, or US$1.1T. Probably all of this went into investments. Yet, China’s $5T economy only
grew by 10%, or $500BB. So the GDP multiplier was less than 0.5 on these new investments.
Although we are not sure what is a ‘normal’ multiplier for investments, we believe it should
be greater than 1.

China is caught in a conundrum with few positive outcomes. If the government does not rein
in credit growth, the real estate and investment bubble will continue to grow, fuelling social
unrest between the ‘haves’ and ‘have-nots’, creating a bigger problem down the road. If it
tackles the problem and pops the bubble by reducing the amount of lending, the millions of
‘haves’ (whose wealth is tied to rising real estate prices) will suffer (and many of the ‘haves’
are government officials themselves!), negatively impacting consumption and GDP growth.
Not to mention the Trillions in loans the Chinese banks have lent to support this bubble. If
you had thought the U.S. bank bailout was huge in relation to the country’s GDP, wait until
Chinese loans start going sour.

3. Europe is a mess

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We don’t even know where to begin. As we understand it, the problem in Europe stems
from countries with vastly different economies and governments trying to use the same
monetary policy. Different countries have different symptoms, but it’s the same underlying
problem. Cheap credit fuelled a real estate boom (and bust) in Ireland. Cheap credit fuelled
a real estate boom (and bust) in Spain. Cheap credit fuelled a government borrowing binge
in Greece.

Although the near-term collapse of Greece and the Irish banking sector was averted with
the ESF bailouts, we think this is a solvency problem and not a liquidity problem that can be
solved by something like the ESF. The Greeks have agreed to austerity cuts, but will it be
enough to stave off default? Will the Irish public agree to bail out their banks and suffer
years of austerity cuts? (Ireland will have an election in March that may allow the Irish
people to say ‘No’ to bank bailouts.) Will Belgium need to be bailed out? Portugal? Spain?
Italy? What about France, masquerading as a fiscally sound nation on par with Germany?
Will Germany get fed up and exit the European Union? There are so many problems being
papered over in Europe, we think it is a major area of concern in 2011 and beyond.

4. U.S. is back to normal?

People look at the U.S. economy growing between 2 – 3% and say things are back to normal.
What they forget (or purposely overlook) is that in order for the economy to grow as feebly
as it has in 2010, the U.S. government had to go into a US$1.4T deficit or 9% of GDP. How is
this good news? Remember, earlier in the year when the Federal Reserve tried to withdraw
stimulus, the U.S. market promptly tanks to S&P 1,022 by July 2.

With the unemployment rate still above 9% and underemployed rate at 16.7%, it will be
many years before the U.S. economy reaches full employment again, if ever (read the latest
FOMC notes). We have read that it will take 5 years of 2.5 – 3 MM new jobs / yr for the U.S.
economy to get back to full employment (with 5 – 6% unemployment rate). The U.S. has
never seen more than 2 such years in a row!

Let’s not forget how the current U.S. administration completely disregarded its own
bipartisan Deficit Commission’s findings and extended the Bush-era tax cuts for everyone for
another 2 years. Will the U.S. ever balance its books? Pundits say, don’t worry. The USD is
the world’s reserve currency. The U.S. has a greater ability to borrow than anyone. True and
true. But if we read Reinhart and Rogoff’s “This Time Is Different” properly, governments
can continue to finance themselves until they can’t. Bond vigilantes don’t send you a
warning before they strike.

For those that want to lose sleep at night, please read the CBO’s Long-Term Budget Outlook
http://www.cbo.gov/ftpdocs/115xx/doc11579/06-30-LTBO.pdf.

These are just some of the biggest problems keeping us up at night. There are other problems, such as a
potential housing bubble in Canada (Mark Carney seems to think Canadians is over-leveraged),

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Australia’s housing bubble, a potential war in Korea (could it be good for weapons manufacturers?),
U.S./Israel relations with Iran, Japan’s 200% government debt to GDP (the chicken will come home to
roost sooner or later), and so on and so forth.
On the other hand, the following could provide positive surprise to the markets in 2011:
1. Continued commodities boom supports Canada (and Australia)

As long as the commodities boom lasts, Canada will continue to reap its benefits. Record
high prices for base and precious metals have the potential to drive returns for Canadian
markets, which has a large plethora of listed mining companies.

In our opinion, the main reason Canada (and Australia) has fared so much better than the
U.S. is not because we have genius central bankers and regulators (although the media likes
to put it that way). Rather, it is because the rise in commodities helped lift employment and
the Canadian economy. The underlying structural issues in the Canadian economy actually
did not improve – house prices are at or near record highs and are increasingly unaffordable
for the working-class.

2. QE3?

Intervention by the central banks and governments of the world has put a floor on how low
equities can go. The argument is that ‘higher than they otherwise would be’ asset prices will
lead to a wealth effect. To us, this sounds wrong. We don’t like to spend more money just
because the value of our shares or house has gone up – it’s not real money that I can spend
until I sell. If unemployment remains above 9% in June when the current round of
quantitative easing expires, will the Federal Reserve decide to do another round? We think
there is a real possibility of QE3 (and 4, 5, 6, 7), so we would not want to be short equities.

Our investment themes for 2011

In a world with so much uncertainty, we think it is prudent to be conservatively positioned and not to
use leverage (we will never use financial leverage in our investment portfolio because the downside far
outweighs the upside to us). Our portfolio currently has a 40% cash balance, and we had been running a
35 – 45% cash balance for most of 2010. We expect this will continue for most of 2011 as well.
Cons. Disc. Materials &
5.1% Agriculture
10.4%
Utilities
Technology 0.0%
0.0%
Cash
Mining 40.7%
10.2%
Media &
Telecom
3.4%
Industrial
Cons.
6.9%
Staple
Financial 9.7%
7.9% Energy
5.7%

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As always, we think value investing (buying securities below their intrinsic value) will be rewarding, as
markets will eventually recognize a security’s true value. Aside from value investing (which is getting
harder as central banks refuse to allow securities to fall for an extended period of time), we think there
are still niches where profits can be made in 2011 despite our gloomy macro outlook above. We will
highlight two themes below:
1. It is our belief that sustainable yields will continue to be an actionable investment theme in
2011, as central banks across the world will be loath to increase interest rates for the
foreseeable future, lest they be accused of stifling nascent recoveries. However, as we see it, the
pool of potential investment opportunities is rapidly drying up as investors have recently bid up
the prices of high yielding equities, regardless of their quality or intrinsic value. Investors who
wish to follow this investment theme should make sure that the potential investments can
sustain their dividends and are not in cyclical industries. Between two companies, one paying a
5% yield with a 50% payout ratio versus the other paying a 9% yield with a 90% payout ratio, we
believe the 5% investment is better for most investors, as it provides safety and peace of mind.
Benjamin Graham once wrote that ‘far more money has been lost in search of yield than at gun
point’.
2. In an economy that is looking to grow 2 – 3% in the coming year, M&A may become a key
source of growth for companies. We have read that the S&P 500 companies have more than
US$900 BB in cash on their balance sheets, so look for some of this cash to be used for
acquisitions. Our approach would be to find strategic assets that are good businesses by
themselves, but may be more valuable to a competitor or a related industry player.

Bottom Line

Hopefully, you have found some of our analysis thoughtful, if not useful. We have been working on this
letter for over a week now, and it is time to send it out. Once again, questions, comments and
suggestions are most welcome.

Disclaimer: Our goal through this blog is to provide analysis and ideas that you, the reader, might find useful in forming your
own investment decisions and hopefully improve our analytical skills in the process. We are not soliciting for the management
of your investments nor seeking to provide financial advice. The Aspiring Analyst blog and letters will not take responsibility for
any investment losses incurred by readers through the trading of securities and strategies mentioned in this blog or its
accompanying letters. The views expressed in this blog and its accompanying letters reflect the author(s) personal views about
the subject company(ies) and its (their) securities. The author(s) certify that they have not been, and will not be receiving direct
or indirect compensation in exchange for expressing the specific recommendation(s). Readers are cautioned to seek financial
advice from qualified persons such as a Certified Financial Planner prior to taking any action in regards to the securities and
strategies mentioned in this blog or its accompanying letters.