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TAMI Q2 2011

TAMI Q2 2011

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Published by Farnam Street

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Published by: Farnam Street on Jul 17, 2011
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After a significant recovery from the March '09 bottom during which our equity compositesoutperformed, the markets suffered a setback in the last quarter, during which our portfoliosunderperformed from the unusual decline in Canadian small caps
the TSX Venture Exchangedown 17% in the quarter and down 22% from its early March high. Investor psychology in thequarter became excessively negative even though stocks generally, and the companies in ourportfolios, became even more compelling with discernible progress ahead. In our view thecurrent investor mindset does not correspond with what should really matter to an investor.
Mind Games
As the markets declined in the quarter, stocks became significantly oversold from the negativepsychology resulting from the negative headlines. And there were and are many of them: thefinancial rescue of Greece, and the implications for Europe and its other precarious economiessuch as Ireland and Portugal and, now, Spain and Italy too; the potential slowing of the Chineseeconomy;
supply chain disruptions from Japan’s earthquake; poor U.S. jobless numbers; a
higher than expected U.S. trade deficit; continued falling U.S. house prices; a potentialdeadlock in the U.S. budget talks and the debt ceiling debate; the Fed cutting its forecasts foreconomic growth; potential headwinds from government austerity programs; fear of a slowingeconomy; fear of deflation; fear of inflation; rising commodity prices and declining stock prices. A mindset of fear and fear. CNBC recently reported that investors were moreconcerned about the economy than at any other time during the past five years; a CBS pollfound that 39% of Americans believe the economy is in a state of permanent decline. We allknow the mind can play tricks. Risk aversion. That wall of worry. But when perceived risk isso great it is typically reflected more than warranted in depressed share prices.
It’s in the
The news doesn’t have to be good, just not as bad as everyone believes.
What Matters
What matters is that, while global growth has slowed somewhat, all of the global liquidity
should induce increased growth later this year, particularly as China’s tighte
ning ends and
Japan resumes its production and growth, as will U.S. factories. China’s economy still
managed to grow 9.5% in Q2 from a year earlier and India continues strong too. U.S.manufacturing activity picked up in May. U.S. purchasing manufacture
r’s index improved in
June. Industrial commodity prices remain strong. The Dow Jones Transports recently hit anall-time high. U.S. housing sales will improve from prices stopping their decline, fromshrinking loan delinquencies, from low new housing starts, from diminished inventories, frominflationary pressures, from easier credit and, best of all, from affordability. Canadian housingstarts strengthened in June. A record high level of Canadian firms expect to increaseemployment over the next year as sales and investment in machinery continue to rise.
U.S. interest rates are at historical lows and the yield curve remains steep
incentives for newlending. Fed stimulus remains in the system even if the Fed were to stop its asset purchases.And if more monetary stimulus is needed the Fed will supply it, no matter how it equivocates.Meanwhile, personal incomes are rising and U.S. consumers are getting stronger
a savingsrate of 5% in May, and the May PCE price index up 0.3%
an inducement not to deferspending. The ratio of consumer debt payments to incomes is the lowest since '94. TheS&P 500 Retailing Index just hit a record high. U.S. exports should strengthen from the weak dollar and stronger overseas growth. While U.S. unemployment remains high as state and localgovernments shed jobs, private sector job growth is slowly improving
all as it should be.Employment will improve as manufacturing and housing pick up. State finances areimproving
California, New York and Texas, for example. The U.S. debt ceiling will beraised and a favourable deficit-
cutting bipartisan deal reached. Natural tsunamis can’t be
man-made ones can. Global growth should accelerate. Left-wing governmentseverywhere are moving to the centre right and compelled to get their fiscal houses in order,ultimately good for growth and good for business. Short-term austerity for long-term
 prosperity. Or, as value investors prefer, “short
-term pain for long-term gain.
But, for we narrow-minded stock investors, what
matters is that valuations are unusuallycompelling, that monetary conditions are very favourable, and, finally, that the psychology hasbecome sufficiently negative to induce the recent rally. To continue climbing the wall of worry. The big caps first, with the smaller, in typical fashion, immediately following.What really matters to us, as stock investors, are corporate earnings and their future growth,and what we have to pay currently for those businesses. Oh, and what we think others arelikely to pay in the future for the then earnings, in order for us to realize our estimated potentialgain.What really matters to us is that currently our stocks are unusual bargains, many trading at thesame depressed valuations as their March '09 lows. What really matters is that S&P 500forward earnings have risen to a new record high and that the forward multiple dipped below12x in mid-June before the recent rally, when fair value is over 15x. What really matters is thathealthy profits will encourage businesses to invest, hire and grow. And rebuild inventories,currently low relative to sales. And that earnings this year are expected to be up 18% andrevenues 8.5%, year over year.Hays Advisory notes that whenever its dependable Monetary Composite is as bullish as it isnow, over the next 18 months the stock market could be up by over 30%. And its ValuationComposite suggests the odds are high that the stock market will be much higher over the next4-5 years. It believes that bad news is good since it causes stocks to be cheap and monetaryliquidity to be plentiful.
What really matters is that corporations are flush with cash which should allow more capitalspending and employment. And increased share buy-backs, dividends and merger andacquisition activity. And what really matters is that, in terms of protecting purchasing power,stocks are safer than bonds.With earnings right back to their long-term trend line and at all-time highs, the S&P 500 isselling at a 15% discount to our Fair Market Value. Yet, bonds, with paltry yields, remainfavoured by U.S. households and pension funds over equities, so equity allocations are atmulti-year lows. The stock market will be propelled higher by the mountain of cash on thesidelines as the overwhelming fear ultimately abates.We think now is an extraordinarily good time to invest. The large-cap indexes areundervalued. Stocks today are, by far, the preferred asset class compared to bonds and cash.
Our TRAC™ and TRIM™ work are positive— 
a number of markets and sectors appear to haveinflected up from key support levels. And, most important, risk-reward parameters for ourindividual holdings are so highly favourable.
These Stocks Matter
Our current portfolio holdings are below-average risk 
that is, the likelihood of permanentimpairment in those securities is minimal, if at all. Even in our downside analysis we forecastgains.We always look for stocks that are mispriced from being misunderstood or unknown. But inthis correction smaller-cap holdings such as ours appear to be unwanted mostly becausenervous investors prefer the perceived safety of cash. To boot, our four largest holdings hadannouncements in the quarter which led to short-term concerns about the companies. In ourview, these were all temporary issues in those companies which all have below-average risk and significant upside potential. And, inasmuch as our targets have not changed, their currentupside is even higher than at the start of the quarter.
Corridor Resources
declined after Apache, its joint venture partner for its shale gasdevelopment, elected not to proceed with a second stage following poor results from twohorizontal exploratory wells. Corridor believes the wells were drilled incorrectly and the
 partner’s withdrawal did not alter our appraisal of the company. Corridor now intends to
proceed with a pilot project of its own with drilling commencing late this year.We expect Corridor, with or without a new partner, to commercialize the Frederick Brook shaleproject. The size of the prize is enormous and should attract lots of interested parties. And,
given the market’s reaction, it seems to be overlooking the fact that Corridor’s first
targetedshale well, its G-41 well, which Corridor itself drilled vertically, had excellent results. If theinitial flow rates from subsequent Frederick Brook wells are less than half of G-41, and even if gas prices remain depressed, the p
economics are still adequate. Also, both wells drilledby Apache encountered strong gas shows while
drilling. Meanwhile, the company’s reservevalue is in line with the current share price, so we’re getting this project
, and the othersignificant potential of Corridor, free.

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