2011 Report Card C+

The Aspiring Analyst Vol. 2 Iss. 1 theaspiringanalyst@gmail.com

As you can see from the title of this note, 2011 was not a great year for your analyst. While our portfolio modestly beat the TSX index, it did so in an ugly fashion, by losing money and by having half of the portfolio in cash. All in all, this was a major letdown from last years performance. In this issue, we will review some of the comings and goings in our portfolio, as well as the 3 main concerns on our minds at the moment: Canadian housing, Europe, and China. We will also discuss some investment themes heading into 2012. So without further ado, lets jump right in. Yours sincerely, Jason Chen The Aspiring Analyst

2011 Report Card C+ Portfolio Performance

The Aspiring Analyst Vol. 2 Iss. 1 theaspiringanalyst@gmail.com

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 -10.2% -11.1% 0.0% 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.
2008 - 2011 Monthly Sharpe Ratio* Portfolio TSX S&P500 Nasdaq 0.16% (0.36%) (0.35%) (0.01%) 4.51% 5.36% 5.95% 6.76% 0.03 (0.07) (0.06) (0.00)

Avg. Monthly Excess Return Std Dev of Montly Excess Return Sharpe Ratio

* Sharpe Ratio calculated as expected excess return over 5-yr Government of Canada bond yields divided by standard deviation of excess returns.

We give our investing performance of 2011 a disappointing C+; passing grade for beating the index, but disappointing for losing money. In 2011, our long-only equity portfolio generated a disappointing return of negative 10%, slightly ahead of the S&P/TSX, but significantly behind the S&P500. We are slightly comforted that our portfolio continues to generate better risk-adjusted returns than the indices, as measured by the Sharpe ratio. Our portfolio had higher excess returns and lower volatility than all indices. However, this is small comfort indeed. Our notable successes of 2011 were: Traditional Value Investing we harvested some gains on two traditional value investing ideas identified in late 2010. These were Global Railway Industries (GBI-TSX; wound up in October) and Bennett Environmental (BEV-TSX). In both instances, we identified companies trading at or near their cash value (net-net) and took small positions. In the case of GBI, our gains were substantially less than originally anticipated, as Management was able to privatize the operating assets at a substantial discount to their on-going values. We tried in vain to raise the issue, but were ignored (how unfortunate). Bennett is an ongoing story. With almost $1.60 in cash, the company remains extremely cheap, trading at just $1.80. In good times, with its thermal oxidation plant running, the company should be able to generate $15 20 MM in EBITDA. The snag is that it must stock-pile remediation materials before it is economical to restart the plant, so for all of 2011, the plant sat idle. The good news is that remediation is expected to restart in Q1/2012, so there should be some cash flow coming in soon. Moreover, Management continues to search for opportunities to deploy its $60 MM in cash (although they have been saying this for the past year and had run into a nasty power struggle with its major shareholders over the deployment of this cash). We continue to hold a small position in BEV, as its shares are simply too cheap to ignore (even a modest 3x EV/EBITDA multiple on the operations gives over $1.00 in value per share, plus the optionality of the cash).

2011 Report Card C+

The Aspiring Analyst Vol. 2 Iss. 1 theaspiringanalyst@gmail.com

Income Securities Our income-focused names continued to perform well, particularly Canadian Helicopters Group Inc. (CHL.A-TSX). We originally purchased shares of CHL in the low teens with an almost 10% yield at a 50% payout ratio. CHL provides helicopter services to many sectors such as mining and oil and gas exploration. They also provide helicopter services to the Canadian and U.S. arm in Afghanistan. Early in 2011, CHL announced the acquisition of Helicopters NZ Ltd., an operator of helicopter services in New Zealand and Australia in a bid to expand its global footprint. With attractive synergies between the two operations (for example, helicopters can be shipped from Australia and New Zealand during their offseason to service Canadian customers), we expect the Company to continue generating solid results. We expect the combined company to generate over $80 MM in EBITDA, which should value the shares at over $27 at 6x EV/EBITDA. There is also potential upside from high margin military contracts or more M&A transactions.

And to make sure we remain humble, we will list our top 3 investing mistakes of 2011: Ram Power Group (RPG-TSX), which we talked about in our March and April newsletters, taught us the importance of risk management and stop losses. We initial bought into the RPG story because of its significant discount to the intrinsic value of its near-term projects. With a NAV of over $3.00 per share, we thought the stock was undervalued at $1.91. After we took our initial position, the company promptly announced development delays and cost overruns, which dropped the NAV of the project to somewhere around $2.00 per share and forced the ouster of its CEO. Furthermore, with the company quickly running out of cash to fund its development, fear of an equity issue kept the stock price depressed. Sure enough, the Company announced a $70 MM equity raise in late April and at this point, we finally had had enough with the Company and decided to call it quits at $0.73, for a stunning 60% loss in two short months (costing us almost 2% of our portfolio). Although the loss was painful, it did prompt us to re-evaluate our margin of safety criteria for resource/commodity-like investments, which hopefully will serve us well in the future. Towards the end of November and early December, RPGs stock price has fallen to less than $0.25 per share, at which point the NAV of the San Jacinto project alone was worth over $0.90. With such a high margin of safety, we re-initiated a small position in RPG and have been promptly rewarded, as the company announced the mechanical completion of phase 1 of the two-phased San Jacinto project. As SJ starts to produce power and development continues on Phase 2 (due in December 2012), we expect the discount to NAV to gradually dissipate. Failing to buy pharma stocks In August, as the world was reeling from S&Ps downgrade of the United States, we foresaw a period of heightened volatility and had spotted some decent value in the Pharma space: Eli Lilly (LLY-NYSE) had traded down to $35, Pfizer (PFE-NYSE) was at $17 and Astra Zenecas ADRs (AZN-NYSE) were trading at $41. We knew there would be a flight to safety trade, as investors bought consumer staples such as pharma stocks. But what prevented us from pulling the trigger were doubts on the valuation of intellectual property. With a looming patent-cliff (expiry of key drug patents) for many companies, we were frankly unable to value 3

2011 Report Card C+

The Aspiring Analyst Vol. 2 Iss. 1 theaspiringanalyst@gmail.com

the companies portfolio of drugs and development pipeline. Ultimately, we missed out on a 1520% rally in pharma stocks. That hurt, especially in a weak year. Too much cash Based on our 2011 outlook, we had kept extremely high levels of cash for most of 2011. This was both a blessing and a curse. On the one hand, cash meant we had ample liquidity to transact quickly if we saw value. On the other hand, it also meant we had to accept a near 0% return on almost half of our portfolio. Ultimately, our doomsday forecast of 2011 did not come to pass, and we were not able to scoop up any true bargains. The key question we have to ask ourselves at this point is whether our margin of safety requirement is too stringent (causing us to pass up some decent valuations)? For example, recently, the highly cyclical stock GMP Capital (GMP-TSX) had traded to the $6 level. We believe the Company is able to earn a normalized $1 per share (through a cycle), and at 12x P/E, we would be willing to take a bet in the high $5 to low $6 range. Unfortunately, the stock never reached our trigger point before rallying by over 25% to the high $7s. Although we know we are better off staying true to our principles and rules, it is hard to stomach.

2011 - What A Year That Was 2011 was certainly a rollercoaster ride. Can you believe that the S&P500 travelled 3,240 points to end the year essentially unchanged? Neither bull nor bear can be satisfied with what has transpired, but that is why once again, we remind readers not too put too much faith into market seers (yours truly included) who claim to be able to foresee the future. There is no point recounting what happened in 2011, since countless other analysts would be doing that. Instead, well start the year by looking at some of the current issues on our mind: Canada, Europe and China. Is Humpty Dumpy About To Fall? Is the Canadian housing market about to fall? Many economists and journalists have been increasingly vocal about the Canadian housing market, some calling it a bubble while others are saying it is merely over-valued. Readers of this newsletter will know my position on the matter (incidentally, my wife and I are considering purchasing our first home. Talk about not eating ones own cooking! We understand the risks but we are not viewing it as an investment. We dont buy the standard argument that paying rent is like throwing money away or paying someone elses mortgage. Economically, renting is the right move for many reasons, including financial flexibility, mobility and ease of maintenance just call the landlord!). However, for those who still view Canadian real estate as a good investment, we offer a few anecdotes: Just before New Years, we saw an article in the Toronto Star, detailing the travails of an investor in the Trump hotel and condo project - http://www.thestar.com/business/article/1108666--starexclusive-distraught-trump-condo-buyer-wants-out?bn=1. Apparently, Ms. Batista bought 2 units in the project on assignment (pre-construction from some other investor, in this case, from the sales director of the project herself talk about conflict of interest!) worth $2.4 MM, and 4

2011 Report Card C+

The Aspiring Analyst Vol. 2 Iss. 1 theaspiringanalyst@gmail.com

now wants to back out of the deal. With the project facing a two-year delay and the condo market souring in Toronto, Ms. Batista wants to wiggle out of her contract to acquire the two luxury condo units. Incredulously, the single mother of three claims that I thought Id be able to get a Trump tower suite for less than everybody else. I didnt think Id get rich. I just thought Id make a little money and maybe have a place to retire someday. Were sorry, but thats reality; there is no free lunch. Real estate, just like any other asset class in the world, can fluctuate in value. If you, as an investor, choose to buy pre-construction condominiums hoping to flip them for a profit, you must accept the risk that the projects may be delayed and that the condos may be worth less than what you paid for them. Real estate pumpers point out that the Toronto condo market is going to be fine, because with the rental markets so tight, as soon as their pre-construction units are finished, they will be able to rent them out. According to the CMHCs Rental Market Reports for Toronto1, the apartment rental vacancy rate is an incredible 1.3% and the secondary market (condos for rent) vacancy rate is even lower, at 1.1%. How plausible are these figures? Lets focus on the secondary market figure of 1.1%, since it is more applicable for condo investors. In figure 4.3.1 of the same report, CMHC says that in Toronto, there are approximately 60,000 condo rental units. For a 1.1% vacancy rate, the CMHC is claiming that only about 700 condo units are available for renting in the whole Greater Toronto Area. We find this rather absurd. A simple search of the real estate website www.mls.ca finds close to 300 condos for rent in the tiny area bounded by Spadina Avenue, Bloor Street and Jarvis Street:

Figure 1: Condo rental search, www.mls.ca

And we are supposed to believe that for the whole of Toronto, there are only 400 other condos for rent, including private listings on craigslist and bulletin boards that dont make it onto the realtor system? Really?
1

CMHC, retrieved January 6, 2012: https://www03.cmhcschl.gc.ca/catalog/productDetail.cfm?lang=en&cat=79&itm=37&fr=1325904647109

2011 Report Card C+

The Aspiring Analyst Vol. 2 Iss. 1 theaspiringanalyst@gmail.com

Incidentally, we were stranded in the 6th floor gym of our 39 floor condo this evening due to a fire alarm and had to trek up to the 27th floor where we reside. Along the way, in one of the two stairwells of our 495 unit building, we saw 22 lock-boxes. Assuming there are no lock-boxes in the second stairwell and the other 12 floors that we didnt have the pleasure of visiting would still leave over 4% of the units in our condo building empty, pending sale or rental (extrapolating our small sample to the whole building would imply over 10% vacancy)!

Inmates Running The Asylum Before Christmas, Dr. John H. Cochrane of the University of Chicago wrote an excellent commentary on the European debt - http://www.bloomberg.com/news/2011-12-22/bad-ideas-worsen-europe-s-debtmeltdown-commentary-by-john-h-cochrane.html. Essentially, the Europeans (politicians, governments, central bankers) have turned a plain vanilla sovereign debt default (Greece) into a banking crisis (by forcing/enticing banks to buy crappy sovereign debt), a currency crisis (devaluation of the Euro; possible reintroduction of the Drachma), a fiscal crisis (plunging government revenues and ballooning government expenses; forced implementation of austerity measures across Europe) and a political crisis (ousting of Irish/Greek/Portugese/Spanish/Italian governments). The real question in our mind is, when will this madness stop? We suspect Europe will continue kicking the can down the proverbial road in 2012, as the European Central Bank has a few more cards up its sleeve. If the latest ECB plan to flood Europe with over $600 BB worth of liquidity2 is not enough to calm the markets (i.e, if European banks does not use the liquidity facilities to purchase sovereign bonds and lower sky-high interest rates), then expect the central bank to engage in direct monetization of European sovereign debt (i.e. QE European Edition). The Math Will Not Work There is simply no other way as Europes largest economies face over $1.0 Trillion in debt rollovers this year3. Whatever austerity measures Mario Monti plans to implement will fail to offset the massive increase in interest payments Italy must face, as it seeks to raise 450 BB4 in debt in 2012 (The austerity measures envision cutting 20 BB5 from the Italian budget over the next three years. However, every 1% increase in borrowing costs adds 4.5 BB in interest expenses!) The math will not work if the ECB cannot find a way to lower sovereign bond yields. What About China? Continuing our coverage of China, we urge extreme caution in 2012, as we witness a real time implosion of their housing market. Housing prices in Ordos, a ghost town in the middle of Inner Mongolia built to
2

Bloomberg, retrieved January 7, 2012: http://www.bloomberg.com/news/2011-12-21/ecb-will-lend-banks-morethan-forecast-645-billion-to-keep-credit-flowing.html 3 Bloomberg, retrieved January 7, 2012: http://www.bloomberg.com/news/2012-01-03/world-s-biggesteconomies-face-7-6-trillion-bond-tab-as-rally-seen-fading.html 4 Bloomberg, retrieved January 7, 2012: http://www.bloomberg.com/news/2012-01-03/monti-prescribes-italianaspirin-for-new-year-s-debt-ache-euro-credit.html 5 BBC, retrieved January 7, 2012: http://www.bbc.co.uk/news/world-europe-16024316

2011 Report Card C+

The Aspiring Analyst Vol. 2 Iss. 1 theaspiringanalyst@gmail.com

spur GDP, have cratered by over 70%6. Property prices in Sanya, Chinas answer to Hawaii, has fallen by 30%7. Everyone understands the direct impact of falling property prices on the Chinese economy (lower investment in real estate will depress GDP), but what about the secondary effects? The knock-on effects of a real estate downturn in China will be huge. For example, local governments rely on selling land to finance their budgets. If they are not able to sell land, then hundreds of billions in local government debt (bank loans, off-balance sheet loans, etc.) will go sour. Unable to sell thousands of flats in inventory, real estate developers will stop work on existing and planned projects, leaving hundreds of thousands of construction workers jobless. Without the ferocious appetite of the Chinese construction industry, global commodities will face a fall-off in demand. Economies such as Canada and Australia will face falling exports and slowing economies. And so on and so forth. The second order effects just boggles the mind. Investment Themes For 2012 The global investing climate is becoming increasingly binary. On the one hand, we fear that the European debt crisis will blow up, forcing the ECB to print lots and lots of Euros to try to inflate away the sovereign debts (in which case, one should buy equities, hard assets and precious metals). On the other hand, we fear the Chinese housing bubble will blow up, causing global recession and deflation (holding cash and income producing securities would outperform in a deflationary world). These two scenarios are so diametrically opposite that it is practically impossible to position ourselves against both. For the moment, we continue to lean towards fear of a global slowdown and a deflationary environment. We think the hyperinflationary world of the Weimer Republic remains fresh enough in German minds that the ECB will not truly risk entering into another hyperinflationary period (sorry gold bugs!). However, we also think the Great Depression (and deflation) influences the current U.S. Federal Reserve to such a degree that they would not hesitate to print the world out of its misery. For now, we think income generating securities will continue to do well. We will also keep higher than normal levels of liquidity, just in case. However, we are tempted to look at precious metal equities, their valuations look cheap relative to their production (although we have not pulled the trigger on any as of yet). Bottom Line Bottom line, expect 2012 to be another volatile year, as consumers and corporations continue to deleverage while governments try to pump up demand via stimulus and artificially low interest rates.

The Standard, retrieved January 7, 2012: http://www.thestandard.com.hk/news_detail.asp?we_cat=2&art_id=117448&sid=34599654&con_type=1&d_str= 20111128&fc=10 7 Bloomberg, retrieved January 7, 2012: http://www.bloomberg.com/news/2011-12-19/sanya-home-bubble-popsas-property-curbs-deflate-prices-in-china-s-hawaii.html

2011 Report Card C+

The Aspiring Analyst Vol. 2 Iss. 1 theaspiringanalyst@gmail.com

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