3rd QTR 2009 Public

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3rd QTR 2009 Public Powered By Docstoc
					David Lee Berkowitz Registered Investment Advisor 510 Thornall Street Edison, NJ 08837 732.632.8854

THIRD QUARTER 2009 INVESTOR LETTER October 24, 2009 To my clients and friends, As I write this letter, the third quarter has ended in what continues to be an incredible year for the stock markets, the economy and the country. Unfortunately, the “regime uncertainty” I wrote about last quarter has not clarified. We still do not know with any more visibility than 3 months ago what the business landscape and the new regulatory rules of the road will be. This uncertainty is killing job growth and investment today. But unprecedented world-wide monetary stimulus is stirring the emerging markets’ economic engine. This means big US businesses are getting more hopeful – but the small business person is still scared to death. Why not? Huge budget deficits, tight credit and extended debates about mandates on healthcare and carbon reductions have created one of the worst small business environments since the 1970s. In light of that, I believe it is important to briefly summarize where we’ve been this year, where we are today and the prospects for the period ahead – and also to highlight some lessons from last year’s financial collapse.
S&P 500 Index July 2007 - October 26, 2009
1600 1500 1400 1300 1200 1100 1000 900 800 700 600 O-07 M-08 M-08 O-08 M-09 M-09 O-09 F-08 A-07 S-07 A-08 A-08 S-08 F-09 J-07 J-08 J-08 J-08 J-09 A-09 J-09 J-09 A-09 N-07 D-07 N-08 D-08 S-09 11/20/08, 752.44 676.53 07/15/08, 1214.91 S&P 500 Index was down -56% from peak in fall of 2007 to the bottom in March 2009. S&P 500 Index is down +58% from March '09 bottom. Good but we still have another 50% to go just to get even with fall 2007 highs. 1554.41 +47% to go

1067.83

Where we’ve been. Six months ago, in early March, it truly did feel like the world might be coming to an end – talk of a return to a Great Depression-like economy dominated the media. Understandably, fear was rampant – and stocks responded to these nightmarish scenarios by hitting the lowest levels in years, with financials especially hard hit. Although no one knew it at the time, that turned out to be the bottom. Since then, the economy has moved back from the

precipice – there is a growing consensus that we’ll return to economic growth in the second half of this year. The Economist recently ran a cover story discussing the extent to which the economic recovery is being led by Asia. How’d we do? The ValueAligned® Folio accounts were up +9.1% for the 3rd Qtr compared to +15.6% for the S&P 500 index. For the year as of September 30, 2009, the accounts were +14.2% year to date (YTD) with 25% in cash ready to go to work when opportunities come up against 19.3% for the S&P 500. The ValueAligned® Fund, L.P. was up +13.4% (net) with only 75% exposure to the market.1 Fallen Angels During the initial stages of historic trading rebounds, much of the market action is whacky. This chart below illustrates how this rally treated low class stocks on the first recoil rally the outperformance of the trashy (below $5) stocks is why there is value in big cap stocks, especially with the US dollar falling so steadily. So the really hot-shots of performance this year (for the first 3-4 months of the rally) owned what looked like dogs that happened to move down below $5 then back to say $9.50 when the crowd figured out they were down but not out. We had our fair share of these companies that had high debt but equally high cash flow and/or assets to make it through the credit crunch – and we hung on and in some cases bought more - companies like Tempur-Pedic (TPX, +196% ytd) or Borders (BGP, +487% ytd) and AC Moore (ACMR, +264% ytd) But in the last two months, we are seeing the traditional disciplines once again start to be rewarded—change in economic performance and value, like Google (GOOG, +80% ytd). What’s happening now? We are about half way through earnings reports for the third quarter and the momentum continues – companies are doing much better than analysts predicted just a few weeks ago. They are also raising guidance at a time on the calendar when they usually are a bit more cautious going into the next year. We are about to put October to bed, which means the best stock market months are coming up - November and December. But September and October haven’t been bad or scary (pun intended), so maybe November/December won’t be as good as usual. This earnings season has been stupendous. Many more companies that are surprising those scared-to-death analysts are outnumbering the disappointments by a 5.6 to 1 ratio.

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Also, the median surprise of the median stock’s earnings on the upside is 7.90%. And that is the third quarter earnings comparison. As we shift 3 more months to comparing against the trough of 2008 despair - the 4th quarter, we should get higher growth and more upside to estimates going into 2010. Tax Harvesting Time Is there anyone anywhere that does not think capital gains rates are going up? We advise you to check with your tax expert to see if you have any carry forward losses from the last two years so you can take gains today to offset those losses. Also, check to see whether any of your bond funds or stock funds will be distributing large capital gains, many of which you might not have earned but will still have to pay taxes on! As long as the penalties for withdrawal are not so onerous, then get out before the funds distribute the gains to the suckers left holding the bag. Then, invest the money with us in one of our ValueAligned® Folios. That way you and your tax expert will control the timing and magnitude of your gains, stock by stock, not fund by fund, which puts you in complete control. Remember in taxable accounts you can most effectively harvest low rate gains or losses to minimize or eliminate tax in the current period. Then what? Much of the earnings gains are coming from trimming underutilized resources – like employees. Revenue growth is low and not beating expectations or bottom line growth – a situation that is unsustainable. This is terrific for big US companies getting more and more competitive, but really bad for the US consumer, whose joblessness is here to stay, unless we get some business friendlier fiscal policy or at least more clarity from the crowd in Washington. Small businesses who employ and hire 2/3 of the US workforce need some visibility – right now they can’t see through the fog and only see higher taxes – not exactly the environment that incentivizes the hiring of new resources. The brightest spot for earnings is the technology sector. Look for more mergers in this sector as the cash rich giants turn to strategic M&A to round out technology and product portfolios. As a result, we’ve had a strong recovery in markets – from their bottom in the beginning of March, stock markets are up over 50%, retracing a good portion of the losses since last fall. Here are four lessons we should have learned from the last twelve months: 1. Trying to beat the market is the wrong goal. Why? 2008 is the perfect example. The S&P 500 lost -38%. If you lost only -30% - you won. Right? You beat the market after-all. Somehow I doubt you would be thrilled with such news. Investing is about achieving long-term goals. That’s the over-arching objective for all our clients - their personal goals. Do you know that there are some hedge fund managers that take performance fees on negative performance as long as they beat the market?

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2. The stock market is risky, volatile, and unpredictable. But we need to ignore it or be ready to buy when others panic as long as we have the right long-term plan.
S&P 500 Monthly Return 1927 - 2009
Sour ce : Blo omberg
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-40% 1929 1933 1943 1947 1957 1961 1971 1975 1985 1989 1999 2003 2007 1927 1931 1937 1941 1945 1951 1955 1959 1965 1969 1973 1979 1983 1987 1993 1997 2001 1935 1939 1949 1953 1963 1967 1977 1981 1991 1995 2005

If you look at the chart above of monthly returns going back to 1926 you’ll notice that the stock market is very volatile from one month to the next. But we found out that it doesn’t really matter as long as at the time we invested we had a plan. Our plan was to leave the money alone for years, maybe even decades. Now let’s stretch out our view of the market from months to 15 year periods as shown in the figure below. When viewed over long periods of time, the stock market isn’t nearly as unpredictable or volatile. And that means it’s not nearly as risky as the media, the gurus and the politicians would have us believe.
15 Year Annualized Rolling Arithmetic Returns 1942 - 2008
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Yet most investors view the market from the perch that only sees today’s market action. They watch it day by day, moment by moment. They get frightened and they panic. They sell at the bottom and buy near the tops – it is human nature and is the most destructive of investor behaviors.

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We think it is much better to set up a plan that takes account of when you need cash and then stick to it. Stop looking at your account each hour, each day or each month – find something better to do! 3. Americans need to save more, spend less and stop relying solely on their assets appreciating for their retirement. Look at the picture below that was published in a Hays Advisory commentary. It shows that Americans have gone on a

spending binge as the their savings rates (blue line) declined. Of course, with that, the actual dollar amount of savings (the yellow bars) fell to historically low levels – house price appreciation and stock market paper wealth made Americans feel that their savings were fine. Until the debt bomb exploded and the liquidation of real estate and stocks – the collateral for those loans – began in earnest, did Americans begin saving from their paychecks once again. This chart shows that Americans spent $1.5 trillion ($1,500,000,000,000) that should have been saved if past savings behavior of about 4% stayed constant. 4. All successful long-term investing is goal-oriented and therefore planningdriven. All unsuccessful investing is market-oriented and performance-driven. Investors were also reminded of the need to focus on what they can control – understanding their cash needs and spending thereby thinking through how much risk they can tolerate to fund those needs.

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Where we are today Two years ago, the market was characterized by rampant optimism. The U.S. market had hit a new high in November of 2007 and any concerns were set aside as minor annoyances. By contrast, six months ago the market was overwhelmed by absolute pessimism – there was no sign of hope anywhere. The chart below measures how the smart money – the Goldman Sachs of the world – is betting in the option market. When they buy more calls than puts they are optimistic. And when Goldman Sachs is optimistic you can bet that the public and other investors are scared to death – like in March of this year. Back when the rest of us had no worries or cares and all things looked A-Ok, Goldman and the other insiders were happy to sell you stock because they knew before all of us that something really bad was brewing.
Two years ago 11/2007 Rampant Optimism

Six Months Ago 3/2009 Point of absolute pessimism

Today, the market is somewhere between those two extremes and many investors can be characterized as extremely nervous. As a general rule, a certain level of healthy anxiety is positive – what gets investors in trouble is an excess of either optimism or pessimism. While today’s mood may be a bit too pessimistic, being cautious in the current market makes sense … provided that prudent caution doesn’t cross the line into panicked inertia or hasty decisions. The good news is that there are still excellent opportunities for investors who are prepared for short term volatility. I spend a lot of time listening to the best market minds and to managers who have lived through multiple cycles. I am reassured that most say that they are still finding very good value – not to the extent that they did earlier this year, but still well ahead of what they would have seen a year ago. The outlook going forward In August, Business Week ran a cover story called “The Case for Optimism.” The premise was simple: Beyond the issues facing the global economy, there are many underlying positives that give cause for optimism if we look out two or three years or beyond.

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Powerful forces under the surface will drive economic growth … and that economic growth will drive stock prices. Examples include the positive impact of technology, the recovering US housing market, the revitalization of economies and the incredible energy from the developing world’s educated youth and emerging middle class. Click here to access the Business Week stories on Why It's Smart To Be Optimistic Sure, it has been a harrowing storm. And now is no time to discount the dangers that still exist. But opening your mind to optimism can help you seize the opportunities ahead. Volatility Let me close by talking about market volatility. In 1907, U.S. financier J. Pierpoint Morgan single-handedly averted a banking panic among U.S. investors. Later in life, someone asked him his best guess as to the direction of the markets. His answer: “They will go up and they will go down.” One hundred years later, that’s still the best technical answer to someone looking for a short-term market forecast. No one can predict market movements in the immediate period ahead – all we can do is understand clearly how much short term volatility we can live with, adjust our portfolios accordingly and stay focused on the horizon as we deal with the rough waters. No one likes volatility … but for most of us it’s the necessary price to arrive at our ultimate destination. But his answer is misleading. It is incomplete. In any given short-term period like a day or a month stocks go up and down sure, but it is more accurate to say that prices in the overall stock market rise a lot, but fall a little. And that means over the long-term the stock market goes up. 175 years of data The chart below is one of the most persuasive to show you that saving and investing now in the stock market is the best opportunity to meet your long-term goals. Previous troughs in the rolling 10 Yr Total Return of the stock market has led to annualized performance of 14.5% over the next 10 years – and that is just an average, about a double every 5 years. The troughs in this chart coincide with very scary times where you feel like our best days are behind us – the Chinese (or Japanese 30 years ago) are taking over. At each trough you would be worried about budget deficits, trade deficits, savings rates, demographics, the US dollar, and inflation as though the current state will always persist into the future. It’s ironic that human nature is wired to believe these scary stories told by supposed experts, rather than believe the message of this simple chart. Use data not emotions to invest and stick to a solid plan.

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We think this time is a fantastic opportunity. And what we do today could make the difference between looking back on this market in regret and reaching our financial goals. We are here to be the anchor for our clients, an honor and a privilege, and a tremendous responsibility to provide perspective, understanding and support. Over the past while, I’ve talked to most of our clients about their portfolios. I would be happy to spend time with any of you that are not yet clients but would like a second opinion. If I missed you for some reason or you would like to discuss your investments in more detail, I am always delighted to have that conversation too.

Best regards,

David Lee Berkowitz

Notes:
The performance and volatility of the S&P 500 may be materially different from the individual performance attained by a specific investor in the funds and managed accounts managed by Rapidan Capital, LLC. In addition, the funds’ and managed accounts’ holdings may differ significantly from the securities that comprise the S&P 500. The S&P 500 has not been selected to represent an appropriate benchmark to compare an investor’s performance, but rather is disclosed to allow for comparison of the investor’s performance to that of a well-known and widely recognized index. You
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cannot invest directly in an index (although you can invest in an index fund that is designed to closely track such index). The quarterly returns as set forth in the first paragraph are estimates. Individual fund performance, portfolio exposure and other data included herein may vary between the various funds and managed accounts managed by Rapidan Capital, LLC. Performance results are based on the NAV of fee paying investors only and are presented net of management fees, brokerage commissions, administrative expenses and accrued performance allocation or incentive fees, if any, and include the reinvestment of all dividends, interest, and capital gains. While performance allocations are accrued monthly, they are deducted from investor balances only annually or upon withdrawal. The performance above represents fund-level returns, and is not an estimate of any specific investor’s actual performance, which may be materially different from such performance depending on fee arrangements, entry times into the Fund. All performance results are estimates and should not be regarded as final until audited financial statements are issued. Past performance is not necessarily indicative of future results. All investments involve risk including the loss of principal. This document is confidential and may not be distributed without the express written consent of Rapidan Capital LLC and does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product. Any such offer or solicitation may only be made by means of delivery of an approved confidential offering memorandum.

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