1st Qtr 2009 Public

Rapidan Capital, LLC Registered Investment Advisor 510 Thornall Street Edison, NJ 08837 732.632.8854

FIRST QUARTER 2009 INVESTOR LETTER April 29, 2009 Dear Investor and Friends, The separately managed accounts called the Value-Aligned® Folios lost -8.6% for the 1st quarter, moving ahead of the S&P 5001, which lost -11.0%, by +2.5% for the year.2 March’s gain of +8.8% in the S&P 500 index has been followed with an April gain of +9.5%! (As of April 29th), and the S&P 500 is now down -3.1% on the year. The Value-Aligned® Folios gained over +8.0% for April and are now just about flat on the year. While it is extremely pleasant for us to report to you that we have gained on the market and other investors so far in 2009, we know that like most investors we are still nursing steep losses over the last 18 months.3 While a loss never feels good, we're very pleased to have done relatively better than many of our most admired competitors. Although we do not and cannot know whether this recent move up in stock prices is the beginning of a new bull market or just another bear market rally, you can be sure we our positioning to take advantage of the inevitable recovery. STOCK MARKET REVIEW

Today is the 100th day of President Barack Obama’s already historic administration. I waited until today to write a quarterly review letter because I wanted to make sure that we would get a complete picture of the beginning of the year since the rally that started on March 9th went right on through April. In some ways, it seems like the stock market has been a walk through hell, and as Sir Winston Churchill once said, “If you’re going through hell, keep going.” So we keep going. We keep going through hell until the day when your humble money manager can define the new normal. We’re not there yet though. On March 9, the S&P 500 closed at a new panic low of 676.53.

In doing so, it completed a 17-month decline (on a closing basis) of very nearly -57% from its all-time high on October 9, 2007. This was the greatest decline of the postWWII period. On a pure price basis, this decline wiped out all the appreciation in the American equity market since 1996. (Adding back dividends, the destruction "only" canceled out 11 years rather than 13.) And 2008 was the worst calendar year for stocks since 1931. Our business and government leaders and all of us everyday citizens are trying to get through the same perfect storm. And today we got another reminder that we still have a way to go. It turns out that first-quarter GDP fell another -6.1% which is on top of the -6.3% decline in the last quarter of 2008. After a brutal 2008 and with economic activity plunging, the S&P 500 index dropped another -8.4% in January and then another -10.7% in February. And yes as we all remember the market was down another -8.0% by the close on March 9th, less than two weeks into the last month of the quarter. (I say we all remember because I spoke to most of you on or around that day to help make the “big” decision that often determines long-term investing success – to get in or stay in, or run for cover in a panic.) It was not easy but it was gratifying that all of you stayed in and agreed to try to save more to put more in stocks around here. In the near-term we have been rewarded, and it probably marks the beginning of double digit annual returns for 3 - 5 years to come. I’ll have more on that a bit later. The first quarter of 2009 ended with a glimmer of hope that the worst is over for the stock market, as the S&P 500 Index rallied +17.9% from its bear market low set on March 9, 2009. For the month of March, the S&P 500 actually gained +8.8%, making it the third best March on record. However, it was not enough to save the quarter, as the S&P 500 lost -11.0% for the first three months of 2009. Most of the first quarter records for the S&P 500 Index were set for abysmal performance: • January’s loss of -8.4% was the worst January ever. • February’s loss of -10.7% was the second worst February ever. • The first two months’ cumulative loss of -18.2% was the worst ever. • The first quarter loss of -11.0% was the worst since 1939. • The first quarter produced the sixth consecutive quarterly loss, resulting in a cumulative loss of -45.8%. The last time stocks fell for six quarters in a row was 1970.

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WHAT DROVE THE MARKET? Many factors drove the market lower during the first quarter. Fourth quarter 2008 corporate earnings, reported in January and February, were much weaker than expected, as analysts had not yet caught up with the rapid deceleration of the economy. In addition, many companies were forced to slash their dividends and suspend buybacks to conserve cash. The economy continued to deteriorate with most experts revising their forecasts downward for all of 2009 and into 2010. The Obama administration’s budget, which called for increased spending and a huge deficit, was poorly received by the financial markets. And while the global financial system was no longer on the brink of collapse (we were told), the repeated injection of capital into major financial firms raised the question of bank nationalization as the ultimate solution to the financial crisis. At its low point, the S&P Financial Sector Index had fallen -84% from its February 2007 peak. In its initial efforts to get its budget and stimulus package passed, the Obama administration warned of another Great Depression, an undefined catastrophe where Americans lose their homes en masse, jobs disappear faster and faster and the biggest banks go bust. All will be OK though, if, and only if, the President’s aggressive spending actions were approved. Don’t you feel better now? The message scared the heck out of Americans and investors everywhere. A CNN/Opinion Research survey released in March indicated that 45% of Americans believed that the U.S. will in fact enter another Great Depression within the next year! Stock market investors were spooked because it was clear that the scare tactics of the administration raised the prospects for historic deficit government spending and greater government involvement in the economy – and of course higher taxes on 100% of the people, not just taxpayers. THE DOW GIVES UP 12 YEARS OF PERFORMANCE – BELIEVE IT OR NOT – A POSITIVE INDICATOR On March 2, 2009 the Dow Jones Industrial Average closed at 6763, its lowest level since February 5, 1997. According to JP Morgan Chase, this marked only the third time since the index was created in 1896 that the Dow had retraced 12 years of performance. The other two times signified a close proximity to a market bottom. The first occurred on April 8, 1932, approximately three months before the market bottomed. The second instance was on December 6, 1974, this time marking the exact day that the market bottomed. This bear market reached its low point on March 9, 2009 at 6547. Hopefully, this indicator works again and we will not see a new bear market low. The Dow closed the quarter at 7609. It is at 8100 today.

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The chart above presents rolling 10 year returns (excluding dividends) for the S&P 500 (SPY) going back to the Great Depression era. The past ten years have been one of the worst in history—ranking in the 1st percentile – the very bottom! The silver lining in this data is that 10 years of negative annual stock market returns have invariably produced attractive returns over the subsequent ten years. That means we should save as much we can and invest it in stocks now. We don’t try to pick bottoms. But to ignore a rational decision that has little risk and a historically large expected payoff, like investing in the stocks of Great Companies now, simply because they might get cheaper, maybe, someday, doesn’t make rational sense – emotional sense yes, but we need to ignore the gut on this one and think with the head. We value stocks of Great Companies. That’s not as difficult as picking the bottom – the exact moment when stocks won’t go any lower. Plus, other investors are frozen by their current position right now. We are taking advantage of their fear. For the past dozen years or so the US broad stock market was a wild roller-coaster ride. The Dow Jones Industrial Average and the S&P 500 index went up and down (and in the process set all-time highs and multi-year lows), stagnated, and traded in a tight range. At some point during the ride, index investors and buy and hold stock collectors will realize that their portfolios aren’t showing much of a return, just like many of us realized in January. Over very long stretches, stocks, on average, have returned around +7% annually. (You used to hear investors cite average long-term returns of about +10% for the broad market, but the recent bear market has depressed that figure.) But in any given year, or even over several years, the stock market can diverge markedly from its long-term average. Throughout the prosperous 1990s, for instance, the S&P 500 Index rose +13% per year. 4

No wonder that S&P 500 index funds were widely touted as can't miss investments; mutual company managers were made out to be geniuses worthy of multi-million dollar salaries; and brokers, financial planners and trust officers grew like weeds while taking larger and larger fees from the amazing run in the 1990s. But the 1990s turned out to be the exception, not the rule. The past decade hasn't been so kind, however. Through March 2009, the S&P 500's annualized 10-year return was negative -3%. It's been a wild ride along the way, too. After soaring in the late 1990s, the index slumped more than -40% in the March 2000 to October 2002 bear market and then rallied steadily before faltering from late 2007 through early March 2009 – more than -55%. LESSONS TO BE LEARNED FROM THE VOLATILITY & LOSSES Lesson One: Buy and Hold without Active Management is Dead We always espouse the importance of thinking long term if you're a stock market investor. But if "long term" means to you 5 or even 10 years, it is not long enough. Stocks may have earned around 7%-10% a year, but that's usually when measured over 20 or 30 year periods. Obviously, if you're younger and saving for your retirement, your time horizon is probably long enough to have most of your investment portfolio in stocks. (Given longer life expectancies, even the not-quite-asyoung should have plenty of stock exposure too.) If your financial goals are short- or intermediate-term in nature, it's not a sure thing that Buy and Hold and Hold (Hang) On works anymore. Lesson Two: You Only Learn in Bear Markets Psychologists Carol Tavris and Elliot Aronson in the 1950s described the motivational power of what they termed as "cognitive dissonance". The engine that drives self-justification, the energy that produces the need to justify our actions and decisions - especially the wrong ones - is an unpleasant feeling called 'cognitive dissonance'. It is a state of tension that occurs whenever a person holds two cognitions (ideas, attitudes, beliefs, opinions) that are psychologically inconsistent, such as 'smoking is a dumb thing to do because it could kill me' and 'I smoke two packs a day'. Dissonance produces mental discomfort, ranging from minor pangs to deep anguish; people don't rest easy until they find a way to reduce it. The last 7 months have provoked much cognitive dissonance in all of us. What's more mentally painful than believing that you think you know what you are doing in the stock market or in picking advisors while being smacked with evidence to the contrary day after day after day? 5

We have resolved that we have two choices: we can rationalize it away, absolving ourselves of the responsibility for the pain because of the "circumstances beyond our control". Or, more productive and lucrative is to learn from recent history to make us better investors. This is tricky because the recent market environment has been so unusual. Or has it? One value investor was pragmatic in explaining his strategy change. He said, "One needs to be a learning machine and be willing to give up some of one's best-loved ideas when the evidence suggests they are flawed." Evidence suggested that our Value-Aligned Investing® process needed refinement. Nothing was sacred during our review. We even questioned whether our method for choosing our watch list of Value-Aligned companies was flawed. (Hint: it wasn’t.) Senior corporate executives are still too often paid to worry about things other than creating shareowner value. And too many are paid to take on too much debt and take too many operational risks because the bad consequences of those decisions are suffered by others, not them. Lesson Three: Buy Stocks When Others Are Afraid – Lowest Cost Wins It's true that you would've been better off putting money under your mattress than into the S&P 500 over the past decade. But most people usually don't put all the cash they'll ever have to save in the stock market at once. We learned that there are two types of markets – investing markets when watching a great portfolio go up over time is the best idea and trading markets when buying at lower discounts than normal in larger amounts and then selling before stocks reach fair value is a strategy that works in these range-bound markets. And despite the tax consequences of taking gains, the after-tax return of this strategy should be much greater than buy and hoping. That’s called active value investing and it takes into consideration the less talked about topic of when to sell a stock. Using shorts and listed derivatives to hedge makes it easier to lock in economic gains and even profit in a down market, but that’s not the point. The point is to learn to buy and especially to sell within your normal long-term time horizons when risk increases. WHAT WE CHANGED First, when “buying undervalued shares of Value-Aligned companies” we learned that we needed to adjust our initial position sizes better. Actual short-term 6

volatility was leading to negative feedback loops causing liquidity drains on some of our favorite positions. This meant that if we had positions that were “too big for its volatility”, the market robbed us of our flexibility to have enough capital (or conviction) to purchase larger shares of those fine mis-priced companies from panicked or otherwise motivated sellers. After all, this crisis was a collateral crisis, where assets were liquidated as those assets held for collateral lost value. Fortunately, (by design) our bottoms-up balance sheet orientation led us to owning only the best credits. If those stocks were being sold, we should have been in there buying from those investors that were forced to sell to satisfy their margin loan calls or alleviate their mental anguish. We could not do that in every instance until we tweaked our process at the end of last year. Our position limits used to be 6% of invested capital at cost on the long side. This policy was derived from our historical batting average plus our +15% per year return objective. We would shoot for an average gain on 10 core positions of +30% giving us a +18% return on just that capital. We figured that we would bat around 50% (a coin toss between winners and losers throughout the year on the remaining 40% of the capital) as we traded in and out of positions, all the while doing research to add to our conviction to get those positions to the maximum position size of 6%. -15% was the maximum loss on these positions, so if we lost -15% on 50% of the remaining 40% we would have about a -3% expected loss to subtract from the +18% earned on the core to get to our +15% target. Why +15%? Because that’s what it takes to double our money over 5 years. That was the old. Now new position sizes are somewhere between 2 - 6% maximum depending upon liquidity, driven by short-term volatility. The more short-term volatility a stock exhibits, the smaller the position size will be at cost. This still leaves enough room for more volatile stocks to contribute to the +18% return of the 60% core while limiting the damage caused by unexpected liquidity vacuums. The consequence is that we will have more than 10 (usually) core positions because the average maximum position size will be less than 6%. Second, we concluded that we needed to pay more attention to macro considerations in individual stock selection and overall portfolio positioning. Like many traditional value investors, we have traditionally left macroeconomic or political forecasting to the pundits and focused almost exclusively on individual, bottom-up stock selection. When we found undervalued stocks that had great earnings power and sustainable returns we built a portfolio around those. Themes would usually emerge from the bottoms-up analysis; we did not usually first look for 7

and find macro or political themes and then search for the stocks that fit those themes. Early last year, however, the mortgage crisis was nowhere near over and as it worsened, large segments of the US financial industry faced big trouble. But because or bottoms-up process led us to own only one financial firm, a specialty insurance company, and in fact, led us to recommend selling Fannie Mae (FNM), Freddie Mac (FRE), American International Group (AIG) among others, at high prices before their collapses, it prevented us from understanding just how widespread the damage of the mortgage meltdown would become. Our mistake, then, was missing the extent of the damage in the financials during September and October, and how that panic would affect our real world companies. We thought a company such as bookseller Borders (BGP), for example, trading at only 4.5x earnings before interest, taxes, depreciation and amortization (EBITDA) was cheap enough and that its business was resilient enough that the stock would do well regardless of the macro environment. What we've learned in the past year is, first, that the earnings of very few companies are immune to a terrible economy; second, even if earnings hold up, the multiple that investors are willing to pay probably will not. On much reduced earnings, Borders traded at just 3.2x EBITDA at the beginning of the 1st quarter. (BGP is up +180% in April by the way.) Another way our macro view is affecting how we manage our portfolio is that we will almost certainly be quicker to take profits on winning positions (as mentioned above). Historically, we would try to buy 70-cent dollars and sell 120-cent dollars but today those numbers are more likely to be buying 50-cent dollars and selling 90-cent dollars. This is not a market to be holding out for the last dollar of value. If it sounds as if we’re hedging, we are. The range of potential outcomes - for the economy and for individual companies - is as wide today as we’ve seen it in our lives and those older than us say the same thing. Most of the near certainties are gone. MAKING MONEY IN RANGE-BOUND MARKETS We took aggressive rebalancing actions at the bottom in November and despite set backs in early March, we added to the best positions in what we thought would be the best sectors. The result was that we earned more than +14% against the market. We went from trailing the S&P 500 by over -6% to outperforming by over +8%. Many investors overlook the importance of the sizing of positions, but it’s the most 8

important contributor to continued success. The ideas in which you have the most conviction are the ones that lead your weightings. Correct sizing also allows you to BUY low and SELL high because conviction and independent thought allows you to buy more when stocks are sold by short-term traders and sell when things look good for everyone. BUY and HOLD, the stock strategy for most investors in the 90s, worked brilliantly through the period of investment history where the stock market was in a trending bull market. Recent research, however, suggests that over the last 150 years stocks are in trending bull markets less than 40% of the time. What happens during the rest of the other 60%+? We get “range-bound” markets, according Vitaliy N. Katsenelson. What’s that? He says, “The most vivid analogy is to a roller coaster. After all the excitement of dramatic up, down, sideways, and pin-your-back-to-your-seat-thrill-ride gyrations, no matter how long the ride lasts, you (and your portfolio) end up back where you started. This is the fate of the inactive value investor, the buy-and-hold and passive index investor during range-bound markets - close to zero stock returns plus meager dividends, with time having passed but little progress toward retirement nest-egg goals.” It turns out that when we look at market history we notice that human behavior just does not change that much. Therefore, we often get cycles that repeat. And it’s funny, but markets go up when we have inflation and markets go down when we have inflation. Markets go up in periods of economic stagnation and they also go down in periods of economic decline. And the same thing happens with interest rates. So what determines subsequent annual returns when investing in the stock market or in a particular stock?

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VALUATION DETERMINES SUBSEQUENT RETURNS At the end of a prolonged bull market like we had from 1982 to somewhere around 2000 maybe all the way to 2007, the average valuation as measured by the price that investors paid for current and future earnings goes to the top of the historical range. It gets the most expensive. That 17 year, 3 month bull market that the graph above shows ending in January of 2000, produced very high price to earnings (P/E) ratios (high valuations). You can tell in the bottom of the graph above for anybody that bought in at that highest valuations, their subsequent returns have been decidedly negative.

1974

1982

Today

And one of the most difficult things for all portfolio managers over the last 7 or 8 years has been the remarkable increase in the profitability of American companies unaccompanied by the same type of rise in stock prices. The thesis, therefore, is that the problem was that we started out at too high a valuation so the realized returns from the beginning of this decade were bound to be very low. 10

Hays Advisory has produced one of the more credible valuation measures. You can see that graph above and you can also tell that buying stocks now has a high probability of yielding well over double digit returns. At the 22% return that Hays Advisory predicts, stocks will more than double in five years. But they won’t get there in a straight line. We are in a range bound market that calls for a more active value strategy. We recognized this some time in October and November of 2008 and have been employing that strategy ever since. Without getting into too much detail we have explained to you that we have lowered the ranges in which we will buy and sell a stock, sometimes selling the stock before it even reaches our estimate of fair value. This updated approach calls for taking profits when you’re at the top of the valuation range and reentering stocks when they are near the bottom of the valuation range. We would be happy to discuss any aspect of the strategy that we’re using for our funds and how we can apply it to separately managed accounts Thank you very much for reading and as always we are here to help, to answer questions and to do our best to educate you on the subject of corporate finance and valuation.

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 cannot invest directly in an index (although you can invest in an index fund that is designed to closely track such index). 1

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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. 3 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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