2009 3rd Quarter Letter

3rd Quarter 2009 “Money problems are not fixed with money. Money problems are fixed with lifestyles.” – Dr. Phil So it is with individuals, companies, and countries. What is intuitive to ten year olds seems to be foreign logic to Ivy League graduates, professors, Fed Chairmen, Nobel Prize winners, and every other individual who has seemingly found their way to a position of economic power in the United States. The country has a debt problem…why lets add more debt, that will fix the problem. Overly reliant on consumption? Easy solution, lets stimulate consumption by, oh yeah, adding more debt. Wall St. is in a frenzy over these “fixes.” Risk appetite is back to near all time highs. A talking pundit on CNBC recently made the statement that now is the time to be greedy. Not only is greed back in style, it is ravenously consuming every corner of Wall St. It has become a panic that seeps into the mind of money managers, lingering and causing concern that they are not being greedy enough. Yet, have lifestyles changed? Has the need for deleveraging been addressed? Is the country more or less intrinsically solvent compared to six months ago, twelve months ago, or twenty four months ago? Has the core foundation been rebuilt? Astute readers can make up their own minds whether we still have money problems and what the end result of those money problems will be. Wall St. has apparently made up its own mind deciding to party like it is 1999. What is there to worry about? Lou Jiwei, head of the China Sovereign Wealth Fund (a tentacle of the Chinese government), fully recognized this reality when he said in August “It will not be too bad this year. Both China and America are addressing bubbles by creating more bubbles and we’re just taking advantage of that. So we can’t lose.” Mr. Jiwei seemingly failed to finish his last sentence. He cannot lose…until the party ends. When that occurs, when the final party is over, the human suffering planet wide will be multiples what it would have been had the problems been properly addressed. In the interim, success for the bubble blowers.

PO Box 331, Shiner TX 77984 361-594-3327 ext 390 http://marketseer.blogspot.com

Jason Kaspar - Principal [email protected] www.kasparinvestments.com 1

Performance The third quarter was a complete strike out for the fund. In the third quarter, the S&P 500 advanced 14.98% while the partnership in the second quarter lost 10.50% net of fees. The S&P 500 is now up 17.03% on the year though still down 31.77% since the fund’s inception. The partnership year to date is down 7.81% while being up 11.49% since inception. The quarter was very frustrating for me on every level. The dash for trash intensified, especially in August which is when the found really got punished. The fund is still positioned for negative performance in the equity markets and to the extent that the markets continue to rally with high correlations among all stocks, the fund will most likely continue to underperform and possibly lose money. The risk in the short term is that money managers continue to buy pushing up the market as they chase performance with little concern for fundamentals. The pages following discuss my fundamental market view and why I continue not to participate in this rally. This past quarter the fund made money in a few long positions. We lost money on our short book, primarily being short retailing and banking. Dunamis Capital LLC Kaspar Investments LP Returns Since Inception (11/1/07)

Kaspar Investments LP - Net S&P 500

Q3 2009

YTD

-10.50% 14.98%

-7.81% 17.03%

Total Return Since Since Inception 11.49% -31.77%

Fund's Net Performance Since Inception

An Initial $100,000 investment

$135,000 $125,000 $115,000 $105,000 $95,000 $85,000 $75,000 $65,000 $55,000 $45,000 Nov 1st 2007 Dec 31st 2007 Mar 31st 2008

June 30th 2008

S&P 500

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Sep 30th 2008 Dec 31st 2008 Mar 31st 2009

Kaspar Investments LP

June 30th 2009

Sep 30th 2009

Portfolio Dynamics The portfolios performance has been dismal the last several months and it has been very frustrating. The frustration has not come from not making money. I am not a trader and do not consider a government manufactured stock market rally and economic rebound a favorable risk reward investment. When do you know when to exit? Every point the market moves higher, the higher the risk becomes embedded in the market that the government induced rally will pop. A higher market means more risk not less. However, I would have wished not to lose money in such a contrived move. Here I have failed and it eats at me on a daily basis. The good news (or bad news depending on the markets continued moves) is the losses are basically unrealized. Because the portfolio utilizes virtually zero recourse leverage (the portfolio is outright short securities but the fund tries to maintain $2 dollars of cash for every $1 short position) the positions that I like fundamentally are still on. I have been able to withstand a never ceasing onslaught of overvalued securities becoming even more overvalued. Any reversal in the markets means the losses should disappear very quickly. However, the market is getting close to where I will have to take action that is not of my desired timing to maintain the risk parameters desired. I have never been forced into this position. Throughout my investment career, volatility was used to rehedge various securities. There has been essentially no volatility of any magnitude since the beginning of this rally. The market has moved up with almost no pause, with high correlations, and “junk” equities vastly outperforming high quality stocks. Once many of the hedges rolled off or were sold in June and July, the portfolio was left very exposed. There is an old saying that the stock market takes a stair step up and an elevator down. This has not been the case this time around. 2008 the market took a stair step down with multiple 10% month long rallies before entering the next corrective phase. If the markets would have not had this volatility, the funds performance would have been much weaker last year as each rally was a chance to re-hedge the long book and add to short exposure that had been taken off. Since the equity bottom in March, the move has been an unprecedented elevator move up. A normal retracement of such a move has not developed. What this means is that equity positions have been getting sold without getting replaced and short bets are becoming larger meaning a larger and larger net short portfolio. This is not my inherent desire but is what has developed with the elevator move up in the markets. More specifically, the short exposure to the retail space is much larger than what I am comfortable with. Valuations appear as ludicrous as the tech sector in certain individual securities in the late 90s if you consider credit lines are being pulled, unemployment is near 10%, and the over leveraged nature of the U.S. consumer. However, nutty overvaluations can continue unabated and try even the most patient of investors. Without some form of corrective action in the market very soon, especially in retail, some of these losses will have to be realized to manage risk. This is terribly discouraging because I pride myself on choosing when to participate in the market, not being forced when to participate in the market.

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Market View Market participants are split into two very distinct camps. Those who believe deflation will continue for the foreseeable future and those who believe the money printing in the Fed will be inflationary in the near term. My mantra has continued to be that deflation will lead to inflation. That natural market forces are deflationary but the intervention of the Federal Reserve will eventually overshoot moving us into a hyperinflationary world. To date, the gaping deflationary hole is so big that it appears we have not passed this tipping point and another serious wave of deflation is ahead before the policy errors of the Fed shoves the economy off a separate cliff. Like nature, markets follow very distinct laws. Capitalistic organisms such as companies and countries are able to operate on certain amounts of leverage. These leverage levels depend on characteristics of the organism itself. If the level of leverage has been surpassed a tipping point is crossed and financial correction is imposed. For companies, the only outcome is a deleveraging deflationary type of process. With, countries that control the printing press, it can be deflationary if government restraint is imposed to allow the cleansing needed to take place or a type of hyperinflation that is death to the system if printing presses go wild. In no way does it appear that the present leaders will show the restraint needed, but the forces of having to much leverage has yet to force the Fed’s hand in which road they will take. To date, the Fed has patched up holes attempting to push off the ultimate decision. The laws that govern capitalistic organisms are in place and will force a decision. Deflation will lead to inflation as it “forces” the Fed’s hand. To understand this, let’s examine a living, breathing capitalistic organism. A Tale of Two Companies Different companies are able to handle different levels of debt based on a myriad of factors. Companies in non cyclical industries can handle higher leverage ratios than a company in a very cyclical industry. Hence, a service company can carry more debt than a steel company. Companies that have hard assets that can be posted as collateral versus goodwill can often times carry more debt on their balance sheet. All companies have a breaking point. The lender and the company may not realize the moment it occurs, that level is often times not knowable, but once that level is pierced, it is simply a matter of time until economic factors and perception shifts conspire to force the company into financial failure. Below is the capital structure of two companies. Company A is a very cyclical company. It relies heavily on production, exporting industrial products all over the world used to grow the business of other companies. Since a large percentage of its sales relies on the growth of other companies, this company disproportionately feels any economic slowdown since other companies cut growth budgets and rein in capital spending. The second company, Company B, is not nearly as cyclical. It is a consumer and service oriented company. It also feels economic slowdowns but since it relies less on capital expenditures and growth plans of other companies, the impact is smaller. Revolver Term Loan Bond Total Leverage

Company A Company B 0.29X 0.52X 0.22X 1.15X 1.35X 1.88X 1.86X

3.55X

The leverage ratios of these two companies are at peek earnings and coincidently, the breaking point for Company A was met and surpassed. The breaking point of Company B is still somewhat debatable but has also probably been surpassed. 4

So who are these two companies? These two companies are actually the same company, just different time periods. Company A saw financial failure, reorganized, grew, matured, and became much stronger morphing into Company B, a more service oriented company. Company B has higher debt levels, which is to be expected, and is trying to convince lenders that is can handle even higher debt levels than is currently incurred. Was the tipping point reached or is the tipping point 4X or 4.5X levered? If the tipping point was not met, there are many signs it has been, why is Company B actively pursuing reaching that breaking point? These two companies are of course the United States. Company A is the United States in 1929. Company B is the United States in 2007. The table below shows the capital structure as a percentage of GDP. Government Debt Financial Debt Other Private Debt

U.S. 1929 U.S. 2007 29% 52% 22% 115% 135% 188% 186%

Total Leverage

355%

The United States in 1929 was a very cyclical economy. Its economy was mostly based on exports that fed the consumption desires of the world. Labor was cheap, resources were plentiful, and its goods helped the world to grow. Every few years there were recessions, some severe, which the United States handled smoothly until the country’s leverage ratios became to high for the cyclicality for the economy that it was built upon. A comparison could be made to Bethlehem Steel. A steel company who prospered for decades until to much debt caused it to go bankrupt in 2001. The United Sates in 2007 was a much different economy. It was much less cyclical relying on consumption, technology, and services. This of course is why the debt level easily surpassed the peak of 1929. It is a different country (company), and can handle a higher debt load than the United States in 1929. Higher does not mean infinite. Was 355% above the breaking point? A comparison could be made to Movie Gallery, a movie rental business that was thriving, serving consumers and made an ill timed acquisition of Hollywood Video with debt to surpass its breaking point that caused it to eventually declare bankruptcy in 2007. Though most investors have probably not thought of it in this way (at least I have not read it presented in this format) the huge battle between bears and bulls, the heated arguments that brutally split the investment community, the unbelievable lack of clarity of what 2010, 2011, and 2012 will look like, all centers on this question. Was 355% above the breaking point? One thing is certain – this time is not different. There is a breaking point. The United States is not any different than a corporate entity. Both are living, breathing capitalistic organisms. Both are bound by invisible laws of leverage and debt servicing. Both require deleveraging and restructuring if the invisible breaking point is surpassed. Is It Different This Time? Maybe it is different this time? Maybe we can engineer our way out of it? Maybe we have smarter individuals at the Fed and Treasury (trying not to burst out in laughter)? Maybe we can fool enough people to make the laws of leverage not apply.

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Let’s look at a third country (company). Japan.

In 1989 at the Japanese bubble peak, it had 269% debt to GDP. Interestingly the government debt to GDP at the peak is very similar to what it was in the United States in 2007 while the private debt was much more skewed towards the corporate balance sheet rather than the consumer. Overall debt to GDP in the United States in 2007 was higher. Japan in 1989 was a cross between America in 1929 and 2007. The country was very export dependent but less cyclical than the United States in 1929 with a much more mature consumer base. Not surprisingly, the leverage breaking point was greater than the United States in 1929 and less than the United States in 2007. Through extend and pretend policies, Japan avoided a United States 1930 style depression. Was this a better outcome? The answer depends on philosophical differences but the end result was Japan never restructured into Company B. It tried to perpetuate what was before and has experienced two lost decades. The stock market in Japan is lower now than it was 5, 10, and 20 years ago. It has lost its competitive edge in the world economy. Its government debt is ballooning. It can be argued that the depression it avoided in the 90s, Japan is experiencing now, and the future of Japan ten years from now seems very dire. The invisible laws of leverage could not be fooled. There is one interesting difference in comparing Japan to the United States. Today, the United States is actively pursuing a different route. Not only has it embraced the ‘extend and pretend’ policies of Japan, we are embracing, running full speed ahead trying to increase overall debt levels. Notice the government debt in Japan stayed around the 50% level for four years once their bubble started to burst. The United States jumped above 70% in 2009 and may well be above 90% by the end of 2010. The government debt level is taking a rocket ship higher as the government tries to stimulate an overleveraged, zombiefied economy. The Keynesians economists, like Nobel Prize winner Paul Krugman, embrace this path wholeheartedly. To an individual with an admittedly lower IQ, it appears over the long run to be throwing gasoline on an already intensely blazing fire. Great, year 2 will be better than Japan’s year 2. What about year 4 or year 8? If the problem, as I have tried to demonstrate, is the invisible laws of leverage that encompasses every living breathing capitalistic organism, how is adding leverage, the medicine needed to fix a leverage problem? More alcohol is not the solution to a hangover. Even inexperienced partiers know this truth intuitively and yet we have experienced award winning economists trying to convince us the equivalent does not hold true for the economy. Mind boggling. 6

Debt to GDP levels always go up after the breaking point is reached. Most of the time, it is against the desire of the creditors and lenders. GDP falls, creditors draw on revolving facilities to keep their operations going which are contractual promises that the lenders wish they could renege on. Overall leverage goes up even as the process of deleveraging becomes an ongoing event forced upon the participants by the market. This occurs in sick companies as well. Profits fall, expenditures are cut, debt is actively paid off, yet overall leverage as a ratio to earnings still goes up. The peak debt ratio for the United Sates occurred in 1933. Four year after the breaking point. In Japan it was 1998 though the private sector peaked in 1996. Even as Japan’s federal government started taking on more and more debt, the net result was still deleveraging. In the United States the goal has become to borrow our way into prosperity. Hence, our leverage ratio as a country is still climbing because of choice. The only reason this choice, as twisted as it is, is even available to the United States is because the U.S. dollar is the reserve currency of the world. Whether the reserve currency status is sustainable requires an entire different discussion. If this continues, the market will eventually force a halt to this “choice.” Capital Structure Composition The presentation of the Company A and Company B capital structure in various debt tranches was not an accident. Total debt leverage in a company is total debt leverage regardless of whether it is a revolver, term loan, or corporate bond. Each is a little different. Typically revolvers and term loans have lower interest rates and higher collateral rights where as corporate bonds have higher interest rates but longer maturity. Either way, 3x leverage is 3x leverage regardless of the balance sheet composition. Arguments are being made that what we are doing currently is different because the government is transferring private debt to its own balance sheet. This is somehow more desirable or a different type of debt. Billionaire investor Wilbur Ross made this argument on CNBC. I would love to discuss it with him because it seems ludicrous to me. The output of the United States is the sum of the individual output of all its producing entities. It is the same for a company. A companies output is the sum of the output of all machines and labor. Overall debt levels match up with the overall output. It does not matter what part of the capital structure the debt resides or in the case of the United States, whether it resides with the government or the private sector. For it to be otherwise, would argue there is an economic free lunch. Transferring it to the government level may save some private players, may keep economic levels higher than they would in year one but the outcome is higher taxes, higher interest rates, and possibly higher inflation after year one. The net draw on society is the same. Japan’s government debt is quickly approaching 200% of GDP. This is being subsidized as private debt to GDP has shrunk. Regardless, the net affect may have been better economic output between 2000 and 2007 but if the deleveraging in the private sector does not keep pace with the increase in government debt, the cost to the country will surely be paid between 2010 and 2020. [For those who want to get into the granular arguments of finance, it seems like it could even be argued it would be more preferable to keep the debt at the private level. Since all Americans are essentially equity holders of the United States (the government is made for, and run by us) it is more preferable at an individual level to keep the debt at the private level (Opco level) than at the public level (Holdco or parent level). A default at the Opco level, would not cause a default at all other Opcos or the Holdco. There would be no cross defaults. A default at the Holdco level would cause the whole system to fail impacting all Opcos. Furthermore, if debt is at Opcos (private levels) you can have defaults in a portion of the debt while other debt remains performing. If all default risk is transferred to the Holdco (U.S. government), a default is a default on all debt. I realize this legal structure does not transfer perfectly as an example for a country and its citizens. I am using it for illustrative purposes only.] 7

The Market Will Win The major difference between the United States today and Japan two decades ago is that the U.S. government is not allowing the nation to delever. In Japan, as the government was taking on more debt the private sector was delevering at a quicker pace. It allowed the government to take on more debt at lower interest rates lowering the overall service burden of the country allowing the country to muddle for years. The United States government is trying to force the private sector not to delever even as it levers its own balance sheet. The invisible laws of leverage guarantees the United States will lose that war. My whole investment thesis and outlook is based on that previous sentence. The U.S. government may win a battle but it will lose the war. The casualties will be much higher than it has been in Japan to date. The reason, if the United States is able to force the private sector to maintain its leverage ratios (it is already losing this battle thankfully) while the government increase its debt ratios by .50% of GDP bringing total debt for the entire country (company) to 425% of GDP, what happens to interest rates? The 10 year probably goes from 3.5% to 4.5% or much higher. This would cause the economy to slam on its breaks forcing the private sector to delever except than the delevering process would be that much more brutal. This is one possible scenario famed hedge fund manager Julian Robertson is betting on with his interest rate curve play. He wins if inflation increases and interest rates rise or if more leverage is forced into the system and the default risk implied in the interest rate increases. All other things held equal, the U.S. government can add .50% of debt to GDP to its balance sheet if the private sector is deleveraging by an equal or more amount and interest rates should stay stable. The U.S. officials in their infinite wisdom are not allowing this to happen and I believe the consequences will be dire as the market will win. Stock Market So where does that leave investors? The chart below shows the gigantic stimulation the U.S. government has poured on the U.S. economy. This is where all the increase in debt to the government’s balance sheet is coming from. It is unprecedented. The bulls have argued for months, that this chart alone is all that really matters. To their credit, they have been right, and I have been wrong.

It has been a great trading call to get long this table. My question has been and continues to be, is it anything more than a trading call? A trading call that I have admittedly gotten wrong. However, if the value of the United States stock market or an individual company is all the free cash flow in the future discounted back to the present, this graph tells me at best we are simply 8

bringing forward free cash flow and at worse destroying long term future free cash flow. Once again, there is no free lunch when it comes to the laws of leverage ratios. The government is piling on debt at the public level. Without an equal deleveraging at the private level, which is not occurring, this means higher taxes, higher interest rates, and possibly higher inflation. Variables that negatively impact the discount rate and negatively impact free cash negatively impacting valuation. If this is correct, than we are in what to me is an obvious bubble and Wall St. is running off a cliff being cheered by the same pundits who cheered them off a cliff just two years ago. If the stock market was cheap, it would be one thing. It is not. Considering the leverage ratios, I did not think it was cheap when the S&P was at 800. An argument could have been made it was close to fair value at that level. It certainly is not cheap at 1100. Consider these facts at the September S&P 1080 high: •

The trailing P/E (for operating earnings) is 26, at the onset of the bear market in October 2007, it was 19

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The trailing price earnings ratio is 184 (reported earnings), on October 2007 it was merely 23 (in October 1987 it was just 20)

•

The price to dividend ratio is at 53, on October 2007 it was 55 and way back at the start of the super bull (1982) it was 16

•

Based on one year forward (operating) earnings the P/E ratio is 16 - highest in 5 years, on October 2007 the forward estimate P/E was 14 (same as on Oct 1987)

•

Price to Book ratio is 2.3 - August 1982 it was below 1 (discount to book)

•

Based on recent Tobin’s Q analysis, the market is 40% overvalued

•

Based upon Benjamin Graham’s 10 year average earnings model, the market is 30% overvalued

Where in the world is the future free cash flow going to come from to justify these valuations? For the bulls, it comes down to the one table above. For the bears, I think it comes down to one chart below which was discussed at length in the pages above.

Does somehow the stimulus trump the debt situation? Wall St. is obviously saying it does but Wall St. can rarely see past the end of its nose, so have they really thought farther than one 9

month out? Everything I know about market history, about economics, and about valuation tells me that stimulus cannot trump debt levels over the long term. Hence, the U.S. market must simply be in another bubble and the markets’ “winners” just made a good trade. It could have just as easily turned out to be a bad trade, as one must believe that others will accept their short term view and must find other fools to sell to at even a higher price when they want out. Market View Conclusion Where could I be wrong? Essentially in believing we have not passed the tipping point to move towards the “Great Inflation” and that more deflation will occur to trigger the next series of events that will cause the demise of the dollar. If my belief in that is wrong, than my view on the markets is wrong. The first round of deflation triggered the market meltdown of 2008 and gave us quantitative easing 1.0. This first wave of money printing is winding down. It has done nothing but buy some time and ultimately make the imbalances in our economy worse. My belief is there will be more deflation which will lead to quantitative easing 2.0 and put the death nail in the structure of our system. My mantra has been that deflation will lead to inflation. This has been my view for over a year. It is possible that we have already seen the maximum deflation and the next chapter begins the “Great Inflation”. If that is what has occurred, I am very wrong in my understanding of where we are on the timeline. Personally, it is my belief the only way to save our system is to enter a depression that allows the system to delever and cleanse itself over multiple years. For spineless politicians, this is not allowable and so the road to something worse will be traveled because the first part of the journey will look more appealing. The Fed has determined that it will not allow Great Depression 2.0 and instead will steer us into Weimer Republic 2.0. This outcome still appears to be several years down the road. Deflation will lead to this inflation.

Closing Thank you for all your support. I appreciate your trust in giving me a portion of your hard earned capital. If I can be of service in any way possible, please do not hesitate to contact me. We remain vigilant in trying to avoid flawed assumptions and ensure the portfolio does not experience permanent capital loss from our investments. These last few months have been a rough patch, but it is my belief that brighter days are ahead. Sincerely, Jason Kaspar Managing Partner

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