Ema Garp Fund - q3 2011 Report

EMA GARP Fund, LP Page 1

EMA GARP GP, LLC ■ 260 Bear Hill Road, Suite 302 ■ Waltham, Massachusetts 02451

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Report for the Third Quarter Ended September 30, 2011 This is the EMA GARP Fund, L.P. report for the third quarter ended September 30, 2011. The Fund declined in value by 9.3% during the third quarter, leaving the Fund down 26.4% year to date. Our net return from inception, January 2006, is +128%.

Quarterly Return* Cumulative

Q3 2011 -9.3% -26.4% Q2 2011 -15.3% -18.8% Q1 2011 -4.1% -4.1%

Monthly Return*

September 2011 -18.8% August 2011 3.1% July 2011 8.4%

Annual Return** Since Inception

2010 47.1% 209.5% 2009 33.2% 110.4% 2008 -5.8% 58.0% 2007 40.5% 67.9% 2006 19.5% 19.5%

* Net fees; incentive allocation is charged in December if the 10% hurdle is reached. ** Net fees and incentive allocation; audited. 2010 not audited yet.

Current Themes Investment Implications

Monetary Chaos Long precious metals, mining stocks.

Anti Garp Short as appropriate for deflation.

Third Quarter Overview In the third quarter of 2011 our return was -9.3%. We had a gain of 8.4% in July, another gain of 3.1% in August and then were down -18.8% in September. We are disappointed with the results so far this year, but we remind ourselves that we were up 47% in 2010 and 33% in 2009 using this theme, and nothing has changed fundamentally. In our opinion this move falls within the normal corrective boundaries of a bull market and we expect things to turn around. If they do not we will make adjustments. Obviously, some of you are probably concerned about this draw down and wonder why we allowed it to grow to this size. As this letter explains, we see upside in the gold and silver mining equities that is many times larger than this draw down. The upside optionality makes it worthwhile to endure the short term



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pain. We sincerely believe that when the market awakens to the fact that printing money is the only option, we are going to see returns of over 100% on our portfolio in a very short time. As we pointed out in our June 30, 2011 report, the gold stocks are incredibly cheap. Since the bull market in gold stocks began in 2001 there have been four major price corrections that have all resolved to the upside. We are now in the fifth correction. Well known and respected gold stock analyst, John Doody computed the returns that occurred following each of these corrections. Doody uses a valuation metric based upon a comparison of market cap per ounce in the ground compared to the dollar value of an ounce of gold. He computes fair value for the gold stocks and then recommends purchase when they are at a discount to fair value. The appreciation figure is the upside that occurred off the bottom. Here is what he found:

AMEX Gold Stock Index (HUI) Performance

Subsequent Time Discount1 Appreciation2 Spring 2003 -18.6% +125% Summer 2005 -10.8% +137% Fall 2008 -35.7% +237% Winter 2010 -9.5% +60% Fall 2011 -19.0% ????? This data helps illustrate the enormous upside in the gold stocks once the primary trend re-asserts itself. Because gold stocks are volatile, and sometimes thinly traded, it is impossible to day trade the up and down moves. We have found that if we wait until a trend is established, we miss 10-20% of the move. An investor needs to find value, buy it and wait for the market to understand the inherent value. During the third quarter gold went on quite a roller coaster ride. On December 31, 2010 the price of gold was $1,405.50 per ounce. On June 30, 2011 the price of gold was $1,505.50, up 7.1% year to date. On August 22, 2011 gold closed at $1,877.50, up 24.7% from the June close, and up 33.6% year to date. Now on September 30, 2011, a little over one month later, gold is selling at $1,620.00, down 13.7% from the August peak. For the last ten years gold has been up about 18% per year. To see it making these kinds of moves in a one month period is a new level of volatility.

1 This discount is proprietary to John Doody and his service, The Gold Stock Analyst. He computes the number of ounces in the ground for each miner and then compares the market capitalization per ounce to the current gold price. He thus computes whether the market is paying above or below fair value for ounces in the ground. A 19% discount implies that the HUI stocks on average are 19% below their fair value. 2 Stock price appreciation is the increase as measured from the low point to the high point which typically occurs in the next twelve months.



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Overall, our weightings during the third quarter, shown below, did not change very much from those of the previous quarter:

Category Weighting Positions Gold Stocks 57% 41 Silver Stocks 25% 10 Bullion 13% Vietnam & Other 2% 2 Private Deals 2% 4 Anti GARP 0% 0 Cash 1% ====== == Total 100% 57

Below we present the third quarter return figures for a number of relevant comparables. Investment 3rd Quarter Return EMA GARP Fund, LP -9.3% DJIA -12.1% S&P 500 Index -14.3% Nasdaq -12.9% XAU Gold/Silver Stocks -8.0% HUI Gold/Silver Stocks +0.9% GDX Gold Majors ETF +1.1% GDXJ Gold Juniors ETF -18.4% SIL Silver Miners ETF -12.1% Gold bullion +8.2% Silver bullion -14.6% The quarterly return figures above provide some interesting information. Notably, all equity assets sold off sharply in the third quarter of 2011. The Dow, S&P and Nasdaq were all down very steeply between 12 and 14%. Declines of this size have not occurred in any quarter since the global financial crisis struck in 2008. The senior gold indexes diverged nicely from the overall stock market. The HUI and the GDX Indices were both marginally positive. These indices contain the largest, most secure gold producers. They are attractive investments, but only a few of them fit the GARP model since their production growth is often slow or non-existent. Note that even with the July/August roller coaster ride in the bullion price, gold still appreciated by 8.2% during the quarter, a very respectable rise. Silver and the silver stocks which are more sensitive to economic conditions performed poorly. The gold junior’s index, GDXJ, performed poorly, down 18.4%. Many of our stocks are in this index and so we take pride in the fact that we handily beat this performance. We believe we have selected the best junior miners in our portfolio. We also hold a 25% weighting in silver stocks and we were able to beat the silver stock index. However, the most important take away from this schedule is that there is a DIVERGENCE here between the quality gold equities and the general equity markets. This is NOTABLY different from the 2008 experience when equity markets sold off due to liquidity concerns and collapsing confidence and the gold



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equities sold off even more. Or said another way, the market is beginning to understand that gold equities are more attractive than general equities. The Federal Reserve Hits The Brakes – Hard. We remain very committed to our current “monetary chaos” theme. Monetary chaos is occurring because many entities (particularly governments) throughout the world are too indebted to service or pay back their debts. These debts will either be defaulted on, or debased (paid with inflated currency). This theme leads us to our top investment category, namely gold, silver and the companies that mine these monetary replacement metals, an area where we see many outstanding growth-at-a-reasonable-price (GARP) opportunities. If you need a refresher on the investment case for the precious metals stocks please re-read our previous quarterly reports. We are now in the third year of what we call: The Grand Monetarist/Keynesian Experiment, which was brought on by the oversized policy response to the 2008 Global Financial Crisis (GFC). As the chart below clearly illustrates, never before in U.S. monetary history has so much money been created so quickly. In our view, the St. Louis Adjusted Monetary Base is the best measure of FED monetary policies. In the first quarter of 2011 the monetary base grew by 18.7%. In the second quarter of 2011 the monetary base grew by 12.7%. So, in the first six months of 2011 the monetary base grew 33.0%. In the third quarter just ended, the monetary base grew by 1.3%-- dramatically slower. The slowdown occurred because the FED let its QEII monetarization program lapse without launching a new comparable program. Why did they do this? We believe the answer is simple.

This spring and summer must have been the Federal Reserve’s worst nightmare. Economic growth is still slow, unemployment is still high, and the price of gold (which even the FED knows is a great indicator of inflation) went on a tear, rising from roughly $1,500 per ounce at the end of June to a peak of $1,900 per



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ounce in August: a 27% move in two months. This break out in the price of gold, when coupled with increasing talk of inflation and rising gasoline prices, must have put the fear of god into the Federal Reserve Governors. Chairman Bernanke’s early 2011 assurances that the recent up-tick in inflation is a “transitory” condition were beginning to look very wrong. Knowing that accelerating inflation is potentially very dangerous, and facing loud internal and external criticism of QEII and money printing, the FED made the decision to step on the monetary brakes—HARD. By temporarily pausing its money printing operations, the FED was able to restrain liquidity in the system, creating a severe price retracement in all asset classes and thereby reduce inflationary expectations. Game Theory: Inflation or Deflation The U.S. Federal Reserve operates with a dual mandate issued to them when they were established by Congress in 1913. They are charged with “promoting full employment” and “maintaining price stability”. Chairman Bernanke often makes reference to taking actions which are in accord with the “dual mandate” of the FED. An additional implied mandate, cited when the Federal Reserve was created, is to be a lender of last resort to prevent liquidity panics. Like most statists, Bernanke seems to believe that the dual mandate can be achieved (we think it cannot). He rather conveniently overlooks the fact that the dollar has lost 98.5% of its purchasing power since 1913, and that the nation underwent its worst period of unemployment under FED management in the Great Depression. Actually, he does not overlook the unemployment of the 1930’s, instead (as an academic expert on the Great Depression) he concludes that the unemployment which took place in the 1930’s could have been solved by additional money printing to prevent deflation. He has vowed that he is not going to let deflation take place on his watch. In our opinion he is working with the wrong economic model. However, he is not stupid, and knows that if the FED loses its credibility or political support then all will be lost. That is why when gold broke out this summer, and inflation was popping out of every corner, he slowed down the growth in the monetary aggregates. He also did a “head fake” by hinting of additional monetary easing (called QE3) to be announced at the September 21 Fed Meeting, but failed to deliver. The broad equity market was obviously expecting QE3 and reacted to the hawkish, tough money, FED by violently selling off. So the question is: who is the real Ben Bernanke? What actions will he take? Are we in for Inflation or Deflation, or both? What are the implications of deflation on our strategy? To answer these questions it is helpful to start a little further back in our thought process. To begin, we know that the world is heavily over-indebted and that we have reached the natural limits to the creation of debt, credit, derivatives and other forms of paper money – GIVEN THE EXISTING PRICE STRUCTURE. There is not enough productive capacity in the world to ever pay back the bloated debt burden at today’s prices. The marginal productivity of an additional dollar of debt has become negative which is why banks are not making new loans. The simplest way to think of this is to view the economy as a junkie and easy money as heroin. We have reached the stage where additional larger doses will bring death (via inflation), and “cold turkey” withdrawal will bring near death (via deflation). The problem began many years ago with government management of the markets and the failure to regulate derivatives. There cannot possibly be any reason for over $600 Trillion of financial derivatives to exist except that they are a profitable way for Wall Street to control markets. Think of table stakes poker. If you have more money than anyone else at the table you can go all in and no one can call your bet. You may have a pair of twos, but you win. Especially if your bet is an insurance bet. You can guarantee low interest rates knowing you cannot and will not pay off in a high interest rate environment.



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The entire world GDP is approximately $50 trillion, and yet there are at least $600 trillion of derivatives outstanding. The credit markets are severely broken. There is no honest price discovery. Without the market for credit derivatives interest rates would be much higher. We believe that the existing “interest rate” is not accurately doing its job of reflecting the true cost of borrowing real savings or capital. In theory the interest rate is the price at which savers are willing to lend their capital to users of capital. It should be set by market forces with the rate being the point at which the supply of savings is balanced against the demand for capital. But that is not what is occurring. We find it improbable that in a free market, someone would lend the U.S. Government money for 10 years at 1.9% or for 30 years at 2.9%. Particularly when stated inflation is running at 3.8%3 An investor loses purchasing power by buying these bonds. Given the U.S. Government’s financial condition such a loan makes no sense. We currently have negative real interest rates and interest rates are too low and have been too low for a long time. The mispricing of the cost of borrowing money led to an excess of borrowing, and the world became over-leveraged. This problem needs to be resolved. There is an old saying that all debt is eventually extinguished in one of three ways: (1) paid back; (2) defaulted upon; or (3) inflated away. We believe that option 1 is unrealistic. The debt load cannot be paid back (on a real basis). The Global Financial Crisis (GFC) which erupted in 2008 exposed the massive amount of leverage throughout the system and cascading defaults and bankruptcies were only avoided with extreme government action including printing huge sums of money (arguably $1 to $3 Trillion dollars), guaranteeing credit worthiness of huge sums of credit/money (GSE debt of $5 Trillion) and fraudulently re-writing the accounting rules for banks, allowing them to carry worthless or impaired assets at full value. These actions run counter to the tenants of free market capitalism, and represent a subsidy from taxpayers to the banks. As Elizabeth Warren, Chairperson, Congressional TARP Oversight Committee, said,” these banks have a great business model: gamble with other people’s money and if they win, keep the proceeds and pay bonuses, if they lose the U.S. Government picks up the tab”. Based upon the substantial evidence that has accumulated since the GFC we conclude that there is no way that existing productive capacity can pay back the debt at this price level. This problem is a worldwide issue and we can see the stresses in many countries (Greece, Ireland, Portugal, and Spain). Government debts are excessive in most of the western world (China is a notable exception.) Thus, option 1 is eliminated. Option 2 is to default on all of the debt and start-over. Option 3 is to try to inflate the price level enough that eventually the debt burden becomes manageable and repayable. We think that while option 2 is a possible outcome, there is no way that government entities are going to knowingly choose austerity. In most cases (Iceland is a notable exception) the holders of the debt have enough power that they can persuade government officials to either bail them out or enact inflationary policies. To date this is what has happened in the United States. Despite overwhelming public opposition the U.S. Government voted to enact TARP which burdened US taxpayers with a $700 billion cost to bail out the bad gambling debts of the banks and other financial institutions. The then Treasury Secretary, Hank Paulsen, might as well have said, “Give us the TARP money or the economy gets it in the neck.”4 When faced with two bad choices: a bail-out and inflation, or a debt collapse Armageddon, most politicians and some citizens will choose the bail-out route. However, even politicians know that bailing 3 This is the all items 12 month CPI including food and energy for the period ended August, 2011. We would argue that this is substantially understated as proven by Shadow Government Statistics. 4 In fact what Secretary Paulsen told Congress in a closed door session is that if TARP was not passed the U.S. financial system would collapse and we would be forced to declare martial law. This threat was reported by Congressman Brad Sherman and Senator James Inhofe.



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out the next crisis will not be politically easy. With these conditions as a backdrop it is pretty clear that option 3, inflation, is the generally preferred route to take to resolve the debt burden. It is also the route that until this quarter has been taken by the Federal Reserve. We believe that Ben Bernanke wants inflation, just not too much. He needs to have modest inflation without a runaway loss of confidence in the dollar. By holding interest rates low and hurting savers he will save the creditors from a total loss (debt default) and he will benefit the debtors by letting them pay back in dollars which buy less. The losers in this arrangement are savers who receive negative real interest rates. There is even a National Bureau of Economic Research paper written by Reinhart and Sbrancia which describes this strategy and gives it the name of “financial repression5”. Dr. Carmen Reinhart, one of the authors of this paper is said to be advising the Obama Administration. The problem with this approach is that people are catching on to the fact that even though he will not admit it, Bernanke must inflate and he will inflate. Since inflation is partially driven by expectations this is problematic because for a long time people have trusted the FED to provide price stability and now that trust is eroding. If that trust completely disappears the dollar is worthless. So, what Bernanke must do is inflate without letting on that he is inflating. Or said another way, he needs to have inflation, but when it appears to get out of control he needs to play tough guy until he has the political breathing room to resume the inflation path. His goal is to steer a path between mild inflation and outright deflation. He is deathly afraid of runaway inflation, as he should be, given the amount of money he has created which is now sitting in the system and ready to jump on the next big trend. The problem for Bernanke is that the system is increasingly becoming unstable and the swings between inflation and deflation are damaging the economy. So in a sense Chairman Bernanke is playing chicken with the markets. He knows that he must print or the entire system will collapse. However, he wants to have the political cover to print and he does not want to be blamed for the ensuing inflation. He also wants to try to keep any inflation manageable. What this means is that we sit and wait. We know how this movie is going to end, the problem is we just do not know when the good part (the gold stock mania) gets started. Policy Choices Will Be Important There are several analytical postulates that we believe and work from in trying to figure out what will happen next. We know that:

• The world is overburdened by debt and can no longer carry the load. • The problem is so large that the world financial system has become unstable. • The desired political outcome is a modest inflation or “financial repression” to slowly unwind the

problem and keep the status quo system intact. • New money/credit must enter the system or a deflationary debt collapse is imminent. • If too much new money enters the system, or people believe inflation will get out of control, then

the loss of faith in monetary authorities can set off a currency crisis.

5 The paper is titled, The Liquidation of Government Debt and is authored by Carmen M. Reinhart and M. Belen Sbrancia, on behalf of the National Bureau of Economic Research, a policy think tank in Cambridge, MA. The paper can be accessed at http://www.nber.org/papers/w16893.



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• The barometer for loss of faith is the price of gold and the end point is a currency collapse and hyperinflation.

So, from these postulates, we conclude that the authorities that hold the policy levers will do their best to steer a policy path down the middle between Deflation and Inflation. These people are not stupid and they see all of the same market information that we see. Thus, when inflation appears to have the upper hand—restraint. When deflation appears to have the upper hand—monetary easing. Yet on balance, some inflation is required. An economist in Britain summed up this dilemma in a very succinct manner:

The world is about to experience deeper stagflation. The cost of living will now rise even more but growth remains stunted. Policymakers will start to veer back and forth between dealing with unemployment and dealing with inflation. The years ahead will be referred to as the “stop go” years because policy will at times try to stop price hikes and at other times will try to push growth. Dr. Pippa Malmgren President and Founder Principalis Asset Management London

Policy makers want inflation, just not too much. We further conclude that if inflation is the choice we are perfectly positioned with respect to our precious metals investments. The bull market in gold and gold equities is in place, no important trend lines have been broken, and we have not had a speculative blow off. We cannot think of a bull market that ended without a speculative blow off. Analytically, we believe that all of the evidence is weighted toward an inflationary outcome. However, for the sake of argument, and to play devil’s advocate, let’s examine how the deflationary outcome will impact our portfolio. What About Deflation? We completely believe that Dr. Bernanke is sincere in his promise that he will not let deflation happen here. He has built his academic career, his self esteem and his life around his studies of the Great U.S. Depression (1930-1939) and he has concluded and publicly stated that the FED under his watch will not let the U.S. enter a deflationary period, thereby repeating what he believes was the FED’s mistake during the 1930’s. This foundational belief on his part was laid out and developed in his “Helicopter Money”6 speech which concluded that the FED had the tools to always create enough new money to maintain the existing price structure and thereby prevent deflation. We think at the end of the day that Dr. Bernanke will be forced to keep printing money because the alternative will clearly be a deflationary debt collapse. Having said that, it is possible that Dr. Bernanke will try to inflate, but will fail. So far he has failed in many of his other actions and predictions, so why should we assume he will succeed at stopping deflation?

6 The now famous speech referred to here was actually titled: Deflation: Making Sure “It” Does Not Happen Here, and was originally delivered to the National Economists Club in Washington, DC on November 21, 2002. A full text of the speech can be found here: http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm



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So, for the sake of argument, let’s say any one of the following things happens:

• A Republican wins the 2012 Presidential race and fires Bernanke. The new Fed chairman is a tight money monetary hawk.

• Bernanke falls ill and dies. A tight money monetary hawk takes over. • The anti-inflation and anti-quantitative easing cries grow too loud and Bernanke is unable to keep

printing. (eg: political pressure halts quantitative easing forever). • Events overwhelm Bernanke and the collapse comes so quickly that Bernanke cannot print fast

enough. Deflation is the result. We do not assign high probabilities to any of these outcomes, although they are all certainly possible. In our mind the most likely one would be if events overwhelm the Chairman, since the financial markets are so tightly interconnected that a contagious deflationary event is certainly a possibility. Deflation is defined by Webster’s as follows: deflation (di-fla-shen): a contraction in the volume of available money or credit that results in a general decline in prices. The last time the United States experienced prolonged deflation is following the bursting of the stock market bubble in 1929. This bubble had been fueled by the newly created Federal Reserve’s easy money policies which led to leverage, excessive credit and speculation in equities and property. (Sound familiar?) The result was wide spread bankruptcy, record unemployment and the destruction of huge amounts of money and credit as un-payable debts were defaulted upon, thereby destroying money and credit. Because money was so hard to come by the general price level during the depression fell precipitously by roughly 30% and houses and other assets could be purchased for 20 or 30% of their pre-collapse prices. Everything became cheaper. It was an environment where it was said that “cash was king”. Of course, because of all of the bankruptcies credit was generally no longer available. This is because either the creditors were broke, or if they were not broke they were very worried about the creditworthiness of potential borrowers. In a deflationary environment cash is the best performing investment asset. In a real deflation the price level of everything drops. Thus, a fixed amount of cash will buy more goods and assets after the deflation takes place. All other equity type investments: stocks, houses, commodities, etc. perform poorly as the there is less available money chasing these goods and their prices fall. Bonds are an interesting case. In theory, bonds will benefit in a deflation because they represent future cash and pay streams of interest income which are cash. The problem is the bonds have to be money good. If the borrower is not credit worthy and is unable to pay the interest and principal then the bond defaults and the lender loses his principal. So, bonds are tricky. In a widespread depression many bond issuers are forced to go bankrupt. For the people who have purchased these bonds cash would obviously have been a better choice. So let’s consider where gold and silver as monetary replacement metals fit into this picture. First, it is important to remember that gold is a form of cash. Long before there was paper money, fiat currencies or our existing financial structure gold and silver were widely considered by mankind to be cash. They did not represent a liability, they had the ability to fully extinguish or discharge a debt or payment. In most parts of the world today gold and silver are still cash although you have to exchange them for local currency to make many purchases. Over time the world adopted paper currencies because they were lighter and easier to deal with rather than hauling around heavy sacks of metal. However, it was found that the “paper money” idea worked best when each unit of paper money was backed by a fixed amount of specie. This way the paper money could not be easily printed, issued or diluted. In early cases in China where the paper money was not backed by precious metals the result was always the same, an over-



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issuance of the paper and then an eventual collapse of the paper currency in favor of gold and silver. In fact, this problem was so well known that for many hundreds of years the world operated with paper currencies that were backed by or exchangeable for gold or silver, and monetary stability was the result. Using paper money which is fully convertible into and backed by gold is known as “The Gold Standard”. A phrase which is now widely interpreted as meaning: “the best way of doing something”. As time passed and economies advanced some quack economists and others realized that the gold standard was a monetary rule that made it hard to cheat. They therefore concocted explanations for why the gold standard did not work, was unfair, was too restrictive, etc. They believed that by moving to fiat currency governments could do a better job of smoothing out the business and credit cycle. Our response would be: “how is that working out for you?” So, as we have chronicled in previous letters, societies slowly drifted away from the gold currency standard and in 1971 the last remaining link to the anchor of gold stability was broken when President Nixon cut the dollar free from gold forever. We know that in a deflationary environment cash is king. So will gold do well in a deflationary environment? The answer is yes. First, gold is cash. Second, it is cash which cannot be debased (something that governments are sure to try in deflation). Third, it is a financial asset which is not someone else’s liability (like bonds or credit) so it cannot default or go bankrupt. Now here is the important part. Cash is not someone else’s liability, or is it? Cash is managed by governments so arguably it is their liability. However, in today’s environment one could make the argument that many governments have finances which are in worse shape than they have ever been. Thus, we would argue that facing a deflation the choice is a “no brainer” when you are confronted with two kinds of cash: government cash and gold cash. Turning to the mining companies it is important to understand that they are different than other companies in a depression or deflationary environment. In a deflation or depression the problem most companies experience is decreasing demand for their products. Decreased demand leads to falling prices and lower volumes. At the extreme the companies fail. Obviously, this is a bad environment in which to hold common stocks of general operating companies since profits plunge. But in a depression/deflation, the demand for cash increases. Well, the mining companies mine gold cash. Their profit margins are determined by the spread between the selling price of the gold they mine and the cost of inputs to mine the gold. In a gold mining operation the three largest inputs are energy, equipment and labor. In a truly deflationary environment the price of their largest inputs would fall and their profit margins would increase. This is why the gold mining stocks were the best performing stocks throughout the entire deflationary period from 1930 to 1939. Gold held its value and/or increased in purchasing power and the inputs necessary to mine gold fell in price. The profit margins became huge and many of the miners had large cash flows and paid substantial dividends. We just returned from the Denver Gold Conference where nearly all of the major and junior mining companies make update presentations on their operating performance. What we were struck by is how profitable some of the companies have become. Many of the companies were making good profits when gold was at $1,200 per ounce and now with gold in the $1,500-1,700 range they are exceptionally profitable. Also, two major companies, Newmont Mining and Hecla Mining made announcements that they are going to base future dividends on a formula tied to the average realized price of the metals they mine. Thus, in the case of Newmont, they have agreed that if the realized selling price of gold goes up by $100 per ounce during a given quarter, then the dividend they pay will go up by $.10 per quarter in



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response.7 This is a HUGE DEVELOPMENT and will attract institutional investors to the miners because one of the biggest criticisms of the mining companies has been that they re-invest all of their profits in drilling new reserves and never return cash to the shareholders. The subject of dividends was brought up in nearly every presentation and we believe that many mining companies will move toward paying dividends as their cash flows become bigger. Thus, we would argue that even in a true deflation the gold miners and the metals are the correct place to be. They are cheap, they work in an inflationary environment, and they also work in a deflationary environment. We think that the outperformance of the large mining stocks during this past third quarter is evidence that the markets are beginning to understand that gold stocks are unique. The schedule presented below shows what is happening to the operating margins of gold stocks:

The dotted line represents the average annual price of gold. The red bars represent the industry average cash profit margin per ounce mined. The black line represents the progress of the HUI Gold stock index. Notice how in 2006, 2007 and 2008 the HUI traded around 400 when gold miners were earning an average of roughly $400 per ounce. Now, several years later the profit margins of gold miners have doubled or tripled and the HUI is trading at 550. So margins have grown by 100-200% and the stocks have appreciated by 37.5%. If you believe, as we do, that stocks are worth a discounted stream of future earnings then we must conclude that the stocks are extraordinarily cheap, or else the market is expecting the price of gold to collapse. We do not believe the gold price will collapse. Quite the contrary, we believe that the gold stocks are unbelievably cheap at these levels and represent a very compelling opportunity. Another way of looking at the price of the stocks relative to the price of gold is presented in the next chart:

7 This is a fascinating development and the math is very favorable for Newmont shareholders because at $1,600 per oz. a 6% increase in the realized selling price of gold will lead to a 21% increase in the dividend. For example, at today’s stock price and gold price Newmont pays a dividend of 2.1%, if gold were to increase to $2,000 per ounce, without a move in the stock price, NEM’s dividend would yield 4.0%. At a gold price of $2,500 per ounce the yield would be 7.1%



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This chart shows the ratio between the HUI Gold stock index and the price of gold. When the chart is going up the stocks are appreciating compared to gold and when the chart is declining the stocks are underperforming the metal’s price. Note how there are only two times when the stocks have been as cheap as they now are when compared to the gold price. These times are the start of the bull market in 2000 and during the liquidity crunch in 2008 when the global financial crisis erupted. You can also see that gold stocks could easily double in price and still only be within their long-term valuation range. Ultimately, we expect gold stocks to trade at a large premium to the historic range because investors will come to appreciate the superior economics of the gold mining business in this climate. Looking backward we want to reflect a little on this recent downturn and risk management. First of all it is interesting that this downturn in the mining sector happened so quickly. On September 9, 2011 the GDX index hit a new 52 week closing high at 65.80. Only 17 trading days later, on October 4th , the index had fallen to 52.5, a 21% percent decline, hitting a new 52 week closing low. This kind of volatility is rare and often precedes a bigger move. In our experience watching markets we have observed that very sharp moves tend to be counter-trend moves. That is, they tend to be sharp and against the long established continuing trend. We believe that this is what we just experienced in the gold stocks. Fortunately, we never use leverage and so we were not forced to sell any positions. We believe that other investors in the gold stock universe may not have been so lucky. If you have been with us for a long time you should still be solidly ahead. If not, we expect to have a quick recovery from this downdraft and we foresee some very good returns as the market comes to understand what we understand. We realize that it is difficult to stomach these ups and downs but we encourage you to take the long term view. Prior to this draw down we had a five year average return of 25.0% per year and we expect to be able to maintain or improve upon this record over the coming five years.



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Thank you for your support and patience and do not hesitate to call if you have any questions or concerns. Sincerely, Larry and Rich Postscript: GAO FED AUDIT Throughout this letter we have discussed the inflation/deflation debate. We remarked that keeping inflationary expectations under control is a key part of the job of the Federal Reserve. With that as a preface, we would like to point to a schedule which was released on July 21, 2011 that we found shocking. The schedule is presented below and is the Government Accounting Office (GAO) audit report on the activities of the Federal Reserve during the period 2007-2010 which encompasses the Global Financial Crisis (GFC). This schedule became available because Congressman Ron Paul, Senator Bernie Sanders and others were able to demand an audit of the FED’s activities during the GFC. In fact they had demanded a complete audit of the FED but were shut down in that request and this limited audit was all they could get. Even though the audit was limited the information provided herein is a blockbuster. Prior to the release of this information the FED claimed they had no secrets and that they were totally transparent as an organization. See if you agree.

(See Schedule, Following Page)



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What this schedule shows is that during the GFC the FED created and loaned out over $16 trillion dollars to financial institutions inside and outside of the United States without telling a single soul or disclosing anything other than the $700 billion TARP program. Let’s put this in perspective because $16 trillion is a big number. The entire US GDP in 2010 was $14.3 trillion. The entire US Monetary Base is $2.7 trillion. The entire US Government Budget is $3.7 trillion. Somehow FED bureaucrats, without oversight, were able to loan out over 5 times our monetary base to financial institutions worldwide in order to prevent a liquidity squeeze? Furthermore, they only disclosed this fact under duress. The $16 trillion was loaned against questionable collateral and the FED claims it has been repaid. Since they did not tell us about the loans to begin with, how can we be sure? Furthermore, we only hear about these loans three years after the fact? Do these facts increase or decrease your confidence in the overall trustworthiness of the Federal Reserve? We thought so. We imagine that other financial analysts worldwide might come to the same conclusion. Keep in mind that the basis of the U.S. Dollar as a store of value and reserve currency is the prudence and trustworthiness of the Federal Reserve. Then consider what you just learned. Obviously, the FED did not want this information to be made public. Most intelligent analysts can read between the lines and when they see a cockroach like this one they also know that cockroaches are never found alone. The conclusion we draw from this disclosure is damning, and more people will be reaching this conclusion as time passes. In our opinion this can only benefit the established trend toward holding excess capital in the form of gold and silver instead of in dollars.

Documents

Ema Garp Fund - q3 2011 Report