EMA GARP Fund, LP
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Report for the Second Quarter Ended June 30, 2011
This is the EMA GARP Fund, L.P. report for the Second Quarter ended June 30, 2011. The Fund declined in value by 15.3% during the second quarter, leaving the fund down 18.8% year to date. Our net return from inception, January 2006, is +151%.
Quarterly Q2 2011 Q1 2011 Monthly Jun 2011 May 2011 Apr 2011 Annual 2010 2009 2008 2007 2006 Return* -15.3% -4.1% Return* -7.6% -10.6% 2.5% Return** 47.1% 33.2% -5.8% 40.5% 19.5% Since Inception 209.5% 110.4% 58.0% 67.9% 19.5% Cumulative -18.8% -4.1%
* 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 Monetary Chaos Anti Garp
Investment Implications Long precious metals, mining stocks. Short as appropriate for deflation.
Second Quarter Overview In the second quarter of 2011 our return was -15.3%. We had a gain of 2.5% in April, suffered a loss of 10.6% in May and were down 7.6% in June. We are disappointed with the results so far, but still believe we will be nicely profitable in 2011. Gold has performed well YTD, confirming our Monetary Chaos theme. Unfortunately, our gold and silver mining stock holdings are severely undervalued relative to the metal. The good news is that in every other instance in which this has occurred in the last ten years, the rebound has produced gains of 60-200%. You will also be pleased to know that the tide appears to be turning as the first few weeks of July have been very positive.
EMA GARP GP, LLC 260 Bear Hill Road, Suite 302 Waltham, Massachusetts 02451 781.209.1177 Fax: 781.209.1177 www.ema2.com
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Overall, our weightings during the first quarter, shown below, did not change very much from those of the previous quarter:
Category Gold Stocks Silver Stocks Bullion Vietnam & Other Private Deals Anti GARP Cash Total Weighting 56% 29% 13% 2% 2% 0% -2% ====== 100% Positions 35 10 10 4 0 == 78
Below we present the second quarter return figures for a number of relevant comparables. Investment EMA GARP Fund, LP DJIA S&P 500 Index Nasdaq XAU Gold/Silver Stocks HUI Gold/Silver Stocks GDX Gold Majors ETF GDXJ Gold Juniors ETF SIL Silver Miners ETF Gold bullion Silver bullion 2nd Quarter Return -15.3% 1.0% -0.4% -0.3% -7.2% -9.1% -9.2% -12.0% -16.0% 4.4% -8.0%
We are not pleased with the Funds performance this quarter, however all bull markets suffer corrections. The second quarter was very unusual because even though the price of gold increased by 4.4%, the major gold and silver stock indices were all down by 7 to 16%. When you consider that gold and silver mining companies produce future streams of gold and silver, it is not logical that the price of the metals would go up and the price of mining companies would go down. Unless, of course, mining company investors are anticipating lower future prices for the metals. We believe that this is what is happening today, and we also believe that these investors are wrong. Wherever we go, we hear talk of gold and silver being in bubbles and investors are sure that todays prices are unsustainable and must decrease in the future. Mainstream financial analysts and even gold company managements have built their models using lower future metals prices. This is only natural since gold and silver prices have increased significantly over for the past 11 years. Prices today do seem high compared to 2001; however, using other methods of analysis we conclude that they have a lot further to go.
Monetary Chaos Still Our Top Theme 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
EMA GARP GP, LLC 260 Bear Hill Road, Suite 302 Waltham, Massachusetts 02451 781.209.1177 Fax: 781.209.1177 www.ema2.com
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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 precious metals stocks please re-read our last three quarterly reports. We presented the chart below in our March 31 First Quarter Report. At that time the top of the chart was 2,400 Billion dollars and the adjusted monetary base was $2,355 Billion. We said at the time that the monetary base had grown by 18.7% calendar year to date. Now the chart shows that the adjusted monetary base is $2,645 Billion and the base has grown by 33% year-to-date. So, in six months the monetary base has expanded by 33%. This means that currency in circulation and bank reserves have increased at that rate. Recall that this is occurring in the context of the US Federal Government and its senior officials telling us that inflation is contained and in the range of 1-2% per annum. Something is clearly wrong with this picture.
Developments In The Second Quarter of 2011 There were several notable events which took place in the second quarter. We think one of the most important, yet little reported, news events is that the University of Texas decided to use 5% of their endowment assets ($1.0B) to purchase gold bullion. Traditionally large institutions and endowments have been very conservative investors with a very long term time frame. It is safe to say that most institutions of this type do not own gold. When one of the largest, well known endowments embraces the gold thesis it is surely a sign of the times that the thought patterns of large investors are changing. The managers at U of T sited that fact that gold cannot be printed as a rationale for making the purchase. Another important development is that the nation of Greece, which only recently worked out a bail-out package with the European Central Bank (ECB) came back to the table asking for more lenient terms on repaying their debts. The ECB in turn said that such a bail out could only occur if Greece agreed to
EMA GARP GP, LLC 260 Bear Hill Road, Suite 302 Waltham, Massachusetts 02451 781.209.1177 Fax: 781.209.1177 www.ema2.com
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substantial austerity measures. This idea was not well received by the population of Greece and they promptly demonstrated in the streets. We believe that we will see more of this behavior as politicians are trapped and cannot cut spending, yet also cannot service their debt burden. The solution will be what it has always been: printing money, debt monetization and attempting to grow out of the debt burden. These policies are extremely positive for the monetary replacement metals, gold and silver. Finally, the formal end of QE2 (quantitative easing) did arrive on June 30, 2011 and the Federal Government reduced its purchases of its own bonds (money printing) to just the amount that occurs naturally as older maturity bonds mature. Surprisingly, the bond market has been relatively stable, although we attribute this to several notable leaks from academia and Federal Reserve officials that have implied that QE3 may be necessary in the future. We believe that QE3 is a near certainty, even if it is not called that name. Without a program of continuing to buy our own bonds the US financial system will collapse.
Is Gold Overvalued? The first chart below presents the current gold market indexed against two other bull markets. The first is the gold market from 1968 to 1980 and the second is the US NASDAQ stock market from 1988 to 2000. Each of these bull markets took twelve years to peak and resulted in peak prices that were 23x and 14x the base starting point. The present gold bull market is 10 years old and has only grown 5.5x its base price. For gold to match these prior bull markets its current price would need to be either $3,640/oz. or $5,980/oz. Both figures that are substantially above todays $1,550/oz.price.
Source: The Aden Report. Another way of looking at the issue is presented in the chart on the next page. Gold is money. It is a substitute for currency, or rather currency is a substitute for gold. The schedule below shows the amount of US currency in circulation in billions of dollars on the right scale. As you can see the currency in circulation has risen from under $50 billion in 1975 to nearly $1 Trillion today. During the same time period the price of gold, as measured in 1975 dollars, and thereby adjusted for the government rate of inflation, has fallen from just under $200 per oz. in 1975 to just over $100 per oz. (1975 dollars) today. In other words the price of gold has not even kept up with inflation, much less with the growth of the
EMA GARP GP, LLC 260 Bear Hill Road, Suite 302 Waltham, Massachusetts 02451 781.209.1177 Fax: 781.209.1177 www.ema2.com
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money supply. The conclusion we reach from this is that the gold price could increase by 5x in dollar terms and still not be overvalued when compared to the growth in the money supply. If gold increases in value by 5x todays price it will be priced at $7,150 per oz. Furthermore, who is to say it will not overshoot fair value. Once it becomes clearer that gold is in a bull market it might exceed its fair value, much as it did in the 1980s bull market.
Present Conditions: The Gold and Gold Share Marketplace By all statistical measures we are clearly in a bull market for gold and gold equities. The price of gold has been up consistently for the last 11 years at a compound annual rate of 18%. The market for gold stocks has also been up substantially since its low in 2001. Using the widely accepted HUI/ARCA Gold Stock Index the gold stocks have appreciated at a 26% compound annual rate since their low in 2001. The charts below clearly look like bull markets to us. It would take quite a correction or turn of events to convince us that these trends in motion were not going to continue.
EMA GARP GP, LLC 260 Bear Hill Road, Suite 302 Waltham, Massachusetts 02451 781.209.1177 Fax: 781.209.1177 www.ema2.com
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The next chart shows the HUI Gold Stock Index on a weekly basis from 1996-Present.
Notably, gold and gold stocks suffered very sharp set-backs in 2008 when the world financial crisis erupted. We believe the memory of 2008 is one reason that gold stocks are presently underperforming the price of gold bullion. Investors fear another liquidity crisis and fear how it could impact gold stocks. But here is the important point to consider. Gold stocks are nothing more than future streams of gold bullion. gold miners invest capital and extract gold. If their capital-weighted cost of extraction is less than the price of gold, they make money. In a sense they are central banks. They make the money of the future. As shown above, notice how the gold equities have generally moved in the same direction as gold; however, they have been more volatile and they took a big dive in 2008. This makes sense because equities represent the value of a future stream of the metal and their valuation depends upon expectations about future metals prices. When investors believe future metals prices will be lower, then the equities sell off. When they begin to expect that futures metals prices will be higher, then equities will trade at a premium to gold. Keep in mind that in spite of this volatility, the equities have outperformed gold by over 800 basis points per year over this time period. In the longer run investors have been paid to take the risk inherent in the equities. Bottom line, the gold and gold mining stocks are highly correlated in their price performance. The stocks, however, are more volatile than the price of the metal since they represent claims on long term streams of gold, the value of which are influenced by expectations of future gold prices. John Doody, is a well-respected and experienced gold stock analyst with an outstanding track record. He sells a subscription service that we take. He recently made the following comments in reference to the chart which he created on the next page: As seen [in the chart below], since the Gold bull market got started in earnest in 2003, whenever Gold stocks were 10% or more undervalued, as evidenced by the green line and green circled points, the stocks were a Screaming Buy. Subsequent gains in the HUI index ranged from 60% to 237%. The stage is now set for gold stocks to explode! John Doody. June 29, 2011
EMA GARP GP, LLC 260 Bear Hill Road, Suite 302 Waltham, Massachusetts 02451 781.209.1177 Fax: 781.209.1177 www.ema2.com
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We could not have said it better ourselves. Gold stocks are silly cheap right now for a few reasons: Fear of deflation and a 2008 repeat. Lack of understanding of gold stocks. Belief that the gold and silver metals are in a bubble and will go lower in price.
This is not to say that what is silly cheap could not become cheaper. It could, and we have risk mitigation procedures in place to hedge against further draw downs. Nevertheless, our point is that unless you firmly believe that gold and silver prices are going to plunge, there has rarely been a better time to purchase the gold and silver mining equities. The funny thing is, do you hear anybody on Wall Street talking about this? Of course not, they are paid to sell conventional common stocks. Lets examine how that has worked out for them. If you bought the DOW ten years ago you have seen your investment appreciate by 9.4% over that time frame. By comparison, if you bought gold your investment has appreciated by 700 % and if you bought gold equities your investment has appreciated by 1000%. To this, some would say, OK you crushed us, but now it is time to revert to the mean. Our response is au contraire, we are just getting warmed up. First, you must accept that gold and silver are going up in response to our out-of-control monetary system. Then you must ask, do things seem to be getting better in monetary affairs, or worse? [see: Greece, Portugal, Italy, Ireland, et. al.] Have we made real progress on our deficit problems in the US and other Western Countries? Is the dollar a better store of value than silver and gold? Once you start to think of the problem in these terms you can see why we are so excited about the prospects for this investment thesis. Monetary chaos is clearly here, and it is going to be with us for a while. Probably we will continue to have monetary chaos until real serious monetary reform takes place, or the existing system collapses, or both.
EMA GARP GP, LLC 260 Bear Hill Road, Suite 302 Waltham, Massachusetts 02451 781.209.1177 Fax: 781.209.1177 www.ema2.com
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Buying GARP What We Do As you know, our core belief is that the best risk/reward tradeoff is always present in stocks which exhibit growth and are reasonably priced. Historically, investing in companies where the top line is growing and the price paid is low represent the best risk-adjusted way to grow wealth. We call these opportunities GARP, Growth At a Reasonable Price. This strategy gives an investor two ways to earn profits. First, growth over time will increase the value of an enterprise, and secondly, low multiple stocks which perform well have a tendency to become higher multiple stocks. This combination of growth and multiple expansion can be a quite powerful means of increasing value. Presently, when all equities worldwide are compared, we find the most compelling GARP in the precious metals equities. We have investments in our portfolio that, frankly, are stunning. For example, we own a gold mining company with the following characteristics: Market Capitalization: $660 million. Calendar 2010 EBITDA or $139.5 million. Calendar 2009 EBITDA of $ 106.2 million. Calendar 2008 EBITDA of $66.2 million. Q1 2011 EBITDA of $44 million. Annualized Q1 EBITDA $176 million. This Company is presently valued at 3.75 times run rate cash flow while cash flow is growing rapidly. Cash flow has historically grown at over 46% per year. They are growing production at their existing mines, and they have a large capacity expansion in the works that will begin operations in late 2012. Over time, this Company will at least double its production of gold. The Company also has resources of 12 million gold ounces in the ground, so the market is valuing each of these gold ounces at $55. Presently it costs the Company about $570 to mine one ounce. Assuming (i) that the gold price stays constant at $1,500 per ounce (many think it will go lower, but we believe it will go higher) and (ii) the Company never discovers anymore gold (surely a conservative assumption), if the Company is able to mine the entire 12 million ounces they will generate $18 billion in revenue. Since it will cost them $6.8 billion to mine this metal, on a net basis, the Company will generate cash of $11.2 billion. Would you pay $660 million for $11.2 Billion over time? Admittedly, it will take many years to mine all of the gold, so a discount factor needs to be applied to the future cash flows; however, a price that represents 6% of total future cash flow (assuming no gold price growth or additional gold discovered) is extremely cheap. Of course, there is a lot that could go wrong. Gold prices could decline. It could take additional CAPEX to mine all the metal, mining costs could increase, etc. Nevertheless, we would submit that this is an interesting risk/ reward trade off. Our greatest fear is that the Company is vulnerable to a hostile takeover offer. So what is wrong with this picture? Not much. The stock is too small to be included in the major gold stock indices. (It is included in the GDXJ Junior gold stock index but it is only a 1.5% weighting). The Company operates in geopolitically safe areas. In our opinion there are two reasons why this valuation disparity exists. First, the Company is small by large investor standards. Large investment firms cannot buy a Company with a market capitalization below $1 Billion (EMA does not have this problem). The Company does not have a large following and does not promote itself. Secondly, the current sentiment in gold and gold stocks is dreadful. The consensus thinking on Wall Street is that the present gold and silver prices are too high and are due to correct since they have come so far so fast. We strongly disagree with this view. If gold prices go down this Companys future cash flows will be lower. However, it would take quite a collapse in the price of gold to make this Company a bad bet. There is a margin of safety or
EMA GARP GP, LLC 260 Bear Hill Road, Suite 302 Waltham, Massachusetts 02451 781.209.1177 Fax: 781.209.1177 www.ema2.com
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downside protection at this valuation. Our experience tells us that if we protect our downside and have a reasonable expectation of upside then we are often surprised by how well we do. Nevertheless, the markets can be irrational at times. Our job is to take advantage of this irrationality. We have increased our position in this stock to a full weighting.
The Road Ahead It is very difficult to predict exactly how the changes we are seeing are going to unfold over the next few years. There are a lot of moving pieces and Government action will play a large role. Nevertheless, we believe a couple of things are clear. Inflation will continue and will get worse, at least in essential goods like food and energy. Policy makers will try to kick the can down the road and will respond to each new crisis in the way that they have in the past, which is to provide liquidity. All of this liquidity will make the inflation problem worse. Eventually inflation will become so severe, and so obvious, that the political cry for a solution will be overwhelming. Something will have to give. At this point, we believe that there will be some kind of political and monetary reform. The alternative will be just too painful. It is difficult to predict the timing of the breakdown and the type of reform. We strongly believe that a stable monetary system based upon metals like gold and silver is the surest means of solving the problem. If this comes to pass then our investments will do extremely well. How we get from here to there is uncertain, but we are pretty certain that this is where we are heading, sooner or later. Fundamentally, not much has changed in our present investment strategy. No doubt, there will be corrections in this bull market for precious metals and mining shares; however, we believe that the long term trend is still strongly upward. Until the issues associated with monetary chaos are resolved or addressed we do not see how the bull market for gold mining shares can be over. In fact, even if the price of gold stays flat, we still believe the mining shares will provide us with excellent returns because the gold miners are growing production and are generating excellent returns on capital. Basically, the miners represent Growth-At-A-Reasonable-Price (GARP). Historically GARP has been a very good bet. We believe it will be in the future. As always, please call us if you have any questions or comments. Thank you for your support.
Sincerely, Larry and Rich
EMA GARP GP, LLC 260 Bear Hill Road, Suite 302 Waltham, Massachusetts 02451 781.209.1177 Fax: 781.209.1177 www.ema2.com
