Ema Garp Fund - q3 2010 Report

8/8/2019 Ema Garp Fund - q3 2010 Report

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EMA GARP Fund, LP Page 1

EMA GARP GP, LLC 260 Bear Hill Road, Suite 302 Waltham, Massachusetts 02451781.209.1177 Fax: 781.209.1177 www.ema2.com

Report for the Third Quarter Ended September 30, 2010

Dear Limited Partner:This is the EMA GARP Fund, L.P. report for the third quarter ended September 30, 2010. The Fundappreciated by 18.9% during the third quarter, leaving us with a year to date return of +21.2%. Our netreturn from inception, January 2006, is +155%. Your results vary depending upon when you invested.

Quarterly Return* Cumulative

Q3 2010 18.9% 21.2%

Q2 2010 4.7% 1.9%

Q1 2010 -2.7% -2.7%

Monthly Return*

September 2010 15.0%August 2010 7.7%July 2010 -4.0%

Annual Return** Since Inception

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.

Current Themes Investment Implications

Monetary Chaos Long gold, mining stocks.

Anti Garp Short as appropriate for deflation.

Emerging Markets Long Vietnam GARP

Third Quarter Overview

In the third quarter of 2010 we earned a return of +18.9%, resulting in a year to date return of 21.2%.After the 4.0% loss in July, we earned profits of 7.7% in August and 15% in September. These resultswere driven by the appreciation of the precious metals and their mining stocks, which performed well inAugust and September as it became more apparent that governments around the world are debasing theircurrencies in an effort to keep deflation from appearing (more on this below).


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Overall, our weightings did not change very much from the second quarter to the third quarter as outlinedin the schedule below:

EMA GARP Fund, L.P. investment holdings as of September 30, 2010:

Category Weighting Names

Gold/Silver Stocks 88% 65Gold Bullion 9%Silver Bullion 0%Vietnam & Other 5% 10Private Deals 2% 4Anti GARP 4% 1Cash -8%

====== ==Total 100% 80

We sold our long position in silver bullion near the end of September. The price performance of gold

bullion and silver bullion are highly correlated (r2

=.95); however, silver bullion is much more volatile asthe market is smaller and silver has a large amount of industrial demand, so it is sensitive to economicconditions. During the quarter the price of silver appreciated by 17%, and most of this move took placein September. Any asset which appreciates almost 17% in one month is due for a correction and silver isnow very extended and sells for 130% of its 200 day moving average. By comparison, gold bullionappreciated by 5% during the quarter.

We are pleased with the Funds performed this quarter versus other asset classes. For comparisonpurposes, we have listed the quarterly performance of a number of stock indices below:

Investment 3 rd Quarter Return

EMA GARP Fund, LP 18.9%DJIA 10.4%S&P 500 Index 10.7%

XAU Gold/Silver Stocks 10.9%HUI Gold/Silver Stocks 7.3%GDX Gold Majors ETF 7.6%GDXJ Gold Juniors ETF 22.5%

Gold bullion 5.1%Silver bullion 17.0%

As you can see, we were able to outperform the overall market and most of the gold and silver indices,although the Gold Juniors ETF (GDXJ) did offer slightly better results. While the GDXJ will generallyperform well in a bull market for mining stocks, we believe that over a multi-year time frame we willexceed the performance of the Gold Juniors ETF because not all of the stocks in that fund are high qualitycompanies.


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Monetary Chaos Quantitative Easing (QE) II 1 Update

As you know from our prior reports, our current investment theme is monetary chaos. Monetary chaosis 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. This theme leads usto our top investment category, namely gold, silver and the companies that mine these monetaryreplacement metals, an area where we see many outstanding growth-at-a-reasonable-price (GARP)opportunities.

In this report we will: show you why we believe deflation is a myth and inflation is inevitable; discusswhere we are in this current gold cycle; present an example of the GARP opportunities we are seeing; andlay out the case for why this area represents such an outstanding opportunity.

We begin with a chart illustrating the way in which the U.S. National Debt is compounding at an everincreasing rate. Note the way that the slope of the curve becomes steeper with each successiveadministration. How long can it be until this goes completely vertical?

1 In this context QE II is not a luxury cruise ship. QE II stands for the U.S. Federal Reserve (FED) policy of quantitative easing, phase II.Quantitative easing is a policy that was originally implemented by the FED in March, 2009. The policy involves the FED using newly createdmoney to purchase bonds and other assets in order to influence their price. In short, QE II is a euphemism for printing money.


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As you would expect, the debt growth mirrors the Net Federal Expenditure Outlays.

In our last report we discussed how the economy was not growing in a so called green shoots rally, butwas rather stagnating, and we are more likely headed for a double-dip downturn. Since that time therehas been more evidence that we are in fact still mired in a no growth or slow growth recession.Joblessness has remained high and economic activity remains slow. This has not gone unnoticed by theU.S. Federal Government and by the Federal Reserve, and so we have begun to see and hear a lot abouthow the Federal Reserve and others must take actions to reduce unemployment and help the economy.

Also, the Federal Reserve changed its tune on its exit strategy. You will recall that when the FederalReserve ballooned its balance sheet with the first round of quantitative easing (QE) they said not to fearbecause as the recovery took hold they would exit the policy of purchasing government debt. Since thenthey have backtracked on this policy. In August 2010, the Federal Reserve said that they did not intend toexit their QE policy; in fact they expect to recycle the funds used in the first QE experiment to conductmore QE. Then over the next six weeks there were a succession of Federal Reserve spokespeople andothers saying that in fact, given the moribund performance of the economy, more quantitative easingmight be necessary in the future. This kind of thinking is not a surprise to us. When you are a hammerevery problem looks like a nail.

Even though printing money has not worked well, policy makers in the U.S. do not know any differently.At the Federal Reserve meeting on September 21, 2010, they changed the language regarding theirmonetary policy, to state:

Measures of underlying inflation are currently at levels somewhat below those the Committee judgesmost consistent, over the longer run, with its mandate to promote maximum employment and price

stability. With substantial resource slack continuing to restrain cost pressures and longer-terminflation expectations stable, inflation is likely to remain subdued for some time before rising to levelsthe Committee considers consistent with its mandate.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent andcontinues to anticipate that economic conditions, including low rates of resource utilization, subduedinflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for thefederal funds rate for an extended period. The Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings.


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The Committee will continue to monitor the economic outlook and financial developments and isprepared to provide additional accommodation if needed to support the economic recovery andto return inflation, over time, to levels consistent with its mandate. (Emphasis added by EMA).

The Federal Reserve Board of Governors.

We believe it is a near certainty that the Federal Reserve will have to engage in more quantitative easing(QE II). In fact there is significant evidence which suggests that the Federal Reserve is already engagedin QE II by using a mechanism known as Permanent Open Market Operations (POMOs) which injectliquidity into the system by continually buying bonds from dealers and then rolling over the purchases.Another mechanism that has the same effect as QE II is one in which the Federal Reserve lends to all of its primary dealers, banks and brokers, at the Fed Funds Rate of 0.25% and then lets the banks andbrokers use this newly borrowed (and newly created) cash to purchase long term government bondsyielding 3.85 %. This puts strong demand under the U.S. Government bond market and increases themoney supply. It is also a subsidy to the banks.

To market participants who have their eyes open, the largest bubble in the world right now is the U.S.Government bond market. We believe it is irrational to lend to a government that is running deficitswhich are equal to 39 % of its budget. Particularly long term money at 2-3 percent rates of interest. Onlysomeone who could borrow money for essentially free, and had a government backstop on being too bigto fail, would consider such an investment.

In spite of the obvious nature of all of these activities, we believe the Federal Reserve will make everyeffort to hide, disguise or deny this activity. The problem is that the Federal Reserve has a dual mandateof low inflation and full employment. Therefore, they want a little inflation, but not too much inflation.With an economy that is addicted to credit growth (as our economy is), this is a very difficult balance toachieve. Not enough inflation and the patient dies of deflation. Too much inflation and the patient diesof hyperinflation, or the dollar collapses (effectively the same thing).

The problem is that once inflation gets started and inflationary expectations become imbedded, it is veryhard to stop inflation from becoming run-a-way hyperinflation. Once people come to realize that themoney they hold (or are paid) buys less goods every year, month, week and even day, they immediatelyrush to convert cash into goods. This conversion creates too much demand and leads to rising prices.Rising prices are inflation, which scares people further, and the cycle becomes self-reinforcing.Ultimately no one wants to hold cash or paper assets because they are steadily losing purchasing power.When this happens a black market emerges and gold and silver coins become money. Historically, this iswhat happened in the MANY hyperinflations that have occurred throughout the world. 2

Inflation: Who Do You Believe, Me or Your Lying Eyes?

For those who have not heard the joke, the punch line title of this section comes from a story where a manis caught in bed with his mistress by his wife, but he knows that he has a trusting wife. So he says whoare you going to believe, me or your lying eyes? In the last Federal Reserve statement, a comment stated

2 Americans are uneducated with respect to the rest of the world on this topic because we have never experienced hyperinflation as a federalrepublic. We did have hyperinflation during the revolutionary war when excess printing of money not backed by precious metals led to thecollapse of the first attempt to form a national currency: the Continental. Unlike most other populations in the world, Americans rather naivelyassume it cannot happen here, yet all of the necessary conditions are in place.


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that they may actually try to raise the inflation rate because they think it is too low. In all of theirstatements the Federal Reserve goes out of its way to say that inflation expectations are well grounded.When we hear this kind of talk from our government officials we are left wondering what planet are theyliving on? Apart from computer performance, there is not one thing in our lives that is staying the same

in price or getting less expensive. Many things, particularly food, are getting significantly moreexpensive.

In prior reports we have discussed how we believe that the U.S. Government CPI and PPI statistics aregrossly distorted to understate the real rate of inflation. This is done by using a core rate excludingfood and energy (as if you could live without them) and by using hedonic adjustments and otherlegerdemain. For an honest look at inflation you really need to consult with the folks at ShadowGovernment Statistics (SGS) 3. SGS is run by John Williams, an ex-government economist, whocomputes inflation the way that it was calculated in the 1970s and 1980s. Using SGSs figures, inflationis currently running at north of 7% per year and has even been worse over the past 20 years, a periodwhere the Government has claimed there is no significant inflation.

So, the Government tells us there is no inflation and yet the price of everything is going up. A top notchanalyst, Richard Benson, captured this phenomenon in a chart showing the recent 12 month change in theprice of many commodities. Remember that commodities are the initial inputs for all goods and services.

Source: Richard Benson, September 2010.

If you have a hard time reconciling these commodity price increases with a reported August 2010 twelvemonth CPI of 1.1% and a PPI of 3.1%, then you are not alone. In our view these commodity priceincreases are a perfect leading indicator of the massive inflation that is coming down the road. In our lastletter we spoke about how the Government and the banks had managed to convince nearly everyone thatthe largest threat to the economy was/is deflation. We believe the schedule above provides conclusiveevidence that they are wrong. As we said in our last report, the most CLEAR AND PRESENT DANGERTO THE US ECONOMY IS MASSIVE INFLATION. Many people and economists are forgetting that

3 For more information on this excellent service, Shadow Government Statistics, see www.shadowstats.com
http://www.shadowstats.com/http://www.shadowstats.com/http://www.shadowstats.com/


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there is a one year to three year lag between the time when money is created and the time when theinflation shows up in the price indices.

The Investing Mosaic

A very wise investor who is a friend of ours likens investing to studying a mosaic in order to determinethe image. Our interpretation of the investing mosaic is why we are so confident of our bet on the goldmarket. There are just too many pieces that all point to the same outcome. While we concede that wecould have deflationary impulses and deflationary scares, we believe that the macroeconomic set-up,when combined with the recent market action and the technical break out in the metals and the shares,makes it highly likely that we are about to commence the next rapid appreciation phase of this gold bullmarket. The way our political and financial system is structured all roads lead to inflation, and there isnot much that can or will be done to change this. Yes, some day the gold bull market will end, but webelieve we are much closer to the beginning than to the end. Figuring out when to sell in the future willbe difficult, but it will be a high quality problem.

There is one set of conditions that could change our views - serious reform. The U.S. Government iseither bankrupt, or on the road to bankruptcy. The numbers make this conclusion clear. The Governmentcould do a pre-packaged bankruptcy: announce a devaluation of the dollar, restructure our debtobligations, severely cut expenditures, reduce future commitments and entitlements and raise interestrates sharply. Or it could back the dollar with gold or silver. If these steps are taken, we would head off the coming hyperinflation, but the results would still be very painful. Given the political situation in thecountry today we think these steps are unlikely to be taken, but we could be wrong.

The Bull Market in Gold: is it a Bubble?

The fact that gold is in a bull market is indisputable. For over ten years now gold has appreciated inprice every year. From a low of $252 per oz. in 2000, to todays price of $1,350 per oz. the value of goldhas increased over 5 times, a compound annual growth rate of 18%. No other financial asset class hasperformed this well over this period of time. After this kind of price appreciation it would be natural tothink, that this cannot continue. In our opinion it can continue.

Is gold in a bubble? With an eye toward building a mosaic, below we evaluate the gold bull market onthe basis of fundamental relative value, technical analysis, movement off of the bottom, time and cycles,and investor sentiment to see if the elements of a bubble are in place.

Fundamentals

Gold (Au) is a rare basic element. It is found at 0.004 parts per million in the crust of the earth. All thegold that has been mined since the beginning of civilization is still around unless it has been lost(shipwrecks, etc.). Gold is generally not consumed except in the form of jewelry, and jewelry enduresover time. It is estimated that 160,000 tons of gold exist in the world (above ground). Mining outputadds 1-2% per year to this base. There is a lot of gold still remaining in the earths crust, but many of theeasy to find rich deposits have already been mined. Finding gold becomes harder every year. Also, untilvery recently gold mining has been a very unrewarding business because the price of gold did not covermining extraction costs. Because of this gold mining output has been falling steadily for years. This willnow change, but there is a significant lag between discovery and production. You cannot just turn on


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production capacity. A new mine can take 3 to 10 years to become operational. Furthermore, even alarge mine might only produce 1,000,000 ounces per year which is 41 tons of gold. The base amount of gold outstanding in the world today (above ground) is 160,000 tons. So the threat of new supplyoverwhelming demand seems unlikely.

Could mankind find another kind of money? Perhaps. Silver has many of the same characteristics, butsilver is consumed. Oil, food and other commodities could serve as money, but they are consumed andthey are bulky. We have 6,000 years of recorded human accomplishments and a majority of that time wewere on a sound money gold and/or silver standard. The era of the worlds reserve currency being apure fiat currency 4 (e.g.: the dollar standard) is actually pretty short when compared to history. The lastlink between the dollar and gold was broken in 1971, only 39 years ago. For a while the experimentworked reasonably well, but when credit and money growth began to exceed the growth of productivitythe system sowed the seeds of its own destruction. No less a figure than Warren Buffet makes theobservation that we dig gold out of the ground somewhere only to put it in a bank vault and concludesthat a visitor from another planet would view this activity as crazy. In theory a well managed fiatcurrency should work, but in practice, because of politics and human nature it will never work over an

extended period of time. The temptation to cheat is just too great. Warren should have listened to hisfather who was much wiser on this matter. Over the span of history all fiat currencies have failed. That isright, ALL. In monetary matters this is as close to a natural law as we have. So, you can bet on theintelligence and stewards of the world monetary system: governments, Ben Bernanke and the banks, oryou can bet on 6,000 years of history. As one of our business school professors used to say: pick one.

Now, having said all of that, this does not mean the dollar has to go to zero or we have to havehyperinflation. At some point the monetary problems we have will be recognized and perhaps evenaddressed. If this happens before hyperinflation gets imbedded we might have a new start with a newcurrency unit. However, unless the new currency is commodity backed it is likely to be just as flawed. If the dollar does totally collapse and all confidence in fiat currency is lost, then it will be very difficult forgovernments to get people to accept a new unbacked paper currency.

Another fundamental aspect to the price of gold is its replacement cost. Presently the marginal cost of mining an additional ounce of gold varies a great deal by type of mine, grade of the ore, etc. However,most gold mines experience marginal mining costs between $200 and $900 per ounce. Those that areclose to $200 are very rare. Studies we have seen indicate that the weighted average marginal cost of mining an oz. worldwide is about $600. This implies a contribution margin of $750 today ($1,350-$600).At first glimpse, a very good business. But this misses the capital component of the equation. Building agold mine is not cheap and the outcome is uncertain in terms of economics. If the ore grade does not holdup or if there are problems with the mine the costs can escalate to exceed the price of gold. This is whysome mines are always closing downthey are just not economic. The capital cost component of miningis huge. Mining operations generally cost at least $100-200 Million for a small operation and can cost asmuch as $3 to $4 Billion for a large mine. Some analysts estimate the capital component adds another$300 to $ 400 per oz. to any mining operation. When these costs are considered it is not as easy to makemoney in the mining business. Particularly since mines can take from 3 to 10 years to finance and build.

FFiat currency is the name given to any money which has value because a Government says it has value. It is decreed to have value by law, orfiat which in Latin means let it be done.. As in a declaration that a piece of paper has value. Since 1971 the U.S. has operated on a fiat moneydollar standard where the dollar is declared to have value but is backed by nothing. In the U.S. the dollar is legal tender for debts, public andprivate. Fiat currency has no backing and is not convertible into any other thing of value. In other words it has no value except that theGovernment decree it is effectively money.


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The notion that higher gold prices are going to lead to a rapidly increasing supply is not built on soundanalysis. No doubt, higher gold prices will lead to an increase in supply, but it will take time.

Finally, in the last part of our fundamental discussion we would like to try to quantify the growth in the

amount of paper in the world versus the growth in the amount of gold. In todays world gold is almostcash and paper money is cash. They both have value, but their value against one another fluctuates.Paper cash or digital credits are necessary for most purchases and transactions in the world today 5;however, gold is priced and sold around the world 24 hours per day in every country. There is no place inthe world where given a days time you cannot convert gold into cash that will spend. So gold and papercash are always competing with one another for the preference of the consumer. Paper is moreconvenient and lighter weight and when it is properly managed it is stable enough that the demand forgold is modest or low. The devil however is in the details because the properly managed piece is easiersaid than done. Gold is bulkier, heavier and harder to conceal or transport, but it has the enormous benefitof having a stable underlying value behind it since it cannot be printed or debased.

A shift in consumer preferences from cash to gold can change the relative values of these two near

substitutes by a great degree. Lets examine how much gold there is in the world and how much cashthere is in the world. Assuming that the two figures were relatively balanced when we were on the goldstandard pre-1971 and gold was priced at $35 per ounce we can look at the growth in paper cash andcredit since that time and make a conjecture as to what the price of an ounce of gold would have to be inorder to have every currency fully backed by gold. The calculations necessary to do this work are quitecomplex and depend upon what we consider to be cash. Is credit cash? How much cash is there out inthe world? Nobody knows with exact certainty. But, we have seen calculations that say that gold wouldneed to trade at $96,000 per ounce to fully convert all cash and credit to a gold standard. We have alsoseen calculations that say that $30,000 would be sufficient and others think $6,000 would be sufficient. Itis difficult to know the correct answer, but suffice it to say that if all paper cash is replaced by gold thenthe price of gold will be much higher in terms of paper cash than it is today.

Technical Analysis

Technical analysis is the study of trends and pattern recognition in markets. In our view there is aNewtonian aspect to market behavior. That is, a trend in motion is more than not likely to persist until itbecomes exhausted or some force acts upon it to reverse it. Now this may sound like a tautology, but it isreally nothing more than visual analysis. If a market is going up, then from a probability point of view itis a better than 50/50 bet that it will continue to go up. Which is not to say it is a certainty. This type of market behavior accounts for the old traders saw the trend is your friend. There is a lot of imbeddedwisdom in that statement.

5 One interesting exception to this rule is Vietnam where many goods are priced in paper and in gold. In fact, in Vietnam if you intend topurchase any real property or real estate you will need to show up at the closing with gold taels. Paper money is not accepted in these bigtransactions.


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The chart below shows the continual uptrend in gold since calendar 2000.

Time and Cycles

In all investment classes there are cycles. These cycles vary in length, yet most assets when measuredagainst other assets swing from one extreme to another over a long period of time. The trend reverseswhen everyone is in on the trade and there is no new money to drive the price higher. This type of analysis is the essence of behavioral finance and basically discredits Burton Malkiels strong version of the efficient market hypothesis. Malkiel 6 took the position that all knowledge was available to allparticipants at all times and so a monkey throwing darts randomly at the stock pages could perform aswell or better than most market participants. In his view stock prices are a random walk. His efficientmarket hypothesis moved the conversation forward because there is some efficiency in markets.Nevertheless, he omitted a huge piece of the puzzle. His model forgot to account for the fact that humanbeings are social creatures and are hard wired to herd in groups in terms of their thinking and actions.This herding drives certain trends to extremes before they reverse. The notion that markets are perfectly

efficient is not supported by history and this theory could only exist in the mind of an Ivy Leagueprofessor. Nonetheless, the entire investment world has built its model around this flawed theory. A pityfor them, but good for us.

6 6 Burton Malkiel is a Professor at Princeton University who wrote a rather famous book on stock market investing called A Random Walk Down Wall Street. In this book Malkiel developed the efficient market hypothesis which then led to the development of the Capital AssetPricing Model which is the basis for nearly all modern investment management models. Because of the flaw in this model GARP opportunitiesexist and provide a better risk/reward trade off than can be explained by the model.


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Below we have presented a chart of golds price cycles since 1800 in constant dollars (ex-inflation).Examining golds price cycles historically going back to 1800 we can see that there have been 5 bearmarkets, with lengths running from 12 to 36 years, with an average duration of 19.4 years. There havealso been 5 bull markets (including the current one) and the average duration of the four prior to the

current bull market is 25.5 years. The four bull markets prior to the present one vary in length from 10years to 39 years. The bull market from 1969 to 1979 was particularly dramatic and was driven by thedropping of the gold standard in 1971. It was stopped in 1980 when the then Treasury Secretary PaulVolcker pushed interest rates up to 20% in order to rescue the dollar and fiat currencies. Could thishappen again? Maybe, but at 20% interest rates there would be a lot of bankruptcies in this country.

Nevertheless, as we stated earlier, the largest risk to this bull market in gold is a strong policy of government reform. Could such a policy arrive? As investors in gold that is what we must be wary of.

Based upon the historical evidence, and our gut feel, it appears to us that we are about half way throughthis bull market in gold. A 20 year bull market in gold would fit nicely with the average length of goldbull markets and we have not even surpassed the inflation adjusted gold price that was reached back in1980. Given that the debt situation and insolvency in our Government is significantly worse now than itwas back in 1980, we think that we have at least five, and perhaps as many as ten, more years to run inthis gold bull market. In our opinion, up until this point the gold bull market has been a stealth bull. Notmany people have acknowledged it or recognized it. This is what is changing. We are moving from astealth bull market to fully acknowledged bull market. Some people interpret this move as a bubble, wethink it is part of the natural progression of a long term trend, and their fears are nothing more thanclimbing the proverbial wall of worry that must exist in all bull markets. When most people think goldcannot go downTHEN we will be concerned.

The next schedule shows 209 years of the ratio between the Dow Jones Industrial Average and the priceof gold. This is a fascinating chart because it shows how investor preferences swing between stocks asfinancial assets and gold as a financial asset.


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There are several interesting takeaways from this chart. First, notice how the swings were within arelatively tight band from 1800 to 1913 when the Federal Reserve was created. After the FED wascreated, effectively allowing banks to provide unlimited credit knowing that they had a fall back lender,the swings became much more violent. The original intent of the Federal Reserve Act was to establish a

system that would prevent bank failures and allow flexible management of the currency. Unfortunately,the creation of the Federal Reserve did not prevent the bank failures of the 1930s and we got a series of wild swings in the value of money and therefore in the economy. We conclude that this experiment with aflexible currency has been a dismal failure. The notion that a government bureaucrat can do a better

job of setting interest rates, or the price of borrowed money, than the free markets is fatally flawed. Webelieve that the world is now beginning to wake up to this fact.

At the last two cyclical highs in gold relative to stocks (1933 and 1980) the price of the DJIA was 2 timesand 1.2 times the value of an ounce of gold. In todays world using current DJIA levels this would implythat gold would have a price of $5,500 per oz. (11,000/2) or $9,166 per oz. (11,000/1.2). Of course goldcurrently is priced at $ 1,350 per oz. Furthermore, there is no guarantee that the present DJIA level willbe maintained. The Dow could slump to 5,000 in deflation or soar to 20,000 in an inflationary

environment. Applying the ratios to these numbers could create a gold price as low as $2,500 and as highas $16,667.

Based upon the trend which is in progress our belief is that the ratio will continue to shrink and the Dowprice and the price of Gold per oz. will continue to converge. If the trend in this direction is broken wewould obviously reassess our position. Once again, there will come a time when this trend will end, butin our opinion it will be at a much higher gold price.


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Movement Off Of The Bottom

Another piece of the mosaic is shown by looking at how far the price of gold would have to move tosatisfy other conditions or to match other bull markets. An important thing to understand here is the price

of gold is denominated in dollars. This is actually an upside down construct. The price of dollars shouldbe denominated in gold. Gold is the truer version of money. Many people make the mistake of anchoring their views on prices. Because the 1980 gold price peak was $800 they assume that todays$1,350 is a high price because it exceeds $800. What they forget is that the constant inflation over this 30year period has raised all prices. In 1980 you could buy a high end luxury car for $10,000. Today thesame car costs $60,000.

So the question is: why hasnt the price of gold kept pace with inflation or anything else? The answer liesin consumer preferences. When stocks and bonds offered superior returns gold became a barbaric relic.Now that stocks and bonds are much less attractive gold is reclaiming its place as undilutable money. Aslong as the credible threat of monetary dilution (quantitative easing, expanding money supply, printingmoney) continues then the gold bull will be alive. The chart below shows how high gold would have to

rise to keep pace with a number of metrics.

Source: Chris Mack

We find it particularly interesting that gold has not even achieved its old inflation adjusted high of $2,382.If you start with a gold price of $800 in 1980 and grow that price at the government stated inflation rateits price today should be $2,382. Nearly all other commodities have exceeded their old inflation basedhighs of the 1980s but gold has lagged behind. Furthermore, as stated earlier we think that thegovernments inflation statistics grossly understate the real rate of inflation. Using the ShadowGovernment Statistics (SGS) inflation figures the inflation adjusted price of gold should be $7,689.Carrying this methodology forward a few years the price of gold would be $10,226 in 2015. Personally,our experience with big multi-year bull markets is that prices off the low tend to multiply by 10 to 20times. Using a low price for gold in this cycle of $250 in calendar 2000 this implies that gold will reach$2,500 to $5,000 per oz. It is literally impossible to know the price at which this bull market in gold willend, but our analysis tells us that it is wrong to think that gold is relatively overvalued at $1,350. Gold isno longer cheap the way it was in 2003 at $320 per oz. when we personally started purchasing coins, butit has yet to become truly expensive compared to the alternatives.


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Investor Sentiment

A very wise investor who has been writing about the markets for 50 years, Richard Russell, says that all

bull markets go through three stages. In the first stage they are completely ignored and totally belittled.Prices of the item start to go up, but no one can believe it because it has been going down for so long thateveryone assumes it will always go down. The really smart money sees a change in trend but no one elsesees it or believes it. Pessimism on the asset class is at its maximum. This is where the gold market wasfrom 2000 to 2005. Gordon Brown, the former Prime Minister of England sold half the countrys goldreserves between 1999 and 2002, a sale which will certainly become one of the worst ever made. Weremember this time frame well. If we mentioned gold people were hostile or looked at us like we wereweird.

In the second phase of a bull market the smart money figures out what is going on and they take theirpositions. The price advances but there are still many skeptics and there are wide swings and corrections.The reasons for the bull market become more apparent, but still most people do not see it or get it. This is

where the gold bull market was during the 2005-2010 timeframe. They say bull markets climb a wall of worry and there was plenty of worry about gold during the 2005-2010 timeframe.

The third phase of a bull market is the public phase which often evolves into the mania phase. In thepublic phase more and more people figure out what is going on and jump on the band wagon, or join theherd. In our opinion we are just starting this phase. The third phase produces the most rapid priceappreciation and only ends when there is no one left to buy. By definition this is an investment mania. Aperfect recent example of this phenomena is the NASDAQ stocks and the Dotcom stocks from 1995-2000. We lived through this market and we remember the crowd sentiment of the times. Everyone wasgetting rich on dotcom stocks, and CNBC was watched in every corner store and barbershop. We do notobserve the same conditions in todays gold market.

Some people believe that we are already in the manic stage of the gold market. They site the increasedinterest in gold and the advertisements on cable TV for gold. They point out that there are gold vendingmachines in other parts of the world. And, while we agree, that these are signs that gold is getting morepopular we then ask the question, do you own any gold? Does your neighbor own any gold? Does yourdry cleaner or shoe shine boy own any gold? Have you heard any gold stock tips from your cab driver?

If this is the manic stage for gold then someone forgot to tell most of the people about it. We think thatwhat is occurring now is a kick off of the manic stage. In other words, you have not seen anything yet.Most people do not own gold or gold producing stocks, in spite of them being the best performing assetclass for the last ten years. When they discover that this is the case they will want to get on board thetrain that is this gold bull market. When there is no one left to convince and analysts are making newpredictions about how high the price of gold can go then it will be time to find another train.

Below we have included several schedules which show how small the investor commitment to gold hasbeen. Note that today gold and gold mining share value represents a fraction of the value that theyrepresented in past gold bull markets.


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In the schedule below, note once again that gold bullion is a fraction of the total value of financial assetsin the world. Imagine if a meaningful portion of those financial assets are converted into gold. Becauseof the small relative size of the gold market it will have a very meaningful impact on the price of gold.

Acquisition Fever

Another piece of the mosaic is the acquisition market for gold companies. Whenever an asset class isperceived to be undervalued in the stock market it is natural for the large companies in that class to beginto purchase the smaller companies in order to capture some of this hidden value. The cost of finding newgold and developing new mines is quite high in todays world. Many of the smaller gold and silver


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mining companies sell at a fraction of the value of their assets in the ground. This anomaly has not goneunnoticed by the larger gold mining concerns and has led to string of acquisitions in the past year. Weprofile the largest of these below:

Kinross Gold / Red Back Mining.Kinross Gold is one of the largest gold mining companies in the world with a market capitalization of $22.1 Billion. In September of 2010 they closed the purchase of Red Back Mining, a rapidly growinggold miner with several operating mines in Africa. Kinross purchased Red Back using stock valued at$7.1 Billion but Red Back had $730 million of cash so the net purchase price was $6.37 Billion. Thisprice is 23.2 times Red Backs run rate cash flow, and represents a price of $14,000 for every ounce of gold Red Back will mine this year. Red Back has total reserves of 18 million ounces in the ground soKinross paid $353 per reserve ounce. Our portfolio is full of companies that are trading at less than $100per reserve ounce.

Newcrest / Lihir Mining

Newcrest is Australias largest gold mining company and is considered by many to be extremely well run.It has a market capitalization of $30.7 billion and is actively trying to replace the reserves that it ismining. Lihir was a large successful miner with operations in Australia, Papa New Guinea, Malaysia andAfrica. In March of 2010 Lihir agreed to be acquired by Newcrest for $9.5 Billion in stock and cash. Thisprice is 23 times Lihirs run rate cash flow. The price also values Lihir at $8,452 per ounce produced and$116 per ounce in the ground. In our opinion, Newcrest got a very good deal on a per ounce in theground basis. Note that they paid fairly rich multiples of cash flow and current production.

Goldcorp / Andean Resources

The most recent major acquisition in the gold mining business is the purchase of Andean Resources byGoldcorp. Goldcorp is a large Canadian miner with operations worldwide and a market capitalization of $32.1 Billion. Andeans largest operations are in Argentina and they are still an explorer, they have yet toproduce their first gold from mining. Goldcorp is paying $3.5 billion for Andean which is quite a highprice for a company without revenues or cash flow. Andeans Cerro Negro project in Argentina hasreserves of 3.1 million ounces of gold and 20 million ounces of silver, for a combined 3.4 million goldequivalent ounces. The price Goldcorp is paying is $1,029 per ounce of gold in the ground which is oneof the highest prices we have ever seen. There are two reasons for this price. First, industry expertsbelieve that there are really 10 million ounces or more at Cerro Negro. Second, the gold is very easilymined and it is projected that with CAPEX of $275 million Cerro Negro will produce 285,000 ounces peryear at a cash cost of $168 per ounce for the 10 year life of mine. Assuming these numbers are correct,Cerro Negro, once fully developed (will take several years), will produce cash flow of $336 million peryear at the current gold price of $1,350, before capital costs.

An Example of GARP in a Gold Mining Company

Another part of the mosaic is discovered by looking at the companies which are operating in the area andseeing if they exhibit growth-at-a-reasonable-price characteristics. If GARP exists, then by the definitionof our investment mandate, the area is an interesting prospect. In fact it is important to point out we donot just pull the candidate themes for GARP out of a hat. We actively screen for GARP by trying to find


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companies whose revenue and profits are growing rapidly. When we find them we try to figure out whythey represent GARP. This allows us to backward engineer our way into attractive areas. Nearly all of the companies in the gold and silver mining space exhibit serious GARP characteristics at a time whenvery few other companies in the public stock markets qualify as GARP. Below we have profiled a

notable example that is a large holding in our portfolio. We have many other holdings with similarcharacteristics.

La Mancha Resources, Inc. (TSX: LMA)

La Mancha Resources was started in 2006 as a spin-off of the gold assets of a large French conglomerate,Areva, and a small Canadian explorer, La Mancha. They operate mines in Australia and Africa. Theirfirst production was in 2007 and they have grown resources and gold production quite consistently. In2007 they produced 53,900 ounces of gold. In calendar 2010 they will produce approximately 140,000ounces of gold. This is a compound annual rate of production growth of 37 %. They are projecting thatthey can continue to grow production such that they will be producing 350,000 ounces per year in 2015.If they achieve this goal they will have grown at 20% compounded from 2010 to 2015. So, even without

any increase in the price of gold, this Companys top line should grow by 20% per year. If gold prices goup then we add this growth rate onto the production growth rate. As you can see, if gold goes up 18% peryear like it has in the past, then La Manchas top line could grow at 38% per year. Pretty impressive, butwe are not done yet because there is also operating leverage. Since a portion of the companys costs arefixed it is likely that annual profit growth will significantly exceed revenue growth. Just this past quarter(June 2010) cash flow increased by 280% year on year when revenue increased 92% year on year.

Now, La Manchas average marginal cost of mining an ounce of gold is $658. In the quarter just endedJune 30, 2010 the Company had cash flow from operations, or EBITDA, of $ 18 million. Justannualizing this rate the Company will generate cash flow of $72 million in 2010. The fully dilutedmarket capitalization of this company on October 11, 2010 is $370 million, or 5.1 times run rate cashflow and it was even cheaper when we bought the stock. For those of you with an investment backgroundyou will recognize that 5x cash flow is a very low multiple and generally is found only in situations withsignificant risk or problems. To the best of our knowledge La Mancha is not facing any significant risks.They are just undiscovered by the larger investing community.

Using two other common metrics to value gold companies La Mancha is exceptionally cheap. In calendar2010 La Mancha will produce 140,000 ounces of gold. The market value of La Mancha is valuing thecompany at $2,500 per ounce produced. This is at the extreme low end of the range for all goldproducing companies. Compare this to the price paid in some of the acquisitions which are detailedabove. La Mancha also has 2.0 million oz. of gold in the ground in reserves. Thus the current marketvalue is assigning a value of $185 per reserve ounce to La Mancha. Keep in mind that this measure of value is contingent upon how much drilling has been completed. There are probably a lot more than 2.0million ounces in La Manchas land package, they just have not focused on drilling them out yet, sincetheir first priority is growing production.

This is how cheap some of the gold stocks remain today because of the brutal sell off that took place in2008 during the Global Financial Crisis when everybody was selling everything they could to achieveliquidity. There is a lot of room for growth in this stock along all measures: production, price realized perounce, profit and multiple expansion. We expect that La Mancha will provide us with excellentinvestment results.


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RisksWhat Could Go Wrong?

In our opinion the micro risks in gold mining are substantial. Governments the world over are not aboveconfiscating or heavily taxing gold mines. As an example, in Venezuela their leader Chavez basically

confiscated Gold Fields mine. This has happened in other countries too. This is why it is important tohold a basket of mining companies and to totally avoid certain jurisdictions. We do both. Other thanpolitical risks, the general risks of operating a gold mine are substantial. In some mines flooding andcave-ins are possible, other mines run the risk of having ore grades deteriorate. At a minimum all minesrun the risk of cost over-runs and time delays in pulling gold out of the ground. This is where knowledgeof the management teams and their credibility are crucial.

At a macro level we have already touched upon the risks but we will emphasize them again. The biggestrisk to the monetary chaos theme is if Governments around the world undertake a real program of reform and work to reduce their debts and make their currencies sound. Presently, all countries are tryingto make their currencies weak because they want to increase their exports in order to fund their tradeimbalances. We do not expect this to change anytime soon.

Conclusion

We apologize for the length of this letter, but the issues raised by this gold bull market are so important,and at times emotional, for people that we thought it would be useful to provide as complete a glimpse aspossible into our thinking. We hope you now understand why we have positioned our capital and yoursin the way that we have. We also want to emphasize that we are open minded to changing events.

We leave you with a quote from a gentleman in the gold community who has a strong opinion of what isgoing on. Clearly, no American wants to contemplate the demise of the dollar. Yet, if you apply hardlogic and math it is no longer impossible or unthinkable.

In a world of lemming-investors, bond-holders have the dubious distinction of being the largest herd,running the fastest, toward the largest cliff. ........, the only way in which Western governments (andJapan) can even temporarily prop-up the worlds largest, most-obvious bubbles (government bonds)is to print-up new money at an even faster rate in order to buy-up their own bonds, or to continuethe current bond-market game of musical chairs.

For those who still havent clued-in to what is happening already in bond-markets, we have thesemorally/intellectually/economically bankrupt Western nations pretending that there is still demandfor their bonds, by printing-up more and more fiat-paper for the sole purpose of buying each othersbonds. Such an exercise usually goes by the name Ponzi-scheme.

Simply put, the only way to prop-up these doomed bubbles day-by-day is through acceleratingmoney-printing, and thus accelerating the speed with which all banker-paper (including bonds) goesto zero real value (irrespective of nominal prices).

Jeff Nielson, www.bullionbullscanada.com

At a societal level we sincerely hope that this gentleman is wrong, but our concern is that he may be right.Let us emphasize that we are not betting against America or rooting for the failure of the dollar. We


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

would very much support any reform measures that prevent the end point that we see coming. We hopethat our leaders, the government, and people in general will work to stop the senseless printing of moneyand the debasement of the currency. We would like to see serious reform of what we believe is a brokenmonetary system. If what we envision comes to pass, there will be a great deal of adjustment and a great

deal of societal pain. We do not wish that on anyone. Also, we are not pessimists, but are in fact quiteoptimistic. Even if these bad events come to pass, they will eventually lead to reform and we believe thatpost-reform the world will be a much better place. In the interim there could be a few rough years.Proper actions by leaders and governments could shorten the transition period.

Irrespective of what we want to happen, our job is to protect and grow your capital and we would not bedoing our job it we did not present our best thinking to you. We will continue to focus on that goal in thistime of rapid change. We think that our approach of finding equities that offer growth at a reasonableprice will serve us well no matter what happens to the larger picture.

As always, we encourage you to contact us if you have any questions or comments. Thank you for yourconfidence in us and for your support.

Sincerely,

Larry and Rich

Ema Garp Fund - q3 2010 Report

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Transcript of Ema Garp Fund - q3 2010 Report