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What a month February turned out to be. With perfect hindsight, the Arab social unrest that has toppled
Tunisia and Egypt’s governments and instigated a civil war in Libya could have been predicted from our
prior observations. Last month, we spoke of the raging commodity inflation that was visible to everyone
but the U.S. Federal Reserve. If we take our observations one step further, we can see that the countries
embroiled in civilian revolt has some of the highest unemployment rates in the Middle East and North
Africa (MENA) and are most susceptible to inflation. For example, Libya had a recent official
unemployment rate of 21%1, and the country must import an estimated 75% of its food2. Idle youths
and hunger does not mix well.

So it is not surprising to us that Saudi Arabia’s King Abdullah recently announced a $36 BB social welfare
package to appease his restive people. Would Saudi Arabia, the world’s largest oil producer, also
succumb to social unrest or will the King’s actions be enough? The unrest scenario is not as farfetched as
some analysts are claiming – Saudi Arabia also suffers from high unemployment (10.8%3) and high
inflation (5.3% in January).

And while the whole world is fixated on MENA, we should not forget about the problems brewing in
Europe – yields on Portugal’s government debt continues to climb ever higher (10 year yields above 7%)
while Ireland’s newly elected government looks set to renegotiate its debts with the ECB (and Angela
Merkel’s hardline rhetoric against the idea).

All in all, not a good time to be fully invested – there are simply too many things that could go wrong
and derail a fragile economic recovery (some claim oil above $120 for a prolonged period will push the
world economy back into recession). Our advice to investors is to avoid leverage and keep some money
on the sidelines so you can sleep well at night (our current portfolio is 34% cash, with another 3% near-
cash pending the closing of an M&A transaction).

Jason Chen
The Aspiring Analyst

1
Tripoli Post, retrieved Thursday, March 2, 2011:
http://www.tripolipost.com/articledetail.asp?c=2&i=2905&archive=1
2
CIA World Factbook, retrieved Thursday, March 2, 2011: https://www.cia.gov/library/publications/the-world-
factbook/geos/ly.html
3
CIA World Factbook, retrieved Thursday, March 2, 2011: https://www.cia.gov/library/publications/the-world-
factbook/geos/sa.html

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In Ben We Trust

Once again, Federal Reserve Chairman, Ben Bernanke, demonstrated his complete lack of touch with
reality during his latest testimony to the House of Representatives4:

"I recognize that the increases in gas prices are very troubling for a lot of people and very difficult, but
they are not inflation per se. Inflation is an increase in the overall price level, which is very low. The
inflation rate right now is 1.2 percent for all goods and services. The main risk from a price stability point
of view would be if higher gas prices, for example, would start feeding into the broader basket because
people came to expect higher inflation, began to demand higher wage increases, or those costs were
being regularly passed on by producers that overall inflation would begin to rise. That would be the
point at which we would become very concerned and make sure that we would take monetary policy
actions to avoid any significant increase in overall inflation. The relative price of oil, again, is primarily
due to global supply and demand."

Again, we reiterate the point we made in last month’s letter. Inflation is not a problem if you do not
drive, eat or heat your home. George Weston (Canada’s largest grocer) is set to raise prices by 5% on
average; the UN’s Food and Agriculture Organization reports that global food prices are the highest
since records were kept; gasoline prices are hitting $3.5 a gallon (still a steal relative to Canadian prices
of over $1.23 a litre); and airlines are scrambling to implement fuel surcharges as a result of crude oil
surging past $100 per barrel. Do we need to go on?

This is the same Fed Chairman that famously said on March 28, 20075:

"At this juncture . . . the impact on the broader economy and financial markets of the problems in the
subprime markets seems likely to be contained."

If he could not spot the Housing Bubble in 2007, why do we trust he will see a Commodity Bubble?

Riding The Tiger

We believe Ben Bernanke and the Federal Reserve have further compounded problems with its
Quantitative Easing programs, which is essentially keeping stock markets and other asset prices “higher
than they otherwise would be”. As we observed at the end of QE1 in mid-2010, when the Fed openly
contemplated withdrawing stimulus by allowing its balance sheet to gradually run-off (the Fed’s balance
sheet has ballooned from under $800 BB before the crisis to over $2.1 Trillion), stock markets promptly
fizzled (the S&P500 sank a 100 points from the end of 2009) and the economy looked like it would head
back into a double-dip recession. The patient, it appeared, could not be taken off life support.

4
Reuters, retrieved Sunday March 6, 2011: http://www.reuters.com/article/2011/03/02/us-usa-fed-bernanke-
highlights-idUSTRE7214KG20110302
5
Federal Reserve, retrieved Sunday March 6, 2011:
http://www.federalreserve.gov/newsevents/testimony/bernanke20070328a.htm

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Luckily, the Fed panicked and did an abrupt U-turn. Instead of allowing its balance sheet to shrink and
withdrawing the stimulus of QE1, the Fed (Ben Bernanke at his Jackson Hole speech) soon began talking
about a second round of Quantitative Easing and in August, formally announced plans to purchase an
additional $600 BB in Treasuries by the end of June 2011.

So what would happen now, as we approach June 2011? Will there be QE3? Currently, Ben Bernanke
has been downplaying the prospects of QE3. But would he be able to stay his trigger finger if the
economy slows in the coming months from the unexpected Arab oil shock? What if stock markets
correct by 5 – 10%? There is a proverb in Chinese that literally translates into “riding the tiger and
unable to get off”. We believe this proverb aptly describes the situation the Federal Reserve finds itself
in with regards to Quantitative Easing. The stock market and the U.S. economy is like Chev Chelios (main
protagonist in the movie Crank), he must constantly inject himself with adrenaline (quantitative easing),
otherwise, he would die.

Now Is Not The Time To Buy The Indices

A few weeks ago, we read a Buttonwood column in the Economist6 arguing caution for investors,
because in the past, the current high level of the Shiller PE ratio (cyclically adjusted price-to-earnings)
leads to low subsequent stock market returns. Being the sceptic, we decided to test out the claim.
Figure 1 graphically depicts the Shiller PE ratio vs. subsequent 10-year compounded returns, as
calculated by the index level of the S&P500 Index plus average dividends over that period7.

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Betting On Ben, The Economist, February 19, 2011
7
For example, at the end of February 2001, the index level was 1,305.75. At the end of Feb. 2011, the index level
was 1,319.88. The average annualized dividend over that time was 21.47. Therefore, the 10 year compounded
return is calculated as [(1,319.88 + 10 * 21.47)/(1,305.75)]^(1/10)-1 = 1.6%.

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50.0x 20.0%

Cyclical PE Fwd 10 Yr Return

45.0x

15.0%
40.0x

35.0x
10.0%

30.0x

25.0x 5.0%

20.0x

0.0%
15.0x

10.0x
-5.0%

5.0x

0.0x -10.0%
1881.01

1886.01

1891.01

1896.01

1901.01

1906.01

1911.01

1916.01

1921.01

1926.01

1931.01

1936.01

1941.01

1946.01

1951.01

1956.01

1961.01

1966.01

1971.01

1976.01

1981.01

1986.01

1991.01

1996.01

2001.01

2006.01

2011.01
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Figure 1: Shiller PE Ratio vs. Subsequent 10-Year Compounded Return Plus Average Dividend .

Currently, the Shiller PE sits at around 24x. While not extremely high by historical standards, the data
does suggest that at current levels, subsequent returns have not been fantastic (less than 5% on
average, see Figure 2). Moreover, the higher the PE ratio when you ‘buy-in’, the lower your subsequent
returns (this is just common sense).

Shiller # of Avg. 10-Yr Return Range

PE Ratio Observ. Mean Median Min Max
0 - 5x 1 12.5% 12.5% 12.5% 12.5%
5 - 10x 228 11.7% 13.0% 3.6% 18.0%
10 - 15x 458 9.3% 9.6% 2.4% 17.4%
15 - 20x 498 6.9% 6.7% -0.9% 17.7%
20 - 25x 182 5.1% 4.8% -3.4% 11.2%
25 - 30x 28 3.6% 7.3% -4.3% 8.8%
30 - 35x 13 3.6% 5.6% -4.9% 6.8%
35 - 40x 13 1.7% 1.6% -1.0% 3.7%
40 - 45x 21 -1.2% -1.0% -2.9% -0.2%

Figure 2: Distribution of 10-Year Returns By Cyclical PE Ratio.

To be fair, there are always caveats to every analysis. In our case, it appears the data is not continuous.
More specifically, it appears that cyclical PE had been a good driver of subsequent returns for more than

8
Source: Data is from Professor Shiller (http://www.econ.yale.edu/~shiller/data.htm); Analyses and errors are
entirely from The Aspiring Analyst.

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a century until the 1980s, but more recent data appears to have a permanently higher average (Special
thanks to Professor Uli Menzefricke at Rotman for teaching every incoming MBA student the basics of
statistical analysis). So perhaps ‘this time is different’ and subsequent returns will be higher than 5%.
Perhaps 13x is the lowest the cyclically adjusted PE will go in this ‘new era’ (aided in no small part by the
Fed’s negative real rates). But why is it different? What caused this shift?

We believe (although with no proof, yet) that the 1980s to 2000s represent a special period in history
where an exceptionally large cohort of ‘baby-boomers’ (those born after World War II) reached their
‘prime savings years’ (35 – 54) and invested heavily in the stock markets by following Wall Street’s ‘buy-
and-hold’ mentality (essentially ignoring price) and lifting the average valuation of equities (a rising tide
lifts all boats).

If our hypothesis is correct (we will look for proof to support our thesis in the coming months and years),
then the coming two decades should be a period of below average valuations for the markets in general,
since those same baby-boomers are now retiring and would need to draw down savings to fund their
retirement because governments are increasingly looking to shed their fiscal responsibilities
(incidentally, the same argument could be made for houses). Now is not the time to buy the indices.
Stock picking and an eye to valuation will become increasingly important!

Good Thing We Didn’t Put All Our Eggs In This Basket...

Your analyst invested in Ram Power Corp. (RPG-TSX) a day before the Company announced a
disappointing update at its San Jacinto project and a week before Hezy Ram, the CEO and company
namesake, resigned. Talk about bad timing!

RPG initially went IPO in 2009 on a three-legged platform – a great management team led by Hezy Ram
(was thought to be the best by all analysts), a great pipeline of projects, and ample capital to see those
projects through to fruition. We invested in RPG with the stock 50% below its IPO price, as several
drilling setbacks had negatively affected the stock. We thought these setbacks were temporary, since
drilling a few dry holes was part of the business. When we invested, the NAV of its advanced stage
projects (San Jacinto, Orita, Geysers) alone was worth over $3.00 per diluted share (50% above the stock
price), giving ample margin of safety. What could possibly go wrong?

Apparently, a lot can go wrong. First, we found out that the Company’s ample capital was no more (on
February 7, 2011, the Company announced it had burned through its capital and had to arrange for a
$50 MM bridge loan). Second, we found out there would be further delays due to the number of dry
wells and sub-par capacity of drilled wells (for example, in September 2010, the SJ9-3 well was initially
estimated to have 8 – 10 MW of gross capacity, but was certified at just 4.3 MW!). Finally, the
supposedly great management team was being replaced (Hezy Ram resigned on February 14, 2011). The
triple whammy cratered the stock, sending it to $1.30, 35% below where we bought it.

Call us stubborn, but we have not sold our position. The updated NAV of RPG is still north of $2.00
(factoring in delays, higher costs and potential 10% dilution from warrants issued as condition for the
bridge loan), although we have less confidence than before in the intrinsic value of the business and in

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the new management team. We believe we will ultimately break-even on this investment because of
our initial and current margin of safety. Nonetheless, we are humbled by the experience and are
thankful for the diversification in our portfolio (no single position is more than 5% of the total portfolio).

We end this letter by quoting our friend who covers the alt-energy space:

“One should never let friends invest in geothermal.”

Disclaimer: Our goal through this blog is to provide analysis and ideas that you, the reader, might find useful in forming your
own investment decisions and hopefully improve our analytical skills in the process. We are not soliciting for the management
of your investments nor seeking to provide financial advice. The Aspiring Analyst blog and letters will not take responsibility for
any investment losses incurred by readers through the trading of securities and strategies mentioned in this blog or its
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advice from qualified persons such as a Certified Financial Planner prior to taking any action in regards to the securities and
strategies mentioned in this blog or its accompanying letters.