Mark Yusko Letter

Q2 2014 Market Review & Outlook
Morgan Creek Capital Management

MORGAN CREEK CAPITAL MANAGEMENT

Q2 2 0 1 4 MARKET REVI EW & OUTL OOK

Letter to Fellow Investors
In last quarters letter, titled Te Year of the Alligator: Why 2014 will
be the Inverse of 2013, we hypothesized that returns in global
investment markets in 2014 would look quite diferent than the
returns in 2013 and that assets that had been shunned (long bonds,
commodities, gold equities) during the Year of the Coyote (so named
for the gravity defying move in global equities) market might fnd
favor with investors. We dubbed 2014 #YearofheAlligator because
the extreme return divergence between risky assets and safe haven
assets was quite remarkable and had created the widest Alligator Jaws
(the divergence between two total return lines on a cumulative wealth
chart) we had seen in many years. In reviewing the Chinese Zodiac
and how our newly added animals might ft within the twelve year
cycle, we wrote that 2014 is technically the Year of the Wood Horse,
which predicts that the year would be full of energy, fnancial volatility
and impulsiveness, a year for taking on new projects and a year
focused on borrowing and spending money (think debt issuance and
M&A activity) and, so far, those themes seem to be playing out as
predicted. Tere has indeed been a high level of market volatility,
punctuated by some truly wild swings in the highest beta segments of
the market during the beginning of the second quarter. If 2014 were
actually a horse, it would be a thoroughbred capable of running with
California Chrome if we measured speed by the incredible pace of
debt issuance, stock buybacks and M&A activity (#M&ABoom).
Companies are clearly following the theme of focusing on borrowing
and spending money (like it is going out of style, which it actually may
be, but more on that later) this year. We also noted that horse years
are typically marked by individuals holding frm to their beliefs, hence
compromise is more difcult and there have been a number of
conficts/wars linked to these yearswe have some concerns about
tensions in the Middle East that could erupt into something more dangerous. Te frst half of 2014 has been flled
with people not being willing to compromise, from U.S. politicians, to Russian and Ukrainian leaders, to religious
groups all over the Middle East, with the recent fare up in Gaza being potentially the most dangerous, as it has the
potential to draw a number of players into the confict. A highly levered economy hit by rising global tension and
societal conficts does not sound like a recipe for stable markets. History has shown time and time again that when
we reach a certain level of stress in the global fnancial system, things do break down and this time is likely to be no
diferent.

Something that seems quite intuitive is that if we anticipate that there will be a period of above average volatility
and risk, wouldnt it be prudent to position portfolios in such a way to try and mitigate the damage that could
occur if the valuation excesses were to adjust back to normal, or the geopolitical tensions were to fare up into
something more serious (#CantPredictCanPrepare)? We spent a good deal of time discussing this issue last quarter

#NotDifferentThisTime
Source(s): quotes.xazina.com , Forbes.

Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 2

Second Quarter 2014

and said that the time to actually play defense is before you really need to play defense. Tere are two key reasons
for this: 1) you dont get to buy the insurance policy afer the event (the coverage has to be in place before the event
occurs), and 2) the cost of insurance is signifcantly lower when everyone is still ebullient and no one thinks you
need insurance. Te problem, as we discussed, comes down to timing and we wrote, so if timing is so critically
important, how do we know when it is time to make a change? Tere are myriad models, indicators, calculations,
rules of thumb, etc. for trying to time the markets (and none have proven to be consistently accurate in every
environment) and some work better than others at diferent times. We went on to discuss the Bradley Turn Date
indicator, which we found provided some useful guidance on major trend changes in the markets. Te fact that the
Bradley Dates were predicated on naturally recurring cycles over many decades seemed intuitively appealing and
the historical evidence was strong that overall market trends did indeed tend to reverse (or sometimes accelerate)
around these dates. We talked about the major Turn Date that occurred this year on January 1
st
and discussed how
the reversal of the trends from 2013 would drive the transition from the #YearofheCoyote to the
#YearofheAlligator as the Alligator Jaws across markets would begin to snap shut. We wrote that positive trend
markets included Japanese equities, U.S. equities (NASDAQ, small and large), European equities (and the Euro),
high yield bonds, MLPs and negative trend markets included Emerging markets equities and bonds (and
currencies), U.S. bonds (particularly long bonds), Commodities, REITs, Gold, Gold Miners and the Yen
(weakening) and we discussed how these trends should invert in the frst half of 2014. As it stands today at the
end of Q2, Te #YearofheAlligator seems like a ftting descriptor, as the performance of these markets has nearly
perfectly inverted from last year with Gold Miners, Gold, Commodities, REITs, Long Bonds and Emerging
Markets leading and Japanese, U.S. & European equities and HY bonds trailing.

So, at the halfway point, 2014 does look very diferent from 2013 but, as we said last quarter, the fact that we were
modestly more cautious coming into the year doesnt mean we cant take advantage of great opportunities and
generate solid returns, we will simply have to adjust our game plan, be a little more balanced and defnitely be more
Tactical to achieve our investment objectives. A couple great examples of those opportunities are that investors in
long-bonds (TLT) are up 14% (on pace to match the 30%+ returns in 2011, not a high probability outcome, but
certainly possible) and those who bought gold miners (GDX), and endured the wild volatility, are up a stunning
27% (or an even more stunning 39% if you bought the junior miners, GDXJ). Te challenge for most investors is
that those were two of the worst performing assets last year and it took some truly independent (and contrarian)
thinking to embrace the #YearofheAlligator theme and buy what the crowd was selling coming into the New Year
(#WorstToFirst). If we look at the equity market in the U.S. we see a similar trend, in that the worst performing
sectors from 2013, like Utilities, Healthcare and Energy, are among the leading sectors in 2014, (something we
mentioned was likely to happen in our iCIO meeting in NYC in December). Interestingly, as we mentioned last
quarter the troubling part of that story is that these are not the sectors that lead in robust economic expansions,
but rather they are the sectors that lead during decelerating economic growth leading to Recessions. While there
do not appear to be many other signs of impending Recession, we do know that markets are leading (not lagging)
indicators, and that Recessions are routinely caused by Fed tightening cycles (which the end of QE may begin).
Quickly, on the Fed and the potential for tightening, we mentioned in the two previous letters that Larry Jeddeloh,
calculated that for every $100 Billion of QE, the S&P 500 rises 40 points, so if there is $500 Billion of QE lef, that is
worth 200 S&P points in 2014 (Tat would equate to 2,050 on the index from 12/31 levels) which is looking like
an increasingly good estimate as we sit at 1978 at a little past the halfway point (up from 1848 to start the year).
Te one risk we see to the QE = Upside thesis is the sternly stated warning from Stanley Druckenmiller last year
that if the Fed were to stop buying bonds, equity markets would go down.


Second Quarter 2014

So with the Alligator Jaws across the various markets beginning to close and an increasing number of pundits and
fnancial commentators describing the New Normal, that somehow it really is diferent this time, and that the Fed
(and other global Central Banks) has banished the business cycle, established permanent foors under equity
markets and has fgured out how to somehow manufacture growth and wealth out of debt (a feat that has never
been achieved in many centuries of trying). In the last letter we discussed the seven-year cycle that seems to exist
with respect to the business cycle (interesting to me that its precisely half of the 14 year innovation cycle I have
written about in the past) and talked about how the peak in markets in 2000 and 2007 was followed by Recessions
and larger losses in the equity markets in subsequent years. Tose two incongruous constructs of
#TeNewNormal and Te Old Normal, coupled with my stumbling across an increasing number of charts and
graphs that show a number of market data follow this seven-year cycle and how another peak was forming in those
same areas again in 2014, led me to start attaching #NotDiferentTisTime to many of my tweets and retweets (for
Twitter users, you can fnd me at @markyusko). Tis hashtag is a play on the famous Sir John Templeton quote,
the four most dangerous words in investing are this time its diferent and the idea to use them as the theme of
the letter prompted me to do a little research on the origin of the phrase and on Sir John as well. What I found was
a very compelling outline of his investment philosophy that I decided to include in the letter to provide some
context for the overall theme. In searching for my opening picture, I found the image of the hourglass with Sir
Johns wisdom and it reminded me of the quote that, the more sand that passes through the hourglass, the more
clearly we can see (more on this theme later). Ten, in a serious case of everything happens for a reason, I had
dinner with Peter Gutrich this week (our partner and a long-time friend) and he had a laminated copy of the 1995
cover of Forbes with a dapper Sir John making the point that to beat the market, you have to start by asking the
right questions (much more on this later) lying on his cofee table in Denver. Amazing serendipity given I had
composed most of this letter already and had decided that Sir Johns wisdom would be the theme.

In 1993, Sir John (who is clearly one of the most successful and intrepid investors of our time) did all investors a
great service by putting his personal philosophy down on paper, 16 Rules for Successful Investing (which was
published in the World Monitor: Te Christian Science Monitor Monthly) in which he captured a lifetime of
investment wisdom for the ages. Many of the individual tenets of the philosophy may seem obvious, or
common knowledge, but taken together they represent an investing discipline that, when executed faithfully
(that is the tricky part), can produce superior results over the long-term. Te challenge of executing the strategy is
twofold: 1) adhering to the entire collection of Rules and 2) sticking to the discipline over time and not making
exceptions when it would be easier or more expedient to do so. Sir John begins the essay with a little humor in
which he says that he could sum up his message by reminding the reader of the famous advice of Will Rogers who
said, Dont gamble, buy some good stock. Hold it till it goes upand then sell it. If it doesnt go up, dont buy it!
He then goes on to say that there is as much wisdom in that remark as there is humor and makes the following
introductory commentary before diving into the 16 Rules: Success in the stock market is based on the principle of
buying low and selling high. Granted, one can make money by reversing the order, selling high and then buying
low. And there is money to be made in those strange animals, options and futures. But, by and large, these are
techniques for traders and speculators, not for investors. And I am writing as a professional investor, one who has
enjoyed a certain degree of success as an investment counselor over the past half-century and who wishes to share
with others the lessons learned during this time. What is truly remarkable about Sir Johns perspective is that his
direct investment experience at the time of writing was six decades (that is some serious volume of sand through
the hour glass) that spanned periods of War and Peace, Prosperity and Hardship, Bull Markets and Bear Markets
and every transitional phase in between each extreme, so the applicability of his Rules is more timeless (in my
opinion) given his vast experience base. So lets review the 16 Rules and discuss how they are relevant to todays


Second Quarter 2014

investment environment and why they lead us to the title of this quarters letter.

Rule No. 1 Invest for Maximum Total REAL Return (#InfationIsRisk)

We could not agree more that this is the most important issue facing long-term investors and is, perhaps, the most
widely misunderstood (or simply disregarded) risk in investing. Sir John makes the statement that investing for
maximum total real return is the only rational objective for most long-term investors and we have told Morgan
Creek clients for all of our ten years of existence that Total Real Returns, the return net of infation and taxes, are
the most important measuring stick over time (as opposed to focusing on some randomly generated index). We
learned in our time managing large Endowment portfolios that the largest risk to investors is not volatility
(standard deviation of returns) or trailing some benchmark for some short period, but rather, failing to achieve a
real rate of return in excess of your spending rate over time. Any investment strategy that does not address the
deleterious impact of infation on invested assets will fnd themselves in the unenviable position of having eroded
the purchasing power of their assets over the long-term. Sir John says it very clearly that one of the biggest
mistakes people make is putting too much money into fxed-income securities and he points to statistics that
show how the value of the Dollar has been eroded by infation over the decades. He points to the fact that in 1993 a
dollar only bought 35 cents of what it did in the 1970s and only 15 cents of what it bought afer WW II. Simply
stated, if an investor buys a ten-year bond today and receives his principal back at the end of the decade, the
purchasing power of those dollars would have been eroded by 32% over that period at the long-term average of 4%
infation. In other words, you would need $147,000 to buy what $100,000 would have bought at the time of the
investment. Lets assume that infation stays at the Feds target of 2% for the next decade (unlikely, but we will
make the assumption), an investor would still need $122,000 to preserve purchasing power. Additionally, all of
this analysis doesnt include taxes, which makes the challenge for fxed income even greater, since fxed income
returns are taxed at Ordinary Income rates and equity returns at least have a chance to be taxed at lower Capital
Gains rates (if employed in a long-term strategy). #RealReturns

Rule No. 2 Invest: Dont Trade or Speculate (#InvestWithoutEmotion)

Te wisdom of the second rule goes back to the Will Rogers quote in that Sir John believed that the stock market
is not a casino, so investors shouldnt gamble by trading too frequently, or by trying to time the market in the
short-term by attempting to capture every move, up or down, of a few points based on news fow and investor
sentiment. Like gambling in a casino, the house wins over time and your profts will be consumed by transaction
costs and losses associated with overtrading (the emotional reaction to noise in the markets). He says to
remember the words of Wall St. Legend, Lucien Hooper, who wrote; what always impresses me is how much
better the relaxed, long-term owners of stock do with their portfolios than the traders do with their switching of
inventory. Te relaxed investor is usually better informed and more understanding of essential values; he is more
patient and less emotional; he pays smaller capital gains taxes; he does not incur unnecessary brokerage
commissions; and he avoids behaving like Cassius by thinking too much. Tere is so much investing wisdom in
these lines and they so completely accurately describe the core personality traits of the best investors I have
interacted with in my career. One example, in my frst job with an equity management frm (aptly named
Disciplined Investment Advisors DIA), the principals had cofee mugs made to give to clients that were
emblazoned with the simple phrase Invest Without Emotion (I have actually seen them on eBay selling for a
healthy premium to our original cost) as their entire investment process was predicated on the fact that patient,
unemotional capital would generate superior returns over the long-term. Te strategy was built around a


Second Quarter 2014

proprietary methodology of buying assets at deep discounts to intrinsic value, which had very low turnover (was
therefore very tax efcient and paid very low trading costs) and generated very strong long-term returns. Tere
were, unfortunately, two small faws in the business model: 1) the value discipline was routinely Early, so there
would be meaningful times when the strategy produced little return as the markets did not see the value that the
model had uncovered, and 2) the strategy was Patient, so there were periods of time where returns would actually
be negative as the model said to hold undervalued assets despite the market making them more undervalued. An
example of how overtrading leads the average investor to underperformance over time can be seen in some of the
client behavior at DIA when I frst joined in 1991. A large investor had just terminated us for poor relative
performance over the previous three years (Value lagged Growth during the Recession and the model was buying
more of the undervalued assets) and was going back to the Growth frm that they had terminated three years
earlier to hire us (afer we had a great three year run coming of the downturn in 1987). You can probably guess
the next part we dramatically outperformed over the next three years (yes, they then fred the Growth manager
and came back to us) as valuation reverted to the mean. Te result was that the institution (a large, sophisticated
investor with a professional consultant) had spent nearly a decade chasing the hot dot (hiring the best trailing
return) and missed all the good performance of both frms (in fact, got all the underperformance of both frms).
Tey were clearly victims of thinking too much as a clearly superior strategy would have been to have 50% of the
capital with each frm and rebalance from the winner to the loser afer each period. Tey should have consistently
been investing, rather than speculating on which style would have the edge in the next period (since, as Yogi Berra
infamously said, making predictions is hard, especially about the future). #Discipline

Rule No. 3 Remain Flexible and Open-Minded About Types of Investment (#OneSizeDoesNotFitAll)

Sir John reminds us that there is no all-weather asset, no one kind of investment that is best in all conditions.
Given the broad array of investment choices across assets classes, Stocks, Bonds, Currencies and Commodities,
across geographies, U.S., Europe, Japan, Emerging Markets and across sectors, Technology, Energy, Healthcare
and Financials to name a few, investors can always fnd something that is attractively valued, IF they are fexible
and open-minded to looking at new ideas and strategies. Another important point he makes is that there will be
times when Cash (which most investors disdain and dont even view as an acceptable asset class) will be the
preferred asset, as sitting on cash enables you to take advantage of investment opportunities which reminds me
of another great quote that is critical for long-term investment success, dont just do something, sit there. To
that end, Jesse Livermore (a famous Wall St. investor) was quoted as saying, It was never my thinking that made
the big money for me, it was always the sitting which goes to the Cassius quote above in Rule No. 2 about not
thinking too much. Two other points Sir John makes here are: 1) that when a particular type of investment
becomes popular that popularity will always prove temporary and, when lost, may not return for many years,
and 2) that despite his admonition to be fexible across types of investments, his clients were predominantly
invested in common stocks over time. A critical point to remember here is the time horizon perspective from
which he is writing is a half-century. Terefore, a predominance of time over 50 years could be 35 years, which
would still leave 15 years (a long time for any investor) where stocks were not the dominant (or at times, not even
an attractive) asset class. With the caveat that equities may be unattractive for meaningful periods of time, Sir John
highlights the long-term attractiveness of stocks vs. fxed income and cash, as he explains again that equities are the
only asset of the three that can overcome the drag of infation over the long term and he says emphatically I
repeat: Tere is no real safety without preserving purchasing power. #InfationistheEnemy


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Rule No. 4 - Buy Low (#BeGreedyWhenOthersAreFearful)

Te description of this Rule begins with a great line, Of course, you say, thats obvious. Well, it may be, but that
isnt the way the market works and he goes on to explain that, unfortunately, just the opposite occurs in practice.
In fact, all of the data on investment capital fows suggests that the line I so ofen use people love to buy what they
wish they would have bought aptly describes the collective actions of investors over time and for some reason,
despite it being obvious, investors do not, for the most part, heed Rule No. 4 and buy low. Te reason that Sir
John posits for this anomaly is that prices are low when demand is low and investors have pulled back because
people are discouraged and pessimistic. It is hard to step up and buy an asset if you have become pessimistic on
the current situation or, more importantly, the future prospects for the asset class, region, sector or individual
company. One of Sir Johns most of quoted lines comes from his belief that long-term investors should capitalize
on the incredible opportunities created by collective pessimism as he says, Bull markets are born on pessimism,
grow on skepticism, mature on optimism and die on euphoria. He goes further to say that the real problem is
that yes, they tell you, buy low, sell high, but all too many of them bought high and sold low. Ten you ask:
When will you buy the stock? Te usual answer: Why, afer analysts agree on a favorable outlook. Terein lies
the fundamental problem. Tat behavior is (in his word) foolish, but not unexpected, as it is human nature to want
to do what everyone else is doing (herd behavior) and avoid doing what is considered non-consensus. In fact, Lord
Keynes famously quipped that worldly wisdom teaches that it is better for reputation to fail conventionally than to
succeed unconventionally, in essence, reminding us that people are even willing to endure failure (so long as
everyone else is failing along with them) rather than do something considered unconventional, even when the
outcome is positive. Sir John points out that buying low requires taking an action that is in direct opposition to
what everyone else is doing, to buy when everyone else is selling or has sold, to buy when things look darkest, to
buy when so many experts are telling you that stocks in general, or in this particular industry, or even in this
particular company, are risky right now, which history and psychology both show us is simply not human nature.
Humans want to be at the center of the herd, where it is comfortable and warm, doing what everyone else is doing
because that must be the right course of action, because everyone cant be wrong, can they? Te inherent problem
is that if you do what everyone else is doing, you cannot, by defnition, have performance that is diferent from the
crowd and, worse, when you buy what everyone is buying, you will likely be doing so afer the price has already
risen and you will be buying high, not low (or vice versa, selling low, not high). Sir John quoted two legendary
investors here on how to invest, Benjamin Graham who said, Buy when most people, including experts, are
pessimistic, and sell when they are actively optimistic and Bernard Baruch, who was even more succinct and said
simply Never follow the crowd. Sir Johns fnal two lines are elegant (and haunting) as they sum up the concept
of Buy Low, So simple in concept. So difcult in execution. #LiveOutsidetheComfortZone

Rule No. 5 When Buying Stocks, Search for Bargains Among Quality Stocks (#WinnersPressWinners)

In describing what Quality is, Sir John lists characteristics like leadership in an industry, or feld, having superior
management talent, a strong balance sheet, a trusted brand and high margins, pointing out that this list is
incomplete and, importantly, that each attribute cannot be considered in isolation. He goes on to give two
examples where threats to Quality Status could arise, saying that a company may be the low-cost producer, for
example, but it is not a quality stock if its product line is falling out of favor with customers. Likewise, being the
technological leader in a technological feld means little without adequate capitalization for expansion and
marketing. In trying to pinpoint precisely what is Quality, we can recall the now infamous quote from Supreme
Court Justice, Potter Stewart, when he ruled on an obscenity case in 1985, saying that while I shall not today


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attempt further to defne the kinds of material I understand to be embraced within that shorthand description [of
obscenity], and perhaps I could never succeed in intelligibly doing so. But I know it when I see it. Every investor
can point to myriad examples of both types of companies they have invested in over time, those that were quality
companies and those that were not, and, more ofen than not, the examples of high quality companies have happy
endings and the stories of poor quality companies do not. Te one caveat here is that the other italicized word in
the Rule matters too, a lot. Te price you pay matters and, as a follow up to Rule No. 4, you cant pay any price,
you have to pay bargain prices to win long term. To this point, we include a great line from Howard Marks of
Oaktree that applies here, where he says that there is no investment good enough that cant be messed up by
paying too much and, conversely, there is no investment bad enough that cant be fxed by paying a very low
price. In essence, even Quality will not protect you from losing money if you pay an exorbitant price and, perhaps
in a little disagreement with Sir John, Howard, as a great distressed investor, does believe that a really, really good
bargain price can allow you to buy a less than quality asset and still make good returns. One other point here is
that a Bargain does not only mean a very low price. Low prices are what are preferred in buying value, trying to
buy dollar bills for 50 cents (or less if you fsh in the really depressed areas where the herd has completely
abandoned particular assets, like Russia and Argentina today). But sometimes, you want to pay what is seemingly
a high price because it is actually low based on future growth prospects. Tis is the essential diference between
Growth and Value investing and really focuses on the life cycle of companies. Young, fast growing companies, will
rarely sell at bargain prices (meaning for less than the value of their assets) because so much of their intrinsic value
is in their future prospects as they take market share and build a dominant franchise or brand (thing Coca-Cola in
the 1930s and Google in the 1990s). Te key to success is recognizing that an upstart business is morphing into a
Quality business (before the herd sees the same thing) and buying a bargain of a diferent variety (buying $2 in the
future for $1 today). A friend pointed out a critically important point to me recently, that every stock that goes up
10X was making new highs all along the way and may never have appeared as a bargain (or value) based on current
metrics (most people never buy these stocks because they think they are always just about to crash). Only the
most intrepid investors, who can truly remain forward-looking, will reap the rewards of investing in these
diferent, but equally important, types of bargains. #PriceMatters

Rule No. 6 Buy Value, Not Market Trends or the Economic Outlook (#MarketofStocks)

Te essence of this rule is that investors should focus on buying companies, not markets, as Sir John reminds us
that a wise investor knows that the stock market is really a market of stocks and while individual stocks may be
pulled along momentarily by a strong bull market, ultimately it is the individual stocks that determine the market,
not vice versa. He goes further to remind us that far too many investors try to, unsuccessfully, invest based on
anticipating market trends, or the economic outlook and lose sight of the fact that: 1) individual companies can
rise in a bear market and fall in a bull market, and 2) Bull Markets do not always correlate with economic
expansions and Bear Markets do not always correlate with economic contractions. Companies rather rise and fall
with their business fortunes, future prospects and, perhaps most importantly, other investors perceptions and
expectations of those prospects. A good example of this phenomenon has occurred over the past fve years, as the
economic expansion in the U.S. has clearly been subpar (compared both to expectations and history) while the
stock market rally has been substantial. Individual companies have been able to expand proft margins through a
combination of downsizing of labor costs and the application of new technologies to enhance productivity or have
been the benefciary of signifcant government largesse in the form of unprecedented fscal and monetary stimulus
(think extended unemployment benefts turning into revenues for Walmart). Additionally, an investor who made
an investment decision to sit out of the market based on the weak outlook for economy would have missed many


Second Quarter 2014

opportunities to earn outstanding returns from stocks that have capitalized on the artifcially low interest rates to
issue debt to buy back stock and raise earnings per share (frighteningly, over 2/3 of earnings growth recently is
from the buyback efect). Another example is that investors who decided not to invest in the China Market
because of fears of the slowdown in economic growth would have missed truly amazing returns available in
individual companies in the Internet, Healthcare, Retail and Alternative Energy sectors, where the incredibly
bright future prospects of these businesses were being masked by the dim view of the market indexes which are
dominated by the State Owned Enterprises (SOEs) where business prospects are indeed depressed for many of
the SOEs as the economy shifs from Fixed Asset Investment to Consumption. Further, even within the totality of
SOEs there are a growing number of these companies that are seeing the light and making meaningful changes in
their strategy and have been recently, and will be in the future, great investments. #CompaniesNotEconomies

Rule No. 7 Diversify. In Stocks and Bonds, as in Much Else, Tere is Safety in Numbers
(#ConcentrationMakesYouRichDiversifcationKeepsYouRich)

As proponents of the Endowment Model of investing, we are staunch advocates of Diversifcation as the optimal
strategy to control risk, but also as a methodology to maximize long-term investment returns through the lowering
of overall total portfolio volatility (maximize the power of compounding). As Sir John so aptly states, no matter
how careful you are, you can neither predict nor control the future and bad things happen. He lists a number of
external events that can cause problems for companies, from natural disasters to technological changes to
regulatory changes and says that then, too, what looked like such a well-managed company may turn out to have
serious internal problems that werent apparent when you bought the stock. So you diversify, by industry, by risk,
and by country. I have said for many years, concentrated portfolios make you rich, diversifed portfolios keep
you rich. While it is true that all large fortunes come from concentrated portfolios (business ownership, land, real
estate, individual stock positions), all small portfolios also come from concentrated portfolios, that is simply what
happens when you stay concentrated too long (large portfolios turn into small portfolios when the inevitable bad
event occurs). While there is nothing wrong with taking concentrated positions, an investor needs to balance the
inherent risk of taking that concentrated position with the potential upside and, most importantly, the investors
capacity to hold on during the inevitable drawdown. One of best ways to make concentration work (and is a
common characteristic of most of the assets listed in above) is to have the concentration in illiquid assets where
there is no choice but to hold the asset through the periodic tough periods, essentially providing protection from
the natural human reaction to sell at the bottom. Two other issues of importance here are: 1) you will make
mistakes, so there is safety in numbers, and 2) by searching the globe for great ideas, you increase the likelihood of
fnding more investment ideas, and perhaps even better bargains, than focusing your search in any single country.
We will cover mistakes in another Rule, and the challenge for #2 is that overcoming the tendency toward Home
Market Myopia (the tendency for investors to have the most money in their home market) is much more difcult
than it would seem. Take today for example, everyone is so enthralled with the great Bull Market over the past 18
months in the U.S. (S&P 500 up 32% last year and up 7% so far in the 1H of 2014) that they dont even see that
both Japan and the GIIPS markets are up more and, further, are more likely closer to the beginning of their Bull
Markets than is the U.S. market. #EyesWideOpen

Rule No. 8 - Do Your Homework or Hire Wise Experts to Help You (#NoShortcuts)

Te primary message of this Rule is fairly straightforward, either resource it or outsource it. If you have the
internal resources to do primary research and investigate investment ideas fully, then do it; if you dont, then fnd


Second Quarter 2014

professional help. Te good news is that there are lots of great organizations that can help, from consultants, to
primary research frms, to investment management organizations, or instead, simply allocate capital into funds
managed by professionals. Sir John says very succinctly, people will tell you: Investigate before you invest. Listen
to them. Study companies to learn what makes them successful. What separates the best investors from the rest is
that they are constantly doing research, continually scouring original source data to isolate companies that have a
distinctive edge in some element of their business that will lead to superior returns in the future. Te challenge of
performing research in an increasingly global world is that it is simply hard to cover the entire landscape
(physically and mentally) on your own and it is expensive (both in terms of time and resources) to get to some of
the most interesting places to invest today. We have been fortunate to have team members all around the world to
help us bring together a truly global perspective at our Monday Investment Meetings but even we bring in outside
experts to help us really drill down on a particular market or opportunity. For example, two Mondays ago we had
four of the best Indian equity managers on the planet call in to give us an update on the state of the India market in
the Modi era. Our years of traveling and developing relationships allowed us to assemble this all-star group of
experts and enabled our large group to beneft from their wisdom without traveling to be with them in New York,
Singapore and Mumbai. We came away from the discussion much wiser on the incredible opportunity that will
unfold in the coming years as the BJP transforms India and we will make much more efective investment
decisions since we spent the time to #DoYourHomework.

Rule No. 9 Aggressively Monitor Your Investments (#WatchTeBasket)

Andrew Carnegie famously said, Concentrate your energies, your thoughts and your capital. Te wise man puts
all his eggs in one basket and watches the basket closely and while he might debate how much concentration is
optimal (see Rule No. 7), Sir John would agree vigorously with the advice to concentrate your energies and
thoughts on watching the basket. Todays conventional wisdom, that a passive, buy and hold strategy is optimal,
was not quite what Sir John had in mind. His position on Aggressive Monitoring was driven by the need for
investors to expect and react to change. No bull market is permanent. No bear market is permanent. And there
are no stocks that you can buy and forget. Te pace of change is too great. Being relaxed, as Hooper advised,
doesnt mean being complacent. An example of change that he talks about is the continual turnover in the
benchmark indices as companies go out of business, are acquired or get displaced by another company that fts the
benchmark criteria better as the world changes (e.g., Yahoo replacing Woolworth in the S&P 500 as the index
upgraded to include more new economy companies). Te natural life cycle of businesses demands that investors
monitor, and react to, the transitions between the various phases from development, to growth and expansion, to
maturity and then decline. Tere will be opportunities across all stages, on both the long side and the short side,
but aggressive monitoring of the companies that you own in your portfolio will mitigate the damage that can be
done as the prospects for a once great business erode. Sir John sums up his view on the monitoring by saying,
remember, no investment is forever. #ChangeHappens

Rule No. 10 Dont Panic (#KeepCalmAndCarryOn)

Invariably, all investors will fnd themselves in a position where they did not heed the corollary to Rule No. 4, to
sell when everyone else is buying, and Sir John reminds us that we will be caught in a market crash such as we had
in 1987. Tere you are, facing a 15% loss in a single day. Maybe more. He advises us not to panic, not to rush out
and sell. At the risk of stating the obvious, he reminds us the time to sell is before the crash, not afer. Te only
thing that has changed afer a sudden downdraf in the overall market is that all security prices are lower, so the

Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 1 0

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right response is to calmly study your portfolio and make a determination whether the rationale from which you
made the original purchase remains intact and, if so, then hold tight (or even buy more, if you have liquidity with
which to react to the opportunity). Te only reason to sell a security in a Bear Market is to make room to buy
something that is more attractive. To this point, I was with one of my favorite Asian managers last week (who has
compounded client assets at 15% for 23 years) who said that you make the bulk of your excess returns in Bear
Markets if you remain disciplined, dont sell into the panic and actually deploy any excess liquidity you might have
to purchase great companies at true bargain prices. Te key is, as Rudyard Kipling shared with us in his classic
poem, IF, that if you can keep your head, while all those around you are losing theirs you will generate
consistently superior returns over the long-term. #StayintheStore

Rule No. 11 Learn From Your Mistakes (#FocusOnTeNextPlay)

An old English Proverb tells us the man who makes no mistakes, usually makes nothing at all and Sir John tells
us that the only way to avoid mistakes is not to invest, which is the biggest mistake of all. Te investment
business is about taking positions in anticipation of future events that are, by defnition, unknowable and every
investor will make some good decisions and some bad decisions, some mistakes. Tere are myriad reasons for
making investment mistakes, including poor quality data, faulty analysis, bad investment process and judgment
error and any of these reasons (and others) can knock your investment of track and lead to losses. Te most
important thing to do when you make a mistake is to forgive yourself for your errors, dont become discouraged,
and certainly dont try to recoup your losses by taking bigger risks. Te ability to maintain composure and focus,
to stick to your discipline, to move forward without dwelling on the past are all characteristics that separate great
investors from average investors. Coach K says it best, great players always focus on the next play, while average
players always focus on the last play. In one sense, great investors actually welcome mistakes because they
understand that their job is to take risks, to move out beyond the comfort zone, they know that they will miss 100%
of the shots they dont take and are not afraid to miss a few, in order to learn what is most efective in each new
environment. Sir John also said that you must turn each mistake into a learning experience. Determine exactly
what went wrong and how you can avoid the same mistake in the future. Te investor who says, Tis time is
diferent, when in fact its virtually a repeat of an earlier situation, has uttered among the four most costly words
in the annals of investing. Te title of this letter stems from those four critical words and speaks to the
importance of recognizing that the investment landscape moves through a repeatable cycle of peaks and valleys
and convincing oneself that somehow the next cycle will be diferent will be very costly indeed.
#LearnFromMistakes

Rule No. 12 Begin With a Prayer (#HopeIsNotAnInvestmentStrategy)

Sir John shares his personal perspective that if you begin with a prayer, you can think more clearly and will make
fewer mistakes. Whether it is prayer, meditation, or spending some time in solitude, anything that clears the
mind will help you make more efcient and efective decisions, which is likely to lead to fewer mistakes. Similarly,
Michael Steinhardt, one of the most successful investors of our time, said to always trust your intuition, which he
described as being more than just a hunch, but rather resembling a hidden supercomputer in the mind that youre
not even aware is there. Intuition is most available to us when we quiet the mind and any means with which we
can achieve that centered state will help us be better investors. Importantly, the one thing that this statement is not
referring to is the construct that we should pray for good results and hope for some divine intervention in our
investments. As I have been known to say on occasion, hope is not an investment strategy, it is, rather, a


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four-letter word. #QuiettheMind

Rule No. 13 Outperforming the Market is a Difcult Task (#HoneYourEdge)

Te market, or rather the indexes that approximate the market, have a number of advantages over even the best
investors: 1) they pay no transactions costs, 2) they have no expenses related to research and 3) they are always
fully invested as they do not have to keep cash available to pay out to redeeming investors. Sir John contends that
the ability to consistently outperform the market is a tremendously difcult task given the inherent advantages of
the benchmarks and further that any investment company that consistently outperforms the market is actually
doing a much better job than you might think. And if it not only consistently outperforms the market, but does so
by a signifcant degree, it is doing a superb job. Given the huge amount of resources that are dedicated across the
investment management industry in the attempt to outperform the market, it is a little surprising that there are not
more frms that have a consistent edge. Terefore, when you fnd an individual, or frm, with real Edge, the ability
to generate Alpha above the market, you should make them a cornerstone of your portfolio. One thing we know
about Alpha is that it is a zero sum game and for every winner (returns above the average), there must be, by
defnition, a loser (returns below the average). Tere are also some that say that there is a huge degree of luck
involved with investment success. In fact, Michael Mauboussian wrote a fascinating book on this subject recently,
Te Success Equation: Untangling Skill and Luck in Business, Sports and Investing. Michael is a great writer, and
the book makes a lot of great points, but I still side with Tomas Jeferson on this particular point when he said, I
am a great believer in luck, and I fnd the harder I work, the more I have of it. #DoTeWork

Rule No. 14 An Investor Who Has All the Answers Doesnt Even Understand All the Questions
(#KnowWhatYouDontKnow)

In a famous press conference many years ago, then Secretary of State, Henry Kissinger, asked the group of
reporters assembled do you have questions for my answers? In investing, Sir John points out that, a cocksure
approach to investing will lead, probably sooner than later, to disappointment if not outright disaster. Te
problem we face is that even if we have the discipline to stick to small set of unchanging investment principles, we
do not have the luxury of applying those principles to an unchanging investment environment. Tere are changes
to government policies, both fscal and monetary, changes to the regulatory environment, changes to the liquidity
of the markets, changes to the makeup of the investors in the markets and myriad other changes that we must
adapt to in real time in order to be successful as investors. Markets, he says, are in a constant state of change, and
the wise investor recognizes that success is a process of continually seeking answers to new questions.
Maintaining a rigid approach to the markets is a sure way to lose money over time and stubbornness and
arrogance are character traits that will mete out disproportionately high penalties to those investors who believe,
incorrectly, that they are right, despite direct evidence to the contrary in the form of investment losses. As Mark
Twain was fond of saying, it's not what we dont know that hurts us, it's what we know for sure, that just aint so.
To this point, when I was in college I noticed a phenomenon that is similar to Sir Johns perspective. When I would
take an exam, how I felt right afer taking the test was inversely proportional to my ultimate results. If I felt like I
did poorly, I ofen did surprisingly well, as I understood the material and the exam questions while maintaining a
healthy respect for what I might not know. On the fip side, when I believed I aced the test, I ofen ended up
having done poorly as it turned out that I didnt even know what I didnt know and didnt maintain that degree of
respect for understanding the questions. Investing is about the future and hence one cannot possibly have all the
answers, but we can continually strive to keep asking the right questions, which is what distinguishes the great


Second Quarter 2014

investors from the rest. One of the best examples of this point is refected on the Forbes cover (and elsewhere in
this letter) that those who want to invest where the outlook is good are clearly asking the wrong question and have
little hope of outperforming the market and they would be better to go. #WhereIsItMostMiserable

Rule No. 15 Teres No Free Lunch (#GetWhatYouPayFor)

If investing was simple, then everyone would be wealthy and there would be no need for professional managers or
advisors and there would be no need for following a disciplined, repeatable, process. In that world, we could
simply buy companies that make the things we know and like and follow tips from friends and colleagues without
doing our own work. Sir John would admonish that both of these things need a Never in front of them. First, he
says to never invest on Sentiment. Te company that gave you your frst job, or built your frst car, or sponsored a
favorite television show may be a fne company. But that doesnt mean its stock is a fne investment. Even if the
corporation is truly excellent, prices of its shares may be too high. Remember the words of Howard Marks here
that there is no investment good enough that cant be made unattractive by paying too much. Second, he says to
never invest solely on a tip. You would be surprised how many investors, people who are well educated and
successful, do exactly this. Unfortunately, there is something psychologically compelling about a tip. Its very nature
suggests inside information, a way to turn a fast proft. When something sounds too good to be true, it always is,
and something important to always keep in mind is that if the opportunity was so great, why is that person sharing
it with you? An investor should always consider the source of any investment idea, but the level of scrutiny that
should be applied to a tip, something usually ofered for free, should be extremely high, as the saying you get what
you pay for clearly applies here. #NoTips

Rule No. 16 Do Not Be Fearful or Negative Too Ofen (#BeOptimistic)

Te fnal Rule is very simple, but critically important for long-term investors, Sir John implores do not be fearful
or negative too ofen, for 100 years optimists have carried the day in U.S. stocks. Tere will be times when a
cautious stance will be warranted, even necessary, to preserve capital and put yourself in position to fght another
day, but, on average, equities rise the majority of the time and it doesnt pay to be fearful of, or negative on, the
markets for extended periods of time. Even in the darkest times for the averages, there will be opportunities and a
fexible approach (see Rule No. 3) will enable an investor to proft from other asset classes, sectors or geographies.
Sir John also reminds us that there will, of course, be corrections, perhaps even crashes, but, over time, our studies
indicate stocks do go up and up and up. Importantly, part of this continuous ascent is money illusion, or
the efect of infation increasing the nominal value of everything, which naturally fows into equity values.
However, there is additional real growth that comes from innovation and the creation of new wealth from secular
forces such as globalization, urbanization and demographic growth. Healthy skepticism about valuations when
assets seem to have moved beyond levels supported by their fundamentals is critical, but excess negativity will
prompt inaction and will result in too many missed opportunities over time. Interestingly, when Sir John wrote
this treatise in 1993 he made a fnal comment that seemingly could have been written today despite all the current
gloom about the economy, and about the future, more people will have more money than ever before in history.
And much of it will be invested in stocks. And throughout this wonderful time, the basic rules of building wealth
by investing in stocks will hold true. In this century or the next its still buy low, sell high. We agree
wholeheartedly with these sentiments on a global basis and see tremendous opportunities in many areas, which we
will cover in the Market Outlook section below. Tat said, we also believe that there is growing evidence that the
U.S. economy, and markets, are heading toward another cyclical peak and we should heed Sir Johns most famous


Second Quarter 2014

words, now updated for the Twittersphere, that it is #NotDiferentTisTime.

While Sir John is right that we should not be fearful, or negative, too ofen, at the appropriate time it makes good
economic sense to be cautious when the weight of the evidence warrants such caution. It is always challenging to
get the timing right on precisely when to be cautious, and two important quotes apply here, you cant predict, you
can prepare, from Howard Marks, and preparedness averts perils, from the Chinese idiom yu bi w hun.
Over the next few paragraphs we will review the mounting evidence that perhaps now is one of those times to be a
little fearful and begin to prepare for a diferent investment environment than we have experienced over the past
fve years. I have talked about a core Investment Rule that I have followed over the course of my career that if I
hear something once, I remember it, if I hear it twice, I write it down, and if I hear it three times, I do something
about it. Last quarter I discussed how in looking at the positioning of three great investors (Julian Robertson,
George Soros and Seth Klarman), they all said that they were close to neutral or net short in their portfolios, or had
substantial cash positions, and I wrote hear it thrice. Maybe they do ring a bell at the top. Maybe these guys are
Early (Julian, like Bufet, began de-risking in 2007 and many questioned both of them then) but I am going with
my Rule and we will begin to lower exposure in our Funds at the margin. We did modestly lower exposure in the
Funds, however, Q2 turned out not to be the period when playing defense was rewarded, so on the margin we
could have done a little better had we stayed more net long. As we have said, the timing of these transitions is very
difcult (Julian and Warren were a year early in 2007), but as we mentioned last quarter, the magnitude, and more
importantly, the speed of the correction when this type of event occurs, means it is far better to be early than late.
We wrote that the average Recession related Bear Market correction in the U.S. has been (38.6%), so when
valuations fnally reach the extreme and the earnings prospects for companies become impaired by a slowing
economy, the adjustment, like a collapsing sand pile, is swif and meaningful. Te best plan of action, like when
dealing with alligators, is to be far away from the pile when things begin to go wrong. Remember how the math
works here. If you started with a dollar and went to cash now and the bear market does come, you still have the
dollar. If you stay for the last 15% upside (Jeremy Grantham now saying the Bubble will peak at 2250) and then get
caught in the downdraf, you end up with 71 cents (1.15 x 0.614). Te other problem is that it is human nature that
once a belief is formed (and worse, once we have committed capital to an idea, or theme) we tend to reject all
evidence that is contrary to our belief when it would clearly be better to use that information to help us avoid
negative outcomes. So lets review the evidence and see if it really is diferent this time.

We have written in past letters about evidence that suggested that there was a natural seven-year cycle in the
markets where excesses that had built up were corrected. We have seen this cycle play out over the decades in
three-year periods around 1973, 1980, 1987, 1994, 2001 and 2008 with each exhibiting similar boom/bust
outcomes. Looking at a great deal of various data series, it appears that this cyclical pattern is repeating with 2014
looking eerily similar to 2000 and 2007 (with some similarities to earlier periods as well, but looking back two dec-
ades is a good amount of sand through the hourglass). We will start with the big picture data on the economy and
work our way down to the equity market and funds. If we just look at GDP in isolation, the recent negative (2.1%)
reading for Q1 is the lowest reading (by far) since 2008 and has actually only been exceeded in the past few decades
in the depths of meaningful Recessions like 1975, 1981, 1983, 1991 and 2008. Many want to say that it was all
weather related, but we have had plenty of cold winters in the U.S. over the years (by my recollection, my frst
winter in Chicago in 1985 seemingly made the Polar Vortex seem a like a little tempest in a teacup) and GDP held
up just fne, so perhaps there was more to the setback than just a deep freeze. Te frst estimate of the Q2 reading
just came in at 4% (with a big inventory component that will likely be revised lower) and given that the bounce was
not as big as expected (the collection of those supposedly deferred sales was not huge) it has been interesting to


Second Quarter 2014

hear the narrative on where the Recovery (Math: -2 & +4 needs a pair of 5s to get to the Fed 3% estimate for the
year no chance). If we take a peek at the Bufett Ratio (reportedly his favorite indicator of value in the
markets), the Market Cap of the S&P 500 over the GDP, we see that today's 125 reading is now uncomfortably
above the 120 reading from 2007 and beginning to approach the crazy reading of 153 from 2000. Tere are some
who want to make adjustments for the globalization of U.S. companies as they get a larger percentage of their
revenues from overseas, which could have some merit, but the adjustment would be modest and the primary point
that we are right on cycle remains. Looking at Tobins Q (created by Nobel Laureate James Tobin of Yale), the
ratio of the actual value of the assets of the companies in the market over their replacement value, we have only
been higher in 2000 and 1968 (the Nify 50 bubble, 7 years prior to 1975). If we transition over to equity markets
and valuations, we see the same patterns. Looking at the most simplistic valuation indicator, the current level of
the markets as a percentage above (or below) the running regression of the long-term growth trend, we see that the
current value of 84% (above the trend line) has only been exceeded twice in over 100 years, 88% in 2007 and 149%
in 2000 (we just exceeded the 81% level in 1929). Clearly there is a lot of room between 84% and 149%, so some
might argue this trend can continue for a while longer. On the fip side, if the valuation were to return to the trend
line, the S&P 500 would fall to 1050 (from 1930 today) and if it were to correct down to the level at the end of
historical Bear Markets, it would fall all the way to 500. Looking at traditional P/E ratios and, more importantly,
the Shiller P/E ratio (which adjusts the E for the trailing ten year average), we see similar data and todays value of
26.2 is in the 98
th
percentile all time and has only been exceeded (wait for it) in 2000 and 1929.

Turning our attention to investor behavior, we see additional evidence of the same trends, the same seven-year
cycle and the same levels of extreme optimism and confdence. Tere are a number of ways to measure investor
confdence (as a group) and we can look at a handful of the most ofen discussed indicators here. Te American
Association of Individual Investors allocation to equities (as a percentage of their total assets) is the highest it has
been since 2007 and was only surpassed in 2000. Similarly, their allocation to cash is the lowest it has been since
the Tech Bubble in 2000. Te Investors Intelligence survey of Bulls and Bears has the second lowest reading of
Bears in history at 23%, it was only lower in summer of 2000, and the percentage of Bulls has reached a level that it
has only seen once in its history at 62%, the last time, of course, October 2007. Another indicator of investor
confdence (or perhaps Financial Repression has worked and the Fed has forced everyone out of cash) is the
ratio of Money Market assets to total mutual fund assets, which has reached a low level only seen twice before in
2001 and 2007. Te investment professionals running the mutual funds are equally bullish as the cash levels in
mutual funds has only been lower in two months, January 2000 and April 2007, in both cases about six months
before the eventual market top. Te most ofen talked about indicator of fnancial excess is the about of margin
debt outstanding and there is some very interesting data that emerges from close inspection. Te frst abnormal
peak in margin debt occurred in March of 2000, which was followed by a market top in August of 2000 and a
Recession in March of 2001. Te next peak in margin debt occurred in July 2007, which was followed by a market
top in October of 2007 and a Recession in December of 2007. Te most recent peak in margin debt occurred in
February and we are now waiting to see if the market top and Recession follow a similar pattern.

If we examine corporate behavior, we also see the same seven-year trends and exaggerated behavior that would
make the case for another cyclical wave getting ready to crest. Given the artifcially low interest rate environment,
companies have been issuing record amounts of debt (high yield issuance is at an all-time high) and using much of
those proceeds (in many instances) to buy back stock. One might ask the logical question of why are they buying
their stock today afer a trebling of the S&P 500 over the past fve years (i.e., why didnt they buy when prices were
60% cheaper?), but they are indeed buying near record amounts of stock. Te trouble with that level of activity is


Second Quarter 2014

the last time we saw this level of activity (when they actually set the record) in buybacks was in October of 2007.
Today, interestingly, the same number, 380 of the 500 S&P companies, are doing buybacks and the $160B level hit
in June was getting close to the record $180B from 2007. Te other activity at the corporate level is occurring in
the deal-making arena with the rapid acceleration of corporate M&A. Tere has been an explosion in mergers and
acquisitions activity in 2014 as total deal volume has eclipsed $1 Trillion for only the second time in history. Yes,
the frst time was in 2007 with $1.1T and we will clearly surpass the record this year. When we look out beyond the
U.S., global deal volume is $2.1T, again second only to 2007, and the U.S. proportion of total deals has reached
48%, the highest level since 1999. One other interesting data point is that deals completed by Financial Sponsors
(LBOs) has never been higher and with nearly $200B spent across 536 deals which is a 91% increase over 2013.
Perhaps the only time we have witnessed more froth in the M&A market was when AOL purchased Time Warner
for an all-time record $164B in January 2000. Tat purchase price ultimately valued AOL stock at $226B. Now, for
the rest of the story Te combined frm had to take a write-of of $99B (yes, you read that right) two years later
and afer a contentious nine-year relationship Time Warner regained control and spun out AOL for $20B in 2009.
Today, the market cap of AOL is $3B, for a cumulative loss of (98.7%). Perhaps in what may (or may not) turn out
to be another signature moment for M&A in 2014 (coincidently at the same time as the peak in margin debt),
Facebooks recent purchase of WhatsApp for $19.1B prompts comparisons to some of the 2000s era deals given the
nearly invisible revenues and earnings and the talk of future revenue per registered user elicits memories of
eyeballs and page views that never did materialize the way the spreadsheet forecasts predicted. Finally, the
rapid increase in IPOs in 2014 has, again, prompted comparisons to 2000, as we have not seen this level of IPO
activity since that vintage. More worrisome than the increase in IPO volume is the quality of those companies
going public as the percentage of money-losing companies going public matches the levels during the Tech Bubble.
All of this selling by corporate insiders (LBOs, VCs and management teams) has prompted me to include another
hashtag in a number of Tweets, #InsidersDontSellAtBottoms (their decision to sell begs the question of why are the
people with the most knowledge of the business so anxious to sell).

So there we have it, a compendium of source data that paints a picture of a very cyclical pattern of economic
activity, investor and corporate behavior following a stable seven-year pattern. Sir John would have us examine the
mistakes we made in 2000 and 2007 to not take money of the table, to not follow outstanding investors like
Robertson, Bufett and Klarman in preparing their portfolios for the cyclical shif, for not taking the information
content of individual investors pouring in (buying what they wish they would have bought) and insiders selling
through IPOs and M&A (happily fulflling the excess demand created by the individuals by creating new supply),
and to ask ourselves why is it diferent this time? He has told us that those are the most dangerous, and most
costly, words in investing and we would be wise to heed his advice to systematically and proactively examine all the
evidence on the current environment to make sure we dont make the same mistake again this time. Tere are
many who say that it truly is diferent this time because of the commitment of Central Banks to QE and that the
excess liquidity and low interest rates have changed the rules of the game. We remain skeptical of that
conclusion, not only because QE will go away in the U.S. in October (interesting timing given the history of
volatility in that month), but, mostly, because debt does not equal wealth. If it was as simple as printing money to
create wealth then everyone would do it and all the paper would get simultaneously devalued (oh wait, that is
exactly what is happening, #CurrencyWars).

We wrote last quarter that markets are cyclical and tend to follow natural patterns over time. Our job is to be ever
vigilant in adjusting portfolios to capitalize on the opportunities in each environment. Te cycles have shrunk over
the decades and the complexity has been increased due to higher levels of central bank intervention, but the keys to


Second Quarter 2014

success remain Discipline, a fundamentally sound investment Process and a Tactical implementation that
capitalizes on the MCCM network and takes advantage of the collective experience of the team and those words
seem to take on an even greater sense of urgency ninety days later as we look at the mounting evidence of another
cyclical peak. Could a series of events unfold that pushes the timing of the cycle out beyond the historical seven
years? Clearly that is a possibility and there does appear to be a cabal of central bankers trying to do just that
through negative interest rates in Europe, Abenomics stimulus in Japan and chatter about new programs (like
equity or REIT purchases) at the Fed. Tere are also many market participants who desperately want to believe
that this time its diferent as they need to make 7% to 8% returns to meet their future liabilities and the 0-3-5
Conundrum (expected future real returns from this point for cash, bonds and stocks) is very inconvenient, so they
are twisting Rule No. 12 and praying for an outcome that is not supported by the math.
#HopeIsNotAnInvestmentStrategy and just because you need a particular return doesnt mean that the markets
must oblige. To achieve those types of returns will require a very diferent approach going forward, one that is
more opportunistic, capitalizes on both the long and short side of the traditional markets and captures the
illiquidity premium from private investments. #WeCantPredictWeCanPrepare clearly applies as we cannot be
certain of the timing of when the current cycle will end but we do know that it will end. As we said last quarter,
#GravityBites. We also quoted Seth Klarman who said that when the cycle does end (as all cycles eventually do),
Few will be ready. Few will be prepared, so we can end this section with one last hashtag and channel the Boy
Scouts, we can #BePrepared.

Second Quarter 2014

Second Quarter Review

In thinking about the results of Q2, it makes sense to
repeat some of the commentary from our last letter on
Te Kindleberger Cycle to provide some perspective
on where we believe that we are in the Cycle and why
the continual repetition of this Cycle over time is the
basis for our view that it is #NotDiferentTisTime.
As we described, the process follows a readily
observable pattern, Insiders begin selling, as they
believe valuations have become too high. Tat selling
pressure (and ultimately some external event) triggers
the frst stage, Crisis where prices begin to fall, slowly
at frst, and then more rapidly, ultimately ending in a
cathartic wave of Revulsion in the second stage, where
the Masses sell. Te cycle then enters the third stage,
Displacement, where there is a period of digestion and
then meaningful restructuring which triggers the
Insiders to begin buying again. As prices begin to rise,
a new Narrative is created to explain why this period
will be the New Normal (think Personal
Computing, Internet Technology or U.S. Energy
Renaissance) and we enter the fourth stage, the Boom
where there is a period of robust growth, strong equity
returns and participants cease to recall the events of
the last Crisis. As the Masses follow the Insiders and
everyone begins to buy again, we reach stage fve,
Euphoria where the excess liquidity and risk seeking
behavior of investors pushes prices to extremes again,
which prompts the Insiders to sell and the Cycle
repeats. We noted that we believed that we had
entered the Euphoria stage in Q1 as valuations in
some sectors (Biotech, Cloud, Internet) of the market
had reached ebullient levels and we expected to see the
beginnings of the selling cycle. Almost on cue, there
was a huge surge in capital markets activity, the
Insiders started selling in waves, as IPOs, secondary
issues, convertible bond issues and M&A transactions
began to spike. Concurrently, we began to see some
small cracks in the host highly valued names and
downside volatility spiked in Biotech, Internet
Technology and Cloud causing some acute pain in the
early part of the quarter. Interestingly, the
#BuyTeDip crowd came to the rescue and as
earnings numbers came in a little better than lowered
expectations, global equity markets actually
performed quite well during the period. An
important point is that this strong performance only
accelerated the pace of Insiders Selling and (we
believe) moved us closer to the beginning of the next
leg down in Te Kindleberger Cycle. Two points here
are worth noting: 1) the number of money losing
companies issuing IPOs was only higher in the Tech
Bubble in 2000, and 2) in the most recent month,
there was a huge surge in IPO activity (to rival 2000
and 2007) and, worryingly, the majority of them
closed below their ofering prices. Pinpointing
precisely where we are in the Cycle is difcult, but it
does appear that a number of factors are lining up that
may make that determination easier in the coming
months. So lets move on to the core of this section of
the letter, providing an analysis of the events that
occurred in the capital markets during the quarter and
providing some commentary on how our views on
opportunities in the various market segments played
out during the period.

Global equities reverted back to their winning ways
(albeit Central Bank liquidity induced) in Q2, with the
S&P 500 jumping 5.2%, EAFE rising 4.1% and EM
surging 6.6%. We wrote last quarter that at the
crescendo of the January sell-of, it was right as
things were beginning to accelerate downwards when
Ben and Janet did their best Sonny and Cher
impersonation singing I Got You Babe during Bens
swansong meeting and reminded investors that they
had their back with the new, and improved, Yellen
Put. Te markets were soothed by the sounds of our
Economic Pied Pipers and Risk-On was back in
vogue. Q2 started very similarly to Q1 and during
the frst ten days of April the S&P 500 was down (4%),
and many high beta names were down well into the
double digits, so it was clear that Ms. Yellen had to
break out the sequin gown and long wig and croon
another verse of I Got You Babe. Tose melodious
words were all the markets needed to hear to resume
their inexorable march upwards. From the trough,
the S&P 500 was up a robust 8% while the NASDAQ

Second Quarter 2014
was up nearly 11%, heady stuf given the multiple
negative surprises on U.S. GDP (Q1 was revised down
twice to a stunning (2.9%) decline vs. expectations of a
1.5% increase) and the disappointing EPS growth.
Unsurprisingly, that is, unsurprising afer so many
quarters of multiple expansion driving equity returns,
the bulk of the market advance came from a rise in the
P/E ratio, which now stands at levels we have not seen
since the Tech Bubble in 2000 (the forward P/E of the
S&P is now 16.4). We have noted in previous letters
that even though the valuation levels of the U.S.
Equity market are around 2 standard deviations above
normal, that there was nothing prohibiting them from
rising further to 2.5 (or even 3), but that eventually
there would be mean reversion (Jeremy Grantham
calls mean reversion one of the most reliable forces in
the Universe alongside gravity). One thing to always
keep in mind is that any data series must spend as
much time below the average as above the average
(that is a simple mathematical identity) and the sum
of the area above the curve must equal the sum of the
area below the curve (another identity). In other
words, the higher the rise, the bigger the fall. Te Fed,
and other Central Banks, may be able to delay the
inevitable adjustment through the provision of excess
liquidity, but at some point the easing will stop and
valuations will adjust. In essence, stimulus simply
pulls forward future returns in the same way that
debt pulls forward future consumption (I borrow
today to buy something I cant aford, but later I must
service/pay back the debt instead of buying something
else).

Diving deeper into the individual market
performances for Q2, we see some interesting
developments related to trends that we commented on
last quarter. First, in the U.S. equity market, the
liquidity driven equity ramp continues, as the S&P
500 has not come close to touching (let alone breaking
through) the 200-day moving average since
November of 2012. Second, we wrote that an
interesting development that will likely be talked a lot
in the next quarterly letter is the rotation from
Growth toward Value by investors in the U.S. equity
market, but little did we know that the rotation
would be extremely short lived as the animal spirits
sparked by Janets crooning would push investors
back toward growth (as if the dramatic drop in
March/April never occurred). To that end, the R3000
Growth and Value indices had identical 4.9% returns
for the quarter despite the Value index having a huge
400 basis point lead afer the April sell of in growth
stocks. Looking a little more closely at the sector
components, small-caps continued to lag (they trailed
large-caps in Q1 for the frst time in a long time),
rising only 2.1% and micro-caps actually had negative
returns during the quarter, falling (1.4%). Given the
very high valuations of the small-cap sector, where the
P/E was rapidly approaching triple digits, the recent
weakness bears careful monitoring as a potential
canary in the coal mine. Te small caps have been the
leaders in the U.S. equity market for a number of
years, serving as the head of the liquidity fed,
momentum monster since the turn in 2009. But, as
my high school wrestling coach used to say, where
the head goes, the body follows so if the head of the
market continues downward, we could see a rapid
shif in momentum in the quarters ahead.

Two other aspects of the U.S. equity markets we
commented on last quarter were the opportunities on
the short side and the prospects for the markets given
the continued tailwind of QE. We wrote as we enter
the second quarter of 2014, that negative momentum
is accelerating in the most over-valued segments of
the market and the return opportunities on the short
side have been nearly as attractive as they were in
2000 and shorting names in biotech, social media
and cloud was a tremendous source of returns for
managers in April and the frst part of May. Te ETFs
for these sectors, IBB, SOCL and SKYY fell (10%),
(20%) and (10%) respectively in the frst half of the
quarter, but then made a dramatic reversal in
mid-May, surging for the balance of the quarter back
into positive territory and then falling again in recent
weeks to end fat over the past three months. With
respect to the overall market, we also wrote that we
continue to believe that there is modest downside risk

Second Quarter 2014
to the U.S. equity market as a whole and that a loss
similar to the (9%) drop in 2000 is possible. Tat said,
there are some arguments against this outcome,
namely that bull markets rarely end with a steep yield
curve (no sign of short rate increases until at least
2015) and historically every $100 billion of QE has
translated into 40 S&P 500 points (calculated by Larry
Jeddeloh at TIS), so with around $600 billion
scheduled for 2014, that would translate into 240
points up upside to 2090, or a gain of 13%.
Interestingly, while the S&P 500 was behind
schedule afer Q1 by that calculation, the strong
returns of Q2 put the index almost exactly in line with
this prospective outcome at 1960, up 110 points and
6% (plus 1% of dividends yields the 7.1% YTD total
return) for the frst half. Tere are a number of other
methodologies for forecasting returns for the year
related to earnings growth and anticipated changes in
valuations relative to interest rates (mostly pointing to
low single digit returns), but Larrys Law of 40
points per $100B has been the best predictor of the
S&P since 2009. Te efcacy of this relationship does
beg an important question, what happens to the
market when QE ends in October? Stan
Druckenmiller has a simple answer that he shared on
Bloomberg TV last November, the market will go
down, but we will have to see what the next two
quarters bring.

Generally speaking, international equity markets were
quite strong in the second quarter as the trends from
Q1 reversed. Japan had an outstanding quarter as we
highlighted was likely in our Around the World with
Yusko Webinar, Te Abe-san Also Rises: Te
Continuing case for Japan (for a copy of the materials
from the webinar, please email
IR@morgancreekcap.com). Investors shook of the
difcult performance of Q1 and focused on the
rapidly escalating profts from Japan Inc. and the
MSCI Japan Index surged 6.7%. Japanese small-caps
fared even better as the Mothers Index jumped an
incredible 17.6% during the period. Even more
astonishing is that the return was made up of a (17%)
decline in the frst half of the quarter followed by a
42% surge of the bottom in mid-May. Even without
additional monetary stimulus from the BOJ, and
without any further depreciation of the Yen, investors
are beginning to understand the incredible earnings
power of the top companies in Japan and the growth
opportunities as they capitalize on supplying goods
and services to support the dynamic growth in
consumption in Asia and Africa. European
performance was also the reverse of Q1 as the Core
was strong and the Periphery weak (with the
exception of Spain which surged another 7.2%). In the
Core, stalwarts Germany and France were modestly
higher, up 1.7% each, while the UK and Belgium were
the standouts in Q2, up 6.1% and 5.1% respectively.
Te GIIPS had a rough quarter (afer their stunning
results in Q1 where Greece was up18.1%, Italy was up
14.6%, Ireland was up14%, Portugal was up 9.7%,
Spain was up 4.8%) as the GIIP countries fell (10.8%),
(9.0%), (0.1%) and (2.6%) and only Spain managed to
continue its winning ways as noted above. We just
updated our thesis on the GIIPS last week in our
Around the World with Yusko Webinar, Peripheral
Europe: When PIIGS Fly (again, if you would like a
copy of the materials from the webinar, please email
IR@morgancreekcap.com) and we continue to see
signifcantly more upside in Peripheral countries vs.
the Core countries given their superior valuations.
Te European Recovery continues apace (and actually
appears to be gaining some momentum) as the ECB
has begun to expand their balance sheet again and has
cut interest rates to below zero to stimulate lending.
We noted last quarter how Q1 was a very good one for
the GIIPS banks. However, Q2 was a very diferent
story, as Alpha Bank and Piraeus Bank in Greece shed
(5%) and (18%) respectively, Bank of Ireland
plummeted (30%), (mirror image of its Q1 gain) and
Bankia in Spain fell (8%), essentially giving back all
their gains for 2014. Concerns about the upcoming
Stress Test and some recent troubles with a bank
holding company in Portugal created selling pressure
across the fnancial services sector. Curiously, the
data on the European recovery continues to gain
momentum, so we would expect to see continued
strong performance from cyclical and fnancial

Second Quarter 2014
services frms in the GIIPS region.

Perhaps the most surprising move in Q2 was the
acceleration of the momentum in Emerging Markets,
particularly given the universal gloom & doom
forecasts at the beginning of the year by market
prognosticators everywhere. Coming into 2014, there
was near unanimity in the belief that the Fed Taper
would crush growth, and hence profts and stock
prices, in EM, with some pundits proclaiming that the
EM run was over and the next decade belonged to the
Developed Markets (despite the presence of the Killer
Ds of poor Demographics, huge Debt burdens and
Defationary threats). We wrote in the last letter that
all of this was a reminder of another Soros quote that
the worse a situation becomes, the less it takes to turn
it around and the greater the upside that we felt
applied to these markets as they had all taken steps to
prepare for a non-QE world (hiring new Central Bank
heads, raising interest rates or instituting more fscal
discipline) and we thought that they were very
attractively priced afer the corrections. Apparently,
global investors got the memo and the MSCI EM
Index outperformed all the Developed Markets
indices, rising 6.6%. Digging a little deeper, there was
some truly outstanding performance in various
regions and individual countries. Te BRICs all
surged with returns of 7.5%, 10.7%, 12.7% and 5.5%,
respectively, as positive developments such as settling
of the Ukraine/Russia tension and the huge election
result in India (the pro-business BJP party gaining a
supermajority for new PM Modi) pushed those
markets to double-digit gains. We commented in
April that we will talk more about the Russian
situation in the Market Outlook section as the events
unfolding there seem to be creating a compelling
opportunity to buy assets at prices that will look like
fantastic bargains in a few years and global investors
again agreed that despite the turmoil, the assets were
too cheap to pass up. China posted a solid quarter
afer many quarters of sub-par performance as some
economic data surprised to the upside and rumors of
PBOC easing drew capital back into the market. We
commented last quarter that one interesting
development to watch is whether the SOEs in China
can enhance their governance policies and unlock
value for shareholders and there could be an
interesting opportunity to mine the listed SOEs for un
-lockable value in some of the largest commercial
enterprises in the world that are the owners of some
really spectacular assets. Interestingly, and while one
quarter does not a trend make, there was some very
strong performance in PetroChina, CNOOC and
China Minsheng bank that rose 15%, 18% and 10%,
respectively. Tat said, we continue to believe that
New China (Internet, Retail, Consumer, Healthcare
and Clean Energy) will be the very best place to fnd
growth opportunities and extract superior returns and
Q2 saw our favorite name in this theme, Vipshop,
continue to surge on rising revenues and profts,
jumping another 25%, taking the total return to an
amazing 145% CYTD and an astounding 550% since
we began talking about VIPS a year ago.

Q2 also turned out quite positively for the Not So
Fragile Five as Brazil, India, Indonesia, South Africa
and Turkey surged 7.5%, 12.7%, 0.4%, 4.5% and
15.1%, respectively, to bring CYTD gains to surprising
levels of 10.5%, 21.9%, 21.7%, 9.5% and 20.6%,
respectively. Tere were, again, no prognosticators
predicting that these countries would produce
outstanding returns for investors coming into 2014
and, in fact, January was a very difcult period as
these markets returned (10.6%), (3.8%), 4.3%, (10.0%)
and (13.3%), respectively (which makes the big CYTD
returns even more impressive). We actually discussed
in a previous letter a concept called the Templeton
Misery Index (I tweeted about this in January as well)
coming into the year based on the idea that Sir John
was right in saying that People are always asking me
where is the outlook good, but thats the wrong
question. Te right question is: Where is the
outlook the most miserable? History has shown that
it is where there is Maximum Pessimism that Bull
Markets begin and great long-term returns can be
found. Te Fragile Five were all quite miserable on
the TMI scale in January as were countries like
Tailand, Taiwan and the Philippines, which have also

Second Quarter 2014
generated strong returns, up 15.6%, 11.5% and 19.9%
CYTD. Sir John said Bull Markets are born on
Pessimism, grow on Skepticism and there is still
plenty of skepticism on EM, so we should expect to
see continued solid returns in the quarters ahead
(albeit with some material volatility). Another one of
our favorite areas over the past year has been the
Frontier Markets (for a full presentation on the case
for Frontier Markets from a recent Webinar contact
IR@morgancreekcap.com), which continued their
surge, rising a robust 11.9% (and a huge 20.2% for the
CYTD), well ahead of all the other global equity
markets. Te MSCI Index number masks the
historical variability across these markets (which is
why we focus on allocating to great country/stock
pickers), but Q2 was pretty strong across the board
with countries like Argentina surging 18.6%, Nigeria
& Ukraine recouping all their Q1 losses, rising 17%
and 26.4%, respectively, and Pakistan rising another
8.5% on top of similar gains in Q1. We continue to
focus on the signifcant tailwinds related to
Demographics, Growth and Low Debt that will drive
these market returns higher for many years to come.
An area we highlighted last quarter was the
opportunity in the GCC countries as they continue to
beneft from young, growing populations, current
account surpluses and tremendous wealth generation
capacity as they covert their petro-dollars into
commercial and consumer enterprises, and while
these markets took a breather in Q2, markets in
Saudi Arabia, UAE and Qatar are up 11.5%, 15.2%
and 14.5%, respectively, for the year.

Contrary to 100% of the economists surveyed by
Bloomberg (67 out of 67 predicted rising rates) to
begin the year, global interest rates did not rise and
global fxed income markets generated solid returns in
Q2. Interest rates continued their inexorable decline
as signs of Defation began to rear their ugly head (so
much so in Europe as to prompt Super Mario to push
interest rates below zero) and global GDP growth
continued to fall short of expectations (with the most
stunning development being the negative (2.9) print
in the U.S.). For the quarter the Barclays Aggregate
Index rose 2%, the JPMorgan Global Bond Index
jumped even more, rising 2.8% as unexpected Dollar
weakness helped domestic investors, the ML HY
Index posted another solid quarter, up 2.6% and the
rebound in EM Debt accelerated as the JPMorgan
Index surged 4.6%. While all of these returns were
solid, the biggest surprise in the bond markets in 2014
continues to be long Treasuries, which surged another
4.7% and now stand well ahead of equities for the
CYTD, up a stunning 12.0%. We wrote in the Q4
letter so while we continue to believe that traditional
fxed income will generate negative returns for the
next fve years (or more), there could be a short-term
opportunity to hide in long Treasuries if the
markets get queasy from QE withdrawal in 2014.
Tis Variant Perception was beyond contrarian as it
was in direct contrast to all of the pundits and market
observers who were certain that rates had to rise.
Our view was based simply on the observation that
every time the Fed had withdrawn stimulus in the past
few years, rates had actually fallen (not risen as
everyone predicted) and that there was a predictable
trend in bond yields that created an opportunity to
proft from the Fed signaling that they are going to
stop buying bonds at some point in 2014. While we
did add some exposure to long bonds in our tactical
allocations, we clearly should have made a much
larger allocation given the historical pattern of returns
during previous QE cycles. Te good news on this
front is that the Source on this trade, Van
Hoisington, spoke at our iCIO Event in May and
reiterated his view that Long Bonds continue to be
undervalued and that the negative surprise in Q1 GDP
nearly guarantees lower interest rates since long rates
should approximate Nominal GDP which will
struggle to make 2% for 2014. Given that prospective
outlook for growth and rates, we will continue
recommend that investors divest from traditional, low
duration, fxed income as investors are nearly
guaranteed a dismal real return over the next decade.
While it is possible that we will follow the Japanese
path and we will have another decade of declining
interest rates that will drive bond yields lower (and
returns modestly higher), but low duration fxed

Second Quarter 2014
income is a terrible risk/reward even in that scenario
as the opportunity cost relative to strategies like direct
lending, distressed debt, EM bonds and other hybrid
approaches (converts & preferreds) is simply too high
to justify holding traditional bonds.

One of the most stunning developments in Q2 was the
acceleration of the return to yield assets, REITs and
MLPs. We wrote last quarter that these assets might
enjoy a tailwind, but we had no idea that it would
turn into a gale force wind driving REITs up another
7% (on top of the 9.9% in Q1) and MLPs up an
amazing 14.2% to push these two assets classes to
eye-popping returns of 17.6% and 16.3% for the
CYTD. Te magnitude of this move caught us
completely of guard as we expected some pause that
refreshes afer such a strong run in Q1 for REITs and
Q4 for MLPs. While we did write in the Q4 letter
(and repeated it last quarter as well) that one scenario
that could play out is that the Lower for Longer
crew, led now by QEeen Janet Yellen, actually creates
some new twist for QEternity (like buying stocks or
REITs) that drives rates so low the Dollar replaces the
Yen as the Carry Trade currency of choice, we
concluded (incorrectly) that Janets lack of any
announcement to replace QE, coupled with the
incessant calls for rising rates by all the
commentators, would deter further capital fows into
these assets, which made us unduly cautious on the
near term prospects for the yield trade. Clearly the
average investor was unfazed by the threat of higher
rates and was simply desperate to escape the penalty
of Financial Repression, which has pushed yields to
zero in traditional savings vehicles. While this was a
meaningful missed opportunity, and we should have
done a better job recognizing the shif in momentum
in these sectors as interest rates continued to fall, we
have beneftted from exposure to energy and other
real assets in other segments of our portfolios.

Performance in hedge funds has been mixed, with
some of the Event Driven strategies producing solid
returns, while the Macro/CTA strategies continue to
struggle and Equity Long/Short falls somewhere in
between. As we observed last quarter, the average
returns do mask some very strong performance from
Activist Funds and a few specialty funds in Healthcare
and China, but overall it was a tough relative quarter
for hedge funds overall afer making up some ground
in Q1. In the ZIRP (Zero Interest Rate Policy) world,
the ability to generate signifcant returns in arbitrage
and relative value strategies has been challenging and
the artifcially low rate environment looks likely to be
in place until at least 2015 (we will take the over on
that timeframe as well). Looking at the indices, the
HFRX Absolute Return Index was up 0.5%, the HFRX
Event Driven Index was up 1.6% and the HFRX Multi
-Strategy Index was up 1.8% (slightly behind fxed
income) and the HFRX Macro/CTA Index managed a
small positive return, up 0.3% for the quarter. For the
CYTD, these indices are up 1.8%, 4.4%, 3.7% and
(0.7%), respectively, and while these returns are
roughly in-line with traditional fxed income returns,
there is still beneft to shifing from bonds toward
Absolute Return strategies since they have a positive
correlation to interest rates (they have foating rate
elements) whereas bonds have negative correlation
(rates rise, bonds lose money), so there is an added
hedging beneft to holding A/R rather than fxed
income in the current environment.

Equity Long/Short hedge fund strategies struggled in
Q2 as the double whammy of volatility on the long
side in the frst half of the quarter was concentrated
more directly in the growth names held by many
managers and the snapback rally during the second
half of the quarter exacted losses on the short side.
Te short squeezes were particularly acute in the most
overvalued segments, like biotech, social media and
cloud, creating an investment environment that felt
(disconcertingly) a lot like dj vu all over again back
to 2013. While Long/Short Funds didnt lose money,
they werent able to extract the dual alpha from longs
and shorts that we anticipated coming into the year.
To that end, the HFR Equity Hedge Index was fat and
the HFRX Equity Directional Index rose 1.7%. As we
discussed last quarter, the one drawback of the HF
indices is that the very best managers do not report, so

Second Quarter 2014
many investors who have exposure to those Funds will
experience very diferent results. Te best performing
area within Long/Short this year has been the HFRX
Technology/Healthcare Index which rallied 1.4%
during the quarter, 7.7% CYTD, as many specialty
managers have been able to capitalize on both the
long and the short side of the market volatility to
generate above market returns.

Despite the big rally in commodities prices in Q1, we
wrote last quarter that there continues to be a lot of
negativity about commodities in the marketplace
related to Chinas plans to transition from Fixed Asset
Investment to Consumption and the purported end of
the Commodity Super Cycle. We also said that we
would continue to side with Jeremy Grantham on his
point that population growth rates are outstripping
our capabilities to produce commodities in sufcient
volumes (and, more importantly, at reasonable
prices), so we would expect there to be outstanding
opportunities in the commodity space for years to
come. Returns in the commodities markets were
highly varied (and highly volatile) in Q2 and there was
a clear demarcation between the Energy & Metals on
the plus side and the Ags on the minus side. Afer a
dramatic rebound from the dreadful performance in
2013 in sof commodities in Q1, the bears were out
again in the Ag space in Q2, as grain prices collapsed
(giving back all their Q1 gains) and cofee slipped
from its peak (but is still up a huge 54% for the year).
Te pain in the grains was acute as corn fell (14.3%),
wheat dropped (17.6%) and cofee slipped (3.9%), but
more concerning was that the underlying tenor of the
markets shifed to be quite negative during the period.
We may not be at the point of maximum pessimism
yet, but we are probably closing in on that level, so
there could be some interesting opportunities in the
upside in these markets soon. Te metals markets
were also very volatile, falling for the frst two months
of the quarter, before fnding a bid and surging quite
nicely in June, with gold rising 1.8%, silver up 4.9%
and copper up a surprising 4.6% (surprising given all
the negative stories about fading China growth and
demand). In nearly a mirror image of the Ags space,
sentiment in the metals markets is quite strong. In
fact, the underlying trends in the stocks of metals
related businesses (Alcoa, Freeport-McMoRan,
Southern Copper & Barrick Gold to name a few) and
have begun to break out all over the place. Te gold
miners deserve a little special attention here, as they
have been incredibly strong (but very volatile) in 2014
(as the Year of the Alligator model predicted) with
GDX and GDXJ up 12% and 17%, respectively, for Q2
and up 24% and 36% for the CYTD through this
week. Te good news is that while these moves seem
large, given the total decimation in the gold miners
since 2011, GDX is still down (57%) and GDXJ is still
down (70%) from the peak three years ago, while the
S&P 500 is up 60%. Te chart of these three securities
makes one of the widest Alligator Jaws we have seen
in a long time so there is likely much more room to
run in this emerging trend.

Overall, the frst half of 2014 has been quite volatile
and very challenging for investors. Te average
balanced portfolio (stocks/bonds/cash) investor is
lagging again as traditional bonds have produced very
little return and many investors de-risked their equity
portfolios during the drawdown in April and missed
the strong rally in Q2. Hedge funds have struggled to
keep pace as shorts were a real drag in Q2, so
investors with high allocations to alternatives are
feeling wrong-footed again as well. Tere were very
few investors (actually none that we are aware of,
unfortunately including us) that put together an
#AlligatorPortfolio (would have been heavy in long
bonds, Ags, gold, gold miners, long Yen and short
equities in Japan, Europe & U.S.) which would have
produced a double-digit return over the past six
months (and would have held up much better than a
traditional portfolio in July as well). We mentioned
last quarter an interesting statistic that is that there
have been 17 years where the S&P 500 has returned
more than 25% and the average return in the follow-
ing year has been just 6% (which is right about where
the equity markets are trending afer the frst third).
Te range of outcomes is quite interesting, however,
as 6 of the years were negative and 6 of the years

Second Quarter 2014
produced double-digit returns again, with the
remaining 5 years closer to the average. At the end
of Q1 it appeared the 6% number was highly likely, at
the end of Q2, it looked like we were headed to the
upper end of the range and as we sit here today at the
end of July, the 6% number is looking pretty likely
again. We have a big unknown ahead with the Mid-
Term election and volatility is historically higher
around these events, so it could be an exciting second
half. We will be back in 90 days, on the eve of that big
event, with thoughts on what transpired in Q3. One
thing we know will write a lot about next quarter is
how the Alibaba IPO will likely make this a
#SeptemberToRemember.

Market Outlook

If the theme of this letter is correct and it really is
#NotDiferentTisTime, and markets really do follow
predictable cycles, then doing a Market Outlook
should be pretty simple. Just go back to the last few
times we were at this point in the cycle, see what did
well over the next few quarters and voil, market
forecast. Tere is an elegant simplicity in this idea in
that economies and markets are large, complex
organisms that are comprised of many sectors and
segments, which have shown to exhibit highly cyclical
behavior over time. Yes, there is an added layer of
complexity due to the processes of Creative
Destruction and Destructive Creation, insofar as new
industries and companies are formed over time and
those new areas will take some share of the collective
capital and wealth allocation from those that fade
away (think transfer of wealth from buggy whip
manufacturers to Henry Ford). But, overall there has
been a relatively consistent pattern of ebbs and fows
across asset classes, geographies, sectors and
industries over time and proactive, tactical, investors
could formulate a solid, core market outlook from
those historical patterns. Tere is also a compelling
contrarian element to this thesis as the average
investor simply looks at the very recent past as
extrapolates that current return patterns will persist in
the near term (e.g., the institution I discussed above
who was consistently chasing the hot dot of recent
performance). What we know from the data is that
the most recent performance in an asset class, or
market, is most ofen a nearly perfect inverse of the
short-term future (this is the primary thesis behind
last quarters title Te Year of the Alligator: Why 2014
Will be the Inverse of 2013) as mean reversion tends
to kick in an move prices that have gone toward one
extreme, back to the mean (and subsequently to the
other extreme). Tis movement actually takes time,
hence the cycles. Te key to overcoming this wealth-
reducing tendency is to look farther back in time in
order to compose a view on how the near term future
is likely to look. Mark Twain said, history doesnt
repeat, but it rhymes, which certainly applies, but the
better quote for this issue is from Winston Churchill
when he said, the farther back you can look, the
farther forward you are likely to see. In other words,
history does indeed repeat, but you have to look back
far enough to see the elements of the environment
that are likely to be most prominent in the next
portion of the cycle (think fashion waves over 20
years) #LookBackToSeeAhead.

Another factor at work is that the current
environment prompts some reaction by market
participants (central bankers change interest rates,
governments change fscal policies, companies change
prices, etc.), which impacts the environment in a
Refexive way (for more on Refexivity, we
recommend Te Alchemy of Finance by George
Soros) and catalyzes the cycle. An example. Tey
(never been sure who they are) say that the cure
for high prices, is high prices, as the rising price of an
asset prompts competition to develop to capture the
higher proft margins, which increases supply, which
sates incremental demand, which leads to lower
prices. Tis refexive cycle played out perfectly in the
iron ore market over the past few years (and created
lots of cyclical opportunities to proft on both the long
and short side) as growing demand in China swamped
current supply, so smart business owners raised prices
(the time to be long since proft margins exploded) to

Second Quarter 2014
try and control demand, which led to lots of new
investment in new capacity which has come on line
recently leading to rapidly falling prices (the time to
be short as margins collapsed due to high fxed costs),
which leads to high-cost capacity being shuttered,
prices stabilize, demand resumes, and the cycle starts
anew (this point in the iron ore cycle could favor
some. We can substitute any good, or service, into
this example and fnd the cyclical pattern repeated
over and over again throughout history and the best
investors, I have found, are great students of history
and have lived through multiple cycles themselves in
order to gain experience, and perspective, on how a
particular cycle is likely to play out. Te best way to
summarize the phenomenon comes from the Good
Book itself, in Ecclesiastes 1:9, what has been is what
will be, and what has been done is what will be done,
and there is nothing new under the sun. Even on the
time horizon of millennia, it is
#NotDiferentTisTime.

One of the things we talked about last quarter was
how it was relatively easier (still not easy) to produce
long-term forecasts (as opposed to short-term and
intermediate-term forecasts) as we wrote these
longer-term forecasts are moderately easier to compile
because they can be more quantitative (less
emotional) and they beneft from the natural
cyclicality of markets and the concept of
mean-reversion. Longer-term forecasts can comport
to one of the most important Rules in that they can be
created without emotion, as they tend to lean more on
the observed data rather than opinion and conjecture.
It is much easier to see when a data series of price,
yield or valuation is at an extreme over a long period
of time than to try and guess the incremental change
over a very short period of time. Tat said,
unfortunately, (once again) the latest long-term
forecasts from GMO show that the bulk of the
traditional asset classes are overvalued today and the
expectations for returns for the rest of the decade are
likely to be well below the long-term averages.
Running through their 7 Year forecasts, they expect
the following compound annual returns: Large-cap
U.S. equities 0.5%, Small-cap U.S. equities (3.0%),
High Quality U.S. equities 4.4%, Large-cap
International equities 2.9%, Small-cap International
equities 2.7%, Emerging Markets equities 5.8%, U.S.
Bonds 2.2%, International Bonds (0.4%), EM Debt
3.8%, Cash 1.8%, Timber (proxy for Commodities)
7.6%. To be clear (for anyone who looks at the GMO
chart and sees that the numbers dont match), I have
restated these returns in Nominal terms (GMO
forecasts in Real terms net of a 2.2% infation forecast)
since most investors think in nominal terms.
Terefore, one caveat to these numbers is that if
infation turns out to be higher than 2.2% over the
whole period the expected returns expectations would
rise an equal amount (we will take the under on that
given infation is hovering around 1.3% today and
would need a similar period above 3.1% to get to 2.2%,
but it is an important caveat). So with these long-
term forecasts, the 0-3-5 Conundrum rears its ugly
head again with cash paying 0%, a diversifed portfolio
of Bonds (some U.S., some Global and some EMD &
HY) is likely to get 3% and a diversifed portfolio of
equities (some Quality U.S., some International,
overweight Japan & GIIPS and some EM) investors
are likely to get 5% over the next seven to ten years.
Broken record time, but any way you want, 10/30/60,
0/60/40, 0/0/100, 0/100/0, you just cant get to a 7% to
8% return (unless you buy 100% bonds AND 100%
stocks, so modest leverage might be the right answer
actually)but investors, of all kinds, NEED, 7% to 8%
to meet their liabilities, so there must another
solution, right? We think there are a couple solutions.
Both require meaningful efort, skill, discipline and
patience to achieve, but they do exist. Te frst is to
fnd managers who can add meaningful alpha on top
of the market beta forecasts. Te issue here is that
Alpha is a zero-sum game (not everyone can be above
average, #NotLakeWobegon) and history shows that
fnding Alpha in quantities to cover the gap is
difcult. Second, investors can lean on more skill-
based investment strategies (vs. market-based
traditional strategies) like hedge funds, private
investments and tactical strategies that seek to exploit
the Alpha opportunities that are foregone by those

Second Quarter 2014
investors who stay with the passive 60/40 model.
Tere are opportunities in both but investors need to
focus on allocating to
#SpecialSituationsSpecialPeople.

Lets take a look at a couple of truly Special Situations
to get a sense of where we see opportunity that is
#OfTeBeatenPath. Te frst is Saudi Arabia (whose
stock market has been closed to foreign investors up
to this point), which made an announcement on July
22
nd
saying that they will begin the process to allow
outside investors to buy and sell shares directly
beginning in 2015 (you could buy, and we have
bought, shares indirectly through the use of
Participating-Notes issued by a Broker Dealer with
operations in Saudi). We have liked Saudi for a while
and actually wrote last quarter that Saudi Arabia is an
outstanding place to invest today as the oil wealth has
created a booming consumer culture that has created
signifcant opportunities in banking, fnancial
services, retail, real estate and other sectors. Te
returns for intrepid investors in the region have been
very strong, in part because of the sheer challenge of
investing (foreign investors must use P-Notes, a
derivative contract that grants exposure to the Saudi
equity market through a fnancial services
counterparty) and partly because of the strong
Current Account and Fiscal situations, which have led
to strong earnings. Te opening of the Saudi market
to foreign investors should serve as a signifcant
catalyst to move the market higher as capital fowing
in from global institutional managers is likely to
equate to a signifcant portion of the current Saudi
market cap. For perspective (and to see why this is a
big deal), the Saudi market has a market cap of $550
Billion, twice the size of Turkey, larger than UAE,
Qatar and Kuwait combined, and about the same size
as the South African and Russian markets.
Additionally, opening the market removes the
primary hurdle that has historically prevented MSCI
from including Saudi in their Indexes. Te inclusion
in the MSCI Emerging Markets Index could attract as
much as many tens of $billions of foreign capital into
the market (i.e., should Saudi account for around 4%
of the Index as MSCI has guided). Tis capital infow
presents a compelling Beta opportunity, especially for
investors that can access the market before it ofcially
opens to foreign investors. Tis re-rating
phenomenon was demonstrated by the moves of
Qatar and UAE afer MSCI announced their inclusion
into the MSCI Emerging Markets Index in June 2013,
both markets increased by 45% over the next 12
months until they were added to the index this June.
Te Saudi Baby Boom generation is even more
pronounced than the U.S. and European versions,
which created quite a Demographic dividend and
consumption boom over the past three decades.
(#HereComesTeKingdom).

Te second Special Situations opportunity is even
further out on the non-traditional spectrum, #Bitcoin.
So what exactly is Bitcoin, and why all the hype, and
why would we actually include it as a potential
investment opportunity? Lets start with a high-level
overview from the WSJ, currently, Bitcoin serves as
an alternative currency, a commodity, and money
transfer system. Over time, its underlying framework
(called the Bitcoin protocol) may develop into a global
ledger and information transfer system along with
applications that are unforeseeable at this point in
time. Tis protean nature explains, in part, why the
IRS categorized Bitcoin as property while FinCEN
treated the technology like a traditional fat currency.
So there you have it, clear as mud, right? Te creators,
and early adopters, believe it is an alternative currency
that will ultimately replace traditional currencies, as
Bitcoin has a built in mechanism (only a specifed
number of Bitcoins are created over time) that
prevents the devaluation of the currency by central
bank printing. Te IRS takes the alternative view
that it is simply another commodity that can be
speculated in and therefore is subject to taxation as
the value rises over time. Te detractors (and there
are some high profle ones) contend there is nothing
new here and it is simply a payment mechanism with
little intrinsic value. To quote Mr. Bufets argument
against Bitcoin, he says the following, "a check is a way
of transmitting money, too. Are checks worth a whole

Second Quarter 2014
lot of money just because they can transmit money?
Are money orders? Te idea that Bitcoin has some
huge intrinsic value is just a joke in my view." No
minced words here. We would ofer some thoughts
on Bitcoin as a truly disruptive technology and as an
interesting investment opportunity. Bitcoin is in the
early stages of mainstreaming today as some of the
most prominent venture capital frms (remember
David Hornick of August Ventures Bitcoin was one
of their top fve investment sectors at our iCIO event
in May) are funding startups that will actually seek to
provide Bitcoin to the masses. Additionally, over the
past several months there have been an increasing
number of examples of integration between Bitcoin
and the fnancial services industry. For example, the
CEO of eBay recently made headlines by claiming that
PayPal is eventually going to have to integrate digital
currencies, such as Bitcoin, into their payment
platform. Likewise, the increased integration has led
to substantive conversations in the government about
regulation (why would we need regulation if this
wasnt going to be a prominent asset?). To this end, in
early July, the New York Department of Financial
Services became the frst state to propose regulations
on virtual currencies. According to the agency head,
Benjamin Lawsky, if virtual currencies remain a
virtual Wild West for narcotrafckers and other
criminals, they would threaten our countrys national
security. While this is clearly an extreme stance (Ben
is known for his penchant for grandstanding, future
political ofce maybe), regulation of how an
alternative currency would integrate in the system is
warranted, but what are the ramifcations of a broader
adoption. Historically, early adopters of Bitcoin
supported it because it was disconnected from the
infrastructure represented by government and
everything else (some might call these the conspiracy
theorists). One thing history has shown is that truly
disruptive technologies always come from the
fringe (#LiveOutsideTeComfortZone). Take PCs
and the Internet; Steve Jobs was a hippie; no big
technology company in the 1980s thought the Internet
was going to be relevant. Bitcoin didn't come from a
JP Morgan or PayPal. It is from the fringe. Imple-
menting regulatory safeguards to protect consumers,
businesses, and entrepreneurs that work with virtual
currencies will be instrumental in bringing Bitcoin
into more of the mainstream which makes it an
attractive theme to keep an eye on going forward. On
the investing front, Bitcoin is so widely discussed
given its meteoric price increase in 2013 when it went
from $14 to start the year to $1,140 in early December
(an 8,100% return, one of the few things better than
Vipshop). Te price has fallen back to $585 today and
the volatility has been huge, but there does appear to
be some increasing stability in the past few months.
Tere are a number of hedge funds starting to take
advantage of the Bitcoin phenomenon (one even
backed by the notorious Winklevoss twins of
Facebook fame) and we have chosen to wait and see
how these Funds develop over time. It is likely that
we will be hearing more about Bitcoin in the quarters
and years ahead and we will continue to look for
opportunities to explore the best means to capitalize
on the trend (thanks to Kyle Engle and Frank Tanner
for pulling all this great information together and for
keeping tabs on the Bitcoin space for the team)
#TrueInnovationAlwaysSoundsCrazy.

Coming into #TeYearofheAlligator we had six key
regional investment themes that we presented in our
frst Around the World Webinar in January,
Argentina, Greece, Spain, India, China and Japan
where we thought intrepid investors could earn excess
returns. Tere were diferent reasons for why we felt
that each market was an attractive opportunity at the
time ranging from the likelihood of an eventual
settlement of the sovereign debt issues in Argentina
(which came to a head this week), to stronger than
expected recoveries in Greece and Spain (which has
indeed transpired), to the potential for a game-
changing election outcome in India (amazingly, the
BJP government won a super-majority), to signifcant
reforms in China (ongoing, but meaningful progress
has been made and markets beginning to
acknowledge) and the continuation of Abenomics in
Japan (real progress was made in Q2 and markets
turned up nicely afer a rough Q1). As we look back

Second Quarter 2014
over the six months since that Webinar, the results in
these markets have been fairly robust, as an equal
weighted basket of ETFs (ARGT, GREK, EWP, EPI,
FXI, DXJ) has returned 15%, nearly double the 8%
returns of the All Country World Index. One small
point to make is that an equally weighted basket
probably understates the returns somewhat as a
couple of the ETFs are small and are not that
representative of the total opportunity set, but they
provide an easy way to do a quick calculation of the
solid performance in those markets this year. Going
forward from here, we still like these regions and will
highlight some of the more interesting opportunities
that we see in each one as we go through the Market
Outlook (#ATWWY).

One tried and true approach to earning excess returns
over the long-term is to continually allocate capital to
areas where there has been a dislocation in prices due
to an external shock or misperception by investors
about some aspect of the asset class, region or sector.
We identifed a few of these opportunities in our Q4
letter and said there were still some places where
these types of assets could be found like Russian oil
companies, Indian cyclical companies and Spanish
and Greek Banks. Russian assets were sufering from
the Putin Discount, Indian assets were sufering
from the uncertainty around the outcome of the
election and assets in the GIIPS countries were
struggling with continuing perceptions of economic
woes (despite direct evidence to the contrary in the
form of higher PMIs and GDP growth). Te biggest
challenge to buying really cheap assets is overcoming
the human tendency of herding behavior, so your frst
response is to sell because everyone else is selling. Sir
John talked about this ofen as he said that people
always wanted to know what area he thought was
doing the best and he turned that around saying it was
the wrong question and people should be asking
where is the most miserable. I started tweeting last
January about the #TempletonMiseryIndex (my less
than quantitative perception of which countries
looked the most miserable and, therefore, were the
best places to look for bargains) and talked about
places like Russia, India, Greece and Spain, as well as
Tailand and Turkey, as being places where long-term
focused investors could fnd great opportunities.

Tat said, another challenge of looking for distressed
assets is that you can be early (the euphemism for
wrong) and, ofen, those assets can get cheaper if there
are further shocks to the system (Russian issues in
Ukraine/Crimea and now the Separatists shooting
down the plane) or there can be a change in
perception of the opportunity that changes capital
fows (Greek banks being tarred with same brush as
highly overleveraged European banks that have not
restructured and recapitalized). We discussed this
particular risk in the Q4 letter as well saying, the
challenge with many of these assets is that they reside
in places perceived to be risky and, in some cases, are
exposed to short-term risks. While cheap assets can
get cheaper, if you buy a high quality asset at a good
price and the price declines due to market sentiment,
or short-term capital fows, your loss is more likely to
be temporal rather than permanent. Te key word in
the last sentence is quality and Sir John says
defnitively in Rule No. 5 that investors should search
for bargains in quality companies. As we discussed
above, quality can be defned in many ways, owning
great assets, having proprietary technology, having a
clean balance sheet among others, and we have found
that buying these types of assets when they go on
sale is a winning strategy. India has seen both
extremes of this activity in 2014. Te misery for
investors increased dramatically in January when the
Fed threats of Tapering caused investors to shun all
countries with high current account defcits
(regardless of the direction of those defcits or the rate
of change, it was simply about level and negative was
bad). Cheap assets got cheaper. Ten, nearly as
suddenly, sentiment began to turn as investors saw the
progress made by the new Central Bank Governor,
Rajan, on controlling the current account and, more
importantly, it became apparent that Mr. Modi was
indeed going to be the next Prime Minister. Suddenly
cheap assets got less cheap and there were
considerable returns to be made, IF you had invested

Second Quarter 2014
before the turn. Te Greek banks had a very diferent
run in 2014 as investors began to pile into these stocks
in Q1 and actually drove the Greek market to one of
the best returns in the world for the quarter.
However, sentiment changed again in Q2 as fears over
the new Stress Tests in Europe might show that banks
needed more capital, but what was missing from the
analysis was that the Greek banks had already done
there restructuring, they had already taken the painful
steps of restructuring. Cheap assets got cheaper again.
Russia has been on a similar roller coaster as the big
drop in March turned out to be a great buying
opportunity (an example is we bought QIWI, a mobile
payments company afer the drop and sold it a
number of weeks later 70% higher than where we
bought it) that, unfortunately, turned out to be short-
lived as the tragic incident around the Malaysian
Airlines jetliner prompted additional sanctions
against Russia which prompted investors to sell
Russian shares again. Really cheap assets went back to
silly cheap levels. We see tremendous opportunities
in all three of these markets and will continue to
search for quality bargains in these bargain basement
markets (#MiseryLovesGoodCompanies).

Our intro slide for the Argentina section of the
presentation was titled Dont cry, its me Argentina
and showed a cartoon of president Cristina Kirchner
flling her purse full of money from a YPF gas pump
(the national Oil company) at a Repsol flling station
(the Spanish company that was supposedly a partner
with YPF). Te juxtaposition of a positive view on the
Argentine market with a picture of a corrupt leader
who showed a blatant disregard for property rights in
her decision to re-Nationalize Repsols stake in YPF
might cause cognitive dissonance for some. However,
the opportunity in Argentina was created precisely by
the terrible track record of the current government as
the fact that she would be gone in 2015 began to creep
into global investors collective consciousness. Te
situation could not have been much more miserable as
Argentina was forced to devalue their currency
dramatically, there were fears of a default on their
sovereign debt (if the hedge funds that had held-out
and didnt agreed to the London Club restructuring a
few years ago were not paid, then they could not pay
other bondholders), infation was spiraling out of
control (back over 40% at one point), economic
growth was collapsing and companies could not get
access to credit with the government bond troubles,
what a perfect time to invest Tose who were able
to #BeGreedyWhenOthersAreFearful have enjoyed
really spectacular returns over the past six months as
the positives associated with the resolution of the debt
issues and new leadership have helped push prices of
the bonds, and equities, up dramatically. Tat is the
good news, but the better news is that this festa may
just be getting started as the high likelihood of an
ultimately favorable resolution to the debt issues
should lead to the opening of the global capital
markets to Argentine companies. With better access
to credit, Argentina should see an acceleration of
growth, and profts, which should lead to higher share
prices in the coming quarters and years. Add the
really good news that Argentina has the worlds third
largest shale oil & gas reserves (behind China and the
U.S.) that are ripe for exploration and production and
this could be a bull market to ride for many years
(#BullsDontOnlyRunInSpain).

Looking at Europe, we continue to see incremental
progress toward recovery and we wrote last quarter
that one of the most positive developments was that
capital is fowing into the region (from investors,
private equity funds, corporations looking to expand
and the slow resumption of bank lending. Our
favorite opportunities continue to be in the GIIPS
markets where we anticipate additional signifcant
upside (albeit with some volatility) over the balance of
the year and into 2015. In Q2 we got a taste of some
of that expected volatility as Greece and Ireland shed
(8%), Portugal dropped (6%), Italy eased (2%) and
only Spain managed a gain, rising 5%. July actually
turned out to be another difcult month for the GIIPS
markets as problems with the holding company of
Banco Espirito Santo ignited fears of a larger problem
for the fnancial sector in Europe and further losses
pushed Portugal, Ireland and Greece into negative

Second Quarter 2014
territory for the year, down around (4%). While
Spain and Italy were not immune from the turmoil,
these markets did hold up a little better and are still up
around 7% for the CYTD. We clearly did not foresee
the problems in Portugal, but we believe this is an
isolated incident and will not have a major contagion
efect on the other countries long-term. Te biggest
surprise to us was the reaction by the Greek banks,
which fell in lock step despite having restructured and
recapitalized. We see very signifcant gains on the
horizon for these assets, as the huge consolidation
down to four major banks will drive higher proft
margins going forward. We also wrote last quarter
that one tremendous upside surprise could also
emerge if Super Mario Draghi fnally fnds a way to
perform a Euro based form of QE (currently
prohibited, but he is working on it), which would
ignite a serious fre under the European equity
markets, and #SuperMario lived up to his name by
cutting interest rates into negative territory, essentially
making people pay to keep cash in the bank, and
inched the Eurozone another step closer to a
full-fedged QE program. Should the ECB start
expanding their balance sheet again, that will provide
a brisk tailwind for European assets and the GIIPS
countries in particular which are much more
leveraged to the upside, as they are starting from a
lower base (#PIIGSCanFly).

I met with one of our favorite managers from London
recently and we had some great discussions on a
number of unique global opportunities, but he also
shared some variant perceptions on potential risks
that he saw across various markets that could cause
some real pain for investors. Many of you will recall
that this is a manager who spent 2013 net short 40%,
yet still managed to produce an 18% return (truly an
astonishing feat given the huge upward moves in
global equities) and he came into 2014 still 40% net
short, and again is somehow up in line with the
ACWI, up 5% vs. 6%, despite being short when the
markets are rising. One of the reasons he is doing so
well this year is he has a huge (around 60% of his
gross exposure) position in government bonds (long
Treasuries and Bunds) as he continues to see a larger
risk of Defation than Infation in the developed
markets, particularly in Europe. Tree very
interesting things came out of our discussion, 1) his
favorite idea (and largest position) is our favorite idea
and largest position, Vipshop, 2) he still thinks banks
in Southern Europe are going to be fantastic
investments over the long-term and has six of his top
ten positions in banks in Spain and Italy and 3) he
told me that he was having a hard time coming up
with a reason not to sell all his other longs and go to
90% net short as he had grave concerns about
valuations and the potential for a meaningful
correction back to fair value. As of June, he had
bumped up net short to 46%, but had not gone all-in
on his short hypothesis. Given his large weighting to
government bonds and very unique positioning, we
expect he will perform very well in the recent uptick
in volatility (#VariantPerception).

When it comes to Japan, our confdence in the long-
term story remains strong, but we discussed last
quarter some of the challenges in the short term;
negative foreign capital fows, slower than expected
changes in local investor allocations (individuals and
the large pensions like GPIF) and, most notably the
BOJs reluctance to put additional QQE into the
system. We wrote that their steely resolve to wait for
the GDP data from Q2 to measure the impact of the
sales tax increase before making any further
commitments to QE is admirable, even it is tough on
the NAV of our investments short-term. Avoiding a
policy mistake is critical and we are willing to take the
long-view on capitalizing on the Japan revitalization
and we continue to believe that they are making the
right decision given that the impact of the sales tax
increase has not been nearly as bad as was originally
feared. Tere continue to be positive signs on the
economic front, from faster than expected GDP
growth, much higher than anticipated EPS growth,
strong retail sales fgures and solid progress on the
infation (or rather, beat defation) front. While there
are many skeptics out there, we are reminded of Sir
Johns second most quoted line bull markets are born

Second Quarter 2014
on pessimism, grow on skepticism, mature on
optimism and die on euphoria, so with the very high
level of Japan-doubters, we wrote last quarter (and
reiterate here) that we are confdent that Abenomics
is on course, that the PM has the conviction, political
will and support to achieve the 3
rd
arrow of reforms
and that it will simply take a little time to reverse the
efects of the unusually long Bear market. Q2
performance in the Japan markets was solid overall
with the Nikkei up right in line with the S&P 500 and
Japanese equities actually surged ahead in July on
continued strong earnings. As Japanese corporate
earnings are growing much faster than the rest of the
developed world, we expect to see continued relative
strength of the Japan markets vs. the U.S. and Europe
in the second half of 2014. One important point here
is that the performance has been uneven within the
Japanese market and in true #YearofheAlligator
fashion what was hot in 2013, in not in 2014, and vice
versa (the turn happened precisely on the Bradley
Turn date on January 1
st
). Te banks (SMFG, MTU,
MFG, Resona, Shinsei) have been particularly weak
(down as much as (20%) in some cases), while the
Zombie companies (Sony, Panasonic, Sharp,
Toshiba) have been much stronger than the indices
(most are actually up vs. down (5%) for the NKY),
contrary to the pundits calling for them to fade into
the sunset. We actually would expect to see this trend
reverse again with the Bradley Turn date that just
occurred on July 16
th
and it could make for some
excellent opportunities for those willing to pay
attention to Sir Johns Rule No. 5, to search for
bargains in the quality companies. Te last point on
Japan is that we continue to see a much weaker Yen
over the long-term and have written that we believe
that Japan has no choice but to pursue a weaker Yen
(to diminish the value of the massive debt they have
accumulated) and we agree with my friend Hugh
Sloane when he said to me in November of 2012, the
Yen will be weaker for the rest of your life. In the
near-term, it is clearly possible that the Yen will
continue to be seen as a safe-haven currency and
could remain stronger than expected if global
volatility continues, but in the end we trust in gravity
and expect a much weaker Yen over the coming years.
Hemingway wrote a famous book on a group of
friends that goes to Spain to run with the bulls and we
have co-opted that title for our Japan theme this year
(#TeAbeSanAlsoRises).

In thinking about Emerging Markets, lets look back
to look forward. At the end of January the cacophony
of talking heads declaring the death of Emerging
Markets was deafening and, to be fair, while their
arguments may not have seemed so compelling to
those of us on the other side of the theme, the fact that
nearly all the EMs were crashing in unison on fears of
the Fed Taper (afer a pretty poor showing in 2013)
was testing the resolve of even the most steadfast bulls
(ourselves included). It was a pretty scary time for
EM investors. Te leader for the month was India,
only down (4%), while the MSCI EM Index was
down (6.5%), China was down (6.7%), Brazil was
down (12%) and Russia was down (10%) and Turkey
was the laggard, down (14%). It took real courage to
step up and follow Rule No. 4 and be a buyer when
everyone else was selling. In fact, I was invited to give
a presentation to the Board of one of our clients in late
January and made the case for why it was the time to
be adding to EM exposure, not reducing exposure as
they had heard from a large investment bank earlier in
the week (that actually gave me a extra nudge of
confdence, as perhaps the best contrarian indicator of
all is what large investment bank research groups
recommend). One never can be sure about timing,
and catching falling knives is something we try to
steer clear from generally speaking (we would rather
let the knife hit the ground and then go pick it up by
the handle, even if we miss the absolute bottom, we
keep all our fngers), but there was something very
illogical about the regions with the highest growth and
the cheapest assets continuing to underperform the
markets with lower growth and signifcantly higher
valuations. In one of the most abrupt turns in recent
memory, the emerging markets actually fnished the
frst quarter up 3% (better than the S&P 500 return of
1.8%) and some of the turns were even more
dramatic, India surged to an 8.2% gain for the quarter,

Second Quarter 2014
Turkey got back to up 5.8% and Brazil moved back
into the black, up 2.8%. China continued to struggle
with slowing growth fears and fnished down (5.9%)
and Russia got hammered by the Crimea situation and
fnished down (14.8%). We wrote last quarter that
there are a large number of people who believe that
these gains will turn out to be ephemeral (read, dead
cat bounces) and that nothing has really been solved
in most instances, so volatility is likely to return and
investors would be wise not to pay attention to the
Siren song of these dangerous shores, and we
presented a case for why we did not think that would
be the result. Even though we were a little early on
our positive call on EM, it has turned out to be quite a
good year for these markets through July, both on a
relative basis compared to the MSCI World index
return of 4.5%, and on an absolute basis, with the EM
Index up 8.2%, Brazil up 12.6%, India surging 23.3%,
China up a respectable 7.4%, and only Russia lagging,
down (13.7%). Looking at some of the other markets,
results are even better with Indonesia up 31.6%,
Turkey up 25.3% (but remember the Taper was going
to kill the Fragile Five), Saudi up 21.8%, Argentina
soaring 33.4% and UAE besting the whole group, up a
stunning 38%. Despite these gaudy numbers, we still
see real value in a number of these markets and expect
continued strong performance. Clearly, there will be
continued volatility and there is continued
geopolitical risk in places like Russia (although
Ukraine equities are up 41% this year, so Sir Johns
strategy of investing when there is Maximum
Pessimism wins again), continued risk of unrest in the
Middle East, risks of policy errors in places like India
and China as the new leaderships try to implement
huge Reform agendas and the normal perils of
investing in less liquid markets where incremental
capital fows can play a larger than normal role in
moving prices. I noted in the last letter that I had a
little debate with a fellow panelist at a conference in
April as she made the comment that the Emerging
Markets story was over, as in her view it was simply
a resources play and the commodity super-cycle had
ended (Jeremy Grantham will take the other side of
that argument for me). Lets just say, with all due
respect, we beg to difer, on both points, and we see
continue to see tremendous opportunities in these
markets going forward and would make EM a core
allocation in any equity portfolio
(#BuildYourHouseWithBRICsPlus).

Just a quick note on Frontier Markets which continue
to be a focus area and have been of particular interest
in structuring our portfolios. We wrote last time that
the Middle East and Africa have massive growth
potential, huge natural resource wealth, young
populations and rapidly developing capital markets
which have produced (and should continue to
produce) outstanding returns in recent years and
these factors create compelling investment
opportunities. As we have said on a number of
occasions in the past the Frontier Markets are
traveling the well worn path of Emerging Markets
twenty years ago and we would anticipate that global
capital will continue to fow toward these regions as
return expectations in the developed world continue
to moderate. Te Financial Repression of the Central
Banks in the developed world is forcing investors to
deal with the 0-3-5 Conundrum and one of the ways
to overcome the challenge is to allocate capital to areas
where the Demographic and Debt profle favor
growth and will allow for continued wealth creation,
as opposed to the wealth redistribution that will occur
in the developed world (#EmergingMarkets2.0).

We started 2014 with a highly diferentiated view on
the direction of interest rates and the opportunities in
long-duration bonds based on our belief that Sir John
was right and it wasnt diferent this time. In the two
previous cycles where the Fed ended QE (for brief
periods before they had to bring it back) interest rates
were projected to rise, but instead fell dramatically.
Owners of long duration bonds made very strong
returns in both instances. As the New Year began we
saw that the consensus was, once again, of the belief
that somehow it would be diferent this time and we
wrote last quarter that the consensus has proven to
have all collected on the wrong side of the boat and
the extreme level of consensus (100% of Bloomberg

Second Quarter 2014
surveyed economists believed interest rates would rise
in the U.S. in 2014) was one of the better buy signals
in recent memory. In direct opposition to the
consensus view, long-bonds have surged in the frst
seven months of the 2014 and returns now exceed
14%. In our December Market Outlook presentation,
we put together a slide that showed that it appeared
that interest rates looked to be setting up for a fall
similar to the drop from 3.65% to 1.8% on the 10-year
during 2011 and that a similar drop this time would
take 10-year yields from 3% to 1.6%. If that
magnitude of rate compression were to occur, the
returns for long-bond owners would be very
compelling and might approach the 30%+ returns of
2011. When we made the comparison and put the
30% number on paper it prompted signifcant
negative feedback and only our favorite bond
manager, Van Hoisington, thought we had any prayer
of being right. A little past the halfway point, that
return doesnt seem quite as much of an outlier and
while we are not declaring victory as there is too
much of the game lef to play yet this year, we are
pointing out that the construct that GDP growth will
surprise to the upside (meaning >3% for the year) is
looking much less likely afer the horrible Q1 number
and without robust economic growth we fnd little
reason for interest rates to move higher, given the low
rate of infation. We remain of the view that it will
continue to pay to have a variant perception on
interest rates and that rates in the developed world are
likely to be #LowerForLonger.

We dont spend that much time talking about private
investments in this quarterly letter, but there are
always some interesting developments that we can
weave into the Market Outlook segment of the letter
given that our views on a particular market, equities,
fxed income or commodities could easily have
applicability in the private markets as well as the
public markets. I hit on this construct last quarter in
discussing Utica Shale and how there was a
tremendous private-to-public arbitrage opportunity
that was available to investors who were willing to
bear some illiquidity. Similar arguments can be made
today about how traditional fxed income investors
are giving up very meaningful return potential, in
exchange for liquidity, by buying bonds instead of
making investments in private lending Funds. Private
equity investors enjoy the same type of excess return
potential by taking stakes in private businesses at
lower multiples of earnings and EBITDA that their
publically traded counterparts (actually not true in all
markets as some of the large LBO Funds are paying
crazy, read 2000 & 2007-esque multiples for
businesses today since available leverage is at new all-
time highs) and will generate far superior returns over
the coming decade relative to public stocks.
Additionally, there are myriad opportunities around
the globe to provide growth capital to rapidly growing
businesses participating in the Middle-Classifcation
of the Developing World where we anticipate
compound annual returns could approach the high
teens (or better with some good fortune). As we have
been saying for a few years, ever since the Global
Financial Crisis and the beginning of the Era of
Financial Repression, investors have shown a distinct
preference for liquidity in their portfolios and that has
created a windfall opportunity to liquidity providers
to capture excess returns above the long-term average
5% illiquidity premium that has historically been
available to private investors. At the risk of over-
emphasis of the point, I will repeat again that we
believe that investors should double their exposure to
private investment strategies today, which means if
you have a long-term target of 10%, move to 20% and
if you have a 20% comfort zone, go to 40%. Just
reading these numbers likely makes some
uncomfortable, but one thing I have learned in my
investing career is that I have made the best returns
when I am doing things that make me
uncomfortable. In fact, I have been tweeting lately
that investors should focus today on the theme
#LiveOutsideYourComfortZone as we expect
traditional asset classes (those where people feel most
comfortable investing) are likely to deliver subpar
returns in the next decade.

As part of the #YearofheAlligator theme, we entered

Second Quarter 2014
2014 with a very favorable view on commodities,
particularly the Agricultural commodities, which had
one of their worst years in 2013. We had a contrarian
view on interest rates, and therefore the Dollar, and
we were in the minority with the view that
commodities could regain momentum. In Q1, did
they ever, and we wrote last quarter that, these
markets really have been the surprise of the year as
Ags have surged, metals have been solid and energy
has been stubbornly high (despite all the forecasts for
collapsing Oil and Gas prices). However, Q2 was less
kind to commodities as the Dollar did stage a late
inning rally and many commodities have now given
back all their early gains. We actually see signs that
those markets are frming again and expect that we
could see some meaningful gains in the Ags (Corn,
Wheat, Soybeans are all at meaningful lows and look
to be basing) again in the second half. Oil has been
relatively stable around $100 for WTI, while NatGas
has been very volatile. Afer spending a couple days in
Texas with some private energy managers and a few
energy hedge funds, I came away very excited about
the investment opportunities in energy. Te smartest
managers of the actual hydrocarbons are forecasting a
steady, but upwardly sloping, price curve for both Oil
and NatGas as they see a continued boom in the U.S.
(thanks to the technological revolution of horizontal
drilling and fracking), being ofset by a continuing
decline in OPEC and Non-OPEC global supply
(geopolitical concerns and corruption), leading to a
fairly well-matched supply/demand balance. Te one
caveat to that view was that one material disruption to
any major producer could cause signifcant moves to
the upside. Te other areas that have shown
surprising strength of late are the industrial metals
and, most recently, steel. We see opportunities
around copper and steel and are beginning to see
some signs of bottoming in rare earth metals afer a
very long bear market. In the precious metals space I
wrote last quarter, that in my hear it three times rule,
frst it was Jim Grant, then is was George Soros and
then it was Russell Clark and we dabbled a bit, but it
might be time to add some real weight to the gold
miners as they have easy comps, a higher than
expected gold price and there has been some
meaningful consolidation and rationalization in the
industry to help with the supply/demand balance that
plagued these businesses. While it has been a roller
coaster ride of volatility, as noted in the Q2 review,
GDX and GDXJ were up big over the past three
months and are now up a very impressive 24% and
36% CYTD. While it feels like a miss to not have
had signifcant exposure to an asset that has moved so
much, it is helpful to remember that these names are
still down a stunning (57%) and (70%) from their
peak, three short years ago, so there is still plenty of
upside lef to capture over the long term
(#AllTatGlitters).

Coming back to the U.S. equity markets, as we
mentioned in the last two letters, we have heard from
a number of our favorite managers that the
opportunities on both the long and the short side are
better than they have been in a long time (you can see
evidence of that in the correlation numbers
declining). While the average returns for long/short
funds have been modest this year, the averages mask
some really spectacular returns from some of the
managers within the space. One common refrain we
have heard is that the opportunities for shorting have
not been this robust in many years as there are some
truly amazing valuations within the technology,
biotech, social and mobile segments of the market.
We wrote about a couple of these last quarter and
given the freworks during the quarter (and the
potential we see for more drama in the coming
quarters) I thought I would provide an update on
them here. We wrote that the selling began in
TWTR and the stock collapsed in the past few
months, chopping $7 Billion of the market cap, but
still has no profts and still sells at a stunning 29X
Revenues (not earnings, because, again, they have
none), and, this is the really ugly part, the true
Insiders (venture backers and later stage investors)
were just released from their post-IPO lock up, so the
real Twitter-bombing may get underway here in May
and it turned out that we were right, for about three
weeks TWTR dropped nearly (25%) the week afer

Second Quarter 2014
the lock-up expired and stayed down until the last
week of May, but then began a steady short-squeeze
lif-of, recapturing all of the losses in June. Afer
some consolidation for a few weeks, the real freworks
hit last week when Twitter announced
earnings (there still were none, but there were
smaller losses than anticipated) and the stock surged
25% in one day, regaining a level it had not seen since
the end of Q1. To put some numbers around that,
TWTR gained $4B in market cap in a single day (back
to an astonishing $26B), yet the company has less than
$1B of revenues in the TTM and has lost close to $1B
over the same twelve months. Fortunately, we werent
short during the big squeeze, but we will likely be
short in Q3. Another example of
#TruthIsStrangerTanFiction (because, as Mark
Twain tells us, fction is obliged to stick to
possibilities, truth isnt), we also wrote how TSLA
now has 23% of the market cap of F and GM
combined (despite still only having 0.5% of the sales),
still has no profts (although they are projected to
make $1.67 this year so it is almost cheap at 130X
forward EPS) and has not shown any capacity to ramp
production at the levels implied by their stock price.
Like TWTR, within a couple of weeks of the letter,
TSLA shed (10%), but then proceeded to squeeze the
shorts even harder (fortunately, we werent short here
either), jumping an amazing 33% over the next eight
weeks. To update the numbers above, the stock has
moved to a 207 P/E as the 2014 EPS estimate has fall-
en to $1.13 (must be trying to move toward the
AMZN model, where you get a higher valuation if you
spend all of your revenues, so there are no profts to
compare to the analyst estimates). If these stories
dont remind you of 2000, then you must not have
been in the business. Tese are just two, of many,
examples of the extreme valuations in the current
environment where we expect to be able to write
about excellent returns on the short side in future
letters and show that it is defnitely
#NotDiferentTisTime.

On the long side, there are actually a number of
sectors in the U.S. equity markets where we see
opportunities either to buy some attractively valued
assets that have fallen out of favor, or participate in
some outstanding growth businesses where valuations
have not gotten out of line. Tere are some
interesting plays within MLPs where the market has
opened up to allow other types of businesses to
participate in the structure (beyond pipelines and
other mid-stream assets), many of which have an
energy services (#Picks&Shovels) orientation, which
we fnd very attractive. We have seen interesting
opportunities in things like fracking sand, wastewater
disposal, logistics and drilling. Similarly, there are
some interesting REIT structures that could provide
investors with continued solid returns, so long as you
steer clear of the overvalued segments in core areas
like malls and apartments (there could be some
interesting shorts here). We discussed in one of our
earlier letters how we liked the Airlines (and we still
do), but we also see continued strength in other travel
related businesses like Car Rentals and Hotels. One of
our #ATWWY Webinars was about Consolidation =
Upside, and all three of these industries have seen sig-
nifcant consolidation which has helped boost
proftability for the remaining players
(#OligopoliesAreGood). Another space that has some
momentum today is the HMOs (AET, WLP, UNH,
CI) as the changes in the healthcare landscape have
created signifcant opportunities for the leaders in this
space (and Hospital operators like HUM, too). In
another nod to Mr. Twain, the rumors of the death of
the PC have been greatly exaggerated and the
#OldTech sector has been, dare I say it, en Fuego (I
have to use this phrase every time someone tells me I
look like Dan Patrick, which happened last week when
I was doing a remote shoot for Fox Business).
Companies like MSFT, INTC, CSCO and HPQ, which
had been relegated to the recycling bin as the Cloud
was to render them all obsolete are staging a serious
comeback and have dramatically outperformed the
Cloud names over the past few months. Another
sector that was pronounced dead last year when all the
discussion of the #Sequester was going on was
Defense yet companies like LMT and NOC continue
to generate strong earnings and cash-fow and in a

Second Quarter 2014
world or rising geopolitical threats, perhaps a
proftable strategy is #PlayDefenseWithDefense for
these tumultuous times. One last long possibility is an
interesting indirect play on the upcoming Alibaba
IPO that we discussed multiple times above. Tere
are two large companies, Yahoo and Sofbank (and
perhaps other smaller ones) that own meaningful
stakes of BABA who will reap large windfall profts if
the IPO goes as well as some Analysts have forecast
(the Bernstein Analyst has a $250 Billion end of day
one valuation target). It appears that the valuations
embedded in the YHOO and SFTBY stocks is
materially under those levels of valuation, so it could
be an interesting trade to pick up these names in
advance of the IPO in September
(#SumofhePartsArbitrage).

Back to the short side, there are four industry groups
that look very poor today and the prospects for
improvement in their businesses in the near-term
seem dim. Consumer Discretionary, Homebuilders,
Industrials and Ofshore Drillers have all rolled over
hard this quarter. With more and more data showing
that the consumer is tapped out (savings rates have
collapsed, leverage has increased), housing is
weakening (new home sales, permits and mortgage
applications are all weak), global economic growth
uncertain (global GDP is still not accelerating
upwards) and oil & gas drilling continues to move
back onshore in the U.S. (horizontal drilling and
fracking are reopening basins that are much more
economic than ofshore, particularly deep water), it
appears that there are more likely to be better
opportunities on the short side than the long side.
Te one caveat to this view is that if the high yield
credit markets were to somehow remain open afer
the Taper ends (given how the short JNK/HYG story
has quickly grown to a consensus, maybe that is
possible), the huge volume of Private Equity and
Strategic capital could turn its attention on these
segments and cause some pain for short-sellers as we
have seen happen in situations like the Coke
investment in GMCR earlier this year. A handful of
bailouts aside, the bigger picture remains negative
and we believe that many consumer businesses are
under attack by e-commerce and that the best
opportunities will continue to be on the short side
(#TinkOutsideTeBigBox).

We could probably dedicate an entire letter to #China
as the economy, the market, the political transition
and the sheer size of the country/population
command an inordinate amount of press coverage,
investor interest and rumor activity, all of which
provide meaty content to weave into a quarterly letter.
Te incredible diversity across the country also
ensures that there are always winners and losers in
various markets and makes China a
#TargetRichEnvironment for investors. Te biggest
overarching story (that with the greatest potential
impact over the long term) is the New Leadership and
their commitment to the Reform agenda. We have an
emerging theme that we have been developing from a
study of history of government leaders that used the
word Reform, or who were labeled Reformers and
the results are quite dramatic (think Ronald Reagan in
the U.S. or Margaret Tatcher in the UK). Tere are a
number of places around the world today where the
Reformer label is being thrown around like India,
Indonesia, Mexico, and, most notably for this section,
China. Just one example is that the new President, Xi
Jinping, has initiated a serious crackdown on
corruption in the Party (so serious that companies
that were dependent on the corruption trade, like
white liquor maker Kweichow Moutai, fell more than
(50%) in 2013) and has put over 25,000 government
ofcials under investigation (or arrest). Mr. Xi clearly
believes in taking short-term pain for long-term gain
and he has shown a signifcant commitment to
policies that focus on shifing the economy from Fixed
Asset Investment toward Consumption and stripping
out the pilferage that was so common in the previous
leadership regimes. Clearly it is likely to still be a
good thing to be a Party member, but perhaps the
slippage per member will be measured in millions
instead of billions going forward and those savings
can be directed to productive activity instead of
condos in Toronto, Maseratis and luxury watches.

Second Quarter 2014
With #Reform as the primary backdrop, we believe
that China could be a very interesting place for
investors in the coming quarters and years (and
perhaps the dramatic turn in the past month is the
leading edge). We discussed the opportunities that we
have seen in the SOEs and how a commitment to
reform within the largest State dominated industries
could provide big upside for investors who get out
ahead of that transition. China Coal Energy is an
example of a company that has been shunned by
investors since 2009, falling over (80%) from $16 to
just under $4, but has recently rebounded 10% on
optimism for the future based on the Reform Agenda.
Time will tell if this is simply another bounce on the
stairs leading down (precisely what the long-term
chart looks like) or whether this is the beginning of a
multi-bagger opportunity for long-term investors.
Another opportunity that could potentially generate
very signifcant returns is the Chinese banks. Te
banks have also been in terminal decline for years,
having fallen between (10%) and (40%) since 2009,
but most recently began to turn up smartly on the
rumors of the beginning of a new PBOC stimulus
program. Tere is a huge amount of Western fear and
trepidation about the level of bad loans on the books
of these institutions, but in talking to one of our
favorite managers in Hong Kong (who has seen the
previous two banking cycles and restructurings), he is
confdent that these companies are in the
#TooBigTooFail camp and that the government will
do their best Super Mario impersonation and
#DoWhateverItTakes to make sure they remain viable
(the government has huge reserves with which to
absorb the bulk of any losses). Another compelling
point he made is that given the global shareholder
base are the ones who have lost money over the past
few years (where they have no vested interest), he
believes that the government will become even more
supportive of the stock prices if they see local
investors beginning to buy the banks at these
depressed prices.

Te shif to Consumption in China is multi-decade
opportunity and we have talked at length in previous
letters about the opportunities we see in
#ChinaInternet, Consumer Retail, Consumer Services,
Healthcare and Alternative Energy. A couple of areas
look quite interesting in the near term as some
signifcant dislocations in prices of auto
manufacturers and businesses related to Real Estate
have been beaten down dramatically during the recent
growth scare and crackdown on property speculation.
Car manufacturer Great Wall Motor Co. had been a
darling of the China equity market, rising an
astonishing 14X (1,400%) since 2009, completely
bucking the Bear Market that had dragged the
Shanghai Composite down (35%) and limited the
Hang Seng Index to a meager 20% return. However,
the fears of an economic slowdown put a dent in
Great Walls stock price over the last three quarters,
chopping the market cap in half. Te company trades
in Hong Kong as 2333:HK and had dropped (35%)
through the beginning of May (while the index was
fat) and has zigzagged higher over the past few
months and looks poised for a breakout. On the RE
front, the loudest China Bears continue to growl
loudly about an impending property implosion in
China and investors fed the scene as companies like
China Vanke, China Overseas Land, China Resources
Land and Poly Property Group (002:CH, 688:HK,
1109:HK, 119:HK, respectively) had been in constant
decline during 2013 and Q1 2014, before fnding a
foor in May and June and bouncing nicely in the past
month (up 18%, 16%, 18% and 9%, respectively). Tis
sector is clearly out of favor and has lots of enemies
who continue to make claims of fraud and other
spurious assertions (ofen with very little hard
evidence other than some old pictures of #GhostCities
#OldNews), so much so, that one might think they
were #TalkingTeirBook and were short (and are
perhaps feeling a little squeezed of late). Te property
developer pain has been more constant over the past
year, but the pain in the e-commerce related real
estate names (SouFun and e-House) has been more
acute. Afer surging 300% from early 2013 through
the beginning of March, fears of slowing RE
transaction volumes sent SFUN & EJ into a tailspin as
they lost half their value in twelve short weeks.

Second Quarter 2014
Suddenly, in early June, rumors of a reversal of the
ban on property purchases emerged and these stocks
were #HotProperties again and have surged 28% and
38% respectively in six weeks. We think there is huge
upside in these companies as they are the dominant
players in the China RE markets. For some
perspective, lets compare SFUN to one of the two
leaders (in quotes since they have a fraction of the
market share that SFUN and EJ have) in the U.S.,
Zillow and Trulia (who just announced a merger last
week) and let the reader decide which one you would
rather own (be short). SFUN expects revenues in
2014 to be close to $800 million and profts to be $300
million and sells at a market cap of $4.6 billion, or
6.7X Sales and a P/E of 15. Z expects to have revenue
of $300 million in 2014, but has no profts, and sells at
a market cap of $5.8 billion, or 24X Sales and an
expected P/E for this year of 483
(#WePreferProfts).

We talked extensively about the Bradley Turn Dates in
the Q1 letter and discussed how these dates tend to
usher in a change in trend of markets - what has been
hot cools of and what has been cold heats up. Te
#YearofheAlligator theme was premised on the
changes that we anticipated would occur around the
January 1
st
turn date and there has been a very strong
correlation over the frst half of 2014 with what we
discussed might occur. Tere was another major turn
date on July 16
th
and it appears that there could be
some predictive power again if the frst few weeks
develop into a more major trend. Interestingly, the
DJIA made a peak precisely on the 16
th
(while the S&P
500 made a peak a few days later), which,
coincidently, was the day that the Malaysian Airlines
jet was shot down over Ukraine, and U.S. stocks have
been struggling (down nearly (4%) in a couple weeks).
Te Shanghai equity markets made a breakout from
their downward channel at the same time and have
been surging ever since (up a little over 10% over the
two weeks) and the CSI 300 A-Share index made a
sharp turn upwards right on the 17
th
(16
th
in the U.S.,
if we get technical on the International Date Line).
Some of the European markets appear to have turned
down hard in recent weeks with Germany changing
direction closest to the Turn Date. Gold and Gold
Equities also look to have made a peak around the 17
th

(Bradley Dates have a three day window), which
conficts with our positive view on the potential
upside, but, our view is a long-term view and there
could be a short-term period of weakness over the
coming months for precious metals (particularly if the
Dollar continues to strengthen) so we will respect the
Bradley information and tighten our stops here.
Another area to watch is interest rates, and the long-
bond in particular, as this asset has followed the
Bradley pattern precisely over the past year and the
incredible strength seen over the past seven months
could easily take a breather, and TLT is sitting just
under its level on the 16
th
today. Again, we will
tighten up our stops and pay close attention to any
additional signs of economic strength (like the recent
4% GDP print) that could prompt investors to sell
bonds, or could prompt the Fed to jawbone about
raising rates sometime sooner in 2015. In
commodities it looks like Oil made a peak around
June/July (this one is not so clearly related to the
Bradley date), but NatGas looks like it may have made
an interesting bottom around the 21
st
(probably close
enough), while the Ags just continued plunging right
through the Turn, although they may have begun a
turn this week (this one is a tough call, but these
markets are really oversold). While the Bradley Turn
Date is just one of many momentum and sentiment
indicators, we have talked to many of the most
prominent traders and investors over the years who
had a very high degree of respect for the logic of the
natural cycles theory and integrated these dates
directly into their investment process
(#RespectTeCycles).

In thinking about the core message of this letter, we
are focusing on the idea that this cycle will be similar
to previous historical cycles and that the Central
Banks have not eradicated the business cycle with QE.
To that end, we appreciate the challenge of the timing
of these cycles and we wrote last quarter that we all
know from experience that its very difcult to say

Second Quarter 2014
precisely when something like a major trend reversal
will occur, but we also know from experience that we
can prepare ourselves for that eventuality by paying
attention to the Kindleberger cycle (when are the
Insiders selling?), and being willing to move our
portfolios to a more protective position. Te key
point here is understanding the cyclical behavior of
the Insiders (those with above average insights
about specifc companies) and the Masses (those
with below average insights about specifc companies)
and how the behavior of each group creates
investment opportunities to be both long and short
depending on where we are in the cycle. We also
wrote about how Stan Druckenmiller said that too
many investors believe they must stay exposed to all
markets all the time regardless of valuation and
potential future returns, which he said is a tragically
fawed assumption. Stan made truly outstanding
returns over the years by ignoring the conventional
wisdom (an oxymoron if ever there was one) that
#BuyAndHold was the superior investment strategy.
He also laid waste to the concept of being bullish or
bearish all the time, saying rather that to be a great
investor, you have to be a Pig, which means that you
are only going to have a couple really great ideas in
any year, so when you have them, you have to invest
BIG. We fnd ourselves in violent agreement with
Stan on these points and we believe in our construct
that it is #NotDiferentTisTime, it is time to
#BeTactical and when we have real conviction in an
idea to #BeAPig.

Update on Morgan Creek

We are pleased to announce that we took over the
management of the AdvisorShares Morgan Creek
Global Tactical ETF at the end of July. We are very
excited about providing an ETF vehicle that refects
our best thinking on global tactical asset allocation.
We believe that this investment solution can play an
important role as a core holding in investors and
Financial Advisors client portfolios providing strong
returns as well as insights on strategic and tactical
asset allocation ideas and regional/sector ideas. For
more information of this exciting new addition to the
MCCM suite of investment solutions, please visit
www.advisorshares.com or contact any of us if you
have questions.

We hope you have been able to join us for our new
Global Market Outlook Webinar Series titled Around
the World with Yusko. We have been hosting this
series of topical discussions on a monthly basis and
most recently have presented our thoughts on why we
believe 2014 will be the inverse of 2013 in
#TeYearofheAlligator, followed by focused sessions
on the fantastic opportunities in Japan and the
Peripheral European markets (GIIPS). Accompany-
ing the presentation of one of our Best Ideas Temes
each month, we also provide a short update on the
Tactical Fund following each #ATWWY call. If you
would like more information, please email
investorrealtions@morgancreekcap.com. For more
specifc information on our Registered Investment
Products, please visit us at
www.morgancreekfunds.com.

Following on the success of our inaugural iCIO
Investment Summit held in New York City last
December, we brought the iCIO show back home to
North Carolina in May and it was a sold-out, smash
hit. Congratulations to Andrea and her amazing team
for taking our Conferences to the next level. Te
Investment Summit format was envisioned to provide
an opportunity to generate high-level Conversations,
Ideas and Opportunities (hence CIO) amongst senior
investment professionals regarding the ever-changing
investment environment and the results have
exceeded our lofy expectations. Te speaker faculty
for the May Summit was our best yet (and that is
saying something since our historical faculty lineup
has been top notch) as we were very fortunate to have
a number of the brightest minds in the investment
business join us, including Kiril Sokolof, Burton
Malkiel, John Burbank, Van Hoisington, David
Zervos, David Hornick and Dan Clifon. Tanks to all
who attended and it was exciting to see such a wide

Second Quarter 2014
spectrum of participants including Foundations,
Endowments, Pension Funds, Family Ofces and
other investment management organizations be with
us in NC. It was also very special to have everyone
join us for the Morgan Creek Capital Management
Ten Year Anniversary Celebration! It was such a
special evening on fun and fellowship and it was
humbling for all of us to have so many of our friends
and extended family take time to help us celebrate
this milestone. We are just getting warmed up at
MCCM and we are excited about what the next
decade will bring.

Our December iCIO Investment Summit will be
here before we know it, on December 9, 2014 and
will be held at Club 101(40
th
& Park) in NYC. We
will be hosting a welcome reception on December 8
th

at Celsius at Bryant Park (5
th
Ave. & 42
nd
St.) from
6pm-8pm. Tis is one of our favorite places to visit
during the holiday season. Come join us as we take in
the views of the ice rink surrounded by many shops
and vendors who are only there during
December. Please go to www.iciosummit.com for
more details. We are pleased to announce that we
have already confrmed KPMGs Chief Economist
Constance Hunter as one of our guest speakers. As
always, Morgan Creek current investors (in any one of
our products) receive complimentary access to the
iCIO event. For more details, please contact Andrea
Szigethy at aszigethy@morgancreekcap.com or Donna
Holly at dholly@morgancreekcap.com.

If you fnd yourself in the Southeast in early October,
we are hosting our annual NC Investment Institute
Forum & Roundtable on October 7
th
at Te
Umstead Hotel in Cary, NC. Te speaker faculty
listing and agenda is available and posted online at
www.ncinvestmentinstitute.org. Tis is a great place
to meet investors, managers and consultants in the
South. Tis main forum is open to anyone interested;
however, our NC Investment Roundtable is open only
to Chief Investment Ofcers, Portfolio Managers or
senior investment team members. We expect this to
close out soon so please register online if you would
like to attend our Fall Program.

As we transition into our second decade, we want you
all to know how grateful we are to have had the
opportunity to provide investment management
solutions to our clients for the past decade and how
excited we are about continuing to work with all of
you going forward. We could have never achieved
such a milestone without the continued support,
loyalty and friendship of such a tremendous group of
friends and partners. It is a great privilege to manage
capital on your behalf and we are appreciative of your
long-term partnership and confdence.

With warmest regards,

Mark W. Yusko
Chief Executive Ofcer & Chief Investment Ofcer

Tis document is for informational purposes only, and is
neither an ofer to sell nor a solicitation of an ofer to buy
interests in any security. Neither the Securities and
Exchange Commission nor any State securities
administrator has passed on or endorsed the merits of any
such oferings, nor is it intended that they will. Morgan
Creek Capital Management, LLC does not warrant the
accuracy, adequacy, completeness, timeliness or availability
of any information provided by non-Morgan Creek sources.

Q2 2 0 1 4 MARKET REVI EW & OUTL OOK

Upcoming Educational Programs
Save the Date for Future Morgan Creek Events

NC Investment Institute
October 7, 2014
(welcome reception Oct. 6
th
)
Te Umstead Hotel, North Carolina
To Register: www.ncinvestmentinstitute.org

Te iCIO Investment Summit
December 9, 2014
(welcome reception Dec. 8
th
)
Club 101, New York City
To Register: www.iciosummit.com

Around the World with Yusko Webinar Series
Next webinar: August 26, 2014, 1:00pm EDT
To Register: Please contact IR@morgancreekcap.com

For more information on any of our upcoming programs please contact Andrea
Szigethy at aszigethy@morgancreekcap.com

Q2 2 0 1 4 MARKET REVI EW & OUTL OOK - DI S CL OS URES
General
Tis is neither an ofer to sell nor a solicitation of an ofer to buy interests in any investment fund managed by Morgan Creek Capital Management, LLC or its afliates, nor shall there be any sale of
securities in any state or jurisdiction in which such ofer or solicitation or sale would be unlawful prior to registration or qualifcation under the laws of such state or jurisdiction. Any such
ofering can be made only at the time a qualifed oferee receives a Confdential Private Ofering Memorandum and other operative documents which contain signifcant details with respect to risks and
should be carefully read. Neither the Securities and Exchange Commission nor any State securities administrator has passed on or endorsed the merits of any such oferings of these securities, nor is it
intended that they will. Tis document is for informational purposes only and should not be distributed. Securities distributed through Town Hall, Member FINRA/SIPC or through Northern Lights,
Member FINRA/SIPC.

Performance Disclosures
Tere can be no assurance that the investment objectives of any fund managed by Morgan Creek Capital Management, LLC will be achieved or that its historical performance is indicative of the perfor-
mance it will achieve in the future. 2005-2013 results are audited. 2014 performance data is not yet audited and is subject to change upon audit. Monthly performance numbers are not individually
audited and only a funds annual fnancial statements are audited. Performance may difer based upon New Issue eligibility, individual dates of admission and actual fees paid. All performance refects
reinvestment of dividends (if any) and all other investment income (which should be evaluated when reviewing performance against other indices). Te performance data set forth in this presentation is
based on information provided by underlying managers and is believed to be reliable but has not been independently verifed by Morgan Creek Capital Management, LLC.

Forward-Looking Statements
Tis presentation contains certain statements that may include "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange
Act of 1934. All statements, other than statements of historical fact, included herein are "forward-looking statements." Included among "forward-looking statements" are, among other things, state-
ments about our future outlook on opportunities based upon current market conditions. Although the company believes that the expectations refected in these forward-looking statements are reasona-
ble, they do involve assumptions, risks and uncertainties, and these expectations may prove to be incorrect. Actual results could difer materially from those anticipated in these forward-looking state-
ments as a result of a variety of factors. One should not place undue reliance on these forward-looking statements, which speak only as of the date of this discussion. Other than as required by law, the
company does not assume a duty to update these forward-looking statements.

Indices
Te index information is included merely to show the general trends in certain markets in the periods indicated and is not intended to imply that the portfolio of any fund managed by Morgan Creek
Capital Management, LLC was similar to the indices in composition or element of risk. Te indices are unmanaged, not investable, have no expenses and refect reinvestment of dividends and distribu-
tions. Index data is provided for comparative purposes only. A variety of factors may cause an index to be an inaccurate benchmark for a particular portfolio and the index does not necessarily refect
the actual investment strategy of the portfolio.

No Warranty
Morgan Creek Capital Management, LLC does not warrant the accuracy, adequacy, completeness, timeliness or availability of any information provided by non-Morgan Creek sources.

Risk Summary
Investment objectives are not projections of expected performance or guarantees of anticipated investment results. Actual performance and results may vary substantially from the stated objectives with
respect to risks. Investments are speculative and are meant for sophisticated investors only. An investor may lose all or a substantial part of its investment in funds managed by Morgan Creek Capital
Management, LLC. Tere are also substantial restrictions on transfers. Certain of the underlying investment managers in which the funds managed by Morgan Creek Capital Management, LLC invest
may employ leverage (certain Morgan Creek funds also employ leverage) or short selling, may purchase or sell options or derivatives and may invest in speculative or illiquid securities. Funds of funds
have a number of layers of fees and expenses which may ofset profts. Tis is a brief summary of investment risks. Prospective investors should carefully review the risk disclosures contained in the
funds Confdential Private Ofering Memoranda.

Russell 3000 Index (DRI) this index measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S.
equity market. Defnition is from the Russell Investment Group.

MSCI EAFE Index this is a free foat-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the US & Canada. Morgan Stanley Capital
International defnition is from Morgan Stanley.

MSCI World Index this is a free foat-adjusted market capitalization index that is designed to measure global developed market equity performance. Morgan Stanley Capital International defnition is from
Morgan Stanley.

91-Day US T-Bill short-term U.S. Treasury securities with minimum denominations of $10,000 and a maturity of three months. Tey are issued at a discount to face value. Defnition is from the Depart-
ment of Treasury.

HFRX Absolute Return Index provides investors with exposure to hedge funds that seek stable performance regardless of market conditions. Absolute return funds tend to be considerably less vola-
tile and correlate less to major market benchmarks than directional funds. Defnition is from Hedge Fund Research, Inc.

JP Morgan Global Bond Index this is a capitalization-weighted index of the total return of the global government bond markets (including the U.S.) including the efect of currency. Countries and
issues are included in the index based on size and liquidity. Defnition is from JP Morgan.

Barclays High Yield Bond Index this index consists of all non-investment grade U.S. and Yankee bonds with a minimum outstanding amount of $100 million and maturing over one year. Defnition is from
Barclays.

Barclays Aggregate Bond Index this is a composite index made up of the Barclays Government/Corporate Bond Index, Mortgage-Backed Securities Index and Asset-Backed Securities Index, which
includes securities that are of investment-grade quality or better, have at least one year to maturity and have an outstanding par value of at least $100 million. Defnition is from Barclays.

S&P 500 Index this is an index consisting of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. Te index is a market-value weighted index each stocks weight
in the index is proportionate to its market value. Defnition is from Standard and Poors.

Barclays Government Credit Bond Index includes securities in the Government and Corporate Indices. Specifcally, the Government Index includes treasuries and agencies. Te Corporate Index
includes publicly issued U.S. corporate and Yankee debentures and secured notes that meet specifc maturity, liquidity and quality requirements.

HFRI Emerging Markets Index this is an Emerging Markets index with a regional investment focus in the following geographic areas: Asia ex-Japan, Russia/Eastern Europe, Latin America, Africa or
the Middle East.

MSCI Emerging Markets Index this is a free foat-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of No-
vember 2012 the MSCI Emerging Markets Index consisted of the following 23 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary,
India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Tailand, Turkey, and United Arab Emirates.

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Q2 2014 Market Review & Outlook

Morgan Creek Capital Management

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