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November 12, 2012 The election is over.

And with it the relentless abuse of political advertisements and campaign bashing comes to end. So now what? Investors woke up November 7th to a sea of red as Mr. Market began to consider the implications for four more years. But was this price action a leading indicator of things to come? We think the answer depends on your time horizon and as such, this letter will serve to outline both our near term market predictions (i.e. essentially educated, but incredibly popular, guesses on short term market direction) as well as our long-term portfolio strategy (i.e. strategic asset allocation that drives the great majority of portfolio returns, but puts most investors to sleep). An Educated Guess History would suggest that markets dont care very much about last weeks election results, at least between now and year-end. On average, year-end rallies have been quite typical in election years, and this one has followed the historical script remarkably close to date. Its worth noting that gains have been even larger in years that the incumbent party has won, and the greatest profits during the Presidential Cycle have been realized in the three-month period beginning in November i.e. starting now. Apparently, who wins is less important than the removal of uncertainty which serves as a catalyst in and of itself.

Source: Business Insider

Broyhill Asset Management, LLC 800 Golfview Park PO Box 500 Lenoir, NC 28645 Office 828-758-6100 Fax 828-758-8919 Toll Free 888-818-4455

The Dow Dove over 420 points in the two days following the election, perhaps sending a stern warning to Mr. President about the dangers of swan diving over the fiscal cliff. We cant remember another instance where markets were so singularly focused on a particular political event. Well, that may be a stretch, but more importantly, this correction in equity markets has relieved excessive optimism across various sentiment measures and has left the market in a shortterm oversold condition, prone to rally Granted, in addition to well-placed cliff concerns, there have been no shortage of horrendous earnings announcements throughout the third quarter, but experience suggests that such a broad degree of pessimism has led to better stock market performance ahead, provided that the bad news is priced in and earnings season is out of the way. From a tactical perspective, business cycles have a greater impact on financial markets than elections. And in post-bubble economies, business cycles tend to be shorter and milder, yet have an even greater influence on risk assets. For now, we believe the business cycle should continue to act as a tailwind for equities as economists catch up to the improvement in industrial activity as evidenced by various Economic Surprise Indices. Additionally, the ongoing and broadening recovery in housing has provided a lift to consumer confidence at the same time that global monetary policy and central bank balance sheet growth provides markets with an additional liquidity boost. The lagged effect of easy money, illustrated in the chart below, should become more apparent in the fourth quarter. Unfortunately, the outlook beyond the fourth quarter and through four more years is not so bright.

Source: Wolfe Trahan & Co

Long Term Investment Strategy Most investors today are stuck in a dangerous comfort zone typified by a heavy allocation to traditional stocks and bonds. Historically, the former has provided market participants with exposure to economic growth, while the latter has offered a predictable stream of income. But past performance is not indicative of future results and the next decade promises to generate much slower growth and much lower income for investors. Disciplined, focused and flexible capital allocation will be critical in achieving long term objectives going forward. And other things being

equal, we believe a high yield is better than a low yield in this environment, as asset classes with higher yields often come with an embedded option on price appreciation as they mean revert to more normal valuations. Rob Arnott, Head of Research Affiliates, recently offered up a similar perspective, in a recent interview: Were drawn to higher-yielding assets not because we want higher income but because we believe that yield is the best predictor of future total returns. Thats why our investment process starts with the building blocks model, which estimates long-term forward total returns from current yields and projected growth rates. Not surprisingly, our models often emphasize income-oriented asset classes; these sectors currently offer spreads over Treasuries, that, when adjusted for bond quality, are better than historical norms. Asset allocation at Broyhill combines this type of disciplined portfolio construction with a broad investment palette. Our objective is simply maximum total return, commensurate with the existing risk profile of markets. Today, this approach has resulted in the broadly diversified portfolio illustrated below, which generates an annual yield of 5.1% and provides a balanced mix of income generation, growth potential and inflation protection.

Fixed Income Given the challenges facing the global economy today and the elevated level of starting equity valuations, fixed income securities serve as the foundation of our asset allocation framework. However, unlike most yield-starved traditional fixed income assets, the great majority of our exposure is invested in structured credit and mortgage-related securities with an average yield of 7.2% today. Our attraction to the asset class, as weve previously discussed, is predicated on the increasingly obvious recovery in residential real estate. Home prices are rising alongside of record affordability, while delinquencies are dropping and new households are now forming faster than homes are being built. The current stabilization in the domestic housing market is also consistent with the historical experience of dozens of major housing busts across OECD countries in terms of average duration and average decline in real home prices.

We believe the best way to capitalize on an improvement in domestic housing is through the structured credit markets, which have not yet reflected the recovery in underlying asset prices. While the distressed phase of this market move is clearly behind us, we anticipate that the pending demand from an institutional shift into higher yielding assets will overwhelm the shrinking supply of this self-liquidating market. As a good friend recently reminded me, the last six to twelve months of a trend are often the most rewarding. We think the attractive yields on offer in the non-agency market, shown below, are likely to be front-end loaded, resulting in significantly greater IRRs for investors, compliments of Chairman Bernanke. Put simply, we are being paid a healthy annual cash flow of 7.2% on our investment, which comes with an embedded option on higher housing prices. Healthy cash on cash returns combined with strong technicals provide us with plenty of downside protection.
Broad Opportunity Set Outside of Government Bonds

Source: PIMCO

Natural Resources Since the range of potential outcomes in a deleveraging process can be extraordinarily wide, we believe the optimal portfolio should maintain a barbell approach to hedging both inflation and deflation risks. At one end, we believe that the cash flow produced by a heavy allocation to income generating assets provides us with a degree of principal protection and a smooth stream of returns in the event that the pace of deleveraging accelerates. At the same time, we recommend a healthy allocation to real assets to hedge the right tale of the risk distribution. Most investors have no memory of owning gold, nor do they feel the need to do so today. As one of our external managers recently reminded us, Gold is durable, rare difficult to mine, very limited in supply growth, and is the only substance which has served as money and a store of value for thousands of years; in fact, it backed the US money supply until the early 1970. Considering the lack of true safe havens around the globe, the coordinated money printing programs of central banks, and the potential for a Developed World Balance Sheet Apocalypse, we think it is reasonable to at least consider the possibility that the money supply is fully backed by gold once again. Such an

occurrence would not be unprecedented as the gold coverage ratio has risen above 100% twice during the past century. Were this to happen today, the value of an ounce of gold would exceed $12,000.

Source: Guggenheim Securities, LLC

Accordingly, we think precious metals have a place in every investors portfolio. Today, gold and gold mining equities represent the majority of our exposure to natural resources. The balance is invested across a basket of MLPs, which yield a healthy 6% today and provide the portfolio with a natural inflation hedge. We outlined our logic for Investing In Infrastructure in a recent Broyhill Letter. Global Equities When measured in terms of the experience set of portfolio managers in the industry today, the current investment landscape and macroeconomic uncertainty is unprecedented. Yet, despite these glaringly obvious risks, equity market valuations have only been higher than current levels 20% of the time since 1926. At 22.2 times trailing ten-year earnings, todays Cyclically Adjusted PE is very high in historic terms. So while a case can be made for fresh near-term highs in equity markets investors should be aware that such a tactical call amounts to a speculative bet on yet higher prices, rather than a long-term fundamental investment derived on the basis of cash flow. And since our business at Broyhill is one of investment rather than speculation, equities represent a rather small allocation across our portfolios today. Importantly, this is not a decision based on a dire economic outlook. Rather, it is a systematic, value-driven approach to asset allocation that alters our asset mix based on the opportunity set offered by Mr. Market. Expected stock returns are just too low today to justify a rigid adherence to a static portfolio mix, dominated by equities.

Source: AQR Capital Management, LLC

As illustrated by the table below, long-term expected returns fall dramatically as the starting level of valuation increases. More specifically, US equity market valuations today imply that real stock market returns over the next decade will not break 1% annually. Relative to the yields on offer in the mortgage-securities market or the upside potential in precious metals, the returns on offer across domestic stock markets are not particularly exciting.

Source: AQR Capital Management, LLC

We have, however, begun putting some dry powder to work in global equity markets over the past quarter, as evidenced by a dwindling cash balance. There is no question that the outlook for the global economy remains extremely challenging, as shortened business cycles are more susceptible to periodic bouts of recession. At the same time, European economies can only hope for such periodic bouts of recession, given that consensus expectations today are moving closer to the Japanafication of the EU. That being said, it is important to remember that the actual risk of

permanent impairment is usually lowest when perceived risk is highest and as such, it is likely that the market has already discounted the impact of a prolonged European recession. The news only needs to be slightly less bad for stocks to rise from todays extremely depressed valuations and it would seem that ECB President Mario Montis recent actions have provided markets with such a catalyst. As we concluded in Q3-11s Broyhill Letter: It would be foolish to doubt central banks capacity to print money to paper over mountains of bad bank and sovereign debt. History suggests that all governments ultimately go down this road after exhausting austerity. The only question is how bad things get before they act. We suggest it is simply a matter of time before Helicopter Mario chooses the seemingly lesser of two evils. It would seem that Helicopter Mario has since made his choice. As a result, a disorderly destruction of the monetary union would appear to be off the table (for now), removing a significant risk from the market. European equities may not have hit bottom yet, but valuations suggest we are getting close. Among the worlds major stock markets, Europe is the cheapest based on current dividend yields. It is also cheapest on cash flow yield, book value yield and earnings yield. A cheap asset can easily get cheaper. Unfortunately, weve learned this lesson the hard way. But weve also learned that unlike buying an overpriced stock which offers roughly zero chance of ever returning to previous valuation heights, investing in a heavily discounted asset can beget temporary losses, but ultimately results in much higher long-term compounded returns. Buying early is the notorious curse of the value investor. However, buying stocks when they trade at low multiples has historically been a rewarding strategy. Ned Davis Research reports that when the Cyclically Adjusted PE on European equity indices has been below 13.5, European stocks delivered annualized returns of 16.2% over the following five years. These markets currently trade at a Cyclically Adjusted PE of 12.2 a multi-decade low.

Source: Morgan Stanley 7

Bottom Line Unless you are analyzing micro caps, like our talented friends at Privet in Atlanta, the only information edge available in the market today is inside information. And unless you are plugged directly into the CBOE and measuring your success in nanoseconds, trading edges are just as hard to come by. So by default, we tend to side with our friends at Virgo Investment Societas who postulate that, time arbitrage is the most obvious structural opportunity to add value in the current market environment. At Broyhill, this means committing capital to undervalued and overlooked assets with significant upside potential on a three to five year horizon, while most investors continue to struggle looking past the next quarter. Weve found that an emphasis on current cash flow can minimize market volatility while we are paid to wait for price to align with value. Today, the result is a portfolio heavily invested in mortgage securities yielding 7.2% on a loss-adjusted basis and short duration credit instruments yielding 5.5% with minimal interest rate risk. Our portfolios maintain a healthy allocation to natural resources, comprised of precious metals and infrastructure assets yielding 6.0% with growing distributions. And finally, while opportunities are increasingly limited in domestic equity markets, we believe recent investments in global equities, with a 5.5% average dividend yield, provide an attractive balance of current cash flow and a cheap option on future price appreciation. We look forward to sharing some of the specifics of our European equity investments with you in the near future. Sincerely,

Christopher R. Pavese, CFA Chief Investment Officer Broyhill Asset Management, LLC