1 Draft of 1 December 2011 19:30:51 a1/p1

SURVIVING

THE

GRAND CONVULSION

DECEMBER 2011

IMPORTANT DISCLAIMER THE

OBSERVATIONS CONTAINED HERE-IN ARE BASED SOLELY UPON ANALYSIS OF PUBLICLY AVAILABLE DATA. HOWEVER,

NEWPORT VALUE PARTNERS

DOES NOT CURRENTLY HAVE

ANY INVESTMENT POSITION IN SECURITIES DISCUSSED IN THIS

MEMORANDUM;

NEWPORT VALUE PARTNERS

EXPECTS IT MAY DERIVE COMPENSATION FOR

ITS EFFORTS THAT IS LINKED, IN PART, TO CHANGES IN THE VALUES OF SECURITIES AND OTHER FINANCIAL INSTRUMENTS DISCUSSED IN THIS

PARTNERS

IS NOT OFFERING FINANCIAL OR INVESTMENT ADVICE.

MEMORANDUM. NEWPORT VALUE THIS MEMORANDUM

HAS BEEN PREPARED SOLELY TO INVITE DISCUSSION WITH SELECTED PROFESSIONAL INVESTORS AND WITH INDEPENDENT EXPERTS.

REPRESENTATIVES OF NEWPORT VALUE PARTNERS ARE PREPARED TO SHARE ADDITIONAL, RELEVANT OBSERVATIONS CONCERNING THESE MATERIALS WITH POTENTIAL INTERESTED PARTIES.

NEWPORT
VALUE PARTNERS

237 Park Avenue Ninth Floor New York, NY 10017

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2 Draft of 1 December 2011 19:30:51 a1/p1 But is the spirit of the people an infallible, a permanent reliance? Is it government? Is this the kind of protection we receive in return for the rights we give up? Besides, the spirit of the times may alter, will alter. Our rulers will become corrupt, our people careless. A single zealot may commence persecutor, and better men be his victims. It can never be too often repeated, that the time for fixing every essential right on a legal basis is while our rulers are honest, and ourselves united. From the conclusion of this war we shall be going down hill. It will not then be necessary to resort every moment to the people for support. They will be forgotten, therefore, and their rights disregarded. They will forget themselves, but in the sole faculty of making money, and will never think of uniting to effect a due respect for their rights. The shackles, therefore, which shall not be knocked off at the conclusion of this war, will remain on us long, will be made heavier and heavier, till our rights shall revive or expire in a convulsion.1

CONTENTS
I II. III. IV. V. Hostage to Unintended Consequences The Perils of Insensible Optimism Structural Causes of Persistent Adversity Planning for Perdition Winning with a Losing Hand Page 3 10 16 22 26

Thomas Jefferson, Notes on the State of Virginia, (1784), Query 17, pages 157 to 161.

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3 Draft of 1 December 2011 19:30:51 a1/p1

I. HOSTAGE

TO

UNINTENDED CONSEQUENCES
TO

THE GREATEST THREAT STRUCTURAL PRESSURE

FINANCIAL SECURITY ON THE UNITED STATES

IS

MOUNTING OF AMERICA

The Grand Experiment fired by Thomas Jeffersons pen is rich in instructive insight. When this modern history is summed into an epitaph, perhaps it will be mans grand plans are foiled by their unintended consequences. And, if we had to nominate one article of post-1789 economic faith as the false dogma contributing in greatest part to the end, it would be that Gross Domestic Product is a useful proxy for a nations credit capacity. We believe the essential support for all asset values and for all debt is private sector income. While politicians and pundits may suggest otherwise, private sector incomes are the primary guarantors for financial security of nations, of prosperity for asset owners and of personal security for every citizen. In contrast, public sector incomes are derived from the private incomes and wealth of householdswhen they are funded with public debt and parceled out as sinecures, they do in fact become weapons of mass destruction as numerous examples painfully demonstrate. Accustomed to material prosperity, an apathetic public and misinformed elite have over-loaded Americas sorely challenged, true economic resources and pointed the nation down a path to ruin. Even now, investors and national leaders appear deaf to calls for caution sounded by students of history who know what happens when Empires relentlessly over-extend. In our view, America and her allies, in achieving the long-held ambition of defeating Communism, finally unleashed a Grand Convulsion in 1989 whose unintended consequences in an open, global environment continue to stoke economic and geo-political tensions far more powerful than any nation and any existing supra-national authority. The First Stage of the Grand Convulsion Occurred between 1989 and 1991. Beginning in 1989, sudden and relatively painless victory in the Cold War ceded global leadership to the United States and brought hundreds of millions of persons in China, in the former Soviet Bloc and in other frontier and emerging nations into the pool of available workers, dwarfing the number of employed elsewhere. The Second Stage of the Grand Convulsion Occurred between 1991 and 2001. By year-end 1991, America had re-validated her military capabilities and re-emerged on world scene as the triumphant global power. Thereafter, investors and managers acquired the technological tools and SUBJECT DISCLAIMER

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4 Draft of 1 December 2011 19:30:51 a1/p1 confidence to begin tapping and training workers who previously had been locked down under and adjacent totalitarian rule. Then, a potent yet tragically ignored enemy attacked America and Western, materialist society. The Third Stage of the Grand Convulsion ran between 2001 and 2008. From September 2001 through August 2008, America and her allies fought to rid the world of a geo-political scourge in militant, fanatical Islam. Facing lethal and determined adversaries abroad, America and other developed nations lost concentration upon a second perilevident failure of expensive, deficit-financed redistributive government using labor that is no longer remotely competitive on world scale. The Fourth Stage of the Grand Convulsion began in September 2008. In our view, the global system formally entered Purgatory during the weekend of 13 September 2008 when major economic powers tore up the rulebook and embraced the deployment of taxpayer resources to protect some private interests. However noble these actions may have seemed then and in their immediate aftermath, we believe the abrupt and still opaque rescue programs actually compounded problems posed by excessive leverage, a global labor glut and uncompetitive productive capacity in many advanced nations. In December 2011, the worlds nations and territories appear to have coalesced into four zones with distinctly different characteristics. Approximately 16 % of the worlds political entities house a proportionate share of persons on 23 % of the worlds useful land. These Gray Zone nations2 consist of older, slow-growth populations that generate 68 % of global demand. In the Gray Zone, vast sums have been invested in infrastructure that needs to be maintained, re-configured, or torn down. Governments in the Gray Zone are engaged in attempting re-distribution of income and of accumulated wealth while also heavily in debt. In contrast to the Gray Zone, 5 % of the worlds nations house 51 % of the worlds persons on 36 % of the worlds useful land. These Growth Zone nations3 are younger, expanding faster than populations in the Gray Zone and so far account for just 22 % of global demand. Unlike the Gray Zone, Growth Zone nations require substantial sums to build out economic infrastructure and have governments that are more intent upon developing private sector incomes and promoting wealth creation. Like the Gray Zone,
2

We divide the 38 Gray Zone nations into 29 Prime and 9 Other nations. The Prime nations include: the 27 Euro-Zone nations, the United States and Japan. The Euro-Zone nations are: Germany, the United Kingdom, France, Italy, Spain, Poland, Romania, the Netherlands, Portugal, the Czech Republic, Greece, Belgium, Sweden, Hungary, Austria, Denmark, Finland, Bulgaria, Slovakia, Ireland, Lithuania, Latvia, Slovenia, Estonia, Cyprus, Luxemburg and Malta. Other Gray Zone nations are South Korea, Canada, Australia, Taiwan, Switzerland, Singapore, Norway, New Zealand, and Iceland. 3 We divide the 12 Growth Zone nations into 7 Emerging nations and 5 Frontier nations. The Emerging nations are Brazil, Russia, Mexico, South Africa, Argentina, and Chile. The Frontier nations are: China, India, Indonesia, Vietnam and Thailand. In China, we include Hong Kong and Macau.

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5 Draft of 1 December 2011 19:30:51 a1/p1 Growth Zone nations are, in the main, hostage to foreign sourced supply of essential energy, located in the turbulent mid-East. However, Growth Zone nations have yet to embrace addiction to financial leverage. Selected Islamic States4 constitute 12 % of the worlds nations and, like the Gray Zone, house a proportionate share of the worlds persons. However, their populations are growing faster than in the Gray Zone. In addition, populations in Selected Islamic States are packed into just 9 % of the worlds useful land. A subset of Selected Islamic States controls an estimated 62% of global energy resources, relying principally upon expatriate workers to develop and market these assets. All other nations combined constitute a 67 % majority of nations with just 20 % of the worlds persons. Their populations are, by far, the youngest and fastest growing and have room for expansion on 31 % of the worlds useful land. But all together, this impoverished group generates just 5 % of global demand. There is nothing truly settled and agreed among these many nations. Resources and talent are not distributed in a way any with knowledge could argue is equitable. No effective and empowered central authority wields just power, surely or wisely. With only 5 % of the worlds population, America struggles to orchestrate a semblance of peace. However, deep and fundamental divisions are elemental and evident signs of financial instability suggest clearly to us that global security will prove a near-term casualty. Though we are optimists at heart, in no way do we support the tentative conclusion that the Financial and Economic Crisis of 2008 has finally ended. SELECTED CONCLUSIONS DRAWN
FROM

AVAILABLE EVIDENCE

The most powerful force in economics is growthactual growth measured in units of solid, abiding value. In contrast, the most destructive tool that is employed in hope of spurring growth is debtespecially when debt compounds in cost, having financed consumption or investments that do not actually provide a true financial return on capital employed. Experience in the new millennium within the developed world illustrates these tenets vividly. The Period since 1999 has proven to be an Economic Bust for All but the Most Entrepreneurial. Measured in nominal terms, but particularly
4

We concentrate upon 29 of the Islamic states: 11 we classify as Energy Rich and 18 we classify as Energy Poor. The Energy Rich nations are Iran, Algeria, Kazakhstan, Iraq, Azerbaijan, Saudi Arabia, Libya, Kuwait, the United Arab Emirates, Qatar and Oman. The Energy Poor states are Bangladesh, Pakistan, Egypt, Turkey, Uzbekistan, Morocco, Afghanistan, Syria, Yemen, Tunisia, Somalia, Tajikistan, Kyrgyzstan, Jordan, Lebanon, Turkmenistan, Bahrain and Djibouti..

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6 Draft of 1 December 2011 19:30:51 a1/p1 in gold terms, investors in most securities have not been fairly compensated for taking risks they have assumed since 1999. In addition, private sector workers of all skill levels in wealthy, developed nations have been hit hard by unforeseen consequences of globalization that have cut their number and pared their individual and aggregate incomes. Workers in other nations have prospered to a degree, but remain far less well compensated, on average, than developed world counterparts. The only out-sized winners (excluding crony capitalists) are the few lucky enough, smart enough and persistent enough to build out new business platforms, unencumbered by legacy costs, to serve vibrant and growing global markets with manifestly value-enhancing goods and services. An Unrestrained Propensity to Borrow in Developed Nations and Lack of Alternative Safe Debt Investments has simultaneously fostered a Structural Debt Crisis. As we illustrated with General Electric Company in the corporate and financial spheres, the market for low-risk debt investments is far less discerning than it should be. We believe the practice of misjudging intrinsic risk among sovereign credits is even more ingrained. This tendency and the well-established practice of miscalibrating debt loads versus the deeply flawed Gross Domestic Product statistic instead of in relation to reliably continuing private sector incomes and truly unencumbered national assets have served all market participants poorly. Levels of total debt carried in developed nations are quite simply way too highthey cannot be reduced other than by restructuring and by default. Unsound Policy Responses Taken by Developed Nation Leaders have Reinforced Potent Threats Posed by the Labor Glut and Companion Debt Surplus. Instead of recognizing that private sector incomes are the key to sustaining economic growth and also to servicing debt, developed nation policy-makers have pushed up the cost of private labor just as hundreds of millions of competent, motivated and lower-cost workers clamor for employment. Instead of stream-lining mammoth public-sector operations, government leaders have made these institutions more formidable, added to the many expensive public sector workers and raised the total cost of public sector employees far above comparable private sector workers. Instead of allowing for the kind of creative destruction that might right-size uncompetitive private and public sector enterprises, leaders have theoretically coddled their populations by pressing central bankers to lower nominal interest rates so long as they could finance continuing cash shortfalls with more borrowings. Instead, these innumerate leaders have yoked their populations into a modern form of economic slavery. In fact, the continuing afflictions seen in volatile financial markets and struggling national economies are symptoms of far greater, structural challenges to progress that urgently require constructive attention. The Grand Convulsion is not, in our view, a cyclical downdraft along a trajectory of sure growth in production, income, and wealth inside advanced nations, where economic activity, wealth, and political power SUBJECT
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7 Draft of 1 December 2011 19:30:53 a1/p1 remain concentrated. Instead, countless poor decisions and their consequences have stretched the global system to its ultimate breaking point. The systemic transformation, well advanced in course, now poses an existential challenge to the Anglo-American political and economic model. Because Anglo-American armed forces provide essential military support and deterrence, the next stage of the Grand Convulsion also poses unprecedented threats to maintaining increasingly fragile world order. SELECTED IMPLICATIONS
FOR

2012

Global Productive Capacity far Exceeds Intrinsic (Un-Financed) Demand for most Goods and Services. As focus sharpens upon regions, nations and portions of nations, imbalances between supply and demand become more acute. Evidence is now clear that traditional fiscal and monetary tools have proven ineffective in raising demand closer to supply. The only realistic way, in our view, to move back closer to equilibrium is to reduce production costs through labor reform and capacity rationalization especially in locations throughout the Gray Zone. We do not believe national leaders can co-operate in reducing this capacity. Existing Institutions and Frameworks are not powerful enough to Forestall Violent Re-Alignment of Competing Interests. We believe poor recorded results for investors and for developed world workers since 1999 measured in gold terms are more than enough warning that the global system remains locked in un-resolved structural crisis. After almost 11 full years in turmoil, some might argue that the system can operate in crisis indefinitely. With no existing government or financial institution solvent enough, respected enough or feared enough to lead the required rebalancing in peace, we believe the world will experience a painful recalibration of economic strength and geo-political standing during 2012 in the midst of widespread civil insurrection and cross-border war. The Governing Pole of Political Discourse will Shift from the Traditional Left-Right Divide to a New and Starker Contest between Young and Old. Revolutions, like wars, are fought by the young. In the developed world, living standards have remained high above those levels elsewhere for decades. The growing pool of seniors among these have become accustomed to comfort and expects to be well looked after, somehow, in retirement. Younger residents in developed nations also have experience chiefly with comfort but now bear the heaviest brunt of the continuing assault upon the number and level of private sector jobs and incomes. Many of these young job seekers have piled up debt to finance their expensive, higher education. With total debt already at towering levels, there is simply no way to reconcile competing hopes of older and younger persons. Unlike political inclinations that can be effectively hidden, age is an obvious marker. We believe that politicians will, most unwisely, try to exploit these

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8 Draft of 1 December 2011 19:30:53 a1/p1 engaged tensions in ways that are certain to stoke conflict before they yield constructive solutions. The Wider Public will then become even more aggressive in Expressing Dissatisfaction with the Status Quo. By comparison to the period 1981 through 1999 (when progress on many fronts was palpable), the period from December 2011 onwards will start stormy and get progressively more stormy. The transformation of a contented and silent Majority into an irascible and vocal Majority will break many conventions in the United States and in other developed nations as incontrovertible evidence piles up weekly and perhaps daily over coming months that the status quo is broken for young and for old as well as for workers and investors alike. Civil Unrest will intensify in the United States and in other Developed Nations that have been following Ineffective, ReDistributive Economic Paths for Decades. In our view, the stage has already been set for continuation of protests that first began to surge in 2010. Dissent and division are in the air and tools to spread competing views are readily available as well as highly effective. Some will manage to contain their activities to peaceful protests. However, we believe the far more likely scenario is that violence will result, especially in the United States where the wider population has more ready access to weaponry and where mobs have proven impossible to restrain. The Spread of Unrest in Developed Nations will prompt Military Adventurism in Numerous International Flashpoints. With the United States and other Western powers beset by vexing financial, economic, and internal political challenges, keen adversaries and even friendly rivals will press for advantage. With retreat by the U.S. from Iraq and Afghanistan a reality, we expect Iran and radical Islamic elements to stoke conflict in the petroleum rich Mid-east and then to attack Western interests elsewhere. We anticipate that China will side with key oil states to secure preferred access for essential energy resources and imagine a renewed push for greater military and political influence not only in Asia but also on the world stage. Russia is likely to flex her muscles even more throughout resource rich states hailing from the former Soviet Union, in energy-starved Europe, in the MidEast and in the Arctic. We also are certain that rogue states such as Pakistan, North Korea, Yemen, and Somalia will choose mounting economic and geopolitical turmoil to wreak further havoc. Exit Flows of Capital from the United States and Western Allies will grow in Size and in Intensity. History shows that the wider investing public consists of many followers and few, rightfully respected leaders. For thirty years, allocating capital to developed market securities has been deemed a sound and prudent investment decision, even though it certainly has not been sensible during this millennium. In 2012, we expect that a new kind of group thinking will cause followers to shift out of developed world financial assets. The shift is likely to start as soon as the first quarter of 2012 and then accelerate through the year as it becomes clear that constructive SUBJECT
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9 Draft of 1 December 2011 19:30:53 a1/p1 economic change is not coming anytime soon to key places like Europe, the United States and Japan. This trend-break will cause trouble everywhere, but we expect some beneficiaries to be precious metals, essential commodities (energy and timber), emerging and frontier market longer duration debt and select few equities whose entry prices get set attractively in view of their realistic potential to generate steady growth in conservatively calculated free cash flow. Now in December 2011, the public is finally beginning to face the most dangerous crisis of alla Crisis of Confidence in the capitalist system itself. We anticipate continued, vexing assaults both internally (during ever more acrimonious national power transitions) and externally from man-made and natural challenges. From now through January 2013 at the earliest, we believe investors will run a punishing gantlet. Accordingly, we believe investors should sell assets denominated in major fiat currencies and allocate proceeds to precious metals and liquid securities denominated in Norwegian Krone, Canadian Dollars, Swiss Francs, and Singaporean Dollars. Sophisticated investors should consider expressing short positions against liquid, over-leveraged, and opaque securities using traditional means as well as derivative instruments. Our concerns are not limited to the investing class, which is a vital but small portion of the global population. In the following pages, we also try to address certain underlying economic issues that we believe are pertinent to ongoing political debates in the United States and in other nations. On their own, these issues seem to us to hold consuming importance. In our view, their resolution is likely to affect valuations of all securities far more than whether a global bellwether like General Electric Company misses or beats an earnings per share estimate.

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10 Draft of 1 December 2011 19:30:53 a1/p1

II. THE PERILS

OF

INSENSIBLE OPTIMISM

INVESTORS AND DEVELOPED WORLD LEADERS HAVE BEEN IGNORING ROOT CAUSES OF EVIDENT FINANCIAL AND ECONOMIC FAILURES
Since 1999, investors in fiat currency securities have been punished. Abundant, unambiguous evidence shows that nominal and risk-adjusted returns earned by the investing class have been poor. We do not believe that economic data for the major nations we follow closely is consistent, but certain time series data produced for the worlds largest integrated economy does confirm that performance recorded in the United States from 1999 onwards is substantially below experience from 1945 to 1999. FIAT CURRENCIES
CONTINUE TO

DESTROY ACCUMULATED FINANCIAL WEALTH

Our analysis shows clearly that investors who elected to retain their holdings in

major fiat currencies have been slaughtered in gold terms5 going back to year-end 1999.
FIGURE 1: Value of $ 1,000,000 as Converted on 31 December 1999 and as Expressed in Gold Ounce Terms in 1999, 2008, 2009, and 20116
3,500 3,000 2,500 2,000 1,500 1,000 500 0 Dollar Euro Dec-99 Pound Aug-08 Yen Mar-09 Yuan Nov-11 Rupee

No system has been devised that allows analysts to compare with precision how investments and economies have performed over time. We accept that norming performance to gold has faults but do not believe use of nominal or inflation-adjusted figures constitute superior approaches. 6 We assumed that investors converted $ 1,000,000 into different major currencies on 31 December 1999. Then, we tested the values of each pile of converted currency in gold terms on 21 August 2008 (the date we issued a research report warning investors of expected turbulence); on 31 December 1999, on 9 March 2009 (the date representative equity indices posted recent historical lows); and as of 30 November 2011 (the most recent month-end).

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11 Draft of 1 December 2011 19:30:53 a1/p1 In gold terms, the U.S. dollar is down a cumulative 83.0 %; the Euro is down 77.4 %; the British Pound is down 83.6 %; the Japanese Yen is down 87.1 %; the Chinese Yuan is down 77.9 %, and the Indian Rupee is down 85.8 %. Investors who were more adventurous and allocated capital to equities on major, global stock market exchanges also suffered grievous erosion in their wealth. Figure 2: Value of $ 1,000,000 as Invested on 31 December 1999 and as Expressed in Gold Terms in 1999, 2008, 2009 and 20117
3,500 3,000 2,500 2,000 1,500 1,000 500 0 Dow DAX Dec-99 FTSE Aug-08 Nikkei Mar-09 Shanghai Mumbai

Nov-11

In gold terms, investors were down a cumulative 82.2 % in the Dow-Jones index; down 80.2 % in the DAX index; down 87.0 % in the FTSE index; down 90.3 % in the Nikkei index; down 63.3 % in the Shanghai index and down 54.3 % in the Mumbai index. In cumulative local currency terms from year-end 1999, investors in major developed market stick indices were up just 4.8 % in the Dow-Jones Index; down 12.8 % in the DAX index; down 20.6% in the FTSE Index and down 55.5 % in the Nikkei Index. We do not believe performance in gold or nominal terms compensated investors for the substantial risks inherent in owning corporate equity securities. In light of golds performance and given considerations regarding reporting standards for all publicly traded securities, we are not satisfied that local currency returns of up 65.9 % cumulatively since year-end 1999 on the Shanghai Index or even up 222.1 % on the Mumbai Index are sufficiently robust to compensate investors for associated risks during this period.
7

We assumed that investors used $ 1,000,000 on 31 December 1999 to invest in units of six major stock market indices. We converted the value of these investments to gold equivalent terms and tested performance in August 2008 (before the crisis emerged in full force); in March 2009 (at recent historical lows); and in November 2011 (at most recent month-end). Evidence suggests that investors have difficulty even replicating results achieved by indices across their entire portfolios. It is also worthwhile noting that benchmark indices have a changing coterie of components. For example, eight members of the Dow-Jones Industrial Index in 1997 were out of the Index by 2009 which means there was 27 % turnover in components during just 13 years.

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12 Draft of 1 December 2011 19:30:53 a1/p1

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SOME OBSERVATIONS

13 Draft of 1 December 2011 19:30:53 a1/p1 CONCERNING ECONOMIC PROGRESS

Listening to media-approved sages, one might be seduced into believing that stock market rallies presage economic progress. Others divine their principal conclusions regarding economic health from reported trends in Real Gross Domestic Producta hoary statistic used by noted analysts as a theoretically useful indicator. We respectfully disagreeand fortunately, data concerning the United States provides fertile ground for more careful analysis8. For starters, we believe economic progress for a nation should be assessed on both an aggregate and per household basis9, during long periods. FIGURE 3: Real GDP, Real GDP per Household10 and Gold GDP per Household (Indexed: 1945=100)
700 600 500 400 300 200 100 0 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 Real GDP Real GDP/Household Gold GDP/Household

During the 65-year period from 1945 to 2010, Real GDP did grow at a compounded annual rate of 2.9 % per annumat surface level, a significant achievement for such an extended period. However, on a per household
8

Economic statistics concerning America have many faults but one virtue is that they go back to 1945 on a consistent basis and also include estimates concerning balance sheet data for households and the amount of debt outstanding. This section concentrates upon certain economic statistics for America which we believe are likely representative of results achieved in other developed nations from 1945 through 2010. 9 In our view, trends in household formation are important. In past periods, household formation was often a positive economic forceintact households sustained economic growth. However, in more recent periods, household formation has actively been driven by the breakup of intact households, which we believe can be a destructive economic force. 10 Information concerning GDP is drawn from Bureau of Economic Analysis Data, available online.

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14 Draft of 1 December 2011 19:30:53 a1/p1 basis, GDP grew at only 1.1 % per annum in real terms, which means that growth at 1.8 % per annum in households was an important contributing factor to the calculated result. A further worry is the differing set of conclusions one might draw from evaluating trends in Real GDP per household and Gold GDP per household from 1968 onwards, after the dollar was de-linked from gold. As we observed in considering time series data for stock market indices traded in various currencies, no simple system affords even near useful comparability for data, especially during long periods. However, the gold-adjusted data, per household, does stand in sharp contrast to real data. Whether one uses real or gold-adjusted data, we believe a clear discontinuity emerges in GDP growth rates experienced from 1945 to 1999 with those recorded from 1999 to 2010. FIGURE 4: Comparison of GDP Growth Rates: 1945 to 1999 versus 1999 to 2010

5 0 -5 -10 -15 Real GDP Real GDP/HH 1945-1999 1999-2010 Gold GDP/HH

Growth in Real GDP dropped from 3.2 % per annum in 1945-1999 to 1.8 % per annum from 1999 to 2010. Growth in Real GDP per household dropped from 1.2 % per annum to 0.6 % per annum and growth in Gold GDP per household dropped from 1.2 % per annum to a staggering decline of 11.1 % per annum. We believe this discontinuity warrants scrutiny of the trend and of the GDP statistic itself. Our review of the process by which Gross Domestic Product estimates are prepared suggests numerous deficiencies11 that we believe combine to
11

These deficiencies include: (a) personal consumption expenditures include two suspect items: (1) implied value of owner-occupied housing and (2) financial services provide without compensation; (b) the value of government expenditures is assumed to be their cost, a debatable proposition; (c) compensation of government workers is counted once as a source of personal consumption expenditures and, unlike in the case of the private sector, a second time within government consumption expenditures; (d) government expenditures count depreciation as a benefit to economic activity when we believe this amount should be removed and further that depreciation on all investment (private and public) should be subtracted from the total estimate of productive economic activity; and (e) changes in the amount of total debt during a period are not considered either as benefits in the rare cases where debt is repaid or costs in the more typical cases where debt levels have increased.

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15 Draft of 1 December 2011 19:30:54 a1/p1 overstate the likely total of productive economic activity while also masking important trends12. In our view, a far superior method to gauge economic progress is to start by tracking the course of private sector incomes as well as the evolution of household net worth. On balance, we believe that historical performance of U.S. private sector income and net worth has been quite volatile, declining and therefore poor, particularly from 1999 to present. Trends in real private sector income per household show a sharper contrast between the 1.1 % compounded annual growth seen from 1945 to 1999 with the 0.7 % compounded annual contraction experienced from 1999 to 2010. FIGURE 5: Real Private Sector Income13 per Household and Gold Private Sector Incomes per Household14 (Indexed in Gold Terms: 1945=100)

300 250 200 150 100 50 0 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 Real Income/Household Gold Income/Household

In gold terms, the discontinuity in growth patterns for per household private sector income was even more pronounced. From 1945 to 1999, per household income growth occurred ar a 1.1 % compounded annual rate whereas from 1999 to 2010, per household income dropped 12.3 % per annum, compounded.
12

Conventions used to estimate Gross Domestic Product obscure, among other trends, changes in the streams of income that support personal consumption expenditures and private investment; the degree to which taxes increase the costs of employment, purchases and investments; the proportion that imports are to domestic demand; and the size of public sector expenditures in comparison to private sector expenditures. 13 We exclude interest, dividends and rent from private sector income as we believe these items need to be re-invested to deliver a true financial return to investors. We exclude items other than wages received and include non-farm proprietors income. Finally, we exclude wages received from employees counted by the Bureau of Economic Analysis as being in the private sector who work in the health, education, and legal services industries. 14 Information concerning household net worth is drawn from Federal Reserve System Z-1 Statistics available on-line. Information concerning labor incomes is drawn from Bureau of Economic Analysis Data, available on-line.

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16 Draft of 1 December 2011 19:30:54 a1/p1 Data in the U.S. is available concerning household net worth for the entire population, but it is not consistently estimated by quintile other than for a few historical years. We expect the recorded fortunes of the minority that has net worth to differ from the results achieved by the majority that lives primarily upon income. FIGURE 6: Estimated Net Worth in Total and Per Household (Indexed in Gold Terms: 1945=100)
900 800 700 600 500 400 300 200 100 0 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 Total Net Worth Net Worth Per Household

On a per household basis, net worth in gold terms mirrors the performance of per household private sector income although less tightly than in the period 1945 to 1981. FIGURE 7: Per Household Private Income and Net Worth (Indexed in Gold Terms: 1945=100)
350 300 250 200 150 100 50 0 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 Net Worth Per Household Private Labor Income

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17 Draft of 1 December 2011 19:30:54 a1/p1

III. STRUCTURAL CAUSES

OF

PERSISTENT ADVERSITY

INSATIABLE DEMAND FOR SAFETY, A GLOBAL LABOR GLUT, AND RE-DISTRIBUTION ADDICTION ARE POTENT, CONTINUING THREATS
Undetected and left unchecked, termites can reduce towering, man-made structures to rubble and dust. Though the end comes suddenly and with great fanfare, the structural damage starts years in advance, while typically failing to attract attention at stages when remedies can be implemented readily and at low-cost. A different swarm of termites has been assaulting the foundation of life in many advanced market-based economies, for decades. One band of pests seduced the public into accepting the false premise that Gray Zone nations can be nourished on growing piles of debt. A second lulled government leaders into ignoring the sure perils caused by migration of private sector incomes to more hospitable foreign locations. While a third sold the false theory adroitly that deficit-financed, public sector incomes and transfer payments are a nourishing substitute for lost private sector incomes.

Strong Demand for Safety led Investors to Assess Gray Zone Debt Credit Risks Inaccurately for Years
United States Government Securities have been a Natural Beneficiary of this natural and Unrelenting Demand. Especially after 1999, yields on benchmark U.S. Government securities have decreased in absolute terms. FIGURE 8: Annual Average Yields on Selected U.S. Government Securities
16 14 12 10 8 6 4 2 0 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

10 Year Notes

6 Month Bills

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18 Draft of 1 December 2011 19:30:54 a1/p1 Strong Investor Interest in U.S. Government Securities has been Surprising Given Persistent and Widening Government Deficits. Since 1965, all government entities in the U.S. combined have recorded a surplus in only 4 out of 46 years or just 8.7 % of the time. FIGURE 9: Expenditures less Revenues for all U.S. Government Entities: 1965 to 2010 (in Billions of Real 2005 Dollars)
500 0 -500 -1000 -1500 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 Surplus (Deficit)

Insatiable Appetite for U.S. Credit Risk, Low Nominal Interest Rates and Evident Propensity to Borrow Pushed up Borrowing Levels well into the Danger Zone. FIGURE 10: Total Debt and Household Debt as a Percentage of Private Labor Income; Total Debt as a Percentage of Gross Domestic Product

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1200 1000 800 600 400 200 0 194 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 5 Total Debt/PLI Household Debt/PLI Total Debt/GDP

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Since 1989, Downward Pressure on Gray Zone Labor Incomes has Intensified15.
The Most Potent, Unheralded Reality Affecting Every Nation is a Persistent Global Labor Glut of Unparalleled Historical Proportions. In the United States, there are an estimated 25.8 million unemployed and under-employed workers, which is 18.6 % of the 138.8 million employed workers. Excluding the balance of the Gray Zone, there are a further 550.2 million unemployed and under-employed workers. This figure is 4.0 times the entire pool of employed workers in the U.S. and is likely to remain a significant depressant to demand for relatively high cost U.S. workers for years to come. FIGURE 11: Selected Labor Statistics
(Persons in millions) Ages 15-64 E.U. U.S.A. Japan Prime Other Gray Zone Brazil Russia Other Emerging China India Other Frontier Growth Zone Energy poor Energy rich Islamic Zone Core Zones Other WORLD
15

Labor Force 237.1 153.9 65.6 456.6 78.3 534.9 103.6 75.6 100.1 279.3 823.5 478.3 201.1 1,502.9 1,782.2 253.4 63.4 316.8 2,633.9 598.1 3,232.0

330.7 205.8 81.7 618.2 104.1 722.3 132.9 100.1 157.9 390.9 970.6 743.9 265.7 1,980.2 2,371.1 410.2 141.8 552.0 3,645.4 777.3 4,422.7

Employ ed 213.9 138.8 62.2 414.9 74.2 489.1 96.3 69.8 91.1 257.2 788.1 426.6 189.4 1,404.1 1,661.3 221.9 56.0 277.9 2,428.4 519.2 2,947.6

UnEmploy ed 23.2 15.1 3.4 41.7 4.1 45.8 7.3 5.8 9.0 22.1 35.4 51.7 11.7 98.8 120.9 31.5 7.4 38.9 205.5 78.9 284.4

Under-Employed16 Persons Total 28.7 10.7 39.4 5.8 45.2 2.7 4.5 26.3 33.5 116.8 12.9 129.7 163.2 74.8 50.0 124.8 333.2 23.7 356.9 51.9 25.8 3.4 81.1 9.9 91.0 10.0 10.3 35.3 55.6 35.4 168.5 24.6 228.5 284.1 106.3 57.4 163.7 538.7 102.6 641.3

The excess supply of inexpensive labor could be reduced by imposing duties on imports from cheap labor cost nations and/or in the event of conflict. Both approaches would yield decidedly unproductive outcomes. 16 Of major nations, Chinas labor force participation rate is highest at 85.4%. The number of employed, unemployed and under-employed workers calculated assumes that the theoretical average labor force participation rate in each nation is 80.0 %.

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21 Draft of 1 December 2011 19:30:55 a1/p1 High Compensation Expectations and the Intractable Relationship of Senior Persons to Employed Persons Erodes the Attraction of Hiring Gray Zone Workers. Cutting the costs of Gray Zone employees is far easier than earning profit on incremental revenues. Employee costs can quickly be reduced by downsizing, by hiring in frontier and emerging markets, by engineering human labor out of operations and by adding robot capacity. In contrast, demand is weak in the Gray Zone and competitors in the Growth Zone are leveraging their own local advantages to evolve as competitors that are ever more formidable. Figure 12: Gross Domestic Demand per Person; Senior Persons versus Employed Persons
($ Billions) (Millions) Employed Persons 138.8 213.9 62.2 414.9 74.2 489.1 257.2 1,404.2 1,661.4 56.0 221.9 277.9 2,428.4 519.2 2,947.6 ($) GDD/ Employee 109,892 76,727 84,608 88,353 72,144 85,894 21,103 6,008 8,345 25,564 7,951 11,501 24,325 5,621 21,031 (Millions) (%) Senior/ Employee 28.5 39.6 45.3 36.8 25.1 35.0 18.9 13.9 14.6 16.3 12.8 13.5 18.6 12.3 17.5

USA E.U. Japan Prime Other Gray Emerging Frontier Growth Energy rich Energy poor Islamic Core Other World

GDD 15,253.0 16,412.0 5,262.6 36,657.6 5,353.1 42,010.7 5,427.8 8,436.9 13,864.7 1,431.6 1,764.4 3,196.0 59,071,4 2,918.6 61,990.0

Senior 39.6 84.7 28.2 152.5 18.6 171.1 48.7 194.9 243.6 9.1 28.3 37.4 452.1 64.1 516.2

An Intractable Labor Glut means Downward Pressure on Private Sector Incomes is an Inalterable Constant. Since 1991, a move towards free trade and global markets, rapid and continuing technological advances, and a slowdown in intrinsic demand within the aged and indebted core nations have accentuated natural efforts in the private sector to bring down labor costs. This reality is actually consistent with notions expressed by Karl Marx:
If the supply greatly exceeds the demand, then one section of the workers sinks into beggary or starvation. The existence of the worker is, therefore, reduced to the same condition of every other commodity. The worker has become a commodity, and he is lucky if he can find a buyer.

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22 Draft of 1 December 2011 19:30:55 a1/p1

And the demand on which the workers life depends is regulated by the whims of the wealthy and the capitalists17.

17

Karl Marx, Economic and Theosophic Manuscripts of 1844.

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23 Draft of 1 December 2011 19:30:55 a1/p1

Gray Zone National Leaders and the Wider Public do not Appreciate the Likely Consequences of a Structural Shift in the Concentration of Economic Activity and Wealth to the Growth Zone.
For the most part, Gray Zone Nations are wedded to progressive government models that have not and will not re-ignite growth in private sector incomes. In a relatively open and mobile world economy, we do not believe that productive re-distribution of income and wealth can be achieved through deficit spending by inefficient, un-accountable public sector bureaucracies. A summary look at the long-term trend in relative contribution to United States income supports our grounds for over-riding caution. FIGURE 13: Private Sector Total Income Compared to Total Public Sector Compensation and Transfer Payments in the U.S.: 1945 to 2010 (Ratio in Percent)
500 400 300 200 100 0 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Private/Public (%)

Recent history has shown that national governments have limited powers to protect private sector jobs and incomes. We believe that close review of data going back to 1929 also shows that aggressive deficit spending and lax monetary policy have not and will not jump-start the private sector within national economies either. Intrinsic Growth Rates in Annual Demand within the Gray Zone have fallen for demographic reasons. History demonstrates that as populations get more prosperous, they decide to have fewer children and tend to live longer, on average. This reality serves to depress demand for most goods and services other than health care and related products. As local populations prosper, multi-national corporations elect to cut hiring and also to source fresh labor in more cost-competitive locations. This reality further SUBJECT
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24 Draft of 1 December 2011 19:30:55 a1/p1 depresses intrinsic local demand. Until recently, prosperous nations were able to mask some of these demand depressants by borrowing to create public sector demand. However, most large nations in the Gray Zone have either passed or approached tolerable credit limits. In simple financial terms, the worth of an asset can be calculated by estimating the likely long-term growth rate of its Free Cash Flow and using a risk appropriate discount rate to determine its net present value. In contrast to Growth Zone nations, we believe Gray Zone nations will experience constrained Free Cash Flows that will grow at much lower rates than experience from 1945 to 1999. Furthermore, we expect the risk profile and required discount rate for Gray Zone nations to rise and the risk profile and required discount rate for Growth Zone nations to fall. Inevitably, the resultant shift in relative private sector income and wealth will decrease the geo-political and military influence of the Gray Zone as compared to the Growth Zone.

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25 Draft of 1 December 2011 19:30:55 a1/p1

IV. PLANNING

FOR

PERDITION
TO

TRADITIONAL INVESTORS HAVE LIMITED TIME LEFT REDUCTION STRATEGIES

IMPLEMENT RISK

We believe the macro-economic and geo-political situation in December 2011 is actually more stressed than it was in August 2008 and earlier in August 2001.

Selected Geo-Political Threats

Radical Islam threatens civil order in the Homeland and essential energy supplies

Russia reasserts influence in conflict theaters and global organization s

Ascendant China strives for global leadership, economicall y, militarily and politically

Rogue actors pose additional risks: North Korea, Iran and Venezuela,

The United States Remains under Maturing Threats that Together Place the Global System in Peril
Nominal interest rates are forced upwards to historical median levels

Inefficient, high-cost government s exhaust their debt capacities

Euro-zone splinters into hard and weak currency nations

Natural and man-made disasters also pose systemic dangers

Selected Economic Challenges

By year-end 2012, we expect trends that have long been in evidence to merge and potentially inflict further pervasive damage upon the investing class and particularly upon the United States and other Gray Zone nations. SUBJECT
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The most Nominally Powerful Financial Institutions in the World remain quite Vulnerable
Our ongoing review of publicly available data calls into question whether conventions used by central banks and major financial institutions are appropriately conservative in light of volatile, unsettled markets and what we believe to be a realistic, sober future for Gray Zone governments and corporations reliant upon Gray Zone customers. Governments could be forced, on short notice, to inject $ 2.0 Trillion to $ 3.0 Trillion or more just to Stabilize Selected Large, Gray Zone Financial Institutions during 2012. The 15 largest Gray Zone financial institutions control an estimated $ 32.6 trillion in tangible assets with aggregate equity of $ 1.2 trillion, which is just 3.8 % of tangible assets. FIGURE 14: Tangible Equity as a Percentage of Tangible Assets for Selected Gray Zone Financial Institutions18
8 7 6 5 4 3 2 1 0

In the stress scenario we believe is realistic and building to a crescendo, sophisticated investors will start to value traded securities of these financial institutions assuming more conservative marks for tangible assets. These investors will also conclude governments will be forced back into rescue mode that will take the form of dilutive capital injections. Investors will then grow to Question the Soundness of the Largest Central Banks that Constitute the Core Foundation for the Global Financial System. In our opinion, the accounting standards, financial statements, governance practices and ultimate funding sources of three Central Banks have not yet been examined closely enough by the wider public, the media and the investing class: The Federal Reserve System, The European Central Bank and the Bank of England.
18

Strictly comparable data is not prepared for these financial institutions. Newport has developed its comparison using the best available information.

BOE ECB BOJ FRS Average Agricole Deutsche ING Mizuho Barclays Sumitomo BNP RBS Santander SocGen Mitsubishi HSBC JPM BAC C Tangible Equity/Tangible Assets

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No Government or Group of Governments is Informed Enough, Nimble Enough, or Powerful Enough to Rescue the Existing Global System on a Pain-Free Basis.
The United States will Forfeit its Accepted Right to Issue Dollars for use as the Worlds Reserve Currency. In our view, the United States Government and the Federal Reserve System have actually supported arguments to replace use of the dollar with some other reserve currency system by continuing actions and initiatives. The Euro Project has faileda Three-Tier Euro Structure is Inevitable. Political integration of diverse nations may well prove to be a lofty ideal, outside realistic grasp of mere mortals. But if coming close is actually possible, we believe a necessary, pre-existing requirement for true integration is submission to the binding authority of one, empowered taxing authority. In our view the current Euro structure will yield to one in which financially weak peripheral nations will exit while the residual group will somehow adopt strong and weak currency constructs. We caution that demise of the Euro could happen much faster than most assumein this event, the U.S. dollar and dollar-denominated securities would be only a temporary beneficiary of flight capital from the crumbling Euro-zone. The Chinese Economic Miracle has arguably run its Course Correcting Natural Excesses will Retard and Further Disrupt Global Economic Growth for more than a few Years. We count ourselves among skeptics who question whether financial statistics concerning the Chinese economy and its leading corporations hold much predictive validity. In the near term, we do not believe Chinas economy or accumulated wealth are large enough to drive needed global restructuring. We do not believe any other nation or existing supra-national authority has the required clout or will gain the necessary clout during the next year to bring down volatility in global financial markets and infuse fiat currencies with accepted and enduring value.

Entrenched Division will prevent the United States from Exercising Required Economic and Geo-Political Leadership.
Before November 2012, the Market will Appreciate that the U.S. Election will not produce a Clear Winner in the Contest between Re-Distributive Government and Responsible Free Enterprise. Even in what we view as a best case analysis, where a truly conservative economic ticket wins the Presidential contest, we believe that the Executive Branch will be forced to attempt governance while contending with a bitterly divided SUBJECT
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29 Draft of 1 December 2011 19:30:56 a1/p1 Congress. In a more likely scenario as of this moment, President Obama will be re-elected and then veer with his supporters even more radically in an anti-capitalist, anti-investor direction than he has done since January 2009. Key Protagonists in the United States will not get Realistic soon enough about the Gravity of the Debt Crisis. Economists and the public express concern about the rising level of government debt in the United States as a percentage of Gross Domestic Product. Since 1974, total government debt in the U.S. has risen from a low of 37.8% of G.D.P. to 80.5 % in 2010a level that remains well under the peak of 118.4 % reached in 1945 at the conclusion of World War II. To get a sense of the challenge involved in bringing the level of total U.S. debt in relation to private sector incomes closer to levels experienced in the recent past, we set forth below two sets of calculations. FIGURE 15: Estimated Changes Required Adjusting Total Leverage Ratios in the United States to Certain Historical Levels
($ Billions, except percentage amounts) 2010 Obama 948.0 19932000 Average Clinton 610.7 19811992 Average Reagan Bush I 533.7 19771981 Average Carter 378.5

President (s) Ratio of total debt/private income (%) Income at 2010 Levels; Debt Drops Drop required Ending debt Percentage reduction Debt at 2010 Levels; Income Rises Rise required Ending income Percentage increase

50,531.8

17,979.7 32,552.1 35.6

22,084.0 28,447.8 43.7

30,356.6 20,175.2 60.1

5,330.3

2,943.1 8,274.4 55.2

4,137.9 9,468.2 77.6

8,020.2 13,350.5 150.5

The mammoth debt reduction (more than $ 15.0 trillion) and/or private labor income gain (more than $ 2.5 trillion) required to bring the U.S. debt ratio into line with levels experienced during the Clinton Administration seem almost beyond ready comprehension. The gaps between present reality and either the Reagan/Bush I era or the Carter period are even more terrifying.

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31 Draft of 1 December 2011 19:30:56 a1/p1

V. WINNING
INVESTORS
MUST CHANGE

WITH A

LOSING HAND
IN THE

MINDSET TO LIMIT FURTHER EROSION REAL VALUE OF THEIR WEALTH

Before 2000, investors routinely prospered by assembling and re-assembling diversified portfolios without giving too much thought to wider economic and geo-political themes. If there is one over-arching message in this memorandum it is that intelligent investors can no longer afford to be so insensible. We believe the global system has already been buckling under the pressure of misguided government intervention, excess debt, and excess labor since September 2008. What is different in December 2011 is that the investing class and the wider public are finally developing a shared understanding of these conclusions and starting to act. To mitigate the risks we anticipate and to succeed in 2012 and beyond, sensible investors will have to make radical course corrections. THE PERILS
OF

PATRIOTIC INVESTING

IN

FIAT MONEY SECURITIES

Chief among patriot investors is Warren E. Buffett, long-time Chairman and Chief Executive Officer of Berkshire Hathaway. When the global economy swirled in a downward vortex on 16 October 2008, Mr. Buffett bravely advised readers of The New York Times: Buy American. I am. The first part of his argument was captured best in the following sentences:
To be sure, investors are right to be wary of highly leveraged entities or businesses with weak competitive positions. But fears regarding the long-term prosperity of the nations many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

The second part extolled the virtues of holding equities in an inflationary environment:
Today people who hold cash equivalents feel comfortable. They shouldnt. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary, and therefore accelerate declines in the real value of cash accounts. Equities will almost certainly outperform cash over the next decade, probably by a substantial degree.

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32 Draft of 1 December 2011 19:30:56 a1/p1 We do not agree much with Mr. Buffett19, but we share his manifest concern regarding the degree to which government (and central bank) actions are likely to cause continuing financial harm. Government actions that have depressed nominal interest rates have, in our view, done poor service to investors in the new millennium. As we have demonstrated above, the real value of most important asset classes (cash, debt, and equities) has been systematically eroded since 1999. With regard to securities, the most important valuation driver is realistic, intrinsic growth in revenues and in associated, recurring free cash flows. Decisions by central banks to reduce benchmark risk-free government bond yields have certainly propped up quoted prices for securities. But other government decisions and difficult-to-reverse, long-time demographic trends constrain fundamental growth in demand per household within Gray Zone nations, where economic activity remains concentrated for the moment. ASSESSING
THE

MARGIN

OF

DANGER

A second area where we actually agree with Mr. Buffett is in his echo of Ben Grahams astute warning to concentrate upon understanding the margin of safety inherent in any investment20. Writing in The Intelligent Investor21, Graham noted:
Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.

In situations such as those prevailing since September 2008, the margin of safety transposes to become a margin of dangersecurities trade at valuations far above their intrinsic worth and long-biased investors hold them and purchase them at their peril. In 1934, when Graham first coined the term margin of safety, securities (and particularly American securities) traded in thin markets well below their intrinsic worth. So much has changed since then it is no surprise that even sophisticated investors have embraced baffling behavior. When (and please note we do not use the word if) benchmark risk-free interest rates are forced for extended time periods closer to reasonable levels, a preponderance of securities will drop in value with equities leading
19

Mr. Buffett has failed to deliver acceptable rates of return to his investors since 1998. In our judgment, Mr. Buffett has strayed from the core principles espoused by his mentor, Benjamin Graham. We believe Mr. Buffett manages too much capital in an opaque format that cannot hope to out-perform managers who are more nimble, more open to short-biased investments, and willing to distribute realized returns to their investors. Three telling examples of his more recent mistakes are: his investments in financial weapons of mass destruction (derivatives); his hasty and ill-advised commitments to financial services firms such as General Electric and Bank of America; and his investment in IBM which is already a core holding for most of his loyal investors. 20 In the preface to the Fourth Edition, Mr. Buffett urged readers to pay special attention to Chapters 8 and 20. Chapter 20 is Margin of Safety as the Central Concept of Investment. 21 Page 512.

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33 Draft of 1 December 2011 19:30:56 a1/p1 the fall. After the correction, many will wonder why they stayed rooted to the ruinous course of chasing seductive dividend yields instead of staying true to the practice of fundamental analysis. Thirty years ago, those with capital to deploy remained gun-shy concerning equities. Since 1981, even after suffering considerable pain in real terms and risk-adjusted terms, most investors have become inured to the substantial risks posed by allocating capital to equity securities. Some of the fundamental investment risks that investors seem to ignore are captured below.
FIGURE 16: Selected Challenges to Achieving Investment Returns Denominated in Nominal Currencies Using a Traditional "Long-Only" Approach
Investor Tasks Consider alternative investments Identify preferred investment Acquire interest at attractive entry price Monitor investment performance Management Tasks

In steady State Perceive a market need Assemble resources to fit this need Obtain supplies Pay suppliers Pay operating and support employees Pay taxes Pay costs of complying with regulations Maintain productive resources Invest for the future Compensate executive talent Attract recurring customers Collect payment from customers Distribute free cash flow to equity holders

Sell interest for market value Pay taxes Receive and redeploy after-tax proceeds When Business is Sold Find purchaser Negotiate exit contracts Complete sale Sell interest for control value Pay taxes Receive and re-deploy after-tax proceeds

During the first quarter of 2012, publicly traded companies will release audited financial results for the full year 2011 and prior periods. Unlike in previous moments, research analysts and a growing band of more engaged professional investors will dig into details contained in these reports. We expect closer review to highlight that revenues for comparable collections of businesses will not show growth inside the United States, Europe and Japan, SUBJECT DISCLAIMER

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34 Draft of 1 December 2011 19:30:57 a1/p1 excluding exports. Enterprising investors who bother to estimate free cash flows by geographic region will also likely conclude that recorded trends inside the major, advanced economies are disheartening. When these more grounded investors bother to consider what sort of downside protection may exist in the form of tangible net worth22 and given true corporate leverage ratios23, they will accept the inevitable conclusion that traded valuation levels prove hype can triumph over realistic hope, even for extended periods of time. Were we to pick just one determinant of success in investing over the longterm, we would have to select entering at an attractive price. In our view, most equity securities continue to be traded at levels far higher than intrinsic worth. Measured in relation to free cash flows, most enterprises are significantly over-valued. In fact, we are sure there is a monumental margin of danger in the current market valuation of publicly traded securities. With limited exceptions, we also believe that sovereign debt does not offer a safe haven for long-term investors. No reliable, uniform standards have emerged that fairly capture the financial position and prospects for government entities. In our view, financial information concerning governments is even worse than for corporations. Following decades of lax policies, scant few central bankers are starting to do the responsible thing they are tightening credit standards and raising interest rates or threatening to do so. Many of the concerns expressed above have been lingering for years and have therefore weakened the innate senses of skepticism and caution to which a sensible investor must harken. We believe the system will not heal itself and that exogenous factors will exercise, catalytic, unpredictable, and destructive force during the period from now through January 2013. Inertia, benefits to those on top of the status quo and fears about consequences of fundamental change ensure that the flawed system will not be replaced from within. The specific obstacles include: (1) the lack of an accepted international governance structure; (2) little prospect for negotiating a new structure peacefully given rivalries and sharp differences in perspective and approach; (3) entrenched national governments; (4) multinationals operating outside effective control by governments; (5) protected markets for government workers versus open markets for private sector
22

We do not accept the theory that goodwill and intangible assets are even close to being hard assets. In our view, indefensibly low risk-free interest rates and what has become blind faith in the eroding value of the U.S. dollar, the Euro and the Japanese Yen have conspired to prop up all asset values well beyond reasonable levels.
23

Balance sheets do not give a fair picture of the kind of stress that will result in the downside scenarios we believe must be given consideration. Sensible investors need to evaluate contingent liabilities as well as dangers arising from potential disruption in the orderly functioning of credit markets..

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35 Draft of 1 December 2011 19:30:57 a1/p1 workers and (6) expert opinions are generally conflicted and thus mainstream view-shapers are unwilling to take on the system. As the foregoing discussion illustrates, government policies have significantly destroyed financial wealth since 1999. We expect the destruction to continue and intensify in the future. A weaker U.S. dollar, higher interest rates and price inflation will likely continue to reduce the value of fiat-denominated investments. We believe that investors should take steps to reposition their liquid portfolios immediately to protect against further destruction, to consider taking advantage of expected declines in the value of certain securities and to profit from heightened volatility. In summary, we endorse considering pursuit of the following general strategy. First, liquidate portfolio positions in: (1) long-dated U.S. Treasuries and other sovereign debt; (2) any fixed income obligations of highly leveraged companies; and (3) equity in financial companies and industrial companies that do not own precious metals, natural resources, or strategic minerals. Second, deploy proceeds in short-dated holdings of more responsibly run currencies such as the Norwegian Krone, the Canadian Dollar, the Swiss Franc and the Singaporean Dollar. Third, increase holdings of physical gold and other precious metals24 to as much as one-third the value of an investors total portfolio. Fourth, employ short investment strategies for special situations: (1) purchase credit default swaps (paying careful attention to counter-party and contractual risks) on sovereign debt, including U.S. Treasury obligations; and (2) take positions on overleveraged financial and industrial companies whose cash flows will be significantly and adversely affected by rising nominal interest rates. Fifth, purchase securities in underleveraged companies that have legally enforceable interests in scarce commodities such as precious metals, natural resources and strategic minerals. Sixth, consider allocating capital to professional investors who are equipped to trade volatility. CONCLUDING CAUTION Early one morning in December 1992, my young son and I rushed down to our hotel beach on Maui to find inviting waves but no other body surfers.

Here we caution that certain governments may elect to limit ownership of precious metals as has happened in the past.
24

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36 Draft of 1 December 2011 19:30:57 a1/p1 Reveling in our luck, we spent several minutes frolicking until, suddenly, I was slammed into hard sand, dazed but not seriously hurt and most fortunately still holding onto a giggling, unharmed child. That is when I came to my senses and finally noticed the ripping red flags I should have spotted well before entering the water. Traditional, long-only investors have been playing in the surf for too long, in our view. Busy chasing profits calculated in nominal terms, most investors have failed to discern their real after-tax wealth is being dissipated in a treacherous, unregulated global market that encourages devaluation of paper money. In these important weeks and particularly during 2012, we urge investors to keep this ancient and astute warning firmly in mind: It is the peculiar and perpetual error of human understanding to be more moved and excited by affirmatives than by negatives.25

25

Attributed to Francis Bacon (1561-1626).

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