Published by SL Advisors, LLC

In Pursuit of Value
January, 2011
Quarterly Outlook Back in September when I wrote our fourth quarter outlook, the likely direction for stocks and bonds was unusually clear. The difference between the earnings yield on stocks and punitively low bond yields had rarely been wider, strongly suggesting that bonds would be a poor investment and that stocks would outperform. Ten year treasury yields duly rose from 2.5% to 3.3% generating a loss of 5.5%, while the S&P 500 rallied from 1,141 to 1,258 returning 10.8% with dividends. Investing would be so simple if everything was so reliably obvious of course it rarely is, otherwise it would be everyones hobby. Economic growth remains solid and the recent tax deal combined with QE II have pushed most GDP forecasts closer to 4% than 3% for 2011. The Presidents Deficit Commission produced a serious roadmap to balance the budget. Alan Greenspan commented wryly that something like it would surely be adopted, the only question being whether it would happen before or after a crash in treasury bonds. However, after several days of somber comments from the Senate about burden sharing and tough choices ahead, gridlock was discarded and common ground quickly found in the form of lower taxes all around. The U.S. will always avoid another Depression no matter what the long term cost; the budget deficit will only receive serious attention when bond investors decide its time. Those two principles never fail to explain events in Washington, and are consequently never far from our thoughts. The case for higher bond yields is well known, and I wont repeat it here. Treasury yields have seemed too low for years, but reported inflation has remained low as well. Having risen around 1% from their QE II inspired lows, the recently established trend towards higher yields makes it very comfortable to expect further increases. Its rarely that easy, and Munis vs Corporate Bonds profiting from being in the consensus often (iShares Muni Bd (MUB) vs DJ Corp Bond Index) Jan 1, 2010 = 100 requires being nimble. We remain 112 underweight bonds in our fixed income 110 accounts, but by no means out of the market. We have securities to sell if yields head 108 back down towards 3%, and if yields drift 106 higher our goal is that coupon income 104 should compensate for capital losses. We continue to maintain 20% non-US$ 102 exposure to emerging market currencies Munis 100 (where growth, inflation and yields are Corp Bonds higher) and Canada (much better fiscal 98 management and large supplies of energy). 96 Fixed income investors have to look outside Dec-09 Mar-10 Jun-10 Sep-10 the U.S. for part of their return. Government policy (very low interest rates, quantitative easing, continued large fiscal deficits) continues to favor a weaker currency. An interesting but little noted feature of the markets is the weakening relationship between treasuries and equities. For several quarters stocks zigged when bonds zagged as the risk on/risk off trade played out. When falling equities were forecasting a double-dip recession the relationship made sense. The high negative correlation between the two made inclusion of treasuries a smart risk reducing addition to most portfolios, and therefore pushed down their yield. Finance theory can show that an asset thats highly negatively correlated with a portfolio doesnt need to generate much return for its inclusion to be

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worthwhile through reduced overall risk. While the mathematical proof is complex, the simple explanation is that as equities and bonds become less synchronized and move independently of one another, bonds are becoming less valuable to portfolio managers, and their yields should rise. In Equities we like exposure to global growth, energy, transportation and commodities. We continue to focus on companies with strong balance sheets, tangible assets and a shortage of enthusiastic buyers. The natural gas exploration and production (E&P) sector offers all of these features. Shale gas extraction technology has created an abundance of cheap domestic natural gas in the U.S., depressing the prices of many stocks in the sector while creating a clear opportunity to reduce our dependence on Middle East oil. Natural gas burns cleaner than crude oil (and much cleaner than coal), is one third the price of oil on an energy equivalent basis, and is here rather than over there. Whats needed is for the U.S. to adopt a selfinterested energy policy that uses taxes and subsidies to guide energy consumption towards a more domestic mix of sources. As I found on a recent trip to Texas to meet many of these companies, the status quo has many well financed proponents in Washington. Big Oil writes big campaign checks, and the Coal industry is old and heavily unionized. The American Natural Gas Association is barely two years old and has yet to find an effective voice for the industry in Washington. However, energy policy may be one area where a newly-centrist President can find common ground with victorious Republicans; meanwhile, were invested in natural gas E&P companies that have strong balance sheets, low costs of production and potential reserves worth substantially more than their current market value. Range Resources (RRC), Comstock Resources (CRK), Southwestern Energy (SWN) and Petrohawk Energy (HK) are all either current holdings or could be at modestly lower prices. SL Advisors, LLC focuses on identifying securities that are trading at a discount to intrinsic value. Shipping is another sector we like, with its exposure to global growth and tangible assets. Some of the stocks trade below the secondary market value of their ships supply of new ships over the next several years is weighing on long term charter rates as well as stock prices. However, well run companies with conservative balance sheets can be found. We like Overseas Shipholding Group (OSG), Genko Shipping (GNK) and Euroseas (ESEA). An interesting complement to this strategy is our recent investment in Aegean Marine Petroleum (ANW) which provides fuel to the shipping industry. In a variation of selling pick axes to gold miners, should the supply of new ships surprise on the upside this will at least create more demand for ANWs services. Ive never been attracted to municipal bonds. Opaque pricing makes it an unnecessarily profitable product for brokers, and many people focus too much on reducing taxes rather than maximizing their real after tax investment returns. Munis are looking like a bet on (i) the economic recovery being sufficient to drive up tax revenues and close budget gaps, and (ii) the willingness of states and the Federal government to engage in bailouts as needed. Most muni investors suffered negative returns in 2010 and substantially lagged high grade corporate bonds. The market still faces many headwinds: no more Build America Bonds; outflows from bond funds; no tax increase and the disdain of Meredith Whitney (who is reprising her early negative calls on bank stocks four years ago with dire warnings of municipal default). Ms. Whitneys forecasts may or may not be accurate her critics highlight low historical default rates which is the same backward-looking analysis that preceded the mortgage collapse. In any case its difficult to profit directly from lower municipal bond prices although theres little doubt that state and local governments face pressure to spend less. To that end were invested in companies that do what they do more efficiently than the public sector. Corrections Corp of America (CXW) is the largest private operator of prisons in the U.S. Public sector prisons suffer from chronic overcrowding as well as an expensive unionized workforce (who naturally oppose privatization and its use of non-union prison guards). CXW has the cost structure and capacity to help relieve budget pressures in many states, and has a business less correlated with GDP than most others. Another investment in that theme is Republic Services Group (RSG), the second biggest waste management company in the U.S. While their fortunes are tied to economic growth (since a stronger economy produces more trash) theyre also in a position to grow through acquiring inefficient municipal and other local governmental waste operations whose fragmented structure allows RSG to run them more efficiently. Finding ways to profit from the depressing picture presented by state budgets is in some respects a personal hedge Ms. Whitney lists New Jersey (where we live) among her five states with the worst fiscal outlook.

Fixed Income Strategy Monthly Returns (%)

Jan 2009 Index 2010 Index 2.7 1.5 1.5 0.4 2.7 0.3 1.8 1.8 -2.1 -0.6 0.3 2.2 Feb Mar April May June July 9.6 7.0 0.8 2.2 Aug 4.3 1.5 0.8 1.9 Sept 6.3 2.2 1.0 0.6 Oct -1.2 1.5 0.3 0.1 Nov 1.8 1.6 -1.0 -0.8 Dec 1.4 -1.5 0.0 -0.8 YTD 24.0 12.7 9.0 8.8

Returns do not include cash balances prior to November 2009. YTD returns are unannualized compounded returns. The Index is the Dow Jones Corporate Bond Index, an equally weighted index of 96 investment grade bonds. Returns are net of fees. Past performance is not indicative of future returns.

Deep Value Strategy Monthly Returns (%)

Jan 2009 Index 2010 -1.3 -3.6 4.3 3.1 3.9 6.0 3.1 1.6 -3.9 -8.0 -4.6 -5.2 Feb Mar April May June July 8.9 7.6 4.9 7.0 Aug 0.6 3.6 7.2 -4.5 Sept 9.3 3.7 7.8 8.9 Oct 1.6 -1.9 1.2 3.8 Nov 1.4 6.0 1.0 0.0 Dec 9.7 1.9 2.7 6.7 YTD 35.4 22.6 28.8 15.1

SL Advisors runs three separate strategies: Fixed Income, Deep Value and Discount Arbitrage. Contact us for more information, or go to our website:
www.sl-advisors.com

Index

Returns do not include cash balances prior to November 2009. YTD returns are unannualized compounded returns. The Index is the S&P 500 including dividends. Returns are net of fees. Past performance is not indicative of future returns.

Discount Arbitrage Strategy Monthly Returns (%)

Jan 2009 2010 0.8 0.0 -0.7 -0.8 -0.6 1.3 0.1 1.6 1.4 -0.1 Feb Mar April May June July Aug Sep Oct Nov -0.2 0.1 Dec 0.9 0.8 YTD 0.7 4.0

YTD returns are unannualized compounded returns. Past performance is not indicative of future returns.

SL Advisors offers separately managed accounts for individuals, family offices and institutions across three different investment strategies. Client assets are held with Charles Schwab, the largest provider of custody services in the U.S. with assets of $1.36 trillion and 7.9 million individual accounts (as of June 30, 2010). Client portfolios are completely transparent via Schwabs extensive website which provides real-time access to accounts and all supporting information. Detailed monthly statements are mailed directly to clients from Schwab. SL Advisors Fixed Income Strategy A diverse portfolio of U.S. government debt, investment grade corporate credit, bank debt, and sovereign emerging market debt. The objective is preservation of capital combined with income generation. The portfolios exposure to interest rates and credit spreads changes depending on the managers outlook and assessment of relative value opportunities in each sector. Income generating investments with appropriate risk are favored when interest rates are stable or rising, while longer duration investments are selected when interest rates are falling. Investments are through ETFs, listed closed end funds and U.S. government securities. This strategy represents the fixed income allocation for balanced accounts, and is most appropriate for individuals, family offices and smaller institutional accounts. SL Advisors Deep Value Equity Strategy A portfolio of 10-20 names that are deeply undervalued. Investments are in listed U.S. equities trading significantly below the value of their tangible assets. In addition, they must have a strong balance sheet with relatively low debt and are likely to be underperforming similar securities in the recent past. Industries include energy, mining, shipping, infrastructure and others with hard assets where tangible value can be assessed. Potential investments are identified through a proprietary screen following which detailed research is performed to assess underlying value. The likely holding period is generally at least several months but can extend to one or two years until value realization occurs. The portfolio is reassessed regularly and all holdings are rated for return potential and risk against their peer group, which often results in rebalancings to upgrade into more attractive opportunities. This strategy is part of the equity allocation for balanced accounts for individuals, and is also appropriate as a deep value equity strategy for institutional accounts. SL Advisors Discount Arbitrage Strategy This portfolio consists of several sub-strategies that seek to extract value from pricing inefficiencies while minimizing market risk. One sub-strategy holds the same positions as the SL Advisors Deep Value Equity Strategy combined with a market hedge. Another sub-strategy takes long positions in closed end funds that are underpriced and hedges out the market risk. A third sub-strategy invests in special situations where a pricing inefficiency can be identified and isolated from overall market risk. Occasionally other sub-strategies will be employed when opportunities appear. Securities used include equities, listed closed end funds and ETFs. Broad equity market exposure is hedged away so this strategy is managed on a market-neutral basis to generate steady returns that are uncorrelated with other major asset classes, and is appropriate for institutional accounts.

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