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"Keep the company of those who seek the truth;
run from those who have found it"
— Vaclav Havel
A letter to investors from
Novo Capital Management, LLC
2010 – 3rd Quarter Letter to Investors
Page 1
Novo Capital Mgmt
210 Jamestown Park, Suite 201
Brentwood, TN 37027
Tel. 615-377-0443
PERFORMANCE UPDATE
In the 3rd Quarter of 2010, Novo Fund, LP (the “Fund”) recorded investment performance of
1.4% under-performing the S&P500 (10.7%) by 9.3%. We ended the quarter with 100% of the
Fund invested in long positions and 22% in short positions. Our Net Exposure was 78% as of
September 30, 2010. Exhibit 1 shows 3rd Quarter returns for the Fund compared to key indices.
Exhibit 1: Performance Third Quarter 2010
1st
Quarter
Novo Fund, LP 15.4%
S&P 500
4.9%
NASDAQ
5.7%
DJ Industrials
4.1%
2nd
3rd
4th
Quarter Quarter Quarter
-10.2%
1.4%
-11.9% 10.7%
-12.0% 12.3%
-10.0% 10.4%
YTD
Since
2010 Inception
5.1%
17.6%
2.3%
-22.3%
4.4%
-10.7%
3.5%
-18.7%
.
Source: Novo Capital Management, LLC and Partnership Financial Consulting, LLC.
Exhibit 2 shows, despite lagging returns in the 3rd Quarter, our performance has been consistently
stronger and better than the market. Through the 2nd Quarter of 2010, the Fund has delivered
6.1% 1 compounded annual growth since inception in January 2008. This performance exceeds the
S&P500 by 14.8% per year as the index’s compounded annual return is -8.8% over the same
period. While our track-record is relatively short, it covers, perhaps, the most challenging
investment environment in the last 70 years. Though we underperformed in 2009 by 10%
(+13.4% vs S&P500 at 23.5%), our long portfolio was up 70% annualized. The takeaway: the
Fund stayed in cash a little too long. In the end, our decision to stay in cash helped us a great deal
more than it hurt us given that we out-performed in 2008 by 34% (-4.4% vs S&P500 at -38.5%).
Exhibit 2: The Scorecard 2 Thru the 3rd Quarter of 2010
2008
2009
2010 YTD thru 3Q10
Annualized thru 3Q10
Yearly
Cumulative
Novo Fund S&P 500
Diff
Novo Fund S&P 500
Diff
-4.4%
-38.5%
34.1%
-4.4%
-38.5%
34.1%
17.0%
23.5%
-6.4%
11.9%
-24.1%
36.0%
5.1%
2.3%
2.7%
17.6%
-22.3%
39.9%
6.1%
-8.8%
14.8%
The Fund returns in Exhibits 1-2 above were calculated by Novo Capital Management, LLC or its administrator, Partnership Financial
Consulting, LLC, all returns for 2008 were audited by Habif, Arogeti and Wynne, LLP, all returns for 2009 were audited by Joseph
Decosimo and Company, PLLC and the returns for 2010 are unaudited. The Fund returns in the exhibits above are net of applicable
Fund expenses but do not reflect deductions for management fees or performance fees because current Novo Fund investors are not
charged management or performance fees. The S&P 500, NASDAQ and Dow Jones Industrial Average are well-known stock market
indices, which are included merely to show the general trends in the equity markets in the periods indicated and are not intended to
imply that Novo Fund’s hypothetical portfolio was comparable to the indices either in composition or element of risk.
While disappointed by our under-performance in the latest quarter, I am pleased to report strong
relative performance during 2010 and since inception. I believe that following our investment
strategy will enable us to continue to deliver positive results.
1
As detailed in prior quarterly letters (available upon request), our actual, audited performance in 2009 is lowered by
the administrative delay in the transfer of $2.24 million out of the Fund in the 3rd Quarter of 2009. For practical
purposes, we were unable to invest the $2.24 million after June. In this letter and prior letters, we show performance as
if the transfer of $2.24 million occurred on June 30, 2010 instead of August 31, 2010. This adjustment affects all
performance periods that include 2009.
2
Id.
2010 – 3rd Quarter Letter to Investors
Page 2
Novo Capital Mgmt
210 Jamestown Park, Suite 201
Brentwood, TN 37027
Tel. 615-377-0443
MARKET COMMENTARY
Thus far 2010 has been a good year for Fund investors, compared to the market. Nevertheless, I
am not happy about losing a large portion of the lead we built versus the market after the 1st
Quarter. Our recent under-performance is a function of expectations for a choppier market rather
than one that rose so strongly. The performance of our Long Portfolio during the quarter matched
the S&P500. Our short portfolio caused our under-performance.
Disclaimer. I am not an expert in macro-economics or monetary policy. Under more normal
conditions, I do not believe an equity portfolio manager would need to be concerned much with
the macro forces as mis-priced stocks tend to exist in all types of environments. However, in the
current environment, an equity portfolio manager has a greater obligation to understand and
assess macro-economic forces such as monetary and fiscal policy given the degree to which they
have affected the rationality of equity markets. Stocks, over the past three years, have moved
more from reaction to changes in the macro-economic environment, which affects all stocks, than
in reaction to changes in the individual future cash flows streams, which affects individual stocks
differently, in my opinion. Empirical evidence of this trend can be found in a recent report by JP
Morgan called “Why We have A Correlation Bubble”. This report shows that correlations
between individual stocks are at the highest level in recent history. In other words, stocks are
tending to move together and in the same direction more than anytime over the prior thirty years.
This phenomenon is a function of the herd mentality that results from the Rise In The Speculative
Movement as defined in the Market Commentary section of my 2nd Quarter Letter to Investors.
Despite the current environment, we remain disciplined value investors not market-timers. I
continue to believe that market conditions will increasingly reward our exacting analytical rigor
especially as the End of the Speculative Movement approaches.
Expectations for 4th Quarter of 2010. We plan to continue to allocate capital to our Short
Portfolio opportunistically as we believe the strong market performance in the 3rd Quarter reflects
adequate optimism about the medium to long-term prospects for our economy and corporate
profits. These expectations, in my opinion, come primarily from the belief that Federal Reserve
Chairman Ben is willing to do whatever it takes (aka “Helicopter Ben”) to keep the market and
economy buoyant. This belief blew wind into the sails of the Speculative Movement. I expect this
belief will gradually wane because the end of loose, easy monetary policy, in my opinion, has
begun. I think the end first appeared on the horizon on October 19, 2010 when China’s
Communist Party announced an interest rate hike and signaled a clear shift in policy toward
ensuring more rational and deliberate capital allocation. This announcement is an historic event
given the Party’s 15-year track record of maintaining growth-at-all-cost policies.
Why Tighter Monetary Policy Reduces Speculation. It is easier to begin the answer to this
question with explanation of how I believe that loose, easy money encourages speculation. First,
people are less fearful of losing money when it is cheap, in high supply and easily accessible.
Second, low interest rates lower the incentive to save thereby increasing the incentive to take risk.
Third, lower interest rates mean a lower cost of capital, which lowers the risk of making
investments and lowers the bar for business success. Therefore, people see more opportunities
and less risk, which creates an environment conducive to asset price bubbles and “irrational
exuberance” as more people seek to cash in on the easy money-making opportunities (e.g.
Greenspan policy around the turn of the century). When money is tighter (i.e. more expensive and
in lower supply), people are more deliberate and diligent about what they do with their money.
They are less inclined to make speculative bets. They are more fearful of losing money because
2010 – 3rd Quarter Letter to Investors
Page 3
Novo Capital Mgmt
210 Jamestown Park, Suite 201
Brentwood, TN 37027
Tel. 615-377-0443
they know it may be harder to borrow. In many ways, loose money is the fuel that keeps the
speculative fires burning. Without cheap, easy money, speculating becomes much riskier and less
attractive.
First Sign of the End of Loose Money: China’s Decision To Remove the Wen Jiabao Put.
Like the “Greenspan Put” supporting high expectations for growth in the U.S. around the turn of
the century, the Wen Jiabao Put represented the expectation that the Chinese government would
do whatever it takes to keep GDP growth greater than 8%. Therefore, investors felt comfortable
placing bets that relied on and benefited from 8%+ GDP growth in China just as investors felt
comfortable piling money into the U.S. housing and capital markets during Greenspan’s tenure.
China removed the Wen Jiabao Put on October 19, 2010 when China’s Communist Party
announced an interest rate hike and signaled a clear shift in policy toward ensuring more rational
and deliberate capital allocation. As mentioned above, I believe this announcement is an historic
event given the Party’s 15-year track record of maintaining growth-at-all-cost policies. China’s
underscored its dedication to the policy change when its central bank announced it will raise
bank’s reserve requirement ratio by half a percentage point on November 10th.
Why Remove the Wen Jiabao Put? Benefiting from seeing mistakes of more advanced
economies, China’s leadership, in my opinion, is taking pro-active steps to avoid the gross
misallocations of capital that result from bubbles in asset prices. By signaling that they will no
longer maintain super low rates that enable loose money and encourage the borrow-and-spend
mentality required to maintain 8%+ GDP, I believe China’s leadership recognizes that the true
growth rate of its economy is lower than 8%. Therefore, artificially spurring growth to higher
levels in the short-term only undermines long-term growth potential by wasting capital and
resources on low-return activities and projects when it could be allocated to higher return
opportunities. In other words, China recognizes the fact that keeping interest rates artificially low
does permanent long-term damage to its economy. For more on how keeping rates artificially low
harms economies in the long term see Appendix 1. As China aims to transition from an exportdriven economy to one that maintains better balance with domestic consumption, it is especially
important to ensure the prudence of capital allocation.
What Does China’s Shift In Policy Mean for the U.S.? First, I believe that China’s decision to
tighten their money supply will also tighten money in the U.S. Higher interest rates in China will
divert capital from U.S. securities back to China. Note that China is one of the largest holders of
U.S. Treasuries. China’s plans to reduce its current account surplus will likely drive a reduction in
our current account deficit. And over time, as the value of China’s and other emerging
economies’ currencies continue to rise, the spending subsidy created by the super-cheap goods
from China will dissipate. In addition, China’s policy shift toward tighter money puts U.S.
politicians and regulators on the clock for following suit or risking major long-term damage to
their legacies, in my opinion. As explained in my 4Q09 Letter to Investors, “one benefit of the
24-hour news cycle is that more people know more about global affairs, which forces politicians
to be more proactive to ensure their country does not repeat the mistakes of others.” Counterbalancing the pressure from China is the fact that politicians will be vilified for supporting or
doing anything that may make the economy worse in the short-term. Unfortunately, our
democratic political system makes it very difficult for elected officials to make the best decisions
for the long-term if they cause any short-term pain. As detailed in my blog post Private Sector to
the Rescue, many politicians and regulators are more focused on getting re-elected or keeping
their job than acting in the best long-term interested of their constituents. Their focus is on
serving the needs of the present and anything that might not improve their ratings until after their
term of office or service is not likely on their radar. In this (albeit narrow) context, one could say
2010 – 3rd Quarter Letter to Investors
Page 4
Novo Capital Mgmt
210 Jamestown Park, Suite 201
Brentwood, TN 37027
Tel. 615-377-0443
that being a Communist country gives China’s political leaders an advantage over U.S. political
leaders. They do not have to worry much about getting re-elected. Consequently, they need not be
as focused on serving the whims of election cycles and can enact policies that despite causing
short-term pain are in the best long-term interests of their country.
The Beginning of the End of Loose Money: Level Of QE2 Stays Steady Despite China’s
Tightening. It appears that the Federal Reserve is already on the same page as China given their
decision to keep QE2 on the low to middle range of expectations after removal of the Wen Jiabao
Put. If the Fed really wanted to boost money supply, it seems it would have had to increase the
level of QE2 to offset the tightening created by China. The Fed’s decision is consistent with its
strategy to provide credit and financial support in an extraordinarily precise manner. In other
words, money has, for the most part, been made loose only to those who have needed it most (e.g.
TALF and MMIFF) 3. Overall money supply growth has been quite tame since the beginning of
2009 because the Fed so accurately delivered the credit to its targeted recipients who quickly (and
thankfully) soaked it up. As a result, very little, if any, excess liquidity spilled over into
imprudent hands as indicated by the current low inflation and low capacity utilization. QE2
follows the same strategy and is aimed primarily at banks to encourage more lending to small and
medium-sized businesses 4. In addition, the Fed has taken unprecedented action to keep the cost of
capital higher and the yield curve flatter by paying banks a small, but significant fee for reserves
they deposit at the Fed. This new payment system also takes the cheapest money out of
circulation because it encourages banks to leave more funds on deposit at the Fed rather until they
identify a more profitable alternative. By keeping the yield curve flat, QE2 pressures banks to
make more higher-return loans as investing in treasuries and short-term facilities provides a lower
and lower profit margin. The Fed’s strategy is to increase money supply through increased bank
lending, which tends to drive growth in business investing which, in turn, creates jobs. Note that
this approach to increasing money supply indicates the Fed is focused on ensuring that money is
allocated to where it can be productive and earn good returns, assuming, of course, that banks are
back in the business of making prudent loans. In addition, QE2, by keeping mortgage rates low,
effectively eases the debts of homeowners and helps households survive the low-employment
environment. In my opinion, the Fed’s recent announcement sends a clear message to the current
political administration: “we have done the best we can do with our monetary policy tools, now it
is your turn to get fiscal policy on track.” Not coincidentally, the Fed’s message encores the
desire for better fiscal policy communicated by the electorate one day earlier.
What Will The Fed Do Next. I think Mr. Bernanke is quite pleased with the current situation. He
wants the markets, despite his actions to the contrary, to think that he is willing to print as much
money as needed to keep the economy growing and keep consumer sentiment sanguine about
economic prospects. He knows that on the margin positive consumer sentiment is required for
economic growth. He is in the business of managing expectations. Accordingly, I think he will
continue to lean toward keeping rates and money supply flat while adjusting to changes in the
pace of economic recovery. As long as the economy continues to improve steadily, I think the
Fed will, albeit very gradually and slowly, lean toward tightening until we see a sustained
rebound in job creation. I believe that optimal implementation of monetary policy results in
gradual and sometimes imperceptible changes in the economy. The Fed is in the business of
3
This assertion is derived from the illuminating report from GaveKal research: “QE2-The Fifth Phase of the Fed’s
Crisis Response”.
4
Most bank lending to businesses has been to large corporations who have hardly needed it. Many borrowed just to
refinance more expensive, pre-existing debt. Banks have remained resistant to adding any risk and have been content to
ride the yield curve as the health of their loan portfolios improves.
2010 – 3rd Quarter Letter to Investors
Page 5
Novo Capital Mgmt
210 Jamestown Park, Suite 201
Brentwood, TN 37027
Tel. 615-377-0443
smoothing business cycles not amplifying them. It is admirable that Mr. Bernanke’s strategy todate has not resulted in any sudden or jerky changes in our economy. Going forward, I think the
Fed will continue to minimize the amount of excess liquidity in the system to avoid the need for a
sudden or large increase in rates that would be required by a sudden, large increase in inflation.
My opinions are based on the beliefs that:
x Mr. Bernanke is keenly aware of the steep fall from grace experienced by Mr.
Greenspan for keeping rates too low for too long.
x He knows his legacy will most likely be formed over the next several months and
that he is smart enough to know that his performance will be measured more by
his long-term results than short-term as was the case with Mr. Greenspan.
x As an economist, he is keenly aware of how keeping interest rates too low for too
long undermines the long-term growth potential of an economy- as discussed in
Appendix 1.
The $64 zillion Question: What About Fiscal Policy: Will U.S. politicians choose to follow
Bernanke’s lead and do what is best for the long-term or the short-term? The answer probably lies
somewhere in the middle and will rely on the interplay of the following dynamics:
1. The biggest bottleneck for job creation is business pessimism, which is due almost
entirely to concerns over taxes, the impact/cost of healthcare reform and changes in
regulation 5.
2. GOP takeover of the House of Representatives signals a strong desire by the electorate
for fiscal policy reform and probably means that the President will be forced to practice
less partisan politics. It also means that financial regulatory and health care reform will
draw lots of scrutiny as that legislation is gradually implemented.
3. The pressure of China’s fiscal and monetary decisions will not abate as the Red State’s
economic decision-making will likely continue to favor long-term prosperity over shortterm appeasement.
4. A deadlocked Congress could make passing any new legislation quite difficult.
5. The President’s track record to-date has not been very business friendly.
Conclusion. The end of the Speculative Movement and the momentum-investing fad means we
are entering an environment more conducive to value investing or, more specifically, an
environment where skill in assessing the true economic profitability and valuation of companies
will determine the success of stock-pickers. As I have stated before, I believe very few money
managers can rival Novo Capital Management’s ability to assess profitability and valuation. For
recent examples of the insights we garner from analyzing Financial Footnotes, I encourage to
read the reports in the Red Flags and Hidden Gems section of my blog. These reports demonstrate
the unique depth and breadth of our research capabilities.
The rare combination of expertise in accounting and finance 6, information-processing technology,
and discipline embodied in Novo Capital Management position us, in my opinion, to continue to
be successful in managing our client’s assets for the foreseeable future.
INVESTMENT STRATEGY
5
According to the NFIB’s Small Business: Problems and Priorities report and as highlighted in GaveKal research:
“QE2-The Fifth Phase of the Fed’s Crisis Response”..
6
David Trainer, “Modern Tools for Valuation” in The Valuation Handbook – Valuation Techniques From Today’s Top
Practitioners, (Hoboken: John Wiley & Sons, 2010), 182
2010 – 3rd Quarter Letter to Investors
Page 6
Novo Capital Mgmt
210 Jamestown Park, Suite 201
Brentwood, TN 37027
Tel. 615-377-0443
The Novo Fund’s strategy remains unchanged. It aims to exploit inefficiencies in the stock
market by seeking to own the most undervalued stocks and short the most overvalued stocks. We
believe we are qualified to implement this strategy, based on our superior knowledge of the
economic valuation of 3000+ stocks. This base of knowledge enables us to trade portfolios of
inefficiently priced stocks. It is important to note that we are not market timers and that we
believe that no one is capable of predicting the future. We believe that our advantage lies in being
able to identify groups of stocks that are most likely to be re-priced as the market, over time,
rectifies misperceptions of economic value created by investors employing less analytical rigor
than we. We derive our advantage from the in-depth analysis of financial statements, especially
the notes to the financial statements, which we apply to the analysis of the underlying economic
value of 3000 firms. We believe our exacting approach to research gives us advantage in the
selection of individual securities for our long and short portfolios as well as in determining the
relative weighting of long and short positions in the Fund.
Please see the INVESTMENT STRATEGY section of my 2nd Quarter Letter to Investors for
more details.
In addition for examples of successful long and short positions that our research has delivered in
the past, please see my Case Studies in the Novo Fund pitchbook.
ADMINISTRATIVE DISCLOSURES
Novo believes that we have very significant investor safeguards built into our structure. All assets
in the Fund are held in custody at J.P. Morgan. Our administrator, Partnership Financial
Consulting, LLC, prepares and distributes monthly and quarterly results. Joseph Decosimo &
Company, PLLC audits our annual results. Seward & Kissel LLP performs the Fund’s legal work.
The initial minimum investment in the Fund is $1,000,000, subject to waiver in the sole discretion
of the Fund’s general partner.
FINAL THOUGHTS
We are honored by the confidence that you have shown in us by your investment in the Novo
Fund, LP. We remain focused on maximizing returns on your investment. We enjoy working hard
to further develop the analytical advantages that enable us to assess the profitability and valuation
of stocks more accurately.
David Trainer
Managing Partner
Novo Capital Management, LLC
210 Jamestown Park, Suite 201
Brentwood, TN 37027
[email protected]
2010 – 3rd Quarter Letter to Investors
Page 7
Novo Capital Mgmt
210 Jamestown Park, Suite 201
Brentwood, TN 37027
Tel. 615-377-0443
Appendix 1
How Artificially Low Interest Rates Harm Economies in the Long Term. Maintaining
artificially low interest rates or excessive money supply does permanent damage to economies in
the medium and long-term because it delays creative destruction, the process of replacing lowreturn investments with higher-return investments. To help illustrate this point, I present the
“Investment Opportunity Schedule” in Exhibit 3, which plots the number of investment
opportunities against the level of potential return for each opportunity. The most important
takeaway from Exhibit 3 is that lowering the cost of capital increases the number of profitable
investment opportunities at the low-return end of the spectrum. Naturally, investors gravitate to
the easiest ways to make money and will allocate capital to low-return endeavors as long as those
low-return endeavors are profitable. The longer interest rates are low and money is cheap, the
more capital gets allocated toward the lower return activities. Simultaneously, as low-return
activities attract excessive levels of undeserved capital, high-return activities are starved for
capital. Therefore, artificially low interest rates subsidize investment in low-return opportunities
at the expense of investment in high-return opportunities.
Exhibit 3: Limited High Return Opportunities – Unlimited Low Return Activities
Investment Opportunity Schedule
High
Cost of Capital
Lower Cost of Capital
Low
Low
# of Investment Opportunities
High
Source: Novo Capital Management, LLC as adapted from The Quest For Value by Bennett Stewart.
This exhibit also illustrates some key facts about capital allocation:
1. There is a finite number of profitable business/investment opportunities, which means
there is a finite supply of capital as well. If not, then financial capital and wealth would
be infinite.
2. The higher the potential return on an investment opportunity, the more competitive the
business and the more difficult it is to maintain a high return on investment
3. There is an infinite number of low-return and money-wasting opportunities.
As long as the interest rates are kept artificially low, profit from lower-return businesses is
possible even if it is not sustainable. Hence, the short-term benefits of artificially lower rates are
that they keep more businesses operational and slow the decline of existing jobs and consumer
spending – which is what helps keep politicians in office and regulators employed. However,
2010 – 3rd Quarter Letter to Investors
Page 8
Novo Capital Mgmt
210 Jamestown Park, Suite 201
Brentwood, TN 37027
Tel. 615-377-0443
since there is a finite amount of financial capital, the opportunity cost of subsidizing investment
in low-return opportunities is lost opportunity to invest in high-return opportunities. I believe that
the longer this pattern persists, the more damaging and the larger the permanent loss of capital,
the longer the delay in creative destruction and the lower the long-term growth potential of an
economy.
I believe the Investment Opportunity Schedule also applies to the capital markets. In the context
of the equity capital markets, speculative investors are those that flock to the easy and plentiful
low-return opportunities that emerge in low-interest rate environments. Their investment returns
rely much more on other speculators following them than on the value created by the underlying
businesses they choose to own. Value investors make their money by finding stocks at the
opposite end of the spectrum: the few high-return opportunities 7. In the same way that artificially
low interest rates lower the long-term growth potential of economies, speculative investing
lowers the long-term growth potential of capital markets because it drives allocation of capital to
lower-returning investments. In fact, taken to its logical conclusion, artificially low rates and
speculative investing can eventually, if left in place for too long, ruin economies and markets
entirely. In addition, speculators, like low-return investors, can be put out of business quite
quickly when rates rise or money gets tighter.
7
In my opinion, Novo Capital Management’s proprietary research platform enables us to identify more of those highreturn opportunities than many other firms.
2010 – 3rd Quarter Letter to Investors
Page 9