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P.O. Box 6643, Annapolis, MD 21401 410.224.


Third Quarter

October 2011

Here we go again. Markets around the world tumbled in the quarter just ended, on ongoing debt concerns and a slowdown in the global economy. Investors fear a repeat of 2008. Notwithstanding our concerns about the global situation, two essential differences are discernable. First, the debt problems are well known and have been headline stories for the past year; housing and credit bears were sidelined in 2007 and early 2008. Secondly, asset prices, including real estate and equities, are not nearly as overpriced as they were three years ago. Indeed, in many cases they are reasonable value. So, while far from complacent about the economic and financial outlook, or the markets in the near term, and while looking for sensible opportunities to raise cash, we are not panicking, realizing that six months, a year from now, prices will be higher.

Stocks and other assets all fall

Stocks in particular were hurt this past quarter, on top of weak performance earlier in the year. In the U.S., the broad S&P Index fell 14%, with only the utilities sector up (and that by just 0.4%). Overseas, the damage was worse, with non-U.S. stocks (per MSCI) tumbling over 20%. All regions fell sharply, with Latin America the worst; Brazil is now off 33% for the year. Commodities also fell, thoughsurprisingly if you only read the headlinesless than most stock markets. Commodities themselves (per DJ-UBS) were down just over 11%, led by silver and copper (the latter down 25% in September alone); gold, despite its recent stumble, is still up on the quarter. Gold stocks however fell, with the XAU index of senior stocks down 8%, while most smaller stocks fell far more.

Our accounts fell a little less, but fell nonetheless

Not surprisingly, with double-digit losses in virtually every market and every sector, our accounts also fell, giving back some of what we gained last year. Our global accounts were down between 12% and nearly 14%--far less than global indices but nonetheless significantly negativewhile our gold and resource accounts fell 11% and 12% respectively, somewhat worse than the major stocks though in line with the broader sectors.* Since we have now used most of the cash that we built up earlier, picking up stocks in both the resource and broader markets over the past few months, we were nearly fully invested for most of the quarter, and so accounts fell in line with the broad markets. We declined less than the global market indices because, for the most part, we avoided the worst performers: Brazil and Latin America, France, Italy, Germany, and emerging markets in Asia. In the gold and resource accounts, we were generally comparable with the broad sectors, though our use of options helped generate some additional returns. As for currencies, though the dollar overall rose during the quarter, our major holdings in the Singapore and Hong Kong dollars were up moderately.

Selling quality at low valuations is not a good idea

Where are we now? Certainly, as we have discussed and will again in this Review, we are concerned about the global financial outlook. We are looking to raise cash where it makes sense, particularly where the risk on a specific stock has grown and is high in absolute terms, regardless of any potential increase.

But for the most part, the stocks in your portfolios represent ownership in solid companies that will survive, while the stocks themselves are frequently trading in single-digit price-to-earnings multiples; or below net asset value; or pay reasonable dividends. These are all measures of acceptable value. Markets overall are selling at valuations lower than they did for most of the past decade, other than perhaps a few weeks at the beginning of 2009. If the companies are positioned to survive, it seems panicky, or at least very short-term oriented, to sell at these levels. So, once again, we are holding inexpensive, quality companies, riding out the volatility, and will no doubt look back 12 months from now and be astonished at the low prices that were available. Where cash is available, we are buyingselectively, no doubt, and in a disciplined mannerbut buying nonetheless. I dont know when the turn will come, but we want to be positioned when it does.

Medicine more worrying than disease

The U.S. economy is perhaps stumbling towards another recession, perhaps just stagnating to a period of extremely low growth and high unemployment. This has been clear for a while, as unemployment remains stubbornly high, while housing is not recovering in any meaningful sense. More distressing, however, is the policy response. The Federal Reserves Bernanke is clearly clueless as to why his policy prescriptions to date have had no effect. (We would argue the impact has been negative, but lets view it from Bernankes traditional point of view.) Finally, the public has awoken to the evident fact that the Fed chief is no maestro, no magician who can wave his wand and make everything better. This realization has driven asset prices down. To those of us who have been distrustful of the Fed ever since we were first sentient, this current situation and inability of the Fed to change it, comes as no shock. One would have thought that this (as well as Europes headline-making debt crisis) was already priced into the market. But apparently not. To mix metaphors rather badly, the emperor has been running around naked for some time, but the crowd has only now realized that the emperor has no clothes. This distrust of the Fed and their erstwhile magical powers has led many to sell stocks, though perversely to buy government bonds. It is perversity itself that the best performing asset over the past quarter has been zero-coupon U.S. government bonds. Why anyone would lend money to the debt-encumbered U.S. government, for multiple decades, in a precarious currency, and at miniscule return with no current yield, beggars belief.

Money, money everywhere but not a drop to lend

The stagnation we referred to above may turn into stagflation, as the money supply continues to expand under Bernanke. Measures of money supply are all up sharply in recent months; the mid-range measure M-2 is up at an annualized rate of 25% in the last quarter. This is a direct result of the Feds expansion of credit earlier this year.
* Please note: Past performance is no guarantee of future results. For complete information on our past performance, including factors to be considered in viewing past performance and other disclosures, please contact our office. Specific stocks mentioned herein are intended solely as illustrative of strategies and types of stocks we are buying or selling, and are not intended as indicative of entire portfolios or of any individual clients portfolio. The numbers mentioned represent our composite averages. They represent all accounts that fall within the stated objectives which have the ability to buy and sell options; they exclude accounts under $200,000 and accounts with significant limitations or restrictions that would make them unrepresentative of the account type. Performance figures for composites referred to herein reflect the deduction of administrative fees, but may not take into account all performance fees attributable to the specific period. The performance of any individual stock or stocks does not take into account fees. Performance numbers include dividends; dividends are not reinvested. Commissions charged may vary depending on the brokerage firm at which an individual account is held. All accounts are managed individually and are therefore different, even within the same broad objective. Factors such as an individuals circumstances, the size of the portfolio, and the time the account opened can affect specific buy and sell decisions. Factors such as price movements and security liquidity can affect whether any trade is made for all accounts. Global Strategic Management, Inc., an SEC-registered investment advisor, does business as Adrian Day Asset Management.

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We discussed this extensively last Review. Though the rate of increase in Fed credit has slowedup at only 10% annualized in the last quarterits significant that it is still expanding at all, despite the end of QE2. The Fed is far from withdrawing the credit it earlier put into the economy (and now, of course, under Operation Twist is rolling over its short term notes into longer-term bonds). As weve noted before, inflation (as measured by the ludicrously under-estimating CPI) is accelerating. The latest figures, for August, show the Consumer Price Index up 3.8% over the past year. Thats up from 3.6% in July, and 1.6% in January. (While not putting much credence in a single months number, August rose at an annualized 4.8%). The direction seems fairly clear. Bernanke meanwhile blathers on about avoiding deflation, and recently made it clear that if inflation fell too far, below peoples expectations, the Fed was prepared to stimulate again. Mmmdidnt work the first time, or the second, so lets try again. How was it Einstein defined stupidity? Whats clear is that interest rates will remain lowfor the next two years most likely, says the Fedand the printing presses will continue to work overtime. The Fed cant raise rates not only because the economy, particularly housing, could not withstand higher rates, but because of the massive government borrowing requirements; even with rates at 70-year lows, borrowing costs are 10% of revenues.

Stocks: Up or down?
This is one reason we are not more bearish on equities. Typically, monetary inflation is positive for stocks (at least in terms of the domestic currency). We would also note that investors are underweighted to stocks (meaning there is buying power on the sidelines); corporate insiders are buying; and valuations are not particularly stretched. On the other hand, the economic outlook appears anything but rosy; corporate earnings growth is likely to slow in the reporting period ahead (for most sectors) as the slowdown in consumer spending combines with less impact from corporate cost-cutting; there is growing distrust of the administrations business and tax policies, as well as the Feds ability to manage the economy; and lastly, as weve discussed, stocks never did fall to typical bear-market levels, not even in early 2009. They may yet. So while we are certainly underweight the broad U.S. stock market, and not aggressively buying, we are holding what we have. As mentioned, most of our stocks are trading in single-digit p/es (for example, Staples or Ares Capital); below net asset values (Loews or Gladstone Capital); and are paying decent dividends (the BDC sector or Collectors Universe). We may shift from one particular company to another, but are in no rush to sell such companies.

Europe drags on
Our thoughts on Europe are not so terribly different. Again, one would have thought that with Europes debt problems dominating headlines over the past year, this would be priced into stocks by now. And the prescription of the European monetary authorities is much the same as the Feds. Short of the breakup of the structurally inane Euro, which would allow Greece to devalue (again), the Europeans will print more money. But each one of these interventions, whether by the Fed or the Europeans (including the massive coordinated dollar injections into Europe last month), has less and less of an impact. The common-place metaphor of a drug addict requiring larger and larger doses is not so inappropriate.

Stocks are inexpensive

Again, while not blind to the seriousness of the debt problem in Europe and its long-range ramifications, as well as the possibility of further short-term impact on the market, we are holding our positions, prepared to ride out further volatility. Some of the stocks we own are incredibly inexpensive: Pargesa, selling at a 40%
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discount to book and yielding 4.4%; Cermaq, selling at four times earnings; Telefonica, yielding over 11%. A collapse in the Euro would hurt the dollar price of these stocks, but these are companies that earn from all over the world. Anytime one sees such extraordinary valuations, one must question them. Telefonica, for example, is down sharply in recent months because of a misplaced association with Spain and its troubled economy. But Spain represents only a third of the former Telefonica dEspanas earnings, and a declining percentage at that. At less than seven times earnings, Telefonica can afford its payout. The European big caps are in fact now the cheapest of stocks in all advanced countries. The so-called Euro Stoxx 50 sells at just nine times earnings, one times book, and yields 5.5%. Also inexpensive are the developing countries markets, trading at around the same valuations, with most of Asia and Brazil yielding in the 4-5% range, and only seven times earnings. They have been among the hardest hit in the recent market turmoil, incongruous though it may be that Asia falls on European debt problems.

Wither China?
Not that Asia is without economic concerns. Perhaps the biggest change in the global economic landscape in recent months has been the slowdown in China, where one manufacturing index has declined for the third month in a row. However, the decline could have bottomed as another indicator, of new export orders, moved up for the second month. More worrying are signs of a downturn in the property market, with not only prices down but overleveraged developers having difficulty obtaining new funding. Given this leverage, a decline could cascade. The response from China would likely be another round of monetary stimulus; its about all central bankers around the world seem to know. Given that inflation is already ticking up above target levelscurrently 6.2%--this could be damaging for the economy, though it would spark another round of gold buying. Also very worrying is legislation passing through the U.S. Senate, championed by Charles Schumer and Lindsey Graham to add duties to imports from China. Maybe these bi-partisan economic illiterates dont realize the yuan has already appreciated about more than 7% over the past year. Though not buying Chinese stocks, we are looking for quality, undervalued Asian companies. As discussed before, throughout the region (taking out China and Japan), government finances are stronger, household savings higher, banks more solid, and currencies undervalued relative to the U.S. and Europe. Given this area also has the highest growth prospects, this is where we will be looking, though prices could come down a little more in the near term.

Commodities fall on dollar and China

The recent evidence of a slowdown in China is one cause of the fall in commodity prices, along with the rebound in the dollar; since commodities are generally priced in dollars, then other things being equal, appreciation in the dollar sees a decline in commodity prices. This has affected prices across the spectrum, from energy to metals. The slowdown in China has particularly hurt copper, where China represents 40% of the worlds demand, and has clearly been the driver of higher prices in recent years. Despite the short-term decline in demand, however, the outlook is favorable, as ongoing mine interruptions have led to a decline in production2011 looks to be lower than 2010, itself lower than 2009. The difficulty of boosting output from mature mines, and of finding and bringing to production new mines, suggests this shortfall will continue. Difficulties in increasing supply as well as ongoing Chinese demandwhether the economy grows at 10% or 5%, thats still a huge increase in demandwill see commodity prices across the board continue to move Page 4

higher over the coming years. Many of the stocks are fundamentally inexpensive: Freeport Copper sells at just five times earnings, with a better than 6% yield over the past 12 months, carrying very little debtand down almost 50% since July; BHP trades at eight times earnings and yields over 4%; and Canadian Oil Sands, with high leverage to oil prices, sells at nine times earnings and yields almost 6%. Unless the long bull market in resources is over, these are compelling valuations for top companies, companies whose stocks are likely to rebound strongly when the market turns.

Gold: Back to trend

Gold has also been affected in recent weeks by the global sell off, but perhaps for somewhat different reasons. Frequently, when there is a decline in stocks and other assets worldwide, investors look to sell that which has appreciated the most and is liquidwhether to meet margin calls, fund redemptions, or to offset losses elsewhere in portfolios. Thus, as often, golds reaction was delayed, but then it fell along with everything else. However, gold had moved sharply above a wellestablished trend this summer, sending it above $1,900. The decline has simply returned gold to trend, and it should be noted that gold remains up for the quarter and the year. There are not many assets that can claim that. The fundamentals remain very positive for gold. On the macro-economic side, the prevalence of negative interest rates in most economies is very positive; there is likely no other single indicator that is so powerful for gold. This will likely continue; and the U.S. and Europe are both increasing their monetary stimulus while China will likely do so if housing or the overall economy decline too far.

Buying from many sources

On the demand side, the outlook is also positive, as central banks continue to add to gold reservesthis year, Mexico, South Korea, Thailand and Russia have all added significantlyin the ongoing move away from the dominance of the U.S. dollar in reserves. Individual investors too are more and more seeing gold as a monetary alternative to the dollar and other paper currencies, currencies whose governments are competing to devalue the fastest. And India, by far the most important private gold market with purchases more than 50% above those in China, is on track to import over 1,000 tonnes this year. Traditionally a price sensitive market, it has turned strongly bullish this year after a decline last.

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The September decline of 15% from the peak is a larger short-term decline than normal, but gold has corrected more than 10% four times in this bull market, and each time bounced back strongly within a few months. We see this level as a good one at which to be adding.

Gold stocks are good value again

The gold stocks in recent months have acted more like stocks than gold, that is, they have declined along with the broad market. By many metrics, gold stocks are close to the lower end of their historic valuation ranges, particularly relative to gold itself. The stocks could be close to 20% undervalued, and again, each time they have reached that level of undervaluationthe last time being early 2009they have bounced back sharply. There are several reasons that gold stocks have outperformed bullion of late. Costs of mining have risen along with the price of gold; gold companies have been inveterate issuers of new equity; and of course the very reasons many are turning to gold, as insurance, suggest a preference for bullion over stocks. In addition, analysts have consistently lagged the gold price. Barrick, for its Denver Gold Forum presentation to analysts and managers, produced a fascinating table demonstrating this. If one ran numbers based on todays gold price, one would find astonishing values.

Seniors better buys for near term?

The undervaluation applies both to the seniors and the juniors. We have emphasized the juniors for some time now, but in the near term, the seniors may be a better bet, other than selected juniors. The juniors could see more selling over the rest of the year, mostly for tax reasons. Many investors generated some gains in the first half of the year, and now face tax bills without a good market to generate gains in the second half. They may sell stocks to generate cash but also specifically generate losses to offset the gainsand many will find those losses in the junior sector. So we are being more selective in this sector, especially careful with stocks that did trade at much higher prices earlier. In sum, all markets have fallen sharply over the course of the last quarter. Not wanting to downplay the seriousness of the debt problems facing the U.S., Europe and Japan in particular, we do see some differences with 2008, and we do not see this as a time for broad selling of quality companies selling at multi-year and in some cases multi-decade valuation lows. The near term could see continued volatility, but we remain positive on gold in particular and other resources in general. And any stabilization of the situation in Europe, or indeed in Chinas economy, may well see stocks recover sharply.

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Review of Individual Accounts

Global Accounts
We started the quarter with low cash holdings and as the quarter progressed, reduced cash further, taking advantage of unusually good valuations in many markets, particularly in Europe. We ended the quarter with just under 7% cash (and most of that set aside for the potential exercise of puts sold). Our overall allocation remains nearly identical, with over 15% of accounts in major global markets, 5% in the U.S. plus another 14% in income oriented investments, most of which are in the U.S. We have a high allocation to gold and resources, with the rest in mutual funds and special situations. Lots of new, undervalued buys We added several companies this past quarter, but mostly in small size for few clients. Much of this buying was in value investments in Europe, including depressed consumer stocks in Portugal, and Telefonica, which we discussed in our commentary above. Back to Brazil We also took a toehold in Brazil, which has been one of the worst performing markets this year. We had sold that market over a year ago, fortuitously. Our buying will be cautious for now, returning to some big-cap banks such as Banco Itau. We also have taken small positions in Research in Motion, whose decline seems overdone, given the companys commanding lead in the business market. Selling at less than four times earnings, with high margins and no debt, it is not a demanding valuation. We exited no stocks this quarter, though we were trimming on rallies and selling options throughout to generate some income. Moving ahead, we will continue to look for ways to raise cash, including taking advantage of any rallies in individual stocks or markets, but are disinclined to be aggressive sellers of deeply depressed stocks, Our allocation within the gold sector has shifted, raising exposure to the seniors (from 20% up to 24%), and mid-tiers (16% to 21%); while the allocation to exploration companies declined slightly, but remains our largest segment at nearly one third of accounts. This is because we see the exploration companies as offering the largest potential. The rest is in bullion and bullion funds, and in silver and other precious metals., and special situations. The modest shift from smaller to larger companies is partly because of relative price movements this past quarter, but also because we see better nearterm potential and less risk in the larger companies for now. More trading in gold stocks As always in gold accounts, we are trading a little more actively, trimming positions on meaningful rallies and trading short-term speculations. This past quarter, we sold virtually half of the European Goldfields we had bought, when the stock rallied after they received their long-awaited permit to mine. The stock is now down some 30% from where we sold, and we may well buy this deeply undervalued stock again. Apart from this trading, we added two new companies recently: Barrick Gold, the worlds
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realizing that recoveries can be as sudden and sharp as declines.

Gold Accounts
We started the quarter fully invested and ended it with barely 2% in cash. Most of that was set aside for the exercise of puts (and unencumbered cash was mostly from new accounts). So we are fully loaded, and expect to see some opportunities for raising cash in the coming months. As discussed above, we remain very bullish on gold, even though the next several weeks could well see some volatility in the gold stocks, particularly with tax-loss selling among the juniors.

largest gold mining company, and explorer Renaissance Gold, a prospect generator with proven management and a solid balance sheet. We also participated in a private placement in a new company, a spin off from Reservoir Capital of its mostly gold properties in Serbia, called Reservoir Minerals. We may buy more in the market when it starts trading, probably early next month. The next few months may provide some opportunities for profit taking, including some short-term speculative trading, in addition to some selling of laggards ahead of tax-loss selling, switching into stronger companies. This may include a further modest shift towards larger companies. We are patient holders of quality companies, large and small, however, and very positive on gold, so expect to remain fully exposed to the sector.

up resource accounts this past quarter, as prices of quality companies came down, buying two new companies: Petrobras, which owns the large offshore Brazil deep oil fields (and which we had sold earlier at higher prices); and Hyflux, a Singapore manufacturer of water systems. The majority of our buying, however, has been adding to favorites at depressed prices, including Freeport Copper, and diversified miners BHP and Xstrata, as well as two juniors in the renewal energy space, Alterra Power and Reservoir Capital. We expect both these companies to be successful in the years ahead. Overall, we expect to remain fully exposed to the broad resource area, though always looking for trading opportunities to shift from one sector to another as conditions dictate. The period ahead may see us increase exposure to oil which has lagged now for the better part of a year. In sum, this continues to be a very difficult year for investors, and the near term promises more volatility and perhaps further weakness. We will use this volatility to acquire quality companies cheaply, as well as, where appropriate, to raise some cash. But we own stocks that for the most part are very inexpensive, and recent history has confirmed again that it is not a good idea to panic out of positions on market declines. Recoveries can be sharp when sentiment changes or simply when selling dries up. Although we will be looking for opportunities to raise a little cash, we intend to be there when that market turn comes. Adrian Day, October 1st, 2011

Resource Accounts
We remain long-term bulls on the resource sector, predicated on growing demand from China and other developing economies, and constrained supply. However, the short-term risk has increased, due to the slowdown in Chinas manufacturing and heightened risk in the real estate sector. As discussed, we expect any slowdown to take Chinas growth from double-digit levels to still-strong growth in the mid-single digits. For an economy the size of Chinas, such economic growth still requires more resources. Our focus remains on gold, copper, energy, the PGMs, agriculture, and uranium. We have topped

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