Q3 2014 Market Review & Outlook Morgan Creek Capital Management

MORGAN CREEK CAPITAL MANAGEMENT

Letter to Fellow Investors

Highway To The Danger Zone

Had the movie Top Gun been released in 1983 (instead of 1986), this letter probably would not have been written. It is highly possible that I would have been so taken by the “Maverick Lifestyle” that I would have been more open to the Navy’s advances when they came recruiting during my sophomore year at Notre Dame and I may have ended up as a Naval Aviator. I was an electrical engineering major that year (switched to Biology/Chemistry the following year) and the Navy routinely trolled the Engineering School to find recruits for their Nuclear Power Program (Submarine Officer). They invited me to the presentation, I thought it was pretty cool, and I subsequently agreed to go to the South Bend recruiting office to take some evaluation tests. One of the instruments was the Spatial Apperception Test that measured potential aptitude for becoming a pilot and I did so well that they offered to fly me out to San Diego for some additional recruiting. Why not, a free trip to CA sounded pretty good during a SB winter. Source(s): movieposter.com. The trip was fun, hanging out in the BOQ (Bachelor Officers Quarters), touring the parking lot full of all the “Nuke Mobiles” (the super sports cars that all the Nuclear Power Officers had, which we found out later they never got to drive since they were always on the Sub…), but we never quite saw the life that was depicted in Top Gun, and they didn’t actually take us up in an F-14 (which is probably a good thing as it might have sealed the deal). So I headed back to South Bend unconvinced, forgot about the Navy, changed my major and headed down the path toward a life filled with investment dogfights instead of aerial dogfights. Full disclosure, when the movie actually did come out, I was in my first year of Business School at the University of Chicago and after seeing if for the third time the opening week, there was a moment of reconsideration, but the fact that I was getting married six weeks later put the final kibosh on any chance of me ever having a “Call Sign.” So why talk about this ancient history here? Two reasons: 1) every year when ND plays Navy I am reminded of that recruiting trip, the incredible respect I have for the Midshipmen, and my secret jealousy of the ones who are headed for a career as Aviators and 2) a friend of mine tweeted me the video of Danger Zone (the Top Gun theme song) in reference to the level of the Dollar (DXY > 89) that some pundits believe could trigger an unwind of the $5 Trillion Global Carry Trade. With that song stuck in my head for the last few days, and dozens of flashbacks to movie scenes that remind me of certain elements of the current investment environment, it naturally became the theme for this quarterly letter. It really isn’t a stretch to get to the Danger Zone theme this quarter given our letters this year have all had a slightly increasing level of caution that pointed to what we thought were market indicators, and risk factors, of a more challenging investment environment on the horizon in 2014 versus the high flying days of 2013. We came into the year discussing the 10 Things I Hate About Spoos where we discussed how, on just about every measure of valuation the S&P 500 (the futures are called spoos) was meaningfully, or even significantly, overvalued. That said, we also discussed how valuation is a necessary, but insufficient, criteria for a market correction and that we saw a number of factors that could counteract the valuation challenge, most notably the continuation of QE by the Fed which we noted that, even with Tapering, equated to $500 Billion of additional stimulus that could be worth 200

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S&P points (based on Larry Jeddeloh’s rule of 40 points per $100B). In the Q1 letter, we talked about The Year of the Alligator and how there were a number of market signals that indicated that 2014 was likely to be the inverse of 2013 and the huge divergences between U.S. stocks and bonds, U.S. stocks and commodities, U.S. stocks and emerging markets could reverse as the Alligator Jaws that were formed in 2013 snapped shut this year. Again, there was a caveat that while we can say that Alligator Jaws do indeed always close, the timing is more difficult to predict, but when dealing with gators, it was better to leave early than to stick around just a little too long. Finally, in last quarter’s letter, titled #NotDifferentThisTime, we discussed Sir John Templeton’s 16 Rules for Successful Investing (with an emphasis on Rule No.11) where he opines that the four most expensive words in investing are “this time it’s different.” We discussed how the economy and market tends to follow the seven year Kindleberger Cycle and that we have seen challenging three year periods around 1973, 1980, 1987, 1994, 2001, 2008 (and likely 2015), so we posited that 2014 was feeling a lot like 2000 and 2007, so it was time to raise the level of caution in thinking about portfolio positioning. Given that we have now seen the end of QE this month and we are only weeks away from 2015, we could be rapidly heading down the Highway to the Danger Zone, so let’s look at how we got here, where we are and where we might go from here.

Top Gun begins with a title card that explains that in 1969 the U.S. Navy created an elite school for the top one percent of its pilots to teach the lost art of aerial combat, dogfighting, to insure that the handful of graduates would be the best fighter pilots in the world. The Navy calls the program Fighter Weapons School. The flyers call it Top Gun. As the credits roll, the movie opens with a great scene showing the crew of an aircraft carrier launching a pair of F-14 fighter jets with a subtitle that reads Indian Ocean. Present Day. We quickly learn that the two pilots of those aircraft are Lt. Bill Cortell, Call Sign “Cougar,” and Lt. Pete Mitchell, Call Sign “Maverick” (our protagonist), and they have been sent out on a recon mission with their RIOs (Radar Intercept Officer), Lt. Sam Wells, Call Sign “Merlin,” and Lt. Nick Bradshaw, Call Sign “Goose,” to intercept an inbound bogey (a potentially hostile MiG-28 aircraft). In the course of a few minutes, the number of MiGs multiplies and suddenly the situation turns tense. Maverick manages to gain the upper hand on one of the MiGs and they bug out. When Maverick and Goose return to find their Wingman, Cougar and Merlin, they discover that one of the MiGs has Cougar in missile lock, but is not firing. Maverick positions above the MiG and puts him in missile lock and the bogey bugs out. The planes turn back toward the aircraft carrier to land as fuel is running low, but just as Maverick is about to land, he hears on the radio from Merlin that Cougar is very shaken up and may not be able to land. Maverick pulls back up and circles back to escort Cougar to the carrier deck. When they are back aboard the ship, the commanding officer calls them to his quarters and the following sequence occurs: Stinger: What's on your mind? Cougar: My wife and kid, sir. I almost orphaned him today. I've never even seen him. I was so scared. Stinger: We've seen this before. Cougar: No, sir. I'm holding on too tight. I've lost the edge. I'm sorry, sir. (Cougar throws his wings on the desk and leaves. Maverick & Goose enter) Stinger: Maverick, you just did an incredibly brave thing. What you should have done was land your plane! You don't own that plane, the taxpayers do! Son, your ego is writing checks your body can't cash. And let's not bullshit Maverick. Your family name ain't the best in the Navy. You need to be doing it better and cleaner than the other guy. Now, what is it with you? Maverick: Just want to serve my country, be the best pilot in the Navy, sir. Stinger: Don't screw around with me Maverick. You're a hell of an instinctive pilot. Maybe too good. I'd like to bust your butt but I can't. I got another problem here. I gotta send somebody from this squadron to Miramar. I

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gotta do something here, I still can't believe it. I gotta give you your dream shot! I'm gonna send you up against the best. You two characters are going to Top Gun. So in thinking about how we got to where we are in the economic and investment environment, we have to set the stage of how Ben Bernanke came to be head of the Fed and why he was put in a position that enabled him to create the QE Program that many would argue has led us to our current situation. If we think about how Maverick’s “do whatever it takes” style of flying put him in position to get a shot at Top Gun, similarly it would be Lt. Ben Bernanke, Call Sign “Helicopter” ’s, commitment to “do whatever it takes” with monetary stimulus that gave him the nod to take the spot at the head of the Fed. Like Cougar, Greenspan was scared of having to deal with the asset bubbles he had created and he was happy to turn in his wings and make way for a more aggressive and well-trained pilot to take the controls. When Maverick and Goose arrive at Top Gun and are in their first briefing session they are greeted by Commander Mike Metcalf, Call Sign “Viper,” who explains to them why they are there, and what they are in for in the coming weeks. Viper: You're the top one percent of all naval aviators. The elite. The Best of the Best. We'll make you better. You fly at least two combat missions a day, attend classes and evaluations. On each combat sequence you're going to meet a different challenge. We'll teach you to fly the F-14 faster than you've ever flown before. Now, we don't make policy here. Elected officials, civilians, do that. We are their instruments and must always act as though we are at war. The reference to how they don’t make policy at Top Gun, but rather serve as instruments of the elected officials and civilians, seems to apply nicely to the Fed as they are supposed to be independent of Congress and the Treasury. In thinking about the Fed as an instrument of financial warfare, the description fits pretty well and thinking about the Global Financial Crisis and the beginning of a hostile exchange, we can envision Helicopter donning his flight suit and firing up his F-14 to battle the enemy bogeys. There is a scene where Viper, and a civilian contractor, Charlotte Blackwell, Call Sign “Charlie,” are evaluating Maverick’s performance in a particularly difficult combat sequence and she looks at his decisions from a “textbook” perspective and finds fault with how he managed the situation. Viper: The bogey has good position right here. Freeze frame. A moment of choice. The F-14 is defensive. He has a chance to bug out right here. Better to retire and save your aircraft than push a bad position. Charlie, jump in here any time. You stay in that diamond another three seconds, the bogey's gonna blow you away. You take a hard right, select zone five...You can extend and escape. You made a bad choice. Charlie? Charlie: Aircraft one performs a split S? That's the last thing you should do. The MiG's right on your tail. Freeze there. The MiG has you in his gunsight. What were you thinking? Maverick: You don't have time to think up there. If you think, you're dead. Charlie: That's a big gamble with a thirty million dollar plane. Unfortunately, it worked. The MiG never got a clean shot. Maverick makes an aggressive vertical move and defeats him with a missile. The encounter was a victory, but we show it as an example of what not to do. Next. Hollywood: Gutsiest move I ever saw, man. As we sit here at the end of QE and reflect on the performance of the Program and on the performance of

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Helicopter as the pilot of the program, we see a lot of parallels in the movie sequence and the events that unfolded in late 2008 and early 2009. Helicopter and Maverick both found themselves in a bad position where they were seconds (perhaps only figurative seconds in Ben’s case) from a “game over” outcome and they had to rely on their experience, their instincts and their creativity to come up with a “Hail Mary” solution to an untenable situation. A friend of mine worked for Bernanke at the Fed during those fateful days and he described the real-time situation as follows, “Ben peered over the edge of the precipice, saw the bottom, and decided to do whatever it took not to go there.” When it is a matter of life and death, you do resort to doing “the last thing you should do” (as Charlie describes Maverick’s maneuver). I think Maverick’s response (and Ben’s response to those who have criticized his decision to implement QE) is the most important line in the movie, is the most relevant link to the environment we find ourselves in today and the best link to how great investors separate themselves from the pack, “You don’t have time to think up there. If you think, you’re dead.” Maverick made an aggressive move and defeated the bogey. Helicopter made an aggressive move and prevented the Global Financial System from seizing. Great investors make aggressive moves, act decisively and trust their instincts rather than trying to overthink every situation. The Best of the Best have an uncanny knack to be decisive when it is most needed, particularly in those times when the average person hesitates and loses. The second half of the initial Top Gun briefing scene hammers this point home. Viper: In case some of you wonder who the best is, they're on this plaque. The best driver and his RIO from each class have his name on it. And they have the option to come back here and be Top Gun instructors. You think your name’s gonna be on that plaque? Maverick: Yes, sir. Viper: That's pretty arrogant, considering the company you're in. Maverick: Yes, sir. Viper: I like that in a pilot. Just remember, when it's over out there, we're all on the same team. This school is about combat. There are no points for second place. Dismissed. While it is true that most of investing is not quite as all or nothing as aerial combat, there are times when the stakes can be very high and bad decisions can lead to outcomes that have very serious, even tragic, consequences. Clearly the situation Helicopter found himself facing at the trough of the GFC required the steely resolve of combat, the situation that Abe-san and Kuroda-san find themselves in today as they try to reverse decades of decline in Japan is combat worthy and the situation that Super Mario Draghi finds himself in today on the precipice of a deflationary death spiral requires combat readiness and in each case, there truly are no points for second place. The situation in Europe calls to mind the scene in the movie where Maverick flies through the jet wash of Iceman’s plane (as he clears away to allow Maverick to take a shot) which causes their plane to go into a flat spin that ultimately results in Goose’s untimely demise as they eject from the cockpit and Goose slams into the canopy during the ejection. When the stakes are very high, one little error can indeed be fatal. To be successful in handling these types of escalated situations, the pilot needs significant confidence and a spirit of invincibility that allows him to act forcefully and decisively to “do whatever it takes” to achieve the desired outcome. This attitude comes through loud and clear during a brief exchange between Maverick and Iceman as they are walking out to their planes before the fateful experience. Goose: It's the bottom of the 9th, the score is tied. It's time for the big one. Iceman: You up for this one, Maverick? Maverick: Just a walk in the park, Kazansky.

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When we look for managers to allocate capital and to partner with in our investment programs, the primary criteria we are looking for are Competitiveness, Confidence and Character, what we refer to as “Edge.” Cougar said he lost his edge when he turned in his wings and we remain constantly vigilant in evaluating our investment partners to insure that they are maintaining (and in fact refining and honing) their edge. The reality is, however, that not every move will work out precisely as planned and there will be setbacks that must be overcome. There is an exchange between Viper and Maverick near the end of the movie that makes the point about confidence very effectively. If you want to be a great pilot (of a fighter jet, or a portfolio) you have to have confidence, you have to be resilient when things go wrong and to do what Viper says and learn from your mistakes. In order to continually be “up there with the best of the best” (the theme from the top of the movie poster) you have to be able to constantly “push it.” Viper: What's on your mind? Maverick: My options, sir. Viper: Simple. First, you've acquired enough points to show up tomorrow and graduate with your Top Gun class, or you can quit. There'd be no disgrace. That spin was hell, it would've shook me up. Maverick: So you think I should quit? Viper: I didn't say that. The simple fact is you feel responsible for Goose and you have a confidence problem. Now I'm not gonna sit here and blow sunshine up your behind, Lieutenant. A good pilot is compelled to evaluate what's happened, so he can apply what he's learned. Up there, we gotta push it. That's our job. It's your option, Lieutenant. All yours. The other characteristic we see in the very best investors is Discipline. Those that have great discipline produce consistently superior returns and suffer far fewer surprise drawdowns. Those that do not have good discipline generally produce lesser returns and have far more untoward outcomes along the way and in some rare instances, crash and burn. We saw the impact of the lack of discipline in the early implementation of QE as the “on again, off again” process in 2010 and 2011 led to heightened volatility and disorder. Market participants were uncertain of Helicopter’s commitment to the program and when there is uncertainty, there is usually discord and volatility. In the movie, there are a couple of scenes that point to Maverick’s early lack of discipline being a problem. In the first scene, Maverick breaks a rule of engagement by going below the hard deck (the minimum altitude that pilots must stay above for training safety) to shoot down Jester during an early training mission. As Maverick and Goose return to the base and are confronted by Iceman (Maverick’s archrival, who is known for flying totally by the book) who points out to the group how Maverick’s lack of discipline is less than desirable. Iceman: You two really are cowboys. Maverick: What's your problem, Kazansky? Iceman: You're everyone's problem. That's because every time you go up in the air, you're unsafe. I don't like you because you're dangerous. Maverick: That's right! Ice…Man. I am dangerous. In the second scene, during a complex training exercise with multiple aircraft and multiple bogeys, Maverick doesn’t follow the wingman protocol because he is distracted by the opportunity to chase Viper. The opportunity to go after the legendary commanding officer is simply too much for his ego to ignore and he is pushed into an over-confident state, resulting in them getting “killed” by Lt. Commander Rick Heatherly, Call Sign “Jester” (who easily sneaks up from behind while Maverick is so overly focused on Viper). In this case, the breakdown of

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discipline leads to a “fatal” outcome and while not every situation in investing has these same stakes, the inability to adhere to a discipline has led to many losses and has disappointed investors over time. Jester: That was some of the best flying I've seen to date - right up to the part where you got killed. You never, never, leave your wingman. Iceman: Maverick, it's not your flying, it's your attitude. The enemy's dangerous, but right now you're worse, dangerous and foolish. You may not like who's flying with you, but whose side are you on? Goose: At least Viper got Iceman before he got us. We've still got a shot at it. Maverick: That was stupid, I know better than that. That will never happen again. Goose: I know...I know. Hindsight is 20/20 and how many investors have uttered those same words that Maverick says to Goose, “I know better than that”? The problem is that humans (particularly when involved in investing) have very short memories and we, unfortunately, tend to repeat the same mistakes over and over. Think about how many investors said they would never again pay the dangerously high prices that they paid for technology stocks during the Tech Bubble (for example, Forbes published a 10 for the next decade list in 2000 and the average P/E was nearly 300, problem was 2/3 lost money if bought them), but did the same thing in buying the financial services stocks at ridiculous valuations in 2007. The key to long-term investing success is not defined as never making mistakes, but rather not making the huge mistakes that can permanently impair your capital and, more importantly, to learn from the mistakes you do make in order to not suffer the same fate again in the future. Yet, here we are again in 2014 (funny how there is that seven year cycle again) and investors are buying small-cap stocks at nearly triple digit P/E ratios (despite the fact that 30% of small cap companies are losing money) and are paying P/E’s that can’t actually be calculated for some sectors like Biotech and Cloud (because many companies have no E to compare to the P). The investing equivalent of “never leave your wingman” is “never leave your discipline” of not paying the wrong price for any asset (no matter how great you think that asset is). We have quoted Howard Marks many times on this topic; “there is no asset good enough that you can’t mess up by paying too much” (conversely, “there is no asset bad enough that you can’t fix by paying a low price,” which we will talk about a lot in the Market Outlook section). In #NotDifferentThisTime, we talked about how we should match our portfolio positioning to the environment we expect in the near term, even if that positioning would be somewhat different than our normal positioning for the long-term. Environments do change, sometimes dramatically, and we must recognize when it is appropriate to try a different tactic or strategy. Consider how optimal maneuvers would change for a fighter pilot in a dogfight from offensive to defensive depending on the number of enemy aircraft, or depending on the technical quality of the combatants’ aircraft. We wrote that “something that seems quite intuitive is that if we anticipate that there will be

a period of above average volatility and risk, wouldn’t it be prudent to position portfolios in such a way to try and mitigate the damage that could occur if the valuation excesses were to adjust back to normal, or the geopolitical tensions were to flare up into something more serious?” The last few quarters have felt a little like the scene from the graduation ceremony at Top Gun when Viper interrupts the celebration and informs the group that some of them must be immediately deployed. 2013 was a great party, but all throughout 2014 the tensions have been rising and it feels as if we are on that Highway to the Danger Zone. Viper: Gentlemen, I hate to break up the party before it gets out of hand...Some of you have to depart immediately. We have a crisis situation.

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Jester: Ice, Slider, Hollywood, Wolfman, Maverick. All: Sir. Viper: Maverick, you'll get your RIO when you get to the ship. If you don't...give me a call. I'll fly with you. (I love this particular scene as you can see the confidence return to Maverick) When they arrive at the aircraft carrier, they are immediately briefed on their mission. This is not a training exercise, the stakes are high and there are serious risks. Stinger: The SS Layton has become disabled and has wandered into foreign territory. A rescue operation will soon begin. Your mission is to give it air support. There are MiGs in the area. If you witness a hostile act, return fire. They carry the Exocet anti-ship missile. They can fire it from 200 miles away. This is the real thing. This is what you've been trained for. Make us proud. Ice, Hollywood, sector two. Maverick, you back them up with Merlin on ready five. The part of the scene that really feels like the current environment occurs as Iceman and Hollywood fly toward the intercept zone they are told that they have two bogeys, but suddenly things change very dramatically and they find themselves truly in the Danger Zone. Iceman: I'm taking the lead. Let's identify them. Hollywood: Roger. I'm on your left side, a little low. Radar: Maverick's up and ready in alert five. Iceman: My bogey's still locked up. He's drifting to the left. Still maneuvering, course. Let's bring it to the right. Slider: Ice, we've got a problem. I have four aircraft on radar. Four bogeys. Iceman: Wood, we've got four bogeys. Slider: Wrong, make that five! Radar: There's five, sir. Hollywood: He's got a radar lock on us. Iceman: Get out of there, Hollywood! Hollywood: I'm hit. We're coming apart. I can't control it! We're going down. What is so great about this particular scene is how well it applies to investing. Going into a situation with the wrong positioning, offensive versus defensive, can be disastrous in investing, just like it nearly was for Hollywood and Wolfman (they ejected and were rescued). Whether Iceman had too much testosterone from winning the Top Gun trophy, or whether he didn’t consider the possibility of additional bogeys because the radar only showed two right up until the point of engagement, or whether he didn’t have enough experience to appreciate the potential for other outcomes other than a two on two dogfight, is not that important, but pushing an offensive posture into a situation that clearly required a more defensive posture is the lesson that we should heed. Perhaps it would have been better to take a more indirect route to try and do more reconnaissance before engaging the combatants, or perhaps it would have been better to take a more defensive position from the beginning as they were in unfamiliar territory. We are clearly in unfamiliar territory with the end of QE and it appears that additional bogeys are popping up on radar every day. As we travel down the Highway to the (Investment) Danger Zone in the recent quarters, it really feels like we have seen this movie before. We discussed this potential change in positioning in the last two letters and highlighted in the last letter that “we spent a good deal of time discussing this issue last quarter

and said that the time to actually play defense is before you really need to play defense. There are two key reasons

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for this: 1) you don’t get to buy the insurance policy after the event, (the coverage has to be in place before the event occurs), and 2) the cost of insurance is significantly lower when everyone is still ebullient and no one thinks you need insurance.” The end of this scene makes the point well as Iceman and Hollywood chose not to buy any insurance, which was a very costly mistake. With Hollywood gone, Iceman has to make a complete change in strategy as he says, “This is Voodoo One, we are defensive.” The final portion of the battle scene is spectacular as Maverick speeds to help Iceman and the plot increase the dramatic tension by having Maverick overcome his demons of Confidence and Discipline in order to emerge as the hero. As Maverick and Merlin arrive on the scene, they fly into one of the MiGs jetwash and go into a spin and Maverick loses his nerve momentarily and implores the memory of his friend Goose to help him summon the confidence to re-engage. Merlin: We just flew right through his jetwash! Get control! Good recovery. Let's get in there and help Ice. Let's get back in the game. Maverick: No, it's no good. Iceman: S#@*! Maverick's disengaging. I knew it! Merlin: Get in there, come on. What the hell are you doing? Ice won't last down there alone... Maverick: Talk to me, Goose. Iceman: Maverick! Radar: Maverick's re-engaging, sir. So Maverick zooms in and shoots down a pair of MiGs that are menacing Iceman and they move into wingman formation to go after the other pair. Maverick: There he is. Get him, Ice! Iceman: Okay, you guys, I'm coming in. Merlin: A MiG's coming round on our tail. Maverick: I can't leave Ice. Merlin: He's gonna get behind us! Maverick: I'm not leaving my wingman. Iceman: I'm on his tail. I'm going for the shot right now. Roger, engaged! I've got radar lock. I'm taking the shot. Fire! Bingo! So Maverick overcomes demon number two and sticks with the discipline and they have a successful outcome. The MiG does circle around and menace Maverick, but with some instinctual flying (“you don’t have time to think, if you think, you’re dead”) followed by a dramatic shift in tactics from offense to defense, he succeeds in outmaneuvering the bogey. Merlin: What are you doing? You're slowing down, you're slowing down! Maverick: I'm bringing him in closer, Merlin. Merlin: You're gonna do what? This is it, Maverick! Maverick: I'm gonna hit the brakes, he'll fly right by. Merlin: S#@*! He's gonna get a lock on us! Maverick: NOW! [Maverick slams on the brakes, MiG passes by, Maverick locks onto the MiG]

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Maverick: Got a good lock, firing. Maverick: Whoo! Scratch four! Merlin: This is Voodoo Three. Remaining MiGs are bugging out. Mission Accomplished. Even the Danger Zone can be successfully navigated with the proper discipline, teamwork and requisite skills, but the posture of the approach can make the difference between success and failure. Investing in markets is the same. We must match our portfolio posture to the environment and be particularly cautious when we are approaching the Danger Zone. I just made my two-day Pilgrimage to Boston for the GMO annual meeting (one of the two things I make sure I attend every year) and it was very interesting that the theme of their meeting was quite similar to the theme of this letter. The title of the conference was indicative of their view of the overall investment environment, What To Do When There’s Nothing To Do, which reflected their conviction that traditional asset classes were modestly overvalued and were unlikely to generate sufficient returns for investors over the next seven years (they make asset class forecasts based on their decades of observation that markets move to fair value over a seven year cycle). The secondary theme of the event was that markets can be priced to offer investors returns that could be described as Heaven, Purgatory or Hell and they used the construct of the Security Market Line (relationship between return and risk for each asset class) to illustrate the point. The Security Market Line (SML) generally slopes upwards (you receive additional return if you take additional risk), but there are times when markets are not normal and the relationship between risk and return can change and the expected outcomes from taking risk can be higher, or lower. The SML can change in either its slope (different return per unit of risk) or intercept (different expected return for cash). Heaven is defined as a normal SML with a slope of 0.7 (meaning you get 0.7% of additional return for each additional 1% of risk/standard deviation) and an intercept of 0 (meaning there is a positive expected return for cash). In this world, investors are rewarded for taking prudent risks and the likelihood of generating an adequate real return over time is very high. A traditional portfolio of 60% stocks, 30% bonds and 10% cash would be expected to deliver a return of approximately 5% real (return above inflation) with a risk (volatility, or standard deviation) of approximately 9%. Clearly, anything better than this, a steeper slope or higher intercept, would be heavenly as well, but under their construct, simply being normal, was defined as Heaven. Hell was the equivalent of the Danger Zone, where the SML was flat, or worse, downward sloping, where investors are not paid to take additional risk, so the prudent posture would be, simply, to not take risk. This was the situation in October 2007, where there were no cheap assets and cash was clearly (both at the time based on the data and with benefit of hindsight) the best investment option. As Jester said in one of the Top Gun training review sessions, “better to retire and save your aircraft, than push a bad position.” The wisest investors, like Jeremy Grantham, Seth Klarman and Warren Buffett, heeded the warning of the inverted SML and followed Charlie’s admonition in that same review session, “you take a hard right, select zone five...you can extend and escape.” Julian Robertson routinely gave the same advice to the Tiger Cubs when the markets would move unexpectedly against them, “disengage (sell your long or cover your short), and live to fight another day.” We find ourselves in a uniquely challenging position today that GMO described as Purgatory (what we might call the Highway to the Danger Zone, not quite there, but on the way…). The slope of the SML is much lower than normal at 0.3, which is neither Heaven nor Hell (hence Purgatory), but the Fed has added another twist through their program of Financial Repression (artificially holding down interest rates to force investors into risky assets) by pushing the intercept below zero (a negative real return on cash). When you go through all the calculations, the forecasts for traditional asset classes over the next seven years are quite unappealing. Cash is priced to deliver a

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negative (0.4%) real return, Fixed Income is priced to produce a negative (0.2%) real return and large cap U.S. equities are priced to deliver a negative (1.5%) return, compounded per year for the next seven years. Looking at a few other asset classes, small-cap U.S. equities look even worse, at negative (3.6%) real, while high quality looks like they will be the lone segment of the U.S. equity markets to generate a positive real return, at 2.2%. Outside the U.S., international developed equity looks relatively attractive at 2.1% real and emerging markets equities are the best (albeit of a pretty lousy set of options) at 3.7% real. James Montier gave a very good talk on the four things investors can do when faced with a Purgatory environment. He said that investors could Concentrate (pick a handful of the least bad alternatives and overweight them), Seek Alternatives (find alternative ways to gain exposure to traditional risk factors like hedge funds and private equity), Leverage (use borrowed money at these incredibly low rates to enhance low risk returns, a la Warren Buffet’s leveraging of low volatility stocks within Berkshire Hathaway), or Be Patient (simply wait on the sidelines in cash for a better investment environment to emerge). We think that is a prudent construct for approaching this very challenging investment environment and we might make some minor tweaks to the nomenclature to expand our opportunity set as we drive along the Highway to the Danger Zone. While we agree with the idea of concentration in the best segments, we would modify the terminology to being Selective in gaining exposure to sub-segments of the markets based in geography, industry, sector or style that could have differentiated performance relative to the traditional, broad, asset classes. For example, we could choose to invest in the cyclical segment of the emerging markets or European markets, as it appears that investors have moved too much capital into the growth segments of those markets and have created a wide dispersion in valuation. We might also invest in the five sectors of the Chinese markets where we see much higher growth (and hence much better opportunities for equity returns) including Internet, Consumer Staples, Retail, Healthcare and Alternative Energy. We could invest in direct lending rather than publicly listed debt as the spread for accepting modest illiquidity is very wide and the absence of traditional banks in lending to the small/ middle markets has created tremendous opportunities. We have never really loved the term Alternative Investments (always say alternative to what, can only own stocks, bonds, currencies and commodities), so we prefer the say that being Creative in how we gain access to normal risk factors such as long/short, arbitrage, market/neutral strategies that allow investors to profit from both undervalued, as well as overvalued, securities is a better way to think about dealing with low returns in traditional assets. Leverage is just one form of Investment Structure that investors can use to their advantage when returns are expected to be suboptimal. We can also use other forms of structure such as derivative instruments like options and futures and actual structured products that take advantage of differing investor preferences for different components of returns. We would also agree that being Patient is excellent advice when the SML is shaped to deliver poor returns, but we would expand the term to being Tactical, which would include keeping some dry powder dry to capture opportunities as they arise, but also acting expediently to take advantage of trading opportunities when they arise due to the increased volatility. An example of being Tactical would be buying the equities of coal companies this week after the Republicans took control of the Senate, as they will not be as quick to push legislation that will depress the use of coal in electricity generation. Another example would be to add exposure to Japanese exporters after the BOJ surprised everyone on Halloween with their commitment to a larger QQE program going forward to weaken the Yen (which helps Japanese companies sell products overseas). The one challenge to being tactical today is having the ability to respond quickly to these developments as they occur, which is critical in a world of instantaneous information and high frequency trading. One the most repeated lines from the movie is applicable to being tactical in this environment.

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Maverick: I feel the need... Maverick, Goose: ...the need for speed. GMO showed a great deal of data that supported the view that we began writing about earlier this year, that there is mounting evidence that now might be a time to be a little more fearful than confident, to be a little more defensive than offensive, to prepare for a different investment environment than we have experienced over the past five years. We wrote last quarter that “with the Alligator Jaws across various markets beginning to close, and an

increasing number of pundits and financial commentators commenting on the New Normal (that somehow it really is different this time) and how the Fed (and other global Central Banks) has banished the business cycle, established a permanent floor under equity markets and has figured out how to somehow manufacture growth and wealth out of debt (a feat that had never been achieved in many centuries of trying) we simply refer to Sir John Templeton, “the four most dangerous words in investing are, this time it’s different.” History is replete with examples of how it never is different this time, yet investors are perpetually drawn to the narrative that tries to explain how some paradigm shift, some new technology or some change in the basic laws of nature (like gravity) no longer apply. The current narrative comes from Professor Jeremy Siegel (the anti-Jeremy Grantham), who was uber-bullish in both 2000 (internet changes the world) and 2007 (housing wealth effect changes the world), who says that corporate profit margins will remain permanently elevated (despite decades of evidence to the contrary that shows them to be one of the most mean-reverting series in finance) and, therefore, corporate profits will not decline. There is no question that there have been huge innovations in technology that reduced operating costs, that excess labor supply has shifted the power to companies and away from employees (employee share of profits near all-time lows) and that accounting rule changes and financial engineering (stock buybacks and M&A) have all helped boost margins to record highs. But like all trends, there is a point of diminishing marginal returns, and we are more likely near the end of this trend than the beginning. Last quarter’s letter was dedicated to Sir John Templeton’s Investing Rules (we have included an abridged version of those rules in the appendix to this letter for those who missed them) and one of the most important things that Sir John believed was that “we should not be fearful, or negative, too often” and we wrote “that said, at the

appropriate time it makes good economic sense to be cautious when the weight of the evidence warrants such caution. It is always challenging to get the timing right on precisely when to be cautious, and two important quotes apply here, “you can’t predict, you can prepare,” from Howard Marks, and “preparedness averts perils,” from the Chinese idiom “y u bèi wú huàn.” We believe that the increasing weight of the evidence points toward an investment environment that could be best described as the Danger Zone. We don’t think we are quite in the heat of the dogfight yet, but we can see multiple bogeys on the radar (and we are hoping they don’t multiply too quickly). We would say that we are squarely on that highway that leads to the Danger Zone as the Fed looks to have begun their tightening cycle by ending QE and talking with increasing frequency about raising interest rates in 2015. We have discussed how the current environment looks, and feels, like the 2000 to 2002 period where there were excess valuations in certain segments of the markets (technology, biotechnology) and evidence that economic growth was slowing down, which ultimately led to the Recession of 2001 and some substantial losses for equity investors in 2002 (in fact, over the three year period, each year was negative and the cumulative loss was over 40%). Certain segments of the markets fared much, much worse, like the NASDAQ Index plunging (80%). The one difference between now and then was that there actually were a number of asset classes that looked quite attractive (and generated meaningful positive returns over the period) including small-cap stocks, REITs and emerging markets. In today’s investment Purgatory, there are very few places to hide in the event that there is turbulence on the horizon.

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In thinking about the highway analogy, let’s look at 20 Mile Markers that we think provide some indication of how quickly we are speeding toward the Danger Zone. 1) The “Buffett Ratio” (the ratio Market Cap of the S&P 500 over total GDP) is around 130 today, uncomfortably above the 120 reading from 2007 and heading toward the “altitude sickness inducing” reading of 154 in 2000. 2) Tobin’s Q (the ratio of the total value of corporate assets over their replacement value) is 64% above its regression average and has only been higher in 2000 and 1968. 3) The valuation of the S&P as a percentage of a regression of the long-term growth trend is 82% and has only been exceeded twice in history, 88% in 2007 and 149% in 2000. 4) The forward P/E of the S&P 500 is 15.6, above the normal cyclical peak of 15. 5) The Shiller P/E ratio (which adjusts the E for trailing ten year average earnings) is 26.5 and is in the 98th percentile all time, behind only 2000 and 1929. 6) The American Association of Individual Investors (AAII) equity allocation is the highest since 2007, and only surpassed in 2000. 7) The AAII cash allocation is the lowest it has been since the Tech Bubble in 2000. 8) The Investors Intelligence (II) survey of Bulls and Bears has the second lowest number of Bears in history at 15.1% (lower only in 1987). 9) The II percentage of Bulls of 54.6 is at the top end of historical readings. 10) The ratio of Money Market assets to total mutual fund assets is at a low level only seen in 2001 and 2007. 11) The cash level in mutual funds has been lower in only two months, January 2000 and April 2007 (both times six months before market tops). 12) Margin debt outstanding peaked in February of this year, reaching levels seen in 2000 and 2007 (both previous peaks were followed by market tops and recessions). 13) High yield debt issuance is at an all-time high. 14) Stock Buybacks are at levels we have not seen since October of 2007. 15) M&A activity in 2014 eclipsed the trillion dollar level for only the second time in history, surpassing 2007. 16) Deals completed by Financial Sponsors (LBOs) have never been higher (at more than $200B). 17) The multiple of EBITDA paid by financial sponsors in LBOs just exceeded the 2007 peak. 18) The debt levels of transactions completed in LBOs have reached a level only seen in the 2007 debt bubble. 19) IPOs in 2014 are at levels last seen in 2000. 20) The percentage of money-losing companies doing IPOs equals the levels seen during the Tech Bubble. As we look at the weight of the evidence that would prompt a prudent investor (like an instinctive fighter pilot) to consider taking a more cautious posture, we wrote last quarter how Sir John might implore us to “examine the

mistakes we made in 2000 and 2007, to not take money off the table, to not follow outstanding investors like Robertson, Buffett and Klarman in preparing their portfolios for the cyclical shift, for not taking the information content of individual investors pouring in (buying what they wish they would have bought) and insiders selling through IPOs and M&A (happily fulfilling the excess demand created by the individuals by creating new supply), and to ask ourselves why is it different this time?” We know that those are the four most costly words in investing, yet we also know how very challenging it is to resist human nature (overconfidence) to think we will be able to sell right before things get really ugly. Is it possible that we are still many miles away from the Danger Zone and can we expect that along the journey there will be bigger, perhaps even flashing, signs that tell us precisely when to change course in order to avoid an undesirable outcome. Or perhaps we don’t have to worry about flying into the Danger Zone because QEeen Janet, Super Mario and Hero Haruhiko will speed to our aid, like Maverick sped to save Iceman in the final dogfight scene in the movie. Global investors have placed a great deal of faith in the ability of Central Bankers to extend the highway and keep us safely out of the Danger Zone. That said, we wrote last quarter that “I have talked about a core Investment Rule that I have followed over the course of my career that if I

hear something once, I remember it, if I hear it twice, I write it down and if I hear it three times I do something about it. Last quarter we discussed how the positioning of three great investors, Julian Robertson, George Soros and Seth Klarman, was close to neutral/net short in their portfolios or had substantial cash positions and we wrote, “Hear it thrice. Maybe they do ring a bell at the top. Maybe these guys are “Early” but we are going with my Rule and we will begin to lower exposure in our Funds at the margin.”

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Thinking about the four ways to manage a difficult investment environment that we discussed above, we have engaged three of them within our portfolios. We have been significantly more selective in how we build the external manager component of the portfolios and have truly implemented a Top Gun like hurdle for their inclusion. We have been very creative in how we gain exposure to traditional equity risk factors by focusing on true Jones Model Hedged Fund strategies and opportunistically using overlays and hedges to further enhance the return profile of the portfolios. We have been increasingly tactical in the portfolios to manage the ever-shortening investment cycles that we have observed and to take advantage of the routine dislocations that appear more frequently in a world of increased uncertainty and volatility. (We have not used the fourth element, structuring, in these portfolios, as we believe that leverage is better applied in the private portfolios in the current environment.) One of the last scenes of the movie makes a point about the value of these types of hybrid strategies. As the planes return to the aircraft carrier after their victory over the enemy MiGs, Iceman and Maverick embrace amidst the entire crew who is celebrating in the deck and the following exchange occurs. Iceman: You! You are still dangerous. But you can be my wingman anytime. Maverick: Bulls@#*. You can be mine. Maverick was indeed still dangerous, but this time to the bad guys, as he had embraced the discipline of the wingman formation and had emerged as truly the best of the best. We believe that utilizing a hedged approach to investing in the equity markets today is the equivalent of the wingman formation and that taking this more defensive posture is critical, as we speed down the Highway to the Danger Zone.

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Third Quarter Review The biggest capital market event in Q3 was the highly anticipated IPO of Alibaba Group, which turned out to be the largest technology IPO in U.S. history. Given the scope and scale of the event, we were not stepping too far out on a limb last quarter when we wrote “one thing we know we will write a lot about

next quarter is how the Alibaba IPO will likely make this a #SeptemberToRemember.” The idea that a Chinese company could bump so many notable U.S. technology powerhouses from the top of the leaderboard shows how far the trend of globalization has come in recent years. BABA now sits as one of the twenty most valuable companies in the world, quite an astonishing accomplishment for a company that had essentially failed after its first IPO in 2007 and had to be rescued by investments from Yahoo and Softbank (who made two of the most incredible venture investments in history by turning tens of millions into tens of billions). Opportunities like BABA do not come around very often, so when they do, you have to take advantage and be flexible in order to capitalize and create outcomes that are truly memorable. In examining the overall market results of Q3, it is helpful to take a step back to the beginning of the quarter and think about the environment we found ourselves facing as summer began. There has been a very interesting pattern in each of the past four quarters, that equity markets fall for the first two to four weeks of the period and then turn sharply upwards when the Central Doctors (Bankers) agree to provide another hit of Monetary Morphine. Q2 followed this pattern (with an extra dose of steroids) as we highlighted in #NotDifferentThisTime that

“from the trough, the S&P 500 was up a robust 8% while the NASDAQ was up nearly 11%, the bulk of the market advance came from a rise in the P/E ratio, which now stands at levels we have not seen since the Tech Bubble in 2000 (the forward P/E of the S&P is 16.4).” When looking at other measures of valuation in the U.S. equity markets it was hard to ignore that

on every measure the markets were in distinctly overvalued territory whether you looked at P/B, Market Cap/GDP, CAPE Ratio, Tobins Q or current P/E relative to trend. The Bull story was that the Earnings Yield (the inverse of the P/E) was significantly higher than the 10 Year Treasury yield and therefore (wait for it…), stocks were not only not expensive they were actually cheap. The flaw with this logic is that an investor doesn’t actually benefit from this “yield” as the only true yield an investor gets is the dividend yield (cash paid out) and the real beneficiary of the increasing multiples on equities are the management teams that have options that are struck at lower prices. The other problem with this story was that the Treasury yield was being artificially depressed by the Central Banks, so the comparative advantage would quickly dissipate in an environment where rates normalize (read, no more QE) and stock prices would likely fall sharply back toward equilibrium. While it was relatively easy to see the overvaluation (at least we thought so), we discussed how difficult it was to get the timing of the adjustment right and said

“that even though the valuation levels of the U.S. Equity market are around 2 standard deviations above normal, there was nothing prohibiting them from rising further to 2.5 (or even 3), but that eventually there would be Mean Reversion (Jeremy Grantham calls Mean Reversion one of the most reliable forces in the Universe alongside gravity).” So, as we began the third quarter, we expected to see some reversal in the market momentum for the first few weeks leading to another shot of Monetary Meds to get the patient moving back on the upward trajectory. Q3 followed the script nicely with a couple of plot twists that set the stage for some potentially very interesting market movements in Q4. The equity markets fell for the first few weeks of the quarter, zoomed back to new highs in August around the Jackson Hole Fed rhetoric, but then stumbled in mid-September and began what appeared to be a fairly ominous decline starting the day of the historic Alibaba IPO on September 19th (which some pundits labeled as the market top given the incredible frenzy

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to get allocation to BABA shares). People have been calling for a market “Top” for many quarters and we doubt that the IPO of a Chinese Internet company would be the event trigger. In fact, we discussed in #NotDifferentThisTime that all the discussion of a market top might be misplaced in the near term in saying “there are some arguments against this

outcome, namely that bull markets rarely end with a steep yield curve (no sign of short rate increases until at least 2015) and historically every $100 billion of QE has translated into 40 S&P 500 points (calculated by Larry Jeddeloh at TIS” with the latter calculation coming up with a year-end 2014 value for the S&P 500 of 2,050 ($500 B of QE = 200 points on top of starting level of 1,846) which turns into an 11% return for the index for the year. Through the end of Q3, the S&P 500 was up 8.3%, actually precisely where it should be if that 11% return was the right number. Given we closed on Halloween at 2,018, there would still be a little upside left for the equity market to reach the 2,050 level by December. If the markets have been driven by the QE equation since 2009, as Larry suggests, the cessation of QE this month does beg the question of what happens in 2015, but that is a question for the Market Outlook section. If we step back look at the quarter from the 30,000 foot view vantage point, it actually looks like a pretty boring three months, with not much excitement and not much movement in the markets as the S&P 500 rose a scant 1.1% and the Barclays Aggregate Bond Index was nearly flat at up 0.2%. But if we zoom in a little closer, we see lots of wild movements during the quarter that may offer glimpses of things to come in the coming months and quarters. While the large-cap indices did fine during Q3, there was some real pain in a number of other segments of the equity markets as small-cap stocks were pounded, falling (7.4%) but small cyclical stocks fell even more with the R2000 Value Index dropping (8.6%). There was a nearly perfect inverse correlation between size and performance during the period as the largest companies surged and the smallest companies plunged as investors began to migrate back to “safe”

sectors like healthcare, technology, telecom, financials and staples which rose 5.5%, 4.8%, 3.1%, 2.3% and 2.1%, respectively. Digging a little deeper into the sector performance, it is actually a little odd to have defensive sectors like healthcare, utilities and technology leading for the CYTD (up 16.6%, 13.9% and 14.1%, respectively) given those are the sectors that lead during economic slowdowns, not expansions, yet all the headlines herald how great the U.S. economy is doing and how a GDP growth rebound is “just around the corner” (despite the actual data pointing to the simple fact that -2.1, 4.5, 3.5 for the first three quarters average to just under 2% which is anything but robust). We wrote in #NotDifferentThisTime that “small caps have been the

leaders in the U.S. equity market for a number of years, serving as the head of the liquidity fed momentum monster since the turn in 2009. But, as my high school wrestling coach used to say “where the head goes, the body follows” so if the head of the market continues downward, we could see a rapid shift in momentum in the quarters ahead.” Perhaps the markets, as they usually are, are leading indicators of trouble ahead for economic growth as the Killer Ds of Demographics, Debt & Deflation continue to rear their ugly heads in the developed markets. Another potentially worrisome sign of potential economic malaise is the rapid decline of oil prices, which dropped a stunning (14%) during the quarter, calling to mind comparisons to the dramatic declines in 2007 right before the Global Financial Crisis. Many are saying “it’s different this time” (which we know from last quarter’s lessons from Sir John Templeton are the four most dangerous words in investing) as the media proclaims that this price decline is Supply driven, not Demand driven, and we would agree that there could be something to that narrative as we discussed last quarter when we discussed the potential for oil prices to decline and wrote “they (never been

sure who “they” are…) say that “the cure for high prices, is high prices,” as the rising price of an asset prompts competition to develop to capture the higher profit margins, which increases supply, which sates

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incremental demand, which leads to lower prices.” The shale oil revolution has clearly dramatically increased supply coming from the U.S., but, interestingly, that was not a new story as that production had been ramping since 2009 and oil prices had continued to climb. Part of the reason for the continued ascent in prices was the inexorable increase in global demand (particularly from emerging markets, most notably China) and the unexpected (and much less discussed) loss of production from a number of Non-OPEC countries that nearly offset the gains from the U.S. shale. Oil prices actually peaked on the day that the Russian sanctions were announced on June 16th and have been in steady decline ever since and there is speculation that the real reason for the decline is a concerted effort by the U.S. and Saudi Arabia to lower prices to put pressure on the Russian economy (similar to the collaboration between the U.S., UK and Saudi Arabia in oil markets to thwart the Soviet Union in the 1980s). Time will tell if the downward spike in prices is the result of a positive Supply shock or a negative Demand shock (from slowing global GDP growth), but this market is likely to remain quite volatile as the inverse of the above rule will begin to apply and “the cure for low prices, is low prices” as production will get shut in when it turns non-economic and that will eventually lead to the potential for an upward spike in prices should demand stabilize, or even rise if global GDP growth turns. One of the biggest surprises in Q3 was the incredible strength of the U.S. Dollar as the currency surged after the ECB announced more rate cuts and hinted (again) at the potential for the European QE (which is still illegal and there is no sign of Germany weakening their resolve to prevent any direct bond purchases). As we have seen over and over with Super Mario Draghi, all he has to do is “say” he is going to do something and the markets “believe” him and we have seen historic moves in a number of assets in response to the ECB musings, including record low Sovereign bond yields and now near record movements in the Dollar, as the Greenback soared nearly 10% in

September alone. The huge move in the Dollar absolutely pounded international and emerging markets equities and commodities and the carnage was widespread. For perspective, the MSCI EM Index dropped (7.4%) and the ACWI ex U.S. fell (4.8%) in September alone. For the quarter, ACWI ex U.S. dropped (5.3%), EAFE was down (5.9%), MSCI EM was off (3.5%) and the DJ UBS Commodity Index was down an amazing (11.8%). Digging a little deeper into the international equity markets, astonishingly, there was not a single developed market with a positive return in Q3, but the pain was really severe for the European countries as the Euro got smacked by the Dollar and losses were large across the Continent with Germany dropping (11.2%), France down (8.4%), Spain down (7.5%), Italy falling (8.7%) and two countries with some banking woes, Austria and Portugal plunging (21.6%) and (25.0%), respectively. Three of the European Emerging Markets, Russia, Turkey and Greece were pounded hard, losing (15.4%), (11.8%) and (20.0%) respectively. There actually were a few Emerging and Frontier Markets that performed well during the quarter as China rose 1.4%, India rose 2.3%, Indonesia was up 3.4%, Thailand jumped 7.6% and the Middle East surged broadly with Qatar up 17.7%, Egypt jumping 28.2%, UAE surging 22.9% and Saudi Arabia rising 15.1%. On Saudi, we said last quarter that “the opening of the

Saudi market to foreign investors should serve as a significant catalyst to move the market higher as capital flowing in from global institutional managers is likely to equate to a significant portion of the current Saudi market cap. Additionally, “opening” the market removes the primary hurdle that has historically prevented MSCI from including Saudi in their Indexes.” Countries like UAE and Qatar that have been included in the MSCI Indices have continued to attract capital and rise over time and we would expect the positive momentum to continue for Saudi Arabia in the coming quarters (which is why we have material positions in all our Funds). One international market that deserves a little more in -depth analysis is Japan. We continue to see the

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strongest upside in the developed equity markets in Japan (in their local currency as they are on a mission to weaken the Yen, so U.S. investors need to hedge the currency) and we wrote last quarter that “as Japanese

corporate earnings are growing much faster than the rest of the developed world, we expect to see continued relative strength of the Japan markets vs. the U.S. and Europe in the second half of 2014.” Looking at the results on Q3, that prediction held true, as the performance of Japanese equities was much stronger than the U.S. and European stocks and while the Yen decline pushed return of the MSCI Japan Index in dollars to down (2.3%), those investors who maintained a hedged approach (for example, bought DXJ) saw gains of nearly 6%. We also mentioned that the prospects for Japan Inc. were bright - “even without additional monetary stimulus

from the BOJ, and without any further depreciation of the Yen, as investors are beginning to understand the incredible earnings power of the top companies in Japan and the growth opportunities as they capitalize on supplying goods and services to support the dynamic growth in consumption in Asia and Africa.” That said, while the Japanese commitment to Abenomics continues to be very strong, there has been some consternation globally about the lack of response from the BOJ to expand the QQE program after the disappointing economic results following the Consumption Tax increase in April. The BOJ’s resolve to wait for the full impact to be assessed in the Q2 data drove many foreign investors out of the markets and caused increased volatility. As Halloween approached, those investors began to act downright ghoulish, pushing the Nikkei and Topix indices down to near the lows for the year. Then in mid-October, the Yen began to weaken and equities began a very sharp rally culminating in the Shock and Awe surprise announcement by the BOJ on Halloween morning that they would indeed “Do Whatever It Takes” in extending QQE and the Yen collapsed from 109 to 112 in a heartbeat and the Nikkei surged nearly 5% for the day (and lucky owners of DXJ, like us, made 6.6%) to close a wildly volatile month. We are reminded that the last time

the BOJ made an announcement like this, the Yen dropped 25% and Japanese equities surged 60% over the next twelve months and while the conditions are not exactly the same as in late 2012, we do sense a similar commitment by Abe-san and Kuroda-san to show the world that the work of Abenomics is far from complete. We wrote last quarter that “when it

comes to Japan, while there are many skeptics out there, we are reminded of Sir John’s second most quoted line “Bull Markets are born on Pessimism, grow on Skepticism, mature on Optimism and die on Euphoria,” so with the very high level of Japan-doubters we expect to see continued gains in Japan.” We would reiterate that view here and think that the events of the last few weeks point to an increasing likelihood that the Japan Bull Market has far to run before it rests. China is another market where we could spend the better part of the whole letter discussing the opportunities and challenges of capitalizing on this rapidly changing country and economy. We noted last quarter that “the biggest overarching story (that

with the greatest potential impact over the long term) is China’s New Leadership and their commitment to the Reform agenda. We have an emerging theme that we have been developing from a study of history of government leaders that used the word “Reform,” or who were labeled “Reformers” and the results are quite dramatic (think Ronald Reagan in the U.S. or Margaret Thatcher in the UK).” In fact, we feel so strongly about this topic that we just did an Around the World Webinar on The Reformers: India, Indonesia, Brazil, Mexico and Argentina. We didn’t include China in this particular presentation as we had done a separate presentation on Beyond Alibaba: The Rise of the Chinese Consumer (for a copy of the presentations and links to the replays please email IR @morgancreekcap.com). We wrote last quarter that

“the shift to Consumption in China is a multi-decade opportunity and we have talked at length in previous letters about the opportunities we see in #ChinaInternet, Consumer Retail, Consumer Services, Healthcare and Alternative Energy.” We discussed a

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number of investment ideas that we thought would benefit from the Reform Agenda and the move toward a more Consumption based economy, including China Coal Energy, Great Wall Motor Co., China Vanke, China Overseas Land, China Resources Land and Poly Property Group (601898: CH, 2333:HK, 002:CH, 688:HK, 1109:HK, 119:HK, respectively) and a basket of China Banks. In Q3, the property names continued to struggle, while the other names had mixed performance. Finally, we compared the on-line Real Estate companies SFUN and EJ to Z and TRLA in the U.S. and pointed out the huge discrepancy between market share, revenue and profits (the Chinese companies have a lot and the U.S. companies have a little) and said we preferred to be long companies with profits and short those without. Turning our attention to Bonds, there has been a nearly universal call since the beginning of the year for higher interest rates in the U.S. as fears of the Fed changing the timetable for raising short-term rates were exacerbated by a series of better than expected economic statistics that were released during the quarter. While we did not share the same level of excitement over falling unemployment rates and a strong Q2 GDP print given our view that these events were expected because of the elimination of extended unemployment benefits in December and very weak growth in Q1, general market participants took every chance to “sell the rally” in bonds. However, by the end of the period, the Bond Bears were licking their wounds again as Long Treasuries rose 2.7% (besting stocks for the quarter and YTD). We wrote last quarter “we started 2014 with a highly differentiated

view on the direction of interest rates and the opportunities in long-duration bonds based on our belief that Sir John was right and it wasn’t different this time. In the two previous cycles where the Fed ended QE (for brief periods before they had to bring it back) interest rates were projected to rise, but instead fell dramatically.” The impending end of QE this month implied (at least to us) that interest rates were more likely to fall, than rise, and that government bonds would continue to be a surprisingly good

investment. We also wrote about one of our favorite managers in London who had managed to produce double digit returns both last year and this year, despite being 50% net short, and explained that “one

of the reasons he is doing so well this year is he has a huge (around 60% of his gross exposure) position in government bonds (long Treasuries and Bunds) as he continues to see a larger risk of Deflation than Inflation in the developed markets, particularly in Europe.” That belief that Deflation is a larger risk than Inflation has been a real moneymaker in 2014, as we actually predicted in Year of the Alligator, and we expect that our friend Russell’s positioning may again look very prophetic at some point in the coming quarters. Maintaining a Variant Perception on interest rates will likely continue to be a profitable stance as interest rates in the developed world are likely to be #LowerForLonger. Q2 was an “all-in” quarter for yield products as everything from high yield to EM Debt to MLPs and REITs surged, but Q3 was more treacherous for those strategies as nervousness about credit quality finally made its way into investors’ collective consciousness. The BoAML HY Index dropped (1.9%) and the HYG and JNK ETFs suffered a little more, dropping (3.5%) and (3.8%), respectively, as investors cashed out of risky debt for the first time in years. REITs were hammered by fears of rising rates (although, again rates actually fell) and gave back (3.2%) which barely dented their spectacular 13.9% return for the year. The returns for EM Debt were quite varied depending on whether you owned Dollar denominated bonds or local currency bonds as the Dollar Bonds fell only (2%), while the Local Bonds plunged (7%), wiping out nearly their entire gain for the year, now up only 1%. MLPs somehow managed to duck the bullets of rising rate fears and a rising Dollar, as the Alerian MLP Index managed a 2.7% return for the quarter, pushing the CYTD return to an inspired 19.5%. Investors are still feeling the effects of Financial Repression and continue to push further and further out on the risk spectrum to find yield. We know how that game always ends, in tears, but until such time when the

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Central Bankers decide to “Release the Kraken” of higher rates, anything with even a mid-single digit yield will be overrun with capital. Q3 was an absolutely miserable time to be a commodity investor as the huge surge in the Dollar in late August and September crushed all things related to commodities. The carnage was severe across all sectors causing double-digit losses in the broad indices, with the DJ UBS Index down (11.8%) and GSCI down (13.8%). Digging deeper into the individual markets, it actually gets worse as Gold was the “winner” falling only (8%), Silver fell (19%), Oil dropped (14%), Natural Gas slipped (10%) and the Ags plunged to lows we have not seen in years with Wheat and Soybeans down (20%) and Corn plummeted (22%). When we wrote the Q2 letter in July, it appeared that the Ags were basing and we said

“we actually see signs that those markets are firming again and expect that we could see some meaningful gains in the Ags (Corn, Wheat, Soybeans are all at meaningful lows and look to be basing) again in the second half.” So clearly we were “early” (the euphemism for wrong) as there was another big leg down in September with the Dollar debacle, but it does appear now that these markets did indeed bottom in early October and they have been rallying strongly in the past few weeks. We will see what the rest of the year brings, but it seems unlikely that we would have back-to-back years of record crop producing weather (there are already reports of unseasonable weather in a number of important regions). We wrote last quarter that “in nearly a

mirror image of the Ags space, sentiment in the metals markets is quite strong. In fact, the underlying trends in the stocks of metals related businesses (Alcoa, Freeport-McMoRan, Southern Copper) have begun to break out all over the place,” but that momentum dissipated quickly when the surging Greenback and metals companies all exhibited negative volatility. Focusing on precious metals for a minute, we did warn that “Gold and Gold Equities

also look to have made a peak around the 17th (Bradley Dates have a three day “window”), which

conflicts with our positive long-term view but there could be a short-term period of weakness over the coming months for precious metals (particularly if the Dollar continues to strengthen) so we will respect the Bradley information and tighten our stops here.” Selling our exposure to Gold was a good thing as GDX and GDXJ plunged (20%), but we clearly should have applied that logic to all commodities, but we (nor anyone else we know) did not anticipate the magnitude of Dollar strength that emerged in September. As we sit here today, the words of Sir John Templeton are running through our minds over and over to look for opportunities where things are the most miserable and on the TMI Scale (Templeton Misery Index) commodities look pretty interesting since the world is convinced that the Dollar is going to surge and that the Commodity Super Cycle is over. Conventional wisdom in investing is a very strong contrarian indicator, so we may find ourselves writing about better returns in these sectors in the quarters ahead. Hedge fund performance has been mixed in 2014 and Q3 was no exception, albeit a mirror image of the first two quarters, as the HFRX Event Driven Index produced negative returns, falling (2.8%) while the HFRX Macro/CTA strategies finally caught the right side of the markets and rose 2.7% and 4.6%, respectively. The HFRX Equity Long/Short Index struggled in the quarter, falling (1.3%) as the short side continued to produce negative returns during the melt-up months like August. Looking at the indices for the CYTD, the HFRX Event Driven Index was up 1.5% and the HFRX Multi-Strategy Index was up 3.1% and the HFRX Macro and HFRX CTA Indexes managed to nearly take the lead for the year on their strong Q3, rising 3.8% and 4.8%, falling only slightly behind the HFRX Relative Value Index, up 4.9%. These returns are roughly in-line with traditional fixed income returns (up 4.1%), however, we believe there is still significant benefit to shifting from bonds toward Absolute Return strategies since they have a positive correlation to interest rates (they have floating rate elements) whereas bonds have negative correlation (rates rise, bonds lose money), so there is an added

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portfolio hedging benefit to holding A/R rather than fixed income in the current environment. Equity Long/Short strategies have struggled much more than we anticipated in 2014, as was the case in Q3, as the extreme volatility on the long side in July was focused on small cap and growth names held by many managers and the sharp rally in August caused significant losses on the short side. Once again (for the seventh quarter in a row) the short squeezes were particularly acute in the most overvalued segments of the markets including tech, biotech, social media and cloud. As Yogi Berra was fond of saying “it was déjà vu all over again.” The difference in Q3 was that unlike the previous two quarters of 2014, the end result of the long and short struggles resulted in a small loss, rather than a small gain and the hedge fund indices fell further behind the S&P 500 (again). The continuing problem during the QE Era has been the inability to extract the usual dual alpha from longs and shorts that has produced the outstanding returns of HFs relative to long-only funds for many decades. One bright spot was that during Q3, some of the highest quality managers outperformed quite nicely. A number of top managers had meaningful exposure to Alibaba which was very accretive to their portfolios. Just for perspective, one manager’s position in Alibaba is up 38% for the year. Through the third turn of the race that is 2014, it has been a volatile and treacherous track for investors and the average balanced portfolio (stocks/bonds/cash) investor is lagging again as a 60/40 portfolio would have generated a 6.6% return (8.3*0.6 + 4.1*0.4), however, mutual fund flows show that many investors unfortunately de-risked their equity portfolios during spring turbulence and didn’t capture the full equity upside. Investors who had too much cash, or had diversified into alternatives are up even less as cash has had no return and alternatives have produced bond-like returns. We mentioned in the Q1 letter an interesting statistic “that there have been 17 years

where the S&P 500 has returned more than 25% and the average return in the following year has been just

6%. The range of outcomes is quite interesting, however, as 6 of the years were negative and 6 of the years produced double-digit returns again, with the remaining 5 years closer to the average.” At the beginning of Q2 it appeared the 6% number was highly likely and as we sit here today at the end of October, the upper end of the range looks possible. There is a big unknown ahead with the mid-term election next week and volatility that historically surrounds these types of events. Another statistic that is interesting is that in every mid-term election year since WW II the equity market return from the last week of October through year-end has been positive, and further, has averaged nearly 9%. So, now everyone “knows” that we will have a Santa Claus Rally and there is also a lot of discussion of how managers will have to “play catch up” with the indexes so they will be taking more risk which will also push up stocks. I can’t help but hear Mark Twain here when he says “it ain’t what we don’t know that kills us, it’s what we know for sure, that just ain’t so…”

Market Outlook Sir John Templeton believed that in order to beat the market, you had to start by asking the right questions. One of his personal pet peeves was that people would always ask him “where are things the most attractive?” and his standard response was that was the wrong question and that they should be asking him “where is it the most miserable?” We wrote in #NotDifferentThisTime how we had embraced this construct and that “I started tweeting last January

about the #TempletonMiseryIndex (my less than quantitative perception of which countries looked the most miserable and, therefore, were the best places to look for bargains) and talked about places like Russia, India, Greece and Spain, as well as Thailand and Turkey, as being places where long-term focused investors could find great opportunities.” For the first half of 2014, Sir John’s approach worked extremely well and nearly all of those countries were up nicely. Only Russia was down, but had showed recent

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promise by clawing back from being down (25%) at the height of the Crimea situation to down (10%). The other five countries ranged from even with the S&P’s 5% gain to 2X, 3X, even 6X that gain, as India rallied hard on the Modi/BJP victory. Then something dramatically changed on June 16th with the announcement of coordinated sanctions against Russia. The impact was very localized in Russia at first, but then began to spread more broadly into emerging markets as the price of oil began a steady move downward. Over the course of the quarter, the move in oil accelerated with WTI dropping (5%), as the Dollar (DXY) rallied 4% in the month and emerging markets were hammered, falling (7.4%) for the month (interestingly, the move in oil reached a fevered pitch in October as WTI plunged (11.6%), perhaps reaching a nadir on election day, down (28%) from the June peak). Interestingly, among the EM countries, Thailand actually kept rallying over the period and India kept its head above water on the momentum from the election, but Russia and Turkey both dropped double digits (one important note is that most of the losses were actually currency losses). The other part of the story that changed dramatically was the concerted moves by the ECB to weaken the Euro, which hurt Spain, and the rise of a dissident faction in the Greek election morass that spooked investors causing Greek shares to plummet (35%) over the past few months. So as we stand here today, we see some wide dispersion with India up 27%, Thailand up 19%, Turkey up 10%, Spain down (6%), Russia down (27%) and Greece down (23%). Clearly things are much less miserable in India, Thailand, Turkey and Spain, but the TMI indicator is flashing brightly in Russia (importantly, the Russian equities are actually up in local currency, but the Ruble’s (38%) collapse leaves Dollar-based investors with losses) and Greece, potentially pointing to significant opportunities ahead. We know there is great misery in both places, but the important question is: what is the catalyst that turns them around? We dubbed 2014 the Year of the Alligator and when we did our first Around the World Webinar in

January we had six key regional investment themes where we thought it would be (to quote Maverick), a Target Rich Environment. In addition to our TMI candidates of Greece, Spain & India, we saw very compelling opportunities in Argentina, China and Japan. We knew that many of these themes were out of favor coming into the year, but our view that 2014 would look very differently than 2013 (the essence of the Alligator Jaws analogy) led us to take a contrarian posture and look beyond the U.S. for the best opportunities. As discussed above, India has been fantastic, Spain has been mixed and Greece has been very challenging in the past few months. Argentina has been truly stunning (albeit very volatile), rising over 29% (the Merval Index is actually up 115%, but the currency devaluation trimmed Dollar-based returns), as they have overcome currency devaluation, a technical default on their Sovereign Bonds (thanks to an impasse with the hedge fund holdouts from the London Club settlement) and continued craziness from their bi-polar president. China was very challenging for the first half of the year as the indices made no progress, but as we have said to focus on specific sectors in Internet, Healthcare, Retail, Consumer and Alternative Energy, there have been some real winners in those segments. We reiterated our view that markets could react to the Bradley Turn Date last quarter and wrote “we discussed how these

dates tend to usher in a change in trend of markets, what has been hot cools off, and what has been cold heats up. There was another major turn date on July 16th and it appears that there could be some predictive power again if the first few weeks develop into a more major trend. Interestingly, the Shanghai equity markets made a breakout and the CSI 300 A-Share index made a sharp turn upwards right on the 17th.” Since then, the China markets have been quite strong with FXI up 3%, CAF up 13%, VIPS up 24% and Phoenix Healthcare (HK:1515) up 21%. Japan had a very difficult Q1 as the BOJ disappointed investors by remaining on the sidelines with respect to additional QQE stimulus and the GPIF (Government Pension Investment Fund) delayed their decision to increase their equity allocation. Then we wrote last quarter

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that “Q2 performance in the Japan markets was solid

overall with the Nikkei up right in line with the S&P 500 and Japanese equities actually surged ahead in July on continued strong earnings,” but that momentum slowed in September as the BOJ disappointed investors again by not increasing stimulus. Then, in a flurry of activity in October, the GPIF announced a big change to their asset allocation policy in favor of equities and Kuroda-san gave everyone a Halloween treat with a big jump in QQE from 50T Yen/mo to 80T Yen/mo of asset purchases and DXJ surged 6% on the last day of the month to finish the April to October stretch at nearly 2X the S&P (16% vs. 8%). If we look across these nine countries during 2014 we see that what primarily separates the winners from the losers is whether they had a significant change in government and that the new leadership is focused on Reform (with the exception being Argentina, which has rallied on anticipation of new leadership in 2015). We believe that there are a number of countries where these reform-minded leaders are creating very compelling investment opportunities and we will continue to focus on them in the coming quarters (we felt so strongly about this theme that we did our last ATWWY Webinar on The Reformers: India, Indonesia, Brazil, Argentina and Mexico). When we begin to create a forward-looking Market Outlook, we start from a baseline of asset class return expectations over the intermediate term (the next seven years). We lean on the quantitative models from GMO to provide real return forecasts for the traditional asset classes (stocks/bonds/cash) and we follow a similar framework to create forecasts for the non-traditional asset classes (hedge funds/private investments). We take GMO’s real return forecasts add an expected alpha component on top of those beta returns and add back the expected inflation to arrive at a nominal expected return. The October forecasts show the bulk of traditional asset classes as overvalued today and expectations for returns for the balance of the decade are likely to be well below the long-term averages. Looking at the forecasts with

alpha included, we see the following expected compound annual returns; Large-cap U.S. equities 2.3%, Small-cap U.S. equities (0.4%), High Quality U.S. equities 5.8%, Large-cap International equities 5.7%, Small-cap International equities 5.8%, Emerging Markets equities 8.9%, U.S. Bonds 2.4%, International Bonds (0.3%), EM Debt 5%, Inflation Linked bonds, 2.9%, Cash 2% and Timber (proxy for Commodities) 9%. In order to avoid confusion (if you look at the GMO chart and notice the numbers don’t match), remember that I have restated the Real returns in Nominal terms (adding back their 2.2% inflation forecast), since most investors think in nominal terms, and added an alpha component that an investor could anticipate from good managers. One caveat to these forecasts is that if inflation is greater than 2.2% over the period, expected returns would rise by an equal amount (with inflation at 1.3% today, we will take the under). So with these baseline forecasts, our 0-3-5 Conundrum continues to challenge investors. With cash paying 0%, a diversified portfolio of Bonds (U.S., International, EM & HY) is likely to deliver 3% and a diversified portfolio of equities (U.S., International & EM) is likely to produce around 5%. An investor who creates a standard Stocks/Bonds/Cash portfolio can mix it up any way they want, 60/30/10, 60/40/0, 100/0/0, 0/100/0, and they just can’t get to a 7% to 8% return (without buying 100% bonds AND 100% stocks, so modest leverage could be the right answer). One caveat is that an investor could achieve an 8%+ return if they concentrated only in EM equities and Timber, but very few investors are intrepid enough to make those kinds of concentrated bets. The true conundrum is that investors NEED 7% to 8% to meet their liabilities, so there must another solution, right? We believe there is a solution, but it requires meaningful effort, skill, discipline and patience to achieve. Investors can focus on building a portfolio of skill-based investment strategies (rather than marketbased traditional strategies) like hedge funds, private investments and tactical investment funds that seek to exploit alpha opportunities foregone by investors who

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cling to the passive 60/40 model. The toughest part of that recommendation is that these strategies have underperformed traditional equities over the past five years, so the natural inclination is to extrapolate the recent past and want to buy more S&P 500 (despite all the historical evidence that buying at these levels produces inferior returns). There was another great chart at the GMO event that broke the U.S. equity valuation environment into quintiles from cheapest to most expensive over the past hundred years, which showed that starting from the most expensive 20% of the time (where we are today) the average Real return over the next decade is less than 2% (around 4% Nominal). To believe that you will earn the average nominal return of 10.5%, you have to believe in an outcome that has never occurred in the history of modern equity markets, essentially that “this time it’s different.” The next step in thinking about the Market Outlook is to take a shorter time horizon perspective that incorporates other factors into the equation beyond valuation. There are many other factors that influence shorter-term (six to twenty-four months) returns including momentum, government or regulatory changes, dislocations from unanticipated events and, in the recent past, Central Bank actions that can heavily influence liquidity and that are routinely driven by non-economic factors that are difficult to predict. In other words, cheap assets can become cheaper and expensive assets can become more expensive in the short-term and avoiding losses that can occur from fighting the trends in momentum, liquidity and sentiment can add value to a portfolio over time. An important issue here is the Principal/ Agency problem in the investment business. When you are a Principal (investing your own money) it is much easier to have a very long-term perspective and also much easier to endure periods of time when your portfolio is out of synch with the momentum in the market. When you are an Agent (investing money on behalf of someone else) there is a consistent pressure to “win” in the short-term as the owners of assets have benchmarks to which they hold their agents

accountable. Therefore, it is much more challenging to hold positions that are out of synch with the markets (even if they turn out to be right in the longterm). Consider the 1999 to 2000 period as an example. There were a large number of firms/funds that believed that the technology bubble had pushed equity prices to dangerous extremes (in hindsight it was very clear we were smack in the middle of the Danger Zone) and based on longer-term valuation metrics, sold their high-fliers and moved into more value focused sectors. Unfortunately, the momentum of investor sentiment kept going for nearly a year after reaching those dangerous levels and just about every active manager/hedge fund on the planet was lagging the S&P 500 (a cap weighted index that, by rule, buys more of things as they become more expensive, so always wins in liquidity driven rallies) as no prudent manager wanted to overweight companies like CSCO and MSFT at triple digit P/E ratios (as opposed to the indexes which had no choice but to own them). After multiple years of relative underperformance, the Principals had seen enough and they began firing their Agents in droves. A number of very famous value managers (Julian Robertson, Gary Brinson, and Tony Dye) actually went out of business and were relegated to becoming Principals (investing only their own money). GMO obviously didn’t go out of business, but at the conference Jeremy shared the HBS Case on GMO where the opening line is a quote from a disgruntled client that says “Sit down. I want you to

know you have done a very bad job managing our money and I don’t want to hear any of that mean-reversion nonsense…” (similarly, I was actually told by my board chair at UNC around the same time that I was not allowed to use the letters G, M or O in a sentence again) and reminded the audience how GMO’s assets dropped from $30B to $20B in a matter of months. We know how this movie ended, the value managers were right (Julian’s portfolio finished the year up 55% while the index fell (9%)), the tech names were egregiously overvalued and those who chased the hot performance of the Index lost a lot of money and those who followed the discipline of value lost significantly less (and ended up with more money

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over the whole period). As we consider short-term factors in looking at markets around the world, we are continually reminded of the 2000 period (and a little of 2007 as well) as there have been lots of recent articles showing how the Indexes are trumping active managers again, how hedge funds have lost their edge and are not worth the fees (similarly, hedge funds had actually been banned at UNC right before I got there in 1998), how there is too much money in private equity and returns have lagged the public markets (for large buyouts, we might agree with this one), why emerging markets are a poor place to invest because developed markets have dominated over the past five years (Central Banks have been much looser in DM than in EM) and why the commodity super cycle is over so financial assets will outperform real assets (we would side again with Jeremy on this one as finite resources would seem to have upward price bias long term). These same articles seem to resurface every cycle, without fail, right near the end of the cycle (which makes sense as easier to write an article if the recent data is supportive of conclusion). So as our baseline for the near-term forecasts we would lean toward Active Management, away from Passive and Indexes, toward Hedged Strategies and away from Long Only in the U.S., toward Private Investments (emphasis on Small Buyouts, Growth Capital (with extra emphasis in EM), Energy and Lending), toward Emerging Markets over Developed Markets and toward Real Assets relative to Financial Assets. From that baseline, we can look across asset classes, geographies and sectors/industries to find investment opportunities where we would expect to earn excess returns in the year ahead. In thinking about the Highway to the Danger Zone theme, if our analog is that 2000 to 2002 period, 2001 was the transition year where the U.S. economy turned down and set the stage for some quite challenging times for equity investors (but it also created some of the most outstanding opportunities to deploy capital into emerging markets, private equity and energy) so 2015 could offer many of those same opportunities. The other notable aspect of that period

was how after a very tough five years of underperformance by hedge funds (relative to the S&P 500 Index), hedge fund performance was vastly superior to long only equity strategies. Some interesting historical perspective here is that we were able to reverse the ban on hedge funds at UNC in early 2000 and we rapidly shifted the portfolio away from long only toward long short by fall of that year. Thanks to those moves, we were able to hold the Endowment flat over the whole three-year period versus a loss of nearly (25%) for the average Endowment or Foundation. The primary point being that opportunities will exist on the long side, the short side and in the private markets, even in a challenging environment in the U.S. for traditional assets. Breaking down the opportunity set today, we can begin with the traditional divisions between Developed Markets vs. Emerging Markets, Equity vs. Fixed Income, Public vs. Private and Financial Assets vs. Real Assets. In the developed markets, we find equity more attractive than fixed income (with one exception of long duration bonds as a deflation hedge, more on that later) and see the best opportunities in Japan, followed by Europe and then the U.S. markets. We will dig deeper within the major categories and discuss where we see the best opportunities in areas like value/growth, large/small, technology/healthcare/ consumer in later sections. We favor Emerging Markets relative to developed markets despite the pervasive fears of the end of QE in the U.S. and Dollar strength causing stress for EM. That said, there are clearly certain countries that will suffer more than others if the Dollar continues to remain strong, so we will dig deeper into how we would segment EM into Service (current account surplus) economies and Commodity (current account deficit) economies below. We continue to favor private investments over public investments in just about every sector. If you have the luxury of not needing liquidity in the short-term, there has rarely been a time when you were rewarded more handsomely for accepting illiquidity risk. We have seen a continued acceleration in the quantity, and quality, of deal flow in the private

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investment markets across a wide swath of sectors including technology, healthcare, manufacturing, retail, energy and natural resources. The other aspect of these markets that is quite attractive today is the opportunity to tailor your exposure to any risk profile as the opportunities cut across the entire capital structure of companies from senior debt, to mezzanine, to preferred stock and common equity. One final area to note is the rapid development in depth and sophistication of markets in regions of the emerging and frontier markets has been remarkable. This point is punctuated by an opportunity we came across in an African Cell Tower deal. This was a triple play deal; the unit economics of the tower business are outstanding (think renting a one bedroom house to five different people simultaneously), the “Africa discount” provided additional upside (given reality is so different from perception) and the short expected hold period is a great J-Curve reducer (already talking about an IPO in 2015). The huge liquidity provided by global Central Banks over the past five years since the Global Financial Crisis has primarily (and somewhat surprisingly to some market observers) found its way into financial assets rather than real assets (unless you were the owner of any real assets in short supply, sports teams, fine art, rare cars/wine etc. where prices have gone totally ballistic). That trend has accelerated in the past year and flows have actually tuned negative for things like Gold and Oil, causing a wide gap in performance between financial assets and real assets. While we continue to believe the risks of Deflation outweigh the risks of Inflation, we see some very attractive opportunities in real assets as we head into 2015. Perhaps, the most surprising market event next year would be if real assets were to somehow outperform financial assets in the face of the huge consensus opinion that commodities will crash and burn, shot down by King Dollar. With the end of QE in the U.S. this October and the threat of the Fed raising rates sometime in 2015, Fixed Income investors are feeling like they have a MiG on their tail with missile lock on, and are clenched and waiting for the missile to head their way. The strange

thing is that it seems a little like the scene in Top Gun where the MiG has Cougar in his sights, has missile lock engaged, and then just flies along without pulling the trigger. Maverick actually says as much to Goose right before he moves into his infamous inverted “MiG Insulter” position where he “communicates” (gives him a one finger salute) while Goose snaps a Polaroid. The Fed has actually been threatening to raise rates (had bond investors in missile lock) for a number of years and, like the MiG pilot, is content to cruise along scaring investors away from bonds into risk assets (Financial Repression). One of the best charts I have seen lately is a sequential quarterly graph of the forward yield curve since 2009, which shows a series of steep upward sloping lines between cash and two-year Treasury notes (implying imminent rate increases) that show how the Fed has keep their finger off the trigger and maintained Fed Funds near zero (ZIRP, Zero Interest Rate Policy) despite the markets “knowing” that they would raise sometime “next year.” So, despite all the Fed jawboning, and the Fed Dots, and the Fed Minutes, rates continue downward and long Treasuries have been one of the best performing assets in 2014 (as we said would be the case last December), up nearly twice as much as the S&P 500. The situation is actually worse in Europe where the ECB has gone totally defensive (like Iceman in the last dogfight) and have been actually shrinking their balance sheet while European government bonds are making new all-time lows in yield seemingly every week, in a sign that perhaps “The Iceman Cometh” (an often used analogy for Deflation). Some would say that both the Eurozone and the U.S. are following the Japanese Deflationary path (Europe eight years behind and the U.S. eleven years behind) and that buying and holding long duration government bonds will be the best performing strategy for years to come (as it has been in Japan with JGBs). We know two awfully good fighter pilots who espouse that strategy today, Van “Treasure” Hoisington (who only owns long treasuries) and Russell “Horseman” Clark (who owns huge positions in long-duration Bonds and Bunds and is also 50% net short in his equity portfolio), who

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would both say that they are staying with the wingman formation for the foreseeable future. We generally agree, but did write last quarter that

“another area to watch is interest rates, and the long-bond in particular, as this asset has followed the Bradley pattern precisely over the past year and the incredible strength seen over the past seven months could easily “take a breather.” Again, we will tighten up our stops on TLT and pay close attention to any additional signs of economic strength (like the recent 4% GDP print) that could prompt investors to sell bonds, or could prompt the Fed to jawbone about raising rates sometime “sooner” in 2015.” TLT flew right past the Bradley date in July and climbed to new heights over the next month, but hit an air pocket in the first two weeks of September on the final GDP revision coming in at 4.5% and fell (6%), giving back one-third of the 2014 gains in ten trading days. Then, on September 16th, TLT went into a pattern almost perfectly mirroring Maverick chasing Jester on their first hop, straight up for four weeks and now straight down since October 15th and heading for the Hard Deck. We will see in the coming weeks whether the Santa Claus Rally materializes and investors continue to sell defensive assets, or whether we are closer to the Danger Zone and long bonds will go vertical again. We continue to side with Treasure and Horseman and think that rates will be “Lower for Longer” (expect that long bonds will outperform in 2015), but expected some turbulence (read market ebullience) post-election, so we did cut our TLT weightings in the Funds by two-thirds. When it comes to Real Assets, there are clearly warring factions in the investment business, neatly divided between the Inflationists and Deflationists. The Inflationists believe that all of the monetary largesse handed out by the global Central Banks will eventually lead to much higher inflation (even hyperinflation) and that investors need to move all of their assets away from “paper” assets into hard assets like Gold, Silver, Oil, Real Estate, Land, Collectibles and other “stuff.” They would make the case that Milton Friedman was right and that “inflation is

everywhere, and always, a monetary phenomenon” and that is only a matter of time before our currencies are worthless and the prices of real assets will skyrocket. While some of those in this camp might be appropriately described as “tinfoil hat wearing conspiracy theorists,” there are plenty of very intelligent people, and very talented investors, who also fall into this camp. The Deflationists believe that all of the monetary largesse is a waste of time and effort because the Killer D’s of Demographics and Debt have destroyed the normal transmission mechanism of money creation and no matter how many trillions of excess bank reserves the CBs create, there is simply not enough demand for credit and the velocity of money is collapsing which will lead to a Deflationary Death Spiral like the one that has gripped Japan for two decades. The Deflationists argue that real assets will continue to deflate along with economies and financial assets as populations age, GDP growth slows and technological advances displace labor and reduce prices of goods and services. There is a great deal of evidence to support both sides of the debate, particularly if we think about the different demographic profile of the developed markets and the emerging/frontier markets. Emerging economies have young populations which are conducive to higher rates of inflation, while developed economies have older populations which are more conducive to lower rates of inflation (disinflation and even deflation). If we look around the world we see a fairly clear bifurcation between the developed/low inflation and developing/high inflation countries and this delineation creates interesting opportunities for investors in real assets. Given that the developing countries’ populations are much larger, and are growing much faster, than the developed countries’ populations, we can see a clear tailwind for asset classes, sectors and companies tied to real assets over the long-term. That said, there will clearly be volatility within this secular trend and we must be mindful of the short-term opportunities, and challenges, that will exist during these alternating periods. For example, we wrote last quarter “in

commodities it looks like Oil made a peak “around”

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June/July (this one is not so clearly related to the Bradley date), but NatGas looks like it may have made an interesting bottom around the 21st (probably close enough), while the Ags just continued plunging right through the Turn, although they “may” have begun a turn this week (this one is a tough call, but these markets are really oversold.” In the past few months, Oil continued on its descent (we will talk more about oil in a separate section) as conspiracy theories swirled on how Saudi and the U.S. were using Oil as a weapon to fight Russia (working so far as Russian currency is down huge and the economy is teetering on edge of recession), so while we see long-term upside for Oil, the short-term momentum has been clearly negative. Natural Gas did make a nice base from July through September and then took a (10%) nosedive in October (along with other commodities) before going vertical in the past few weeks, up 20%, on the arrival of Polar Vortex 2.0 in the U.S. (temps will feel like Siberia in some places) and we expect continued strong momentum this winter as the northern producers suffer production disruptions like last year. It was a good thing we used the word “may” in describing the Ags bottom as there was another Dollar induced descent in September, but now it does appear that the soft commodities have found a bid as prices have jumped 10% to 15% in the past five weeks. We expect that food will continue to be a hot commodity in the years ahead as the developing markets become wealthier and change their diets to resemble the developed markets (eat more protein which will require significantly more grain). The other key line here is that in commodity markets, the cure for low prices is low prices, as capitalism works, supplies shrink and prices recover and move back into an upward trend. One proven methodology for producing strong returns in the shorter-term (six months to twentyfour months) is to systematically allocate capital to areas where there has been a dislocation in prices. That dislocation could come from an external shock (sanctions), an internal change (government change) or a misperception by investors about some aspect of

the asset class, region or sector (confusing currency weakness with fundamental weakness, misunderstanding complexities of a particular form of security). As we constantly scan the investment horizon for opportunities, we encounter these types of dislocations with high frequency, but the magnitude of the dislocation varies widely from too small to really capitalize on due to transaction costs (closed end bond funds during the Taper Tantrum), to so large that it prompts a change in the rules that prohibits investors from taking advantage (the EU banning short selling in 2008) and every level in between. Capitalizing on dislocations requires the same skills we highlighted that make great fighter pilots, Discipline and Courage/Confidence. You need discipline to have a set of rules that you continually compare to current market conditions to identify when an opportunity has become attractive enough to warrant action (an enemy bogey in their own airspace prompts no response, but a bogey nearing a strategic asset demands a swift engagement) and you need the courage/confidence to be able to engage and execute with precision in order to capture the value available. The most challenging part of the latter is that the speed with which investors must react, engage and execute has shrunk so dramatically in the world of the global Internet that it makes it very difficult to capture the full opportunity. Two examples of this occurred recently. We have liked Japan since Abe-san was elected two years ago and have been overweight most of that time. We had anticipated that Kuroda-san would have to continue to weaken the Yen and we have hedged the bulk of our Japan equity exposure to capture that weakness, so we were in fairly good position when Kuroda-san surprised the world on Halloween by increasing QQE. The problem was that after the announcement, the Yen moved from 109 to 114 in a matter of minutes and unless you had your finger on the trigger to sell more Yen, you missed an opportunity. We had good discipline to know that Yen was headed lower, so our existing positions did well, but we didn’t have the confidence to build the position larger in anticipation of the announcement (as we had been disappointed twice earlier in the

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year). The second example was a missed opportunity where we had good discipline, but failed to execute quickly when the event occurred. We had played in the coal space earlier in the year and were smart enough to step aside when the Democratic Senate began to lean toward more stringent rules for coal burning. We watched the sector closely as it collapsed in recent months and had concluded that some of these companies might go bust, or conversely, the Republicans would win the Senate and these equities would have a dramatic “dead cat bounce.” The good news is we had the right theory, but the bad news is we hesitated last week after the election and missed the move (as it occurred in three short days). Shortterm opportunities can sometimes be very short indeed in the New Abnormal (there is likely more upside here, but it will be volatile) so you have to be even more nimble and tactical than in the past in order to capitalize on these opportunities. When it comes to talking about dislocations, there are few places that have been more dislocated that the PIIGS countries in the past few years (there are some, but not many), so this is a good place to start talking about opportunities. We did an ATWWY Webinar entitled When PIIGS Fly a few months ago and we summarized our view on the region in the last letter by saying “should the ECB start expanding their

balance sheet again, that will provide a brisk tailwind for European assets and the GIIPS countries in particular which are much more leveraged to the upside, as they are starting from a lower base.” Unfortunately, Super Mario got his wings clipped by Frau-Nein Merkel and there has been no EuroQE (or perhaps it will be called QQQE since the U.S. has QE and Japan has QQE), so we didn’t get the tailwind we were looking for. On top of that, Banco Espirito Santo collapsed in Portugal and Greece got hit with the triple whammy of Troika problems, fears about the AQR’s (Asset Quality Review Stress Tests) impact on the banks and the rise of the radical left in the election. Add it all together and after a very solid first half of 2014, the PIIGS got slaughtered in Q3 and October with IIS countries falling (15%) and PG

countries falling (25%). On top of all that, Europe as a whole has been officially left for dead as a recent Economist cover shows an obviously dead parrot with Frau-Nein Merkel standing next to it saying “it’s only resting…” (The cover story is actually good news given we know the inverse relationship between Economist covers and future market performance). One of our favorite pilots (managers), Horseman has six of his top ten positions in Spanish and Italian banks and we know a number of other very skilled investors who have similar exposure to banks on the region. When we look at the Greek banks, we wrote last quarter that “Greek banks had a very different run

in 2014 as investors began to pile into these stocks in Q1 and actually drove the Greek market to one of the best returns in the world for the quarter. However, sentiment changed again in Q2 as fears over the new Stress Tests in Europe might show that banks needed more capital, but what was missing from the analysis was that the Greek banks had already taken the painful steps of restructuring. But unfortunately, cheap assets got cheaper again.” We could write the same thing after Q3 as the nearly all of the Greek banks passed the Stress Tests with flying colors (they took their medicine last year, restructured and raised new capital), but the nose dive continued as new fears about the Syriza party gaining momentum (they want to pull Greece out of Euro) grew and the four primary banks shed (25%) in the past few months. We continue to see significant upside in Alpha, Piraeus and Eurobank as they have solid capital bases and huge operating leverage to any recovery (which appears to be gaining traction given tourist volumes). The CAPE ratios for these countries tell us that the returns over the next decade will be very strong, but the outlook for the next ten months is less clear given all the uncertainty related to government transitions, ECB policies and Euro membership jockeying. We are finding lots of cheap assets across a wide swath of the markets, but we are cognizant of the near-term risks, so will be cautious in our angle of ascent in the PIIGS allocation. If we jump back to the U.S. equity markets for a

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moment, we see a number of interesting pockets of opportunity despite our belief that the overall market is overvalued and heading toward the Danger Zone. On the classic demarcations like Value vs. Growth and Large vs. Small it appears that there isn’t much that is attractive. The high dividend payers in the Value camp have been bid up to levels that appear quite stretch given their reduced growth rates (resulting from people looking for “bonds in the stock market”) and the Growth camp is chock full of very egregiously valued companies where the abnormally low discount rates (thanks to Financial Repression) has allowed investors to “justify” 2000’s style P/Sales multiples (can’t use P/E multiples so many of these companies have no E…). So we would have a modest tilt toward Value as the “less overvalued,” but that is not very attractive overall. The Large vs. Small debate looks easier to call given the truly wild multiples ascribed to the junkiest small-caps. Like in 2013, the most heavily shorted names have rallied harder than the less shorted names (we know from history that the heavily shorted names do eventually do much worse) and the P/E ratio on the Russell 2000 is somewhere between 45 and 130 depending on how you treat companies with no earnings, so we would agree with GMO that the prospective return to this segment of the market will be negative over the next seven years. An interesting trade here would be to go long the high quality large caps (to “hide,” if you really must have general U.S. exposure) and short the junky names against them, so long IWL and short IWM (or long RWM which is short for you). The real opportunities in the U.S. are at the sector and security level as there continues to be lots of winners and losers in sectors such as healthcare, technology, financials, consumer and financials, so we expect strong performance from our sector specialist managers on both the long and short side. In healthcare, the biotech sector looked stretched again IBB is now 8% higher than the February peak that preceded the (20%) correction in March. While there are some great companies in this space like GILD, AMGN, CELG and REGN, the multiples seems bit extended after another huge run in 2014. In technology, the dispersion has been quite

dramatic as the old tech names like MSFT, INTC, ORCL and HPQ are up 30% while the new tech names like PCLN, EBAY, GOOGL, and NFLX are flat. There is an even wider dispersion between FB, up nearly 40%, and AMZN, down (20%), and we would expect to see some mean reversion in these segments in the next few quarters. In financials, we continue to believe that the big banks have been “Dodd-Franked” and have been turned into utilities as they can no longer lever up to levels to generate big returns in a ZIRP world. The problem for C, BAC, JPM and GS are that they are over regulated like utilities, but can’t pay big dividends, so investors are not treating them as such, so XLU is up 22% this year, while the banks are up single digits. In the consumer space, we came into the year thinking investors needed to “think outside the big box” as e-commerce was going to make it tough on traditional retail and it has indeed been a rough ride for those stocks as SHLD is flat (only because Eddie Lampert pulled a surprise REITization last week and Sears jumped nearly 80% over a few days to rally from being down (40%)) and JCP, HGG, BBY and BBBY are down (10%), (20%), (60%) and (20%), respectively. We think there will be continued pressure on these business models, but there are two short-term factors that may make these temporary longs. Rumors of activist activity or take-private transactions have boosted BBBY and PETM in recent months and there could be others that jump on more takeout speculation. Second, the rapid decline in oil prices may give consumers some extra spending money for the Holidays and sales could come in ahead of reduced expectations. We would expect the usual pattern of a rally through Black Friday/Cyber Monday and then a decline as the sales numbers don’t actually meet revised expectations as consumers pay off a little debt rather than buy another iPad. We will discuss energy later in the Oil section. In Europe, the story continues to deteriorate as GDP and PMI data come in below expectations nearly every day. Italy has slipped back into recession and German business confidence has fallen sharply which

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has led to some wicked corrections in the core European markets in recent months. Most interesting is that the corrections in Europe coincide precisely with the announcement of sanctions on Russia and the German, UK, Belgian, Austrian and French markets falling in lockstep with oil and Russia from June to mid-October, with declines of (12%) to (18%) vs. Russia and oil down (20%), before participating in the Halloween melt-up to finish down (12%), (9%), (6%), (14%) and (10%), respectively. The core performance has been nearly as poor as the peripheral countries like Spain and Italy, down (11%) and (15%), and the rhetoric toward the ECB and Super Mario to “do something dramatic” is growing stronger, and louder each month. The faith in Central Bankers vs. the economic realities of Demographic, Debt and Deflation are coming to an abrupt confrontation. Like Maverick going head to head with a MiG in the opening dogfight scene, it will be interesting to see who blinks first. We favor the economic realities in the long-term, but there is real risk of another 2011 “we will do whatever it takes” moment if the ECB does find a work around to expand their balance sheet again. Therefore, in the near-term, we are hesitant to look for too many shorts in Europe and actually are on the hunt for long opportunities in the Value segment of these markets as the Misery factor has risen dramatically with respect to future GDP growth, so cyclical shares and financials appear to be undervalued. Japan continues to be our favorite developed market and the recent decision by the BOJ to expand the QQE program is more evidence of the commitment to Reform that Abe-san and Kuroda-san have made and how they will indeed, do whatever it takes, to reverse the decades of deflation and reflate their economy and markets. We see lots of opportunities in Japan as earnings continue to hit new records and valuations are actually better than they were before the rally started in 2012 (the P has not risen as much as the E). With the renewed commitment to a lower Yen, the exporters continue to look attractive and we wrote last quarter that “the “Zombie” companies (Sony,

Panasonic, Sharp, Toshiba) have been much stronger than the indices (most are actually up vs. down (5%) for the NKY), contrary to the pundits calling for them to fade into the sunset” and we think these names will be long-term winners. Perhaps the most compelling opportunity is one we also wrote about last quarter (a little early…) when we said “the banks (SMFG, MTU,

MFG, Resona, Shinsei) have been particularly weak (down as much as (20%) in some cases) and we believe that the banks have now bottomed and now have very significant upside (could rise as much as 60% to 100%) as their ROEs continue to recover. Similarly, the brokerage firms like Nomura and Daiwa should be very strong performers as domestic trading volumes increase and foreign capital returns to the Japanese market. Finally, we reiterate the point the we have discussed for many quarters now that “Japan has

no choice but to pursue a weaker Yen (to diminish the value of the massive debt they have accumulated) and we agree with my friend Hugh Sloane when he said to me in November of 2012, “the Yen will be weaker for the rest of your life.” One very interesting part of this story is how the Yen has followed the Bradley dates nearly perfectly this year turning up on January 1st after an amazing run down in Q4 of 2013, and then turning down on the July 16th date and has continued to weaken toward the 120 target we discussed in Q1. With Shinzo “Alpha” Abe and Haruhiko “Hero” Kuroda as pilot and RIO, we are confident that Japan is going to fly like an F-14 for many years to come and are excited about both the long-term and the shortterm opportunities. In Emerging Markets, we believe it makes sense today to split countries into two groups, Service based and Commodity based, as the latter appear more vulnerable to the global growth slowdown and China’s reduced appetite for commodities in particular. For example, the Commodity countries would include Russia and Brazil, while the Service countries would include India, Taiwan and Korea. As we discussed earlier, there is another cut we are looking at today which relates to which countries have elected Reform minded leaders who have a clear agenda to push a pro

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-business agenda with those reforms. Those countries include China, India, Mexico, Indonesia and perhaps Brazil and Argentina if Dilma can become more Lulalike and if the new leadership in Argentina is less Kirshner-like. In an additive fashion, the serviceoriented economies led by Reformers (India, China, Mexico) should present very significant opportunities for investors in the near term. Looking more closely at a few places where we see particularly interesting developments would include Russia, Argentina, India and China. Regarding Russia, we noted last quarter that

“additional sanctions against Russia prompted investors to sell Russian shares again and really cheap assets went back to silly cheap levels.” Some of the cheapest assets on the planet exist in Russia today, in particular the Energy companies like Lukoil, Bashneft and Rosneft (Gazprom is really cheap too, but there continue to be governance issues there that keep cash away from shareholders), the largest bank, Sberbank and the primary Internet company, Yandex. While it is hard to see when the negative Russia rhetoric will ebb, we are confident that long-term investors who buy these assets as these prices will make multiples of their money. A point to keep in mind is that most of the loss this year in these names has actually come from Ruble depreciation and we expect that trend is nearing its end. Regarding Argentina, we wrote last quarter “the situation could not have been much more

miserable as Argentina was forced to devalue their currency dramatically, there were fears of a default on their sovereign debt, inflation was spiraling out of control, economic growth was collapsing and companies could not get access to credit with the government bond troubles, what a perfect time to invest…” We have invested in the Sovereign Bonds this year (bought in the 70’s and sold in the 90’s) and are looking for another entry point when markets are disappointed that they don’t settle with the Hold-Outs on January 1st (but rather wait for later in Q2 to provide a political boost for the Peronistas) and we have played in three equities, Macro Bank, Pampa Energia and YPF, since the Q1 devaluation. We also

discussed how rising share prices was the good news, but “the better news is that this fiesta may just be

getting started as the high likelihood of a ultimately favorable resolution to the debt issues should lead to the opening of the global capital markets to Argentine companies. With better access to credit, Argentina should see an acceleration of growth, and profits, which should lead to higher share prices in the coming quarters and years.” We also believe that the massive opportunity to develop the vast shale reserves in Argentina will lead to huge investment opportunities in the coming years as global energy companies spend hundreds of billions of dollars to partner with local companies to monetize this incredible asset. Clearly there are risks that the politicians continue to mismanage the economy and Argentina joins Brazil a “country of the future and always will be,” but we think the rewards outweigh the risks at present, so we will continue to scale into opportunities as they arise. Looking at India, we wrote last time that “sentiment

began to turn as investors saw the progress made by the new Central Bank Governor, Rajan, on controlling the current account and, more importantly, it became apparent that Mr. Modi was indeed going to be the next Prime Minister. Suddenly cheap assets got less cheap and there were considerable returns to be made” and that positive sentiment has continued to grow as Modinomics takes hold. The new Prime Minister has taken a very forceful approach to changing the government from a dysfunctional Parliamentary System toward a well-functioning Bureaucracy. Now many might think that the word Bureaucracy has negative connotations (think redtape, inefficiency and waste), but the Modi Model is a high functioning structure more akin to a military organization where the participants are workers, rather than politicians, so they are not beholden to special interests and they are evaluated on output and outcomes, rather than effort and favors. One of my favorite stories is that the PM himself is randomly calling people at 8:00 AM to check that they are at work, so the entire team (which he has whittled down

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to around 50 key people) has to be at work early on the off chance that they will be called. The Modi Reform agenda is aggressive, progressive and big. Great leaders think big, dream big, act big and Modi fits that description to a tee. There are so many opportunities in India that it is difficult to pick only a few to discuss in this letter, but suffice it to say that investors will be rewarded for having exposure to industries and companies that help India grow to their full potential (Engineering, Construction, Electric Power), expand their middle class (Banking, Finance, Insurance) and help grow their consumption (Internet, Retail, e-Commerce). India has lagged China over the past decade in infrastructure and Internet connectivity and they will catch up in a hurry to set the foundation for what could be a very robust three or four decades of economic growth as their very young population (25% of the world’s population under 25) ages into the peak consumption years. Looking at China, we continue to focus on the five growth segments, Internet, Retail, Consumer Staples, Healthcare and Alternative Energy as the new Leadership refocuses the China growth story from Fixed Asset Investment to Consumption. We refer to the Reform agenda embedded in the Five Year Plan as the XiBoom and believe that there will continue to be considerable opportunities to make big returns. The domain knowledge that we have acquired from investing in China for decades and by having a team on the ground provides us with a meaningful edge in sourcing, securing and developing investment opportunities. We believe that the Chinese equity markets are on the verge of a significant breakout as the government implements the Through Train (connection between Shanghai and Hong Kong markets) and we have been increasing our exposure to the A-Share market to capitalize on the increased investment activity that will result from this expansion of market access. The energy and natural resources markets have been incredibly volatile in the past few months as the surge in the Dollar and fears of slowing economic growth have put pressure on oil & gas, metals and agricultural

commodities. We had cut exposure to energy systematically over the course of Q3 as the decline accelerated and we hit stop losses in our E&P, energy services and metals names. The discipline of having prices set at which we would retreat to follow Julian’s rule to “live to fight another day” was very accretive to the portfolios as the selling pressure became very acute in September and October, which fortunately we avoided by selling early. We were positive on the outlook for gold and gold miners at the beginning of the year, but have evolved our thinking over the past few months as many of the smart investors in the sector have convinced us that there is a huge gap between the few, dominant, mining companies that can survive in the current environment and the rest. We anticipate that we will find an increasing number of short ideas in the mining space in the coming months and had to laugh at one analyst’s description of mining companies as “holes in the ground with a liar on top.” Conversely, we will be doing additional work on the dominant franchises like BHP and Vale to see if they have retreated far enough to be attractive. In energy, the losses were quite severe since the peaks of June, as some companies lost more than half their market cap and even the broad ETF, XLE fell (20%), before rebounding slightly with the markets over the past couple of weeks. The team did a deep dive into the energy space and we came up with a shopping list of attractive names that we wanted to buy at specific “sale prices” which were reached in early October. We have begun to reengage in certain basins like the Permian and Bakken for oil and the Marcellus for natural gas and have purchased a number of companies at prices that we think reflect, in many cases, a fraction of their fair value. We see very significant upside potential in companies like EOG, FANG, CPE, KOG, WLL, PXD, RSPP and RICE as they execute on their development plans and commodity prices stabilize as supply and demand come back into balance. We also continue to see opportunity in the GPs of MLPs like ETE and PAGP, which have a preferred claim on the operating cash flows of the pipeline assets. There will continue to be tremendous opportunity in the energy services space

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as companies like HAL, SLB and BHI help companies drill more wells to maintain production levels and hold leases (you must drill within a certain amount of time in order to maintain lease on acreage) and we particularly like the unit economics of the sand companies HCLP, SLCA, FMSA and EMES. It is always a good idea to own the manufacturers of the picks and shovels in a gold rush and we expect the rush for black gold to provide ample opportunities to make big returns in these companies. One final idea in the energy space, as we discussed above, the Republican win in the Senate sets up the potential for legislation that will be more favorable to the coal companies, so if they can avoid bankruptcy in the near term, there could be some interesting opportunities in names like ACI, BTU, ANR, WLT, CNX and CLD. In the Market Outlook of #NotDifferentThisTime we got very specific with a number of ideas in sectors where we saw opportunities on both the long and the short side. We said “TWTR and TSLA are just two, of

many, examples of the extreme valuations in the current environment where we expect to be able to write about excellent returns on the short side in future letters” and results were mixed as TWTR did fall (9%) and is still wildly overvalued, but TSLA actually rose another 8% and is even more wildly overvalued. Valuation shorts are treacherous, particularly with “story stocks” where “losing less” is equivalent to making money and short squeezes can be painful, but skilled investors can use these as hedges for other growth longs with better valuation metrics. We mentioned that we had “discussed in one

of our earlier letters how we liked the Airlines (and we still do), but we also see continued strength in other travel related businesses like Car Rentals and Hotels.” Q3 was another solid quarter for the airlines, albeit a little more volatile, but investors are underestimating the positive impact of the dramatic decline in oil prices on airline profits in the coming quarters, so we may actually be even more excited about them than we were a quarter ago. The other travel related business have not fared so well in recent months as the Ebola scare punished many companies in the

short term. As we believe this too shall pass without much impact, we continue to see upside in the car rental and hotel businesses where consolidation is helping to drive higher returns. We commented

“another space that has some momentum today is the HMOs (AET, WLP, UNH, and CI) as the changes in the healthcare landscape have created significant opportunities for the leaders in this space (and Hospital operators like HUM too).” We have like healthcare for many years as the demographic tailwind is huge in this sector and the creative destruction and destructive creation in the industry creates compelling opportunities on both the long and short side. This basket of companies did quite well in the past few months as they rose 7%, 16%, 18%, 11% and 18%, respectively, with the equity market up 5%. We also discussed opportunities in technology and wrote “in another nod to Mr. Twain, the rumors of

the death of the PC have been greatly exaggerated and the #OldTech sector “has been, dare I say it, en fuego.” Companies like MSFT, INTC, CSCO and HPQ, which had been relegated to the recycling bin as the Cloud was to render them all obsolete are staging a serious comeback and have dramatically outperformed the Cloud names over the past few months. That momentum faded a bit in recent months as this basket converged with the S&P and MSFT continued to surge, up 12%, but the others were flat to up 2% while the index rose 5%. We looked briefly at “another

sector that was pronounced dead last year when all the discussion of the #Sequester was going on, was Defense, yet companies like LMT and NOC continue to generate strong earnings and cash-flow and in a world or rising geopolitical threats, perhaps a profitable strategy is #PlayDefenseWithDefense for these tumultuous times.” This theme worked very effectively during the period LMT jumped 20%, NOC rose 10% and GD was up 12%. We expect continued strong growth in this segment as geopolitical tensions rise and countries like Japan and China increase military spending. We said last quarter that we would likely be writing a lot about Alibaba in the Q3 letter, so here we are writing about it again. We mentioned

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last time that “One last long possibility is an

interesting indirect play on the upcoming Alibaba IPO that we discussed multiple times above. There are two large companies, Yahoo and Softbank (and perhaps other smaller ones) that own meaningful stakes of BABA who will reap large windfall profits if the IPO goes as well” and the IPO went very well indeed and the value of these companies’ stake increased dramatically. Softbank complicated the equation with a failed bid in telecom, so the value of the BABA stake remains embedded, i.e., still a buy. Yahoo shares surged 35% since our last letter, are still assigning a negative value to the core business, so we see continued upside. One breakout scenario is that BABA buys YHOO to capture the embedded tax gain (essentially a big stock repurchase) and establish a foothold in the U.S. market (and get a dynamic U.S. CEO to boot). Many believe this deal wouldn’t get approved, so it won’t happen. We believe it is a great option that has a serious shot. Stay tuned. Finally, we talked about opportunities on the short side and said there were “four industry groups that

look very poor today and the prospects for improvement in their businesses in the near-term seem dim. Consumer Discretionary, Homebuilders, Industrials and Offshore Drillers have all rolled over hard this quarter.” Results here were mixed as Consumer did lag the market, but Homebuilders and Industrials caught a bid and were up a little more than the S&P’s 5% rise. On the plus side, the offshore drillers continued to “get drilled,” falling (25%), making the basket quite attractive despite a poor batting average. An interesting development is that if some of the Shale plays get put on hold in a lower oil price environment, it could prompt some incremental drilling offshore and the wildcard is the change in the Senate could lead to more offshore exploration permits, so we would cover these shorts and perhaps even consider going long. The declines appear to be reaching extreme levels and there could be opportunity in names like RIG, DO, NE, EXV, ATW, RDC and SDRL, so we will be looking for signs of a momentum turn to wade into the space (Jack

Schwager wrote that the difference between a good trader and a great trader is that a good trader sells/ covers while a great trader reverses his position). As we head down the Highway to the Danger Zone and anticipate an interesting (read challenging) year for investors in 2015, we are reminded of a couple of truisms in generating strong long-term investment returns: 1) Follow Roy Neuberger’s three rules - i) don’t lose money, ii) don’t lose money and iii) don’t forget the first two rules and 2) Invest without emotion and focus on eliminating unforced errors (which reminded me of this line from Goose to Maverick). Goose: You wanted to know who the best is? That's him. Iceman. He flies ice-cold. No mistakes. Wears you down. You get bored, do something stupid, and he's got you. 3) You can’t predict, you can prepare. We can see that the number of bogeys on the radar keeps rising and we have been well trained for the dogfight that is on the horizon, so as we prepare for those more challenging times ahead we are left with one final thought from “Mother Goose.” Goose: He’s still back there Mav, do some of that pilot s@$#!

Update on Morgan Creek We hope you have been able to join us for our Global Market Outlook Webinar Series entitled “Around the World with Yusko.” The monthly series has been launched for almost a year now and we have been pleased to see many of you participating. We have had many interesting and topical discussions in the last few months (see the list below). If you missed one and would like to receive a recording, please contact a member of our Investor Relations team at [email protected]. Mark your calendar now for our December 16th “Best of 2014” webinar at 1:00pm EST. I will go back through all of my

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Third Quarter 2014

Gluskin Sheff + Associates Inc. Grant Williams, Author, Things that Make You Go Hmmm… and Founder, Real Vision Television

presentations over the past eleven months and compile what I believe to be the best topics of 2014 for our discussion.



Topics & Recordings Available for download: August: Global Energy Renaissance: Beyond the Bakken September: Beyond Alibaba: The Rise of the Chinese Consumer October: The Reformers: India, Indonesia, Brazil, Argentina and Mexico November: Kind Dollar: The Race to Debase

Please go to www.iciosummit.com for more program details. As always, Morgan Creek current investors (in any one of our products) receive complimentary access to the event. For more details, please contact Andrea Szigethy at [email protected] or Donna Holly at [email protected].

Our Winter NYC iCIO Investment Summit is quickly approaching on December 9th at Club 101 in Midtown NY. In addition, we will be kicking off the Summit with a reception on December 8th at Celsius in NYC. Celsius is a beautiful holiday venue overlooking the Winter Village shops, the ice rink and the holiday tree in Bryant Park. We have a top-tier line up of presenters this year who will be joining me in New York including:

As always, we want you all to know how grateful we are to have had the opportunity to provide investment management solutions to our clients for the past decade and how excited we are about continuing to work with all of you going forward. It is a great privilege to manage capital on your behalf and we are appreciative of your long-term partnership and confidence. I personally hope that you will join us in New York City this December. With warmest regards,



Betsy Battle, Founder & Chief Investment Officer,

Lone Peak Partners 

Barend de Loor, Director Property Development,

Eris Property Group 

Dennis Gartman, Editor/Publisher, The Gartman

Letter 

Christopher Holt, Co-founder, The Alliance for

Institutional Dialogue

Mark W. Yusko Chief Executive Officer & Chief Investment Officer

 

Constance Hunter, Chief Economist, KPMG Adi Divgi, President & CIO, EA Global (Family Office)  Simon Lack, Author of The Hedge Fund Mirage & Bonds Are Not Forever, Founder, SL-Advisors  Don Lindsey, Chief Investment Officer, American

Institutes for Research Raoul Pal, Founder, The Global Macro Investor/ Real Vision TV  Cathleen Rittereiser, Founder, Uncorrelated, Inc. 



Ralph Gustavo Rosenberg, CIO & Founding Partner, Perfin Investimentos  David Rosenberg, Chief Economist & Strategist,

This document is for informational purposes only, and is neither an offer to sell nor a solicitation of an offer to buy interests in any security. Neither the Securities and Exchange Commission nor any State securities administrator has passed on or endorsed the merits of any such offerings, nor is it intended that they will. Morgan Creek Capital Management, LLC does not warrant the accuracy, adequacy, completeness, timeliness or availability of any information provided by non-Morgan Creek sources.

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Sir John Templeton’s Rules For Investing Success

We are including an abridged version of Sir John Templeton’s rules for investing success taken from our last letter, #NotDifferentThisTime, for anyone who missed them last quarter. In 1993, Sir John (who is clearly one of the most successful, and intrepid, investors of our time) did all investors a great service by putting his personal philosophy down on paper in an essay entitled, 16 Rules for Successful Investing in which he captured a lifetime of investment wisdom for the ages. Many of the individual tenets of the philosophy may seem “obvious,” or “common knowledge,” but taken together they represent an investing discipline that, when executed faithfully (that is the tricky part) can produce superior results over the long-term. The challenge of executing the strategy is twofold: 1) adhering to the entire collection of Rules, and 2) sticking to the discipline over time and not making “exceptions” when it would be easier, or more expedient, to do so. Rule No. 1 – Invest for Maximum Total REAL Return (#InflationIsRisk) We learned in our time managing large Endowment portfolios that the largest risk to investors is not volatility (standard deviation of returns) or trailing some benchmark for some short period, but rather, failing to achieve a real rate of return in excess of your spending rate over time. Sir John says it very clearly that “one of the biggest mis-

takes people make is putting too much money into fixed-income securities.” Rule No. 2 – Invest: Don’t Trade or Speculate (#InvestWithoutEmotion) The wisdom of the second rule is that Sir John believed that “the stock market is not a casino,” so investors shouldn’t gamble by trading too frequently, or by trying to time the market in the short-term. There is one similarity to gambling in a casino, however, the house wins over time and your profits will be consumed by transaction costs and losses associated with overtrading (the emotional reaction to “noise” in the markets). Rule No. 3 – Remain Flexible and Open-Minded About Types of Investment (#OneSizeDoesNotFitAll) Sir John reminds us that there is no “all-weather” asset, no one kind of investment that is best in all conditions. Two other points Sir John makes here are: 1) that when a particular type of investment becomes popular “that popularity will always prove temporary and, when lost, may not return for many years,” and 2) that despite his admonition to be flexible across types of investments, his clients were predominantly invested in common stocks over time. Rule No. 4 - Buy Low (#BeGreedyWhenOtherAreFearful) One of Sir John’s most oft quoted lines comes from his belief that long-term investors should capitalize on the incredible opportunities created by collective pessimism as he says “bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” Sir John quoted two legendary investors here on how to invest, Benjamin Graham who said, “Buy when most people, including experts, are pessimistic, and sell when they are actively optimistic” and Bernard Baruch, who was even more succinct and said simply “never follow the crowd.” Sir John’s final two lines are elegant (and haunting) as they sum up the concept of Buy Low, “So simple in concept. So

difficult in execution.” Rule No. 5 – When Buying Stocks, Search for Bargains Among Quality Stocks (#WinnersPressWinners) In describing what Quality is, Sir John lists characteristics like leadership in an industry, or field, having superior management talent, a strong balance sheet, a trusted brand and high margins. The one caveat here is in the other italicized word in the Rule matters too, a lot. The price you pay matters and, as a follow up to Rule No. 4, you can’t

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Sir John Templeton’s Rules For Investing Success

pay “any” price, you have to pay bargain prices to win long term. One other point here is that a Bargain does not only mean a very low price. Low prices are preferred in buying “value,” trying to buy dollar bills for 50 cents. But sometimes, you want to pay what is seemingly a high price because it is actually a great value based on future growth prospects. This is the essential difference between Value and Growth investing and focuses on the life cycle of companies. Rule No. 6 – Buy Value, Not Market Trends or the Economic Outlook (#MarketOfStocks) The essence of this rule is that investors should focus on buying companies, not markets. He goes further to remind us that far too many investors try to, unsuccessfully, invest based on anticipating market trends, or the economic outlook and lose sight of the fact that, 1) individual companies can rise in a bear market and fall in a bull market, and 2) Bull Markets do not always correlate with economic expansions and Bear Markets do not always correlate with economic contractions. Companies rather rise and fall with their business fortunes, future prospects and, perhaps most importantly, other investors’ perceptions and expectations of those prospects. Rule No. 7 – Diversify. In Stocks and Bonds, as in Much Else, There is Safety in Numbers (#ConcentrationMakesYouRich #DiversificationKeepsYouRich) As proponents of the Endowment Model of investing, we are staunch advocates of Diversification as the optimal strategy to control risk, but also as a methodology to maximize long-term investment returns through the lowering of overall total portfolio volatility (maximize the power of compounding). As Sir John so aptly states, “no matter how careful you are, you can neither predict nor control the future” and bad things happen. Two other issues of importance here are: 1) you will make mistakes, so there is safety in numbers, and 2) by searching the globe for great ideas, you increase the likelihood of finding more investment ideas, and perhaps even better bargains, than focusing your search in any single country. Rule No. 8 - Do Your Homework or Hire Wise Experts to Help You (#DoTheWork) The primary message of this Rule is fairly straightforward, either resource it or outsource it. If you have the internal resources to do primary research and investigate investment ideas fully, then do it, if you don’t, then find professional help. Sir John says very succinctly, “people will tell you: Investigate before you invest. Listen to them. Study companies to learn what makes them successful.” What separates the best investors, from the rest, is that they are constantly doing research, continually scouring original source data to isolate companies that have a distinctive edge in some element of their business that will lead to superior returns in the future. Rule No. 9 – Aggressively Monitor Your Investments (#WatchTheBasket) Andrew Carnegie famously said, “Concentrate your energies, your thoughts and your capital. The wise man puts all his eggs in one basket and watches the basket closely” and while he might debate how much concentration is optimal (see Rule No. 7), Sir John would agree vigorously with the advice to concentrate your energies and thoughts on watching the basket. Today’s conventional wisdom, that a passive, buy and hold strategy is optimal, was not quite what Sir John had in mind. His position on Aggressive Monitoring was driven by the need for investors to “expect

and react to change. No bull market is permanent. No bear market is permanent. And there are no stocks that you can buy and forget.” Sir John sums up his view on the monitoring by saying, “remember, no investment is forever.” Rule No. 10 – Don’t Panic (#KeepCalmAndCarryOn)

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Sir John Templeton’s Rules For Investing Success

Invariably, all investors will find themselves in a position where they did not heed the corollary to Rule No. 4, to sell when everyone else is buying, and Sir John reminds us that we will “be caught in a market crash such as we had in 1987. There you are, facing a 15% loss in a single day. Maybe more.” He advises us not to panic, not to rush out and sell. At the risk of stating the obvious, he reminds us “the time to sell is before the crash, not after.” The only thing that has changed after a sudden downdraft in the overall market is that all security prices are lower, so the right response is to calmly study your portfolio and make a determination whether the rationale from which you made the original purchase remains intact, and if so, then hold tight (or even buy more, if you have liquidity with which to react to the opportunity). The only reason to sell a security in a Bear Market is to make room to buy something that is more attractive. Rule No. 11 – Learn From Your Mistakes (#FocusOnTheNextPlay) Sir John tells us “the only way to avoid mistakes is not to invest, which is the biggest mistake of all.” The investment business is about taking positions in anticipation of future events that are, by definition, unknowable and every investor will make some good decisions and some bad decisions, some mistakes. There are myriad reasons for making investment mistakes including, poor quality data, faulty analysis, bad investment process and judgment error and any of these reasons (and others) can knock your investment off track and lead to losses. The most important thing to do when you make a mistake is to “forgive yourself for your errors, don’t become discouraged, and certainly don’t try to recoup your losses by taking bigger risks.” The ability to maintain composure and focus, to stick to your discipline, to move forward without dwelling on the past are all characteristics that separate great investors from average investors. Rule No. 12 – Begin With a Prayer (#HopeIsNotAnInvestmentStrategy) Sir John shares his personal perspective that “if you begin with a prayer, you can think more clearly and will make fewer mistakes.” Whether it is prayer, meditation, or spending some time in solitude, anything that clears the mind will help you make more efficient and effective decisions, which is likely to lead to fewer mistakes. Similarly, Michael Steinhardt, one of the most successful investors of our time, said to “always trust your intuition.” Intuition is most available to us when we quiet the mind and any means with which we can achieve that centered state will help us be better investors. Importantly, the one thing that this statement is not referring to is the construct that we should pray for good results and hope for some divine intervention in our investments. Rule No. 13 – Outperforming the Market is a Difficult Task (#HoneYourEdge) The “market,” or rather the indexes that approximate the market, have a number of advantages over even the best investors: 1) they pay no transactions costs, 2) they have no expenses related to research and 3) they are always fully invested as they do not have to keep cash available to pay out to redeeming investors. Sir John contends that the ability to consistently outperform the market is a tremendously difficult task given the inherent advantages of the benchmarks and further that “any investment company that consistently outperforms the market is actually doing

a much better job than you might think. And if it not only consistently outperforms the market, but does so by a significant degree, it is doing a superb job.” Therefore, when you find an individual, or firm, with real Edge, the ability to generate Alpha above the market, you should make them a cornerstone of your portfolio. Rule No. 14 – An Investor Who Has All the Answers Doesn’t Even Understand All the Questions (#KnowWhatYouDontKnow)

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Sir John Templeton’s Rules For Investing Success

In investing, Sir John points out that, “a cocksure approach to investing will lead, probably sooner than later, to disappointment if not outright disaster.” The problem we face is that even if we have the discipline to stick to small set of unchanging investment principles, we do not have the luxury of applying those principles to an unchanging investment environment. Markets, he says, are “in a constant state of change, and the wise investor recognizes that success is a process of continually seeking answers to new questions.” Maintaining a rigid approach to the markets is a sure way to lose money over time and stubbornness and arrogance are character traits that will mete out disproportionately high penalties to those investors who believe, incorrectly, that they are “right” despite direct evidence to the contrary in the form of investment losses. Rule No. 15 – There’s No Free Lunch (#GetWhatYouPayFor) If investing was simple, then everyone would be wealthy and there would be no need for professional managers or advisors and there would be no need for following a disciplined, repeatable, process. In that world, we could simply buy companies that make the things we know and like and follow tips from friends and colleagues without doing our own work. Sir John would admonish that both of these things need a “Never” in front of them. First, he says to “never invest on Sentiment. The company that gave you your first job, or built your first car, or sponsored a fa-

vorite television show may be a fine company. But that doesn’t mean its stock is a fine investment. Even if the corporation is truly excellent, prices of its shares may be too high.” Rule No. 16 – Do Not Be Fearful or Negative Too Often (#BeOptimistic) The final Rule is very simple, but critically important for long-term investors, Sir John implores “do not be fearful or negative too often, for 100 years optimists have carried the day in U.S. stocks.” There will be times when a cautious stance will be warranted, even necessary, to preserve capital and put yourself in position to fight another day, but, on average, equities rise the majority of the time and it doesn’t pay to be fearful of, or negative on, the markets for extended periods of time. Even in the darkest times for the averages, there will be opportunities and a flexible approach (see Rule No. 3) will enable an investor to profit from other asset classes, sectors or geographies. Healthy skepticism about valuations when assets seem to have moved beyond levels supported by their fundamentals is critical, but excess negativity will prompt inaction and will result in too many missed opportunities over time.

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General This is neither an offer to sell nor a solicitation of an offer to buy interests in any investment fund managed by Morgan Creek Capital Management, LLC or its affiliates, nor shall there be any sale of securities in any state or jurisdiction in which such offer or solicitation or sale would be unlawful prior to registration or qualification under the laws of such state or jurisdiction. Any such offering can be made only at the time a qualified offeree receives a Confidential Private Offering Memorandum and other operative documents which contain significant details with respect to risks and should be carefully read. Neither the Securities and Exchange Commission nor any State securities administrator has passed on or endorsed the merits of any such offerings of these securities, nor is it intended that they will. This document is for informational purposes only and should not be distributed. Securities distributed through Town Hall, Member FINRA/SIPC or through Northern Lights, Member FINRA/SIPC. Performance Disclosures There can be no assurance that the investment objectives of any fund managed by Morgan Creek Capital Management, LLC will be achieved or that its historical performance is indicative of the performance it will achieve in the future. 2005-2013 results are audited. 2014 performance data is not yet audited and is subject to change upon audit. Monthly performance numbers are not individually audited and only a fund’s annual financial statements are audited. Performance may differ based upon New Issue eligibility, individual dates of admission and actual fees paid. All performance reflects reinvestment of dividends (if any) and all other investment income (which should be evaluated when reviewing performance against other indices). The performance data set forth in this presentation is based on information provided by underlying managers and is believed to be reliable but has not been independently verified by Morgan Creek Capital Management, LLC. Forward-Looking Statements This presentation contains certain statements that may include "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements, other than statements of historical fact, included herein are "forward-looking statements." Included among "forward-looking statements" are, among other things, statements about our future outlook on opportunities based upon current market conditions. Although the company believes that the expectations reflected in these forward-looking statements are reasonable, they do involve assumptions, risks and uncertainties, and these expectations may prove to be incorrect. Actual results could differ materially from those anticipated in these forward-looking statements as a result of a variety of factors. One should not place undue reliance on these forward-looking statements, which speak only as of the date of this discussion. Other than as required by law, the company does not assume a duty to update these forward-looking statements. Indices The index information is included merely to show the general trends in certain markets in the periods indicated and is not intended to imply that the portfolio of any fund managed by Morgan Creek Capital Management, LLC was similar to the indices in composition or element of risk. The indices are unmanaged, not investable, have no expenses and reflect reinvestment of dividends and distributions. Index data is provided for comparative purposes only. A variety of factors may cause an index to be an inaccurate benchmark for a particular portfolio and the index does not necessarily reflect the actual investment strategy of the portfolio. No Warranty Morgan Creek Capital Management, LLC does not warrant the accuracy, adequacy, completeness, timeliness or availability of any information provided by non-Morgan Creek sources. Risk Summary Investment objectives are not projections of expected performance or guarantees of anticipated investment results. Actual performance and results may vary substantially from the stated objectives with respect to risks. Investments are speculative and are meant for sophisticated investors only. An investor may lose all or a substantial part of its investment in funds managed by Morgan Creek Capital Management, LLC. There are also substantial restrictions on transfers. Certain of the underlying investment managers in which the funds managed by Morgan Creek Capital Management, LLC invest may employ leverage (certain Morgan Creek funds also employ leverage) or short selling, may purchase or sell options or derivatives and may invest in speculative or illiquid securities. Funds of funds have a number of layers of fees and expenses which may offset profits. This is a brief summary of investment risks. Prospective investors should carefully review the risk disclosures contained in the funds’ Confidential Private Offering Memoranda. Russell 3000 Index (DRI) — this index measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market. Definition is from the Russell Investment Group. MSCI EAFE Index — this is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the US & Canada. Morgan Stanley Capital International definition is from Morgan Stanley. MSCI World Index — this is a free float-adjusted market capitalization index that is designed to measure global developed market equity performance. Morgan Stanley Capital International definition is from Morgan Stanley. 91-Day US T-Bill — short-term U.S. Treasury securities with minimum denominations of $10,000 and a maturity of three months. They are issued at a discount to face value. Definition is from the Department of Treasury. HFRX Absolute Return Index — provides investors with exposure to hedge funds that seek stable performance regardless of market conditions. Absolute return funds tend to be considerably less volatile and correlate less to major market benchmarks than directional funds. Definition is from Hedge Fund Research, Inc. JP Morgan Global Bond Index — this is a capitalization-weighted index of the total return of the global government bond markets (including the U.S.) including the effect of currency. Countries and issues are included in the index based on size and liquidity. Definition is from JP Morgan. Barclays High Yield Bond Index — this index consists of all non-investment grade U.S. and Yankee bonds with a minimum outstanding amount of $100 million and maturing over one year. Definition is from Barclays. Barclays Aggregate Bond Index — this is a composite index made up of the Barclays Government/Corporate Bond Index, Mortgage-Backed Securities Index and Asset-Backed Securities Index, which includes securities that are of investment-grade quality or better, have at least one year to maturity and have an outstanding par value of at least $100 million. Definition is from Barclays. S&P 500 Index — this is an index consisting of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The index is a market-value weighted index – each stock’s weight in the index is proportionate to its market value. Definition is from Standard and Poor’s. Barclays Government Credit Bond Index — includes securities in the Government and Corporate Indices. Specifically, the Government Index includes treasuries and agencies. The Corporate Index includes publicly issued U.S. corporate and Yankee debentures and secured notes that meet specific maturity, liquidity and quality requirements.

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HFRI Emerging Markets Index — this is an Emerging Markets index with a regional investment focus in the following geographic areas: Asia ex-Japan, Russia/Eastern Europe, Latin America, Africa or the Middle East. HFRI FOF: Diversified Index — invests in a variety of strategies among multiple managers; historical annual return and/or a standard deviation generally similar to the HFRI Fund of Fund Composite index; demonstrates generally close performance and returns distribution correlation to the HFRI Fund of Fund Composite Index. A fund in the HFRI FOF Diversified Index tends to show minimal loss in down markets while achieving superior returns in up markets. Definition is from Hedge Fund Research, Inc. MSCI Emerging Markets Index — this is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of November 2012 the MSCI Emerging Markets Index consisted of the following 23 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and United Arab Emirates.

Q 3 2 0 1 4 Market Review & Outlook - DISCLOSURES