MATTER OVER MIND

After a significant recovery from the March '09 bottom during which our equity composites outperformed, the markets suffered a setback in the last quarter, during which our portfolios underperformed from the unusual decline in Canadian small capsthe TSX Venture Exchange down 17% in the quarter and down 22% from its early March high. Investor psychology in the quarter became excessively negative even though stocks generally, and the companies in our portfolios, became even more compelling with discernible progress ahead. In our view the current investor mindset does not correspond with what should really matter to an investor. Mind Games As the markets declined in the quarter, stocks became significantly oversold from the negative psychology resulting from the negative headlines. And there were and are many of them: the financial rescue of Greece, and the implications for Europe and its other precarious economies such as Ireland and Portugal and, now, Spain and Italy too; the potential slowing of the Chinese economy; supply chain disruptions from Japans earthquake; poor U.S. jobless numbers; a higher than expected U.S. trade deficit; continued falling U.S. house prices; a potential deadlock in the U.S. budget talks and the debt ceiling debate; the Fed cutting its forecasts for economic growth; potential headwinds from government austerity programs; fear of a slowing economy; fear of deflation; fear of inflation; rising commodity prices and declining stock prices. A mindset of fear and fear. CNBC recently reported that investors were more concerned about the economy than at any other time during the past five years; a CBS poll found that 39% of Americans believe the economy is in a state of permanent decline. We all know the mind can play tricks. Risk aversion. That wall of worry. But when perceived risk is so great it is typically reflected more than warranted in depressed share prices. Its in the market. The news doesnt have to be good, just not as bad as everyone believes. What Matters What matters is that, while global growth has slowed somewhat, all of the global liquidity should induce increased growth later this year, particularly as Chinas tightening ends and Japan resumes its production and growth, as will U.S. factories. Chinas economy still managed to grow 9.5% in Q2 from a year earlier and India continues strong too. U.S. manufacturing activity picked up in May. U.S. purchasing manufacturers index improved in June. Industrial commodity prices remain strong. The Dow Jones Transports recently hit an all-time high. U.S. housing sales will improve from prices stopping their decline, from shrinking loan delinquencies, from low new housing starts, from diminished inventories, from inflationary pressures, from easier credit and, best of all, from affordability. Canadian housing starts strengthened in June. A record high level of Canadian firms expect to increase employment over the next year as sales and investment in machinery continue to rise.

U.S. interest rates are at historical lows and the yield curve remains steepincentives for new lending. Fed stimulus remains in the system even if the Fed were to stop its asset purchases. And if more monetary stimulus is needed the Fed will supply it, no matter how it equivocates. Meanwhile, personal incomes are rising and U.S. consumers are getting strongera savings rate of 5% in May, and the May PCE price index up 0.3%an inducement not to defer spending. The ratio of consumer debt payments to incomes is the lowest since '94. The S&P 500 Retailing Index just hit a record high. U.S. exports should strengthen from the weak dollar and stronger overseas growth. While U.S. unemployment remains high as state and local governments shed jobs, private sector job growth is slowly improvingall as it should be. Employment will improve as manufacturing and housing pick up. State finances are improvingCalifornia, New York and Texas, for example. The U.S. debt ceiling will be raised and a favourable deficit-cutting bipartisan deal reached. Natural tsunamis cant be avoidedman-made ones can. Global growth should accelerate. Left-wing governments everywhere are moving to the centre right and compelled to get their fiscal houses in order, ultimately good for growth and good for business. Short-term austerity for long-term prosperity. Or, as value investors prefer, short-term pain for long-term gain. What Really Matters But, for we narrow-minded stock investors, what really matters is that valuations are unusually compelling, that monetary conditions are very favourable, and, finally, that the psychology has become sufficiently negative to induce the recent rally. To continue climbing the wall of worry. The big caps first, with the smaller, in typical fashion, immediately following. What really matters to us, as stock investors, are corporate earnings and their future growth, and what we have to pay currently for those businesses. Oh, and what we think others are likely to pay in the future for the then earnings, in order for us to realize our estimated potential gain. What really matters to us is that currently our stocks are unusual bargains, many trading at the same depressed valuations as their March '09 lows. What really matters is that S&P 500 forward earnings have risen to a new record high and that the forward multiple dipped below 12x in mid-June before the recent rally, when fair value is over 15x. What really matters is that healthy profits will encourage businesses to invest, hire and grow. And rebuild inventories, currently low relative to sales. And that earnings this year are expected to be up 18% and revenues 8.5%, year over year. Hays Advisory notes that whenever its dependable Monetary Composite is as bullish as it is now, over the next 18 months the stock market could be up by over 30%. And its Valuation Composite suggests the odds are high that the stock market will be much higher over the next 4-5 years. It believes that bad news is good since it causes stocks to be cheap and monetary liquidity to be plentiful.

What really matters is that corporations are flush with cash which should allow more capital spending and employment. And increased share buy-backs, dividends and merger and acquisition activity. And what really matters is that, in terms of protecting purchasing power, stocks are safer than bonds. With earnings right back to their long-term trend line and at all-time highs, the S&P 500 is selling at a 15% discount to our Fair Market Value. Yet, bonds, with paltry yields, remain favoured by U.S. households and pension funds over equities, so equity allocations are at multi-year lows. The stock market will be propelled higher by the mountain of cash on the sidelines as the overwhelming fear ultimately abates. We think now is an extraordinarily good time to invest. The large-cap indexes are undervalued. Stocks today are, by far, the preferred asset class compared to bonds and cash. Our TRAC and TRIM work are positivea number of markets and sectors appear to have inflected up from key support levels. And, most important, risk-reward parameters for our individual holdings are so highly favourable. These Stocks Matter Our current portfolio holdings are below-average riskthat is, the likelihood of permanent impairment in those securities is minimal, if at all. Even in our downside analysis we forecast gains. We always look for stocks that are mispriced from being misunderstood or unknown. But in this correction smaller-cap holdings such as ours appear to be unwanted mostly because nervous investors prefer the perceived safety of cash. To boot, our four largest holdings had announcements in the quarter which led to short-term concerns about the companies. In our view, these were all temporary issues in those companies which all have below-average risk and significant upside potential. And, inasmuch as our targets have not changed, their current upside is even higher than at the start of the quarter. Corridor Resources declined after Apache, its joint venture partner for its shale gas development, elected not to proceed with a second stage following poor results from two horizontal exploratory wells. Corridor believes the wells were drilled incorrectly and the partners withdrawal did not alter our appraisal of the company. Corridor now intends to proceed with a pilot project of its own with drilling commencing late this year. We expect Corridor, with or without a new partner, to commercialize the Frederick Brook shale project. The size of the prize is enormous and should attract lots of interested parties. And, given the markets reaction, it seems to be overlooking the fact that Corridors first targeted shale well, its G-41 well, which Corridor itself drilled vertically, had excellent results. If the initial flow rates from subsequent Frederick Brook wells are less than half of G-41, and even if gas prices remain depressed, the projects economics are still adequate. Also, both wells drilled by Apache encountered strong gas shows while drilling. Meanwhile, the companys reserve value is in line with the current share price, so were getting this project, and the other significant potential of Corridor, free.
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Our target remains $16 over the next 3 years, more than 5 times the current share price. Our appraisal adds the current reserve value plus only a fraction (3% net of an anticipated partner) of the potential value of the 59 Tcf Frederick Brook shale resource with zero value ascribed to: higher natural gas prices; Old Harry in the Gulf of St. Lawrence (potentially 2 billion bbls of recoverable oil in place where we anticipate a partner shortly, with drilling to begin in '12/'13); and Anticosti Island (a potential shale oil project where Corridor just announced results of an independent engineering report with a best estimate showing Corridors interest of 19.8 billion barrels of oil equivalent resources). We expect a partner to be announced for Anticosti as well this year. St Andrew Goldfields had slower than anticipated production in the first part of the year, but which is expected to ramp up in the second half and over the next several years, and with exploration news coming on a regular basis from its expanded drill program. St Andrew holds the largest land position in the Timmins mine campthe third most prolific mine camp globallywith 120 km along the Porcupine Destor Fault. Interestingly, all gold stocks, but particularly the juniors, suffered in the quarter, notwithstanding high bullion prices. Gold stocks in general appear to be historically cheap versus bullion and St Andrew trades at a material discount to its Net Asset Value (a 25% discount even using a $1200 gold price). Gold stocks should overtake bullion. Unlike bullion, stocks get a rate of return and grow. So should St Andrew. Even assuming no material addition from exploration growth, we have an upside target of $2.40 in 3 years (assuming only $1350 gold and 7x cash flow), nearly 3 times the current share price. Orca Exploration declined after the announcement that the company needed to do remedial work on the liner of some wells which temporarily slowed production and utilized cash. However, the company just released that Songas agreed to increase the capacity of the Songo Songo gas plant by 22%, a very material announcement. Including only the reserves of Songo Songo East produces a valuation over 70% higher than the current share price. With Tanzania and surrounding regions power starved, production should continue to increase. Value should also grow from exploration properties in Italy and Songo Songo West. Our 3-year target is $16 or 3 times the current share price. Xcite Energy, which ran up 10 fold from its 2010 low aided by drilling success at the Bentley field in the North Sea, fell precipitously after publication of a reserve report misunderstood by the market. Most importantly, the company has proven the commerciality of the Bentley field. Because the company was intending to begin a phased field development plan, the engineers assigned the company 28 million barrels of reserves, leaving another 87 million barrels as contingent. In our opinion it is merely a technical discrepancy which separates these categories. Assuming, as we anticipate, the company has a staged process, then all 115 million barrels could be included as proven and probable reserves. Even assuming anticipated share dilution, the value of the company today is nearly twice the share pricea value we expect to be driven higher over the course of 2012 with drilling outside the core area and from additional prospects from enhanced oil recovery techniques. The lower-risk development project should begin in the fall and our 3-year target is more than 4 times the current share price.

Manitok Energy, though well off its high, has had nothing but good news. Its initial Stolberg well (1,350 bpd once on line) was a success and when added to current production (350 bpd), plus the land value and its cash, we arrive at a value nearly 2 times the current share price. Manitok is focused on development wells in the Alberta foothills where they reenter existing well bores or twin nearby wells. Land prices had fallen back to '98 levels and the company was recently successful in posting highly prospective land adjacent to its existing land holdings. Chance of success is high due to the development nature of its drilling, and the commensurate rates of return on capital spending are high too. The company has a competitive advantage in its region, very high expected internal rates of return from conventional drilling and a proven management team that has drilled over 50 wells per year in the area for several years. We expect a ramp in production to 8,000 bpd over the next 18 months which could increase the value of the company to more than 4 times the current share price. Dell, though somewhat misunderstood, has held up well in the recent correction. Its PC business is now a negligible portion of profits. Like other IT giants, Dells business has morphed toward the enterprise market and IT services. Dell remains one of the leading global brands yet the shares are valued at merely 5x free cash flow, excluding its net cash. Even in a no-growth scenario which we dont foresee, but which allows us to stress-test Dells valuation, the companys actual trailing 12-month free cash flow supports a value in excess of the current share price. The companys growth strategy is paying off. We anticipate a potential lift back to 12x free cash flow and about 10% annualized growth which should combine to lift the shares by over 40% per year, to twice the current share price, over the next 2 years. Hewlett-Packard, like Dell, has reinvented itselfits PC business now representing less than 10% of overall profits. Even assuming no growth in actual trailing 12-month free cash flow, H-P is worth about 40% more than its current share price. Whereas, in fact, H-P has shown, and should continue to show, strong growth and its higher margin repeatable IT service and software related segments, along with the printer and associated cartridge business, continue to dominate. The company now has the ability to provide a wide range of converged infrastructure hardware solutions, integrating servers, storage, software, networking and consulting. Trading at less than 7x free cash flow, more than a 40% discount to our appraised value, this top 10 global brand is undeniably undervalued. Also, like Dell, we anticipate more than a 40% per year return from H-P, or a double, over the next 2 years. We did sell an initial H-P position in late May after it declined from quarterly results giving us a TRAC sell signal. We sold Cisco for the same reason. But after H-P recently declined even lower, to a floor, we bought it back. When Microsoft fell recently to a TRAC floor, we added it too. The company has steadily grown its FMV, with a greater increase over the last couple of years on the back of Windows 7. Windows 8 looks even better and the Office suite of software continues to drive earnings. Xbox is now contributing too. The share price has languished for years as it remained substantially overvalued for some time. But now, at 8x earnings, ex the cash on hand, it too has high potential and we expect a rise of about 37% per year, nearly a double, over the next 2 years.

Specialty Foods continues to produce healthy profits. Cash on hand at year end should equal the current price we carry it atenough to repay our debentures. However, the debentures we hold are convertible into equity and there are opportunities for Specialty Foods to grow its business which would benefit equity holders. We would like to see the company enter into a new contract with its hotdog licensor, Nathans Famous. Even if the existing contract ends up expiring in March of 2014, the convertible debentures should have an equity value that is at least double our carrying price. Porto Energy has just begun to exploit its 1.8 billion bbls resource. They have 7 major identified exploration trends and more than 45 mature, mostly oil, drilling targets. The company already discovered natural gas which only requires reserve certification and a tie-in to a pipeline to move it to proven producing status. Assuming they book reserves of only 15 million bbls, a small fraction of the overall resource, we arrive at a value over 30% higher than the current price. The company should be able to demonstrate at least $3 per share of value shortly from its lower-risk development opportunities aloneover 3 times todays share price. We own a position in Pivot Acquisition via a convertible debenture with a 12% coupon. Pivot is a private company which intends to go public in the next few months. Revenues are already ahead of our projections and pre-tax earnings from their value-added IT reselling businesses should exceed $50 million this year. Valuation is highly compelling and the conversion price is favourable (about half the ultimate IPO price), and if the company fails to list within its first 12 months, we receive a 10% bonus. We anticipate at least a double in the next year. Also, in small-cap land, we added further to our Fortress Paper position. Fortress trades at only about 4x next years earningsmuch too low. And, there are near term catalysts that should lift the shares up toward reality, not the least of which is the startup of its newly converted dissolving pulp mill in Quebec. Though we continue to pursue larger-cap companies, until our more undervalued smaller-cap holdings recover, we will proceed patiently because, even though they are more volatile, the small-cap holdings clearly still offer much better value on a risk-reward basis. Their stock prices are also so depressed that each could be an attractive target to an acquirer. We pointed out in our last quarterly letter that valuation risk was low for our holdings. Its even lower now after their recent declines. At the same time, our companies also have lower than average financial risk since they operate with clean or cash laden balance sheets. And, operational risks appear below average as they operate in safe jurisdictions and/or are low cost operators and/or operate with stable profit margins that have potential upside. Meanwhile, potential tailwinds are also in place from our macro views that could push overall sectors uplike a recovery in tech spending, or rising energy prices. And, the key driver, our holdings trade well below our conservatively appraised values giving rise to our expectations for outsized potential gains.

Top of Mind The next few months should bring major developments to our key holdings: Corridor should procure joint venture partners for all three of its major projects and complete a small financing (likely flow through shares at a premium) to fund a pilot test of the Frederick Brook; St Andrews production should lift materially into year end and we expect continued exploration news which should be market moving as they hone in on key areas; Orca will expand production significantly and commence drilling exploration wells in Italy and Songo Songo West; Xcite will receive government approval to proceed with its development project, finalize its debt and equity financings and begin drilling and cash flowing; Manitok and Porto just started their drilling programs and a continuous flow of results is expected; Pivot and Specialty Foods debenture holdings will likely be converted to equity to realize on the significant underlying value. Minding Your Income In our income accounts we continue to hold: Specialty Foods convertible debentures and, as above-noted, the company has nearly as much cash as debt; Advantex debentures which are fully secured by the companys receivables; Student Transportation shares, an extraordinarily steady school busing business; High River debentures, the only non-project debt of the company with material asset and earnings coverage; CompuCredit notes, the company having more cash than next years put price of our debentures; Dynacor debentures, the only debt of the company which is secured and well covered by assets and earnings; Ticketmaster bonds which should be priced higher given the companys oligopolistic position; Pivot Acquisition convertible debenturesa fast growing company led by a world-class management team with substantial interest coverage; and Southern Pacific Resources convertible debentures where the companys low-risk oil sands assets generously cover the overall debt. We recently bought Lender Processing Services 8.125% July 2016 senior notes. LPS is far and away the market share leader in its mortgage servicing field; its interest obligations are extremely well covered by profits and the company should generate enough free cash to retire the bonds even if sales remain flat. We also purchased Armtec Holdings 8.875% September 2017 senior notes. Armtec is a Canadian construction/infrastructure company whose bonds are very well covered by the companys valuable assets. A selloff in the common shares and concerns about a refinancing knocked the bond price down to about 16% below par, where we entered. Theres very little debt senior to our bonds, sufficient cash flow available to service the bonds and an asset value about double the total bond issue. We sold all of our Pizza Pizza position when it breached our appraised FMV level, Arctic Glacier bonds as we were concerned about its restructuring and Chukchansi and Connacher bonds as both lifted to the point where we saw better value elsewhere. Most of our bond/debenture holdings have well above market yields and, in some instances, offer potential conversion privileges which could lead to substantial capital gains.

Matter of Fact A client recently commented that he thought we were always bullish. Interestingly, Hays Advisory got the same comment from its clients. As value investors, we obviously believe we hold cheap stocks with little downside risk and substantial upside potential, so we must usually be bullish on our holdings. In the years prior to '08 we could not find value in big-cap names so we shunned them, and emphasized cheap smaller-cap names. That cheapness didnt matter in the Panic of '08 and early '09 when the bids disappeared. We remained invested because the overall markets were not overvalued and the values of our holdings were inordinately compelling. Clearly, though, were not always bullish. In 2000 and 2001, when most others were bullish, we believed the market was inordinately overvalued, and were 40% short, including Nortel, then constituting a third of the TSX, and now in bankruptcy. Despite, or perhaps because of, the poor last quarter, we are very bullish today. The volatility of the last quarter should not imply that the portfolio is risky. It should rebound smartly. Indeed we think our current portfolios may comprise the best values weve ever had, both big-cap and small. We continue to grow the big-cap component because, while having less upside potential than our smaller-cap names, we are prepared to trade off some value for liquidity. And although we are investors, not traders, our TRAC and TRIM work should allow us to trade some of our bigger-cap names if they go on sell or on buy at ceilings and floors in our work. We can also use options, in accounts that allow it, for some risk protection, as we recently did as a hedge with S&P put options on two occasions when the voting outcomes in the Greek Parliament were in question, threatening global markets. We are positive for the short term, and, for the longer term, encouraged by the improving conditions for corporate earnings growth. We also continue to be bullish on commodities and maintain our significant overweightings in energy stocks. We believe depressed natural gas prices are set to move considerably higher. Important for Corridor. U.S. storage levels are below last years level and the 5-year average. Consumption is rising and production is declining with fewer gas drilling rigs at work. Oil prices relative to natural gas prices are at a whopping 22:1 ratio, and gas is cheap compared to coal too, an incentive for power utilities to switch to gas. Minding Our Business Not only do we believe our portfolios are the best theyve been, we believe our team of analysts who uncover and cover the ideas are the best too. Jeff Sayer, Anthony Visano and R.J. Steinhoff, each with a distinct skill set and interests. And our experienced team of portfolio managers and dedicated marketing people who believe in our capabilities to outperform for investor clients. We pride ourselves in having a philosophy of continuous improvement. We continually enhance our TRAC workto better optimize our entry and exit from stocks. We have added TRIMan indicator of momentum to help perceive the next panicour back test to WWII caught all major (>20%) market declines with the exception of the '87 crash, a massive one day decline. And, we have added the potential use of options to hedge our accounts if our TRIM work or other signals point to a serious market decline. We have also raised our target rates of
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return. Big caps need to offer a potential 2-year 25% per year return. And, a small-cap stock must now provide us a potential 40% annualized return over the next 3 years or were not interested. Its not that we are trying to shoot the lights out, we simply want to make sure the discrepancy between price and value is widera larger margin of safety. And, were trying to be less complacent. In '08 we held a handful of companies that took on debt and then became vulnerable in the credit crunch/panic period. We plan on being more proactive should that threaten again. Frame of Mind There will be market corrections along the way, such as the last quarter, and we are striving to get better at anticipating them and minimizing their impact. But these are normal fluctuations in an improving market and world economy, and corrections should be seen as opportunities to add. Value investing requires patience. We recognize that, as professionals, our analysis gives us a greater tolerance for market fluctuations, for short-term pain, than our clients. But, short-term pain for long-term gain, trite as the expression may be, surely applies to value investing. Waiting is an essential part of the value investing process. After all, we buy whats unpopular and need to wait for it to become popular. For the milestones. For better markets to appreciate those bargains. For what we believe are the inevitable positive outcomes with minimal downsides. For what we believe will be ultimate gratification. Peace of mind.

Herbert Abramson and Randall Abramson, CFA July 14, 2011

The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. This report is not to be construed as an offer, solicitation or recommendation to buy or sell any of the securities herein named. We may or may not continue to hold any of the securities mentioned. Trapeze Asset Management Inc., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities named in this report. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein. E.&O.E.