LSGI Advisors, Inc. October Beaver Creek Drive Duncanville, Texas (972)

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1 LSGI Advisors, Inc. October Beaver Creek Drive Duncanville, Texas (972) Dear LSGI Investor: The Dow Jones index had its strongest September since 1939 despite underlying concerns that the U.S. economy is recovering too slowly to sustain growth. The Dow Jones index closed 7.72% higher than the previous month. The Russell 2000 small cap index was up 12.5% for the month. Meanwhile the LSGI Fund also had a good month our best month performance wise in more than four years. The excellent earnings and revenue growth reported by LSGI Fund companies has helped, and the ongoing frenzy of mergers is creating an investment environment where undervalued firms are becoming more reasonably valued. LSGI Fund holding Arc Sight Inc. (ARST) was bought by HP last month, the second major position we have had acquired in the last six months. In this environment we would not be surprised to see another undervalued LSGI Fund holding acquired by year-end. $8,000 $7,500 $7,000 $6,500 $6,000 $5,500 $5,000 $4,500 $4,000 $3,500 $3,000 $2,500 $2,000 $1,500 LSGI Portfolio Comparative Performance* LSGI Portfolio Value - Gross Returns 6 Month Moving Average - LSGI LSGI Portfolio Value - Net Returns Berkshire Hathaway Cl A Russell 2000 Index Fidelity Growth Fund Nasdaq Composite Index Dow Jones Industrial Average Putnam Voyager Growth Fund S&P 500 Index Janus Fund $1,000 $ Vanguard US Growth Fund Firsthand Tech Value Fund The accompanying chart for the LSGI Technology Venture Fund L.P. portfolio ( LSGI portfolio or Fund ) represents estimated returns as of October 1 st on a hypothetical investment made on April 1, LSGI portfolio gross returns represent performance and all reinvested dividends after payment of the 1% annual administration fee and all related Fund costs and expenses, including accounting and legal expense. LSGI portfolio net returns reflect estimated portfolio performance after payment of the manager s annual performance incentive fee (20% of gains) on January 1 st of each applicable fiscal year, taking into account the high water provisions of the Fund, and calculated pursuant to the terms of the Second Amended and Restated Limited Partnership Agreement. Returns of the LSGI portfolio will vary with market conditions, and past performance does not reflect potential future performance. The objective of the Fund is aggressive growth. We invest in the small and microcap sector of the market. Data contained in this report is derived from sources believed to be reliable but we can make no guarantee as to the accuracy or completeness. The LSGI portfolio was established on July 1, The Fund or LSGI Advisors Inc. may have positions in, and may from time to time buy or sell, securities mentioned herein without prior notice to our investors. This Report is prepared solely for the limited partners in the LSGI Fund and is not an offer to buy or sell securities. It is not intended for use by third parties

2 Record Correlations Begin to Decline The Wall Street Journal published a story last month on how the correlation between individual stock prices and the major market indexes have reached unheard of levels. Correlations have risen to levels not seen since the Great Depression. Recent correlations approached 80%, meaning stocks and the stock indexes moved together much closer than we have seen historically. At this degree of correlation all stocks tend to move together, upward or downward. When stock correlations are this high it is very difficult for managers to select stocks that will outperform since most stocks tend to move in unison. During 2000 to 2006 the correlation of the S&P index and stocks was 27% (see chart from Wall Street Journal article). Individual stock prices moved relatively independent from the index. When we have such high correlations the market becomes very inefficient. As stock prices move in unison the profitability, growth, business niche, and prospects of each individual company are not reflected to the extent they should be in the share prices and companies become mispriced. As correlations return to more normal levels these inefficiencies should be corrected and if not the firms will be prime acquisition candidates for larger competitors. As can be seen on the chart above, while correlations are still well above historical averages they are declining toward more normal levels. If this continues we think stock selection will once again provide opportunities for active managers to generate excess returns for investors. Oil & Stocks Throughout 2010 the Wall Street Journal noted the movements in the price of crude oil has also correlated very closely with the movement of the S&P 500 index (see chart at right). Historically these assets have not correlated closely in fact many times had a negative correlation. The article noted the close correlation between crude oil prices and the stock market has begun to decline to more normal levels last month (see chart at left). During the financial crisis the price movement of many asset classes correlated closely even though they had not done so historically, so the fact that the correlation of some of these assets is returning to more normal levels is a positive sign that the global economy is healing. 2

3 Investment Charts & Trends Most of the indicators we follow remain positive: TED Spread The TED spread is a measure of the health of the banking sector. The TED spread is the yield differential between the 90-day T-Bill and Eurodollar contracts. It is a real money gauge that measures the risk within the global banking system. Eurodollars are the primary instrument of inter-bank lending unregulated and uninsured dollars. When the banking or credit markets are stressed money flows into T-Bills while Eurodollar funds become more expensive, hence the divergence or spread in rates. When this measure rises it is a sign the risks in the banking sector are increasing. The TED spread fell to around 10 in the first quarter, then rocketed upward to almost 50 in June on concerns over risks related to European debt, only to fall back to roughly 14 at month end. The fact that the TED spread has sharply declined is a very positive sign that issues in the banking and financial sector are being addressed (chart courtesy Bloomberg). TIPs Spread The TIPs spread is the difference between the yield on treasury bills and the yield on Inflation Protected T-bills. The difference between the two is the expected rate of future inflation. From 2004 through most of 2008 the 5 and 10 year TIP spreads forecast an inflation rate of roughly 2.5% per year. With the economic meltdown in 2008 the TIPs spread predicted a deflationary environment with an annual decline in prices of over 2% at one point an environment that could be very destructive for the economy and reminiscent of price declines seen in the Great Depression. The 10 year TIPs spread currently anticipates an inflation rate of roughly 1.84%, falling from expectations of 2.02% four months ago. We would like to see the spread widen to roughly 2.5%. Stocks tend to perform poorly in a deflationary environment. A mildly inflationary environment is positive for equities (chart courtesy Hays Advisory). ISM Manufacturing Index The Institute for Supply Management s latest data indicates manufacturing continued to expand in the U.S. The U.S. purchaser manager s index (PMI) is used to measure the strength of industry. It fell to 54.4 from 56.3 in August, but a reading above 50 indicates the manufacturing economy is in a period of expansion. A reading below 50 indicates a general contraction of the industry. Electrical Generation Year to date the U.S. has used 4.5% more electrical power than the year earlier period according to data from the Edison Electric Institute, an indication that economic activity continues to expand. The hot summer increased demand, but recent gains appear non-weather related. Electrical demand and economic activity correlate closely. The Baltic Dry Index The Baltic Dry index is prepared by the London-based Baltic Exchange. The index provides an assessment of the cost of transporting the major raw materials grains, ore, and fuel - by sea. Taking in 26 shipping routes the index covers carriers transporting a range of commodities including coal, iron ore, and grain. 3

4 This month the index closed at roughly 2,504 falling steeply from the 4,156 level four months ago. The Baltic index represents real time business transactions, and actual freight rates, so has carried quite a bit of weight historically as an indicator of overall demand for materials and supplies. The recent surge in shipbuilding activity has influenced shipping rates. The supply of ships has jumped sharply upward over the last year depressing shipping rates and making the Baltic index less accurate as a forecasting tool (charts courtesy Hays Advisory). The fact an alternative method to measure bulk shipments (railroad traffic) has not declined in the last three months in our opinion indicates the decline in the Baltic Index is a function of the massive supply of new ships as opposed to a decline in shipments (see Railshare charts below). Railroad Traffic - Railshare publishes a weekly report on developments in North American railroad traffic. The most recent data indicates that total railroad traffic, as well as intermodal traffic, continues to significantly outpace last year s traffic levels. The four week rolling average of loaded units can be seen in the charts at right - an indication that the U.S. economy continues to recover. Charts courtesy Railshare. The Yield Curve The yield curve is a comparison of long term and short term interest rates, in this case the yield on the 10 year note less the T-bill. Many academic studies show this curve is one of the best leading economic indicators. Don Hays of Hays Advisory notes that if we had to pick only one monetary indicator to watch, this probably would be the one. The higher the value on the chart at right, the more accommodative the monetary policy. Currently the monetary reading is accommodative, historically a positive environment for stocks. At month end the yield curve was 2.5. Value Line Appreciation Potential Value Line analysts calculate a 3-5 year target price range for their 1700 stock universe based on historical growth and valuation measures. The current inflation rate is subtracted from the projected Value Line stock return. The median appreciation potential has a 69% correlation with actual five year returns historically. The current projection of 10.2% annual return on equities, after inflation, over the next five years is above historical averages (chart courtesy Hays). This forecast is up from an 8.0% annual return forecast four months ago. 4

5 Hays Advisors Indicators Hays Advisors publishes a visual summary of their statistical analysis of the market every week. All four of their composite indicators are in bullish territory: Consumer Confidence - Hays Advisory also prepared an interesting analysis of consumer confidence for one of their research notes last month. They note that over the last thirty years every time: (1) consumer sentiment dropped under 70, and (2) the Hays market valuation model was extremely undervalued a powerful buy signal was generated that resulted in a massive bull market that lasted several years. Specifically Hays notes we have had four buy signals in the last 30 years. Visually the relationship is quite striking: Rolling Returns & Mean Reversion Frank Holmes, CEO of U.S. Global Investors, published an interesting note last month on how after periods of poor stock market performance investors may generate impressive gains once the markets turn for the better. First, Holmes draws attention to the cyclical nature of markets as can be seen in the accompanying chart from Stifel Nicolaus. This chart shows the 10-year rolling return of the S&P Stock Market Composite going back nearly two centuries. Current performance (inside the circled area) is at low levels only seen during the Great Depression. Holmes summarizes: The negative news flow keeps many investors on the sidelines waiting for sunnier days, while those who believe that what goes down eventually comes back up may see an opportunity to snap up equities at bargain prices. 5

6 Second, the MSCI World Index (a measure of stock market performance across the world including the U.S.) can swing wildly based on global events according to Holmes (see chart at right). But what s clear is that the negative rolling 10- year growth since 2008 is unmatched in the past four decades. Markets have always bounced back. Last, Holmes notes that over the past decade Treasury bonds have outperformed U.S. equities by nearly 90 percent. This is the widest margin of such outperformance over a rolling 10-year period in more than a century. J.P. Morgan points out that history shows equities eventually reversing that trend, and when they do, they on average climb more than 250 percent over 10 years a compounded annual growth rate of 13.6 percent. He concludes It s often said that hope is not an investment strategy, and that s certainly true. It s also true that hopelessness is also not an investment strategy. History and cycles are not perfect predictors, but it s worthwhile to pay attention to these indicators. Hays Market Valuation Model Hays Advisory publishes a market valuation model developed using decades of back-tested data. Historically there has been a very good correlation between the readings on their model and future market performance. Right now the markets are extremely undervalued according to the Hays model. They estimate the S&P 500 index is 38.43% undervalued at current levels. The index is in the most undervalued quintile. The model indicates the market is extremely undervalued one of the most extreme readings in 30 years. When markets are this undervalued the Hays model forecasts 16.2% annual return from the S&P 500 index over the following 48 months well above historical averages. This model supports the outlook of the Value Line Appreciation Potential model (which is net of inflation) discussed above. We expect that small cap stocks, since they are more volatile, would perform better under the Hays model than the S&P 500 index (chart courtesy Hays Advisory). Conclusion Most of the indicators we follow remain positive for equities. The opportunity for potential long term outperformance is in place if the models are correct. 6