Formula Growth - Quarterly report - September 30th, 2008

Quarterly report - September 30th, 2008

October 10, 2008

Dear Unitholders:

The net asset value of Formula Growth Fund as of September 30, 2008 was $2,915.44 per unit. In U.S. dollars, the Fund decreased 13.4% in the third quarter and 23.6% in the year to date period. In Canadian dollars, the Fund decreased 9.8% for the third quarter and 18.0% for the first nine months of 2008. Our performance is in-line with the indexes below and the average Small Cap U.S. Growth manager who is down 21.1% year to date.

As of the date this letter, the North American and European stock markets are down 40% and the Asian markets 50% from their 2007 highs. The speed, breath and depth of these declines are unprecedented. Real estate has experienced steep declines since 2007 as well. Credit markets and commodities have been performing as poorly as stocks and real estate. Derivatives of these asset classes are performing the worst of all.

Before describing to you in greater detail what has happened and what to expect, here are the critical points:

We do NOT believe that this is the second coming of the Great Depression,
Over-leverage is the culprit,
The World has been in a recession for months and the market has already “priced in” an economic catastrophe,
Stocks, especially Formula Growth, generally have swift and powerful reversals off the bottom.

While credit markets and derivatives are largely invisible to the average citizen, their proper functioning is critical in an economy. Credit markets, in essence, lend against collateral. Derivatives help borrowers, lenders and producers transact. The quick asset deflation we have seen in real estate and stocks is causing collateral to erode, derivatives to unspool and lenders to worry. This unwinding has caused credit spreads to spike to record levels indicating that credit markets are nearly frozen. The result is that many banks are unwilling to lend to other banks. Small and mid-sized businesses, along with individuals, are having trouble borrowing in the short-term credit markets.

Essentially, we are witnessing a massive margin call and forced selling of assets at any price to obtain liquidity. We are in a credit crunch induced bear market the likes of which the world has not seen for some time. Probably the most similar recent experience was the crash in October 1987. After a decade of rapidly rising debt levels, the U.S. and, for that matter, the world now faces a forced deleveraging for consumers, businesses, financial institutions, and, eventually, the government.

The stock market decline suggests that the credit crunch will cause the U.S. to sink into a depression. We do not agree. Unlike in the 1930s, governments world-wide are acting aggressively and in the right direction. Government programs (such as the U.S. $700 billion Bailout package) to purchase bad loans from banks or to inject capital will improve the banks’ balance sheets sufficiently so that they will eventually be able to lend again. In addition, it is important to remember that banks entered the current crisis with far more capital than they had in the 30s. In the 1930s unemployment was over 25% and about one-half of mortgages were in default. Comparable numbers today are 6% for both unemployment and defaults. It is hard to conceptualize a rise in these metrics to levels experienced in the Great Depression.

While the blame game is creating much finger pointing, the villain in this unfortunate drama appears to be simply leverage gone horribly wrong. The systemic unraveling of this borrowing has in turn lead to tremendous fear and uncertainty and is creating a vicious circle of even more selling. We are disturbed that the U.S. and other governments’ efforts to stabilize the markets and rebuild confidence are instead becoming political hot potatoes to argue over. We should not be surprised with the poor communication out of the politicians as Wall Street itself has historically failed to effectively explain its vital role in keeping Main Street working. We are also disappointed that regulatory initiatives from the early part of the decade (Sarbanes-Oxley et al) did nothing to help avoid the current debacle and, in fact, probably created false comfort.

Our guess from here is the world will simply experience an economic recession from the deleveraging that will last longer and be deeper than average. This means a painful period of readjustment involving slower economic growth, constrained corporate earnings, and sluggish employment. Governments around the world are likely to have to accept higher taxes and lower spending. Governments will also be more involved in the financial markets with, hopefully, more intelligent rigor this time.

According to a recent study by the International Monetary Fund, the average recession since 1945 lasts about twelve months. Those caused by housing busts or credit crunches have lasted fifteen months. Therefore, based on these bench marks, we conclude the economy probably has another year of tough sledding. We feel the U.S. has been in a recession for sometime already and so we are probably about half way through it. If this is true, the stock market could bottom soon. Typically market bottoms are made half way through economic downturns. The average bear market since 1945 has taken the market down 30%. The three most serious crashes in this time frame were 1973-74, 1987 and 2000-02. Each of these bear markets fell around 50% top to bottom. We are roughly in that stage of decline now which, again, points to a market bottom.

From these crisis bottoms, the recovery in stocks is usually swift and steep as well as persistent. The following has been our performance off the bottom compared to the market, one and two years later after various notable crises:

We see no reason to believe this sort of performance will not be the case again as the stock market is loaded with bargains. Out of 9194 stocks tracked by Compustat, 3518 are now trading at less than 8 times their earnings over the past year – or at levels less than half the long-term average valuation of the stock market as a whole. Nearly 1 in 10, or 876 stocks, trade below the value of their holdings in cash.

We are actively reviewing our earnings models for the balance of 2008 as well as 2009 (and 2010) in order to stress test them for the continued tough business conditions we envision in coming months. Even after reducing our expectations, the portfolio is inexpensive compared to the market. We are also very actively communicating with the managements of our holdings to round out our analysis and ensure that we are on the right track with our financial modeling. Where appropriate, changes are being made to the portfolio.

To sum up our current view, we feel now is the time to summon your courage and buy stocks. Normally as an investor, you must always ask yourself what is my edge; something which is generally difficult to achieve. Today, however, you need only two things in order to have an advantage: cash and courage. Using the table above, had you made each of the crises your “friend” instead of hiding from them and invested $10,000 at the respective bottoms (for a total of $100,000) you would have today $8,545,714.

For our taxable Canadian residents, there are no realized capital gains so far this year. Please do not hesitate to contact the office towards the end of the year for tax planning purposes and clarification.

Yours truly,