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November was yet another difficult month in a difficult environment. As the chart below indicates, our Hedge Fund fell approximately 13% while the Income Fund managed to decline less disappointing 5.6%.

1. The performance of the Venator Investment Trust approximates the performance of the Venator Founders Fund.
2. As the Venator Income Fund was launched in August, 2008, YTD represents four months of performance. Benchmark results for the S&P/TSX Income Trust: Monthly Return -11.1%, YTD -32.9% (since inception of the Venator Income Fund).

Venator Founders Fund:
The Founders Fund was hit exceptionally hard in the month relative to the market, as the last week saw a significant market rally that left our small cap companies in the dust. Indeed, going into the final five trading sessions, our Fund was down approximately 16% (while markets were down over 20%) but only managed to recoup 3% in the ensuing 15%+ market rally, despite a net 70% long position. We note that small caps did significantly underperform large caps in the month, and it was our Canadian small caps in particular that held back the Fund in the rebound. We believe this was largely due to Fund redemptions/liquidations overwhelming these less liquid stocks with “Sell” orders in combination with a continued disproportionate interest in resource stocks in Canada, as investors have a difficult time letting go of “yesterday’s bubble” (remember it has been less than six months of Bear after 8 years of Bull in the resource market).

Venator Income Fund:
The Income Fund experienced a 5.5% loss in the month. Small cap apathy was part of the problem, but we also had one of our larger positions report a disappointing quarter, which accounted for approximately one-half of the loss for the month.

What The Heck Just Happened?!?:
This recent market drop has admittedly caught us off guard. Unlike previous market collapses, there was no massive run-up through the old highs (markets were fairly flat for the 18 months heading into August), and valuations weren’t particularly high. In 2000, the most recent market crash, people were devastated by unsustainable valuations in technology stocks. Cisco going from 60x earnings to 20x earnings, dropping the stock by over 60%, was not the end of the world. As a former technology analyst I was able to find technology companies with high growth rates that traded at less than 15x earnings going into the crash, and those stocks came out significantly higher. Furthermore, you could have made money in virtually any sector outside of technology. But in this de-leveraging market, money is coming out, rather than shifting around. Simply avoiding financials and resources and hoping the money comes to the more neglected sectors is not working this time around. Maybe it is different this time, but people were losing their jobs and savings in 2000, too!

That being said, we failed to appreciate the effect that the current debt issues have caused for the market at large. Leverage, to the extent it is manageable and backed by strong free cash flows, has always been the hallmark of efficient companies (Biz school 101 – debt is cheaper than equity). However, in these times when the Street appears exceptionally concerned about access to capital, even debt amounting to 2x free cash flow can prove punitive. We were also caught off guard by the increased lack of interest in Canadian small cap non-resource companies, which we thought were at a point of maximum neglect for the previous two years. We failed to appreciate that solid growing (yes, they are still growing), free cash flow positive companies with little or no debt could fall from what we perceived of low valuations of 9x earnings, to lower multiples in the 5-7x earnings range.

IF I HAD $1 BILLION DOLLARS (where is Private Equity?):
It amazes us how shockingly wrong private equity got it — levering up to buy low growth and efficiently operating business without much room for margin improvement at north of 20x earnings. We wrote about this over a year ago, suggesting that both the valuations paid and the leverage employed would result in a near impossibility of a decent return for their investors. But if there was the perfect business to get into right now, it would be private equity.

There are some great, non-cyclical, not very economically sensitive businesses out there that can be easily had for 10x earnings (which would amount to 50%-100% premiums to where these stocks are trading today). After stripping out some costs, Private Equity could yield 10%+ free cash flow yields without taking on additional leverage. We are aware that levering-up their investments is considered mandatory for Private Equity, and that they are effectively shut down due to the credit market slowdown, but in buying these companies, you can take a 10%+ free cash flow yield and wait for the credit markets to loosen up so you can lever them up later.

As an example, Pet Valu has long been a core holding of the portfolio. It’s not great growth, but it does grow and its most recent quarterly earnings of US$0.45 easily beat our US$0.35 estimate (and were up 45% over last year). With 70% of their business coming from their private label pet food product, we consider this business to be fairly defensive. In a good market environment, investors would never have been willing to part with Pet Valu for 10x earnings, but in this environment that represents 80% upside from the current share price.

Another excellent example would be our largest holding, Futuremed Healthcare Income Fund. Futuremed is the market leader for providing disposables to nursing homes across Canada, with dominant market share in Ontario, Quebec and Alberta. This is a business we believe has near guaranteed growth of 8%+ for the next 10 years (again, not great growth, but growth you can count on regardless of the economy). We believe that Futuremed can earn as much as $1.00 per unit next year on a fully-taxed basis, putting the stock at 6.5x earnings with a 13% dividend. Give me 10x earnings (50% upside) and I might consider it.

These are just two examples of Private Equity “no-brainers”, but hardly isolated ones within the portfolio. Just as low-growth and cyclical companies were not worth 30x earnings at the top, non-cyclical/defensive growing companies are worth more than the 5-7.5x earnings they are trading at today. Private Equity beware: investors will not be willing to take these prices forever.

Where we are Investing (and What we are Avoiding):
We have not dramatically altered the makeup of the portfolio. We got a little less short in mid-November and the Fund is now 90% long and 20% short for net market exposure of 70%. We have been adding to our growing healthcare investments and have purchased some selective US large caps that we believe have either good visibility, or internal controls that allow them to quickly adjust costs to revenues in the event of an up to 10% decline from 2008 revenue levels.

We continue to avoid resource stocks, as cycles rarely last three months (so don’t expect oil to get back to $100.00, or even $70.00 any time soon), and these companies generally require debt financing to expand production of a depleting resource. We continue to avoid US financials, as they still remain drastically over-levered, and still need to dilute their shareholders on a massive scale though equity issues. We continue to avoid certain cyclicals in the industrial and retail sectors. While P/E multiples look low on the surface, we note that applying 2006 gross margins to 2008 revenues would yield some very expensive multiples. We are very aware that 10% revenue drops can cause 20%+ earnings shortfalls for many manufacturers. While recent market bottoms may have discounted overly pessimistic scenarios for many companies, we think the more cyclical parts of the economy could see much larger drops in profitability than current stock prices are discounting.

Thank-you for your continued support,

Brandon Osten, CFA
President, Venator Capital Management

This is intended for informational purposes and should not be construed as a solicitation for investment in any of Venator’s Funds. The Funds may only be purchased by Accredited investors with a medium-to-high risk tolerance who are seeking long-term capital gains. Read the Offering Memorandum in full before making any investment decisions. Prospective investors should inform themselves as to the legal requirements for the purchase of shares. All stated Venator returns are net of fees. It is important to note that past performance should not be taken as an indicator of future performance.

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MIND IF I TAKE A MULLIGAN???

This was as tough a month for Venator as for anyone. As the chart below indicates, our Hedge Fund fell approximately 15%. On the other hand, our Income Fund (which doesn’t hedge) actually managed to post a small gain!

Instrument	Monthly Return	Year-to-Date Return
Venator Founders Fund*	-14.8%	-12.0%
Venator Income Fund	-0.7%	-6.2%
TSX Composite	-16.8.0%	-29.4%
Russell 2000	-20.4%	-29.8%
S&P Toronto Small Cap	-24.0%	-45.0%
S&P 500	-16.8%	-34.0%

Venator Founders Fund: With North American stock markets facing their worst month in decades, our hedges failed to adequately protect us from the severe drop in markets and, more specifically, from the severe drop in some of our less liquid small-caps, which suffered from collapsing markets, a lack of buying interest in small caps, and the forced selling by other funds experiencing redemptions in this difficult environment. Surprisingly, our Hedge Fund managed to stay slightly ahead of the markets, which is somewhat uncharacteristic of our performance in months where markets have early collapses followed by late, sharp rebounds. For those of you who are new to our Funds, we historically tend to experience a “lag effect” in sharply rebounding markets, as our small cap stocks don’t rebound so quickly (they don’t tend to get a lot of buying interest as a lack of liquidity make them a poor vehicle for traders to get back in the market quickly). Conversely, our more liquid, mid-cap shorts tend to move up in-line, or more sharply than the markets. To illustrate the point, when markets were down about 30%, the Founders Fund was down less than 20%; however during the late 10% market bounce in the final week of October, the Founders Fund only managed to pick up about 5% of performance.

1. The performance of the Venator Investment Trust approximates the performance of the Venator Founders Fund.

2. As the Venator Income Fund was launched in August, 2008, YTD represents three months of performance. Benchmark results for the S&P/TSX Income Trust: Monthly Return -14.1%, YTD -24.5% (since inception of the Venator Income Fund).

Venator Income Fund: The Income Fund, which finished with a small gain despite being 100% invested, managed to stay comfortably ahead of the market collapse throughout the month. We took the opportunities provided by the market bottom to initiate some new positions which caused us to lever up by 15%, but have subsequently reduced the fund to 100% invested. The Fund currently has a yield of approximately 11%.

We figured, given the difficult month, it would be illustrative to provide a longer, more comprehensive, overview of how we are dealing with these markets, and our views and strategy going forward.

What We Like (assuming low valuations):

Doing something special: We like companies with very specific plans to increase earnings during the next twelve months. Hammond Power Solutions represent just such an opportunity, where the falling Canadian dollar is set to increase US sales by 25% (so if same-currency sales go down 10%, reported growth will still be 10%) and lower copper prices will also serve to reduce costs while they keep expenses on a tight rein. Furthermore, by moving more standard product manufacturing to Mexico, the Company is set to increase margins further. Finally, new distribution relationships with major buying groups will bring in sales from new channels they previously didn’t have. In short, if industry sales dropped 10% in Canada and the US, Hammond could still pull off modest revenue growth and better than 10% earnings growth. We can’t say that this will happen, but the pieces are in place to give this scenario a decent probability.

Gaining Market Share: We recently got back into Research in Motion and Apple. Big caps aren’t normally our thing, but these companies were both recently trading at under 10x our earnings expectations and we couldn’t resist the no-growth scenarios the market appeared to be discounting. These companies both have very small market share (under 10% combined) of the global cell phone market. If smartphones can increase their market share of the overall cellphone market (and Apple can continue to build its market share in PCs) then these two companies can grow, even in a cellphone sales environment that shrinks by 5% and a PC market that goes flat. The main caveat is these companies sell some relatively expensive products, with the offset being that these are products that people really want.

Canadian/US dollar trade: This is an important trade that really hasn’t received the air time it deserves. The Canadian dollar is down over 25% from its highs. While this is a boon for Canadian exporters, we are sufficiently worried about the economy and uncertain of how much the currency effect will be able to offset economic weakness. But considering that Canadian companies which primarily manufacture and sell to the United States (or deal in US dollars) will get a straight 20% gain on their earnings in Canadian dollar terms, we believe there are some great opportunities. As previously mentioned, this includes Hammond Power, and we have re-purchased Neo Materials which reports in US dollars but only trades in CDN. We note that investors in Research in Motion hit the stock when the company announced that it would see gross margins drop by 5%, but hoped to recover 2% through economies of scale for a net loss of 3% on operating margins. What the Street has failed to recognize is that a significant portion of personnel expenses are in Canadian dollars which can go a long way to recouping the other 3% of potentially lost margin.

Defensive and Cheap: Cheap isn’t good enough. There are a lot of cheap companies, and you can find cheap companies in any market environment. Many of them are cyclical or turnarounds, both of which you don’t want to bet on in a recessionary environment; however, really cheap AND economically defensive is a good mix. Companies like Pet Valu (Ontario’s leading pet supply retailer, which sells mainly pet food rather than other more discretionary items) and Futuremed, the leader in selling disposable medical supplies to nursing homes in Ontario and Quebec, exemplify defensiveness. Pet Value trades at 7x earnings while Futuremed trades at 8x taxed-equivalent earnings expectations and pays a better than 10% dividend – cheap and defensive.

Dividends/Yield: As the relative outperformance of our Income Fund is demonstrating, the market seems to agree that high dividends are a good place to be, and better than higher yielding debt. If you can stay cheap and defensive, such as the aforementioned Futuremed, you can make 10% even in a flat market environment.

What We Don’t Like:

The Commodity Cycle (cycles don’t last three months): Is this just a violent price correction in a long-term secular bull market for commodities, or is this a cyclical downturn? Rising supply capacity over the past several years and lower demand suggests the latter. Natural Gas production is going to go a lot higher for the next four years; oil production cuts mean more spare capacity (bearish until demand growth reinvigorates and catches up), and copper demand likely weakens with the economy while $1.50 copper is fine with the major producers in terms of expansion plans. Fertilizer prices are weakening in North America and North American producers are always one contract negotiation away from a 50% price cut from China. Coal and Molybdenum prices, to name two more recent fads, are just starting to roll over now. Zinc and nickel have possibly bottomed as they started their plummet last year, but in general investors should look for a tough year in commodities. Commodity cycles don’t last three months, so don’t count on a quick sustained bounce.

Gold (ignore conspiracy theorist Gold Bugs): We have said this before, but we believe that gold is not likely to zig when the market zags. With commodity prices collapsing, we no longer need a hedge against inflation. Gold bug conspiracy theorists have maintained that central banks have managed to keep currencies strong by holding gold down through reserve sales. Times have changed. Governments need money to deal with financial crises and gold bugs should be thankful that central governments aren’t dumping reserves in order to raise funds! Do people really think that the roughly $250BB that the US holds in gold reserves is in any way strategic at this point? I am guessing that if the US government could sell it without killing the price, and redirect the proceeds towards the financial bailout, they would do it in a second.

The coming REIT disaster: If your broker still has you invested in Real Estate Investment Trusts in order to generate income we would advise you to shift into industrial income trusts. REITs are in a horrible position as virtually all of them have huge debt refinancing risk (whether it’s sooner or later doesn’t matter, it is inevitable). In many cases, a mere 2% increase in interest rates on their mountains of debt could wipe out 40% of their cash flow. But it gets worse. Unlike income trusts, REITs have no avenue through which to pay down debt other than share issues. This is because REITs must distribute nearly all of their operating cash flow in order to maintain their tax-advantaged status. Therefore, all else being equal, a REIT that cuts its distribution from $1.00 to $0.50 in order to prudently pay down debt before it matures will only be able to use $0.15 to pay down the debt, while the other $0.35 goes to government in the form of tax. You are better off with less leveraged Income Trusts that will likely start paying down what debt they have in two years when the Trust structure disappears.

High Debt Growth: We are on the lookout for low growth companies that managed to look like growth companies due to easy access to capital. REITs obviously qualify, but so do lesser names like Iron Mountain. Iron Mountain (which we are short) has piled on a lot of debt recently because its capital intensive growth results in little free cash flow. Yet this 10% organic growth, highly levered, low cash flow business continues to maintain a P/E in excess of 20x earnings. These are the kinds of companies that are getting into trouble as the market recognizes their inability to grow or generate cash if more debt does not become available to them.

The Euro vs. the Greenback: We continue to believe that Europe is in the early stages of dealing with what the US is the later stages of dealing with in terms of the financial crises. It is amazing that Europe has held its interest rates in the 4% range while its economies flounder and inflation concerns dissipate with commodity prices. Couple this with stronger demand for the more stable US dollar (so much international debt is denominated in US dollars, but the US is in the enviable situation of having its own debt denominated in its own currency) and we think the Euro should move closer to parity over the next six months. This is going to hurt a lot of exporting companies, including those servicing the international infrastructure markets and big cap tech. Certain consumer products plays will also run into issues if they get too much of their revenues from overseas.

What We Are Doing Now:

We believe that the recent market collapse has created some great buying opportunities for larger, more liquid, big cap companies. As a result, we are seeing better opportunities in this area than we are seeing in our bread-and-butter small cap universe. All else being equal from a valuation standpoint (i.e. P/E, PEG, cash flow ratios etc.), we would rather buy a larger company over a smaller company, and a more liquid over less liquid stock. In other words, we would rather buy Research in Motion at 10x our internal earnings estimate (which is where it was at US$40.00), than RuggedCom (a great little Canadian company, but a very illiquid stock) at that same multiple. As a result, we have been shifting our assets into some of these more liquid opportunities as we fear that Fund closures, tax loss selling, and general market caution could keep these small caps under pressure for the next little while. To be clear, we do not forecast a long-term change in our small-cap mandate, and when RIMM gets back through 17x earnings (or $70.00) we will be shifting back to our beloved small caps, as they will likely be selling for good relative value at that time.

Unfortunately, volatility continues to be more our enemy than our friend. For one thing, protracted and large market drops eventually wear our small caps down, as panicked investors inevitably hit the thin bids for these stocks, while short sharp upturns leave our small caps behind temporarily. Furthermore, we try to avoid shorting companies where we can lose a lot of money in too short a period of time. This is largely why we did not capitalize on our prescient bearish calls on oil and fertilizer stocks that we had made earlier in the year. Shorting oil at $90.00 and Potash Corp. at $140.00 would have been extremely painful as these investments would have gone 50% against us before working out. Furthermore, as our exposure increased we likely would have reduced our short positions on the way up, and may have only ended up breaking even on these calls. Sometimes, we will need to be satisfied with our avoidance of popular mainstream investment themes that collapse, even when we are disappointed that we didn’t profit on our prescient contrarian calls directly.

At the end of the day, it’s better to be too early than too late. There is a lot of money sitting in cash investment funds that are down well over 20% YTD. These Funds cannot afford to fall further behind the market in the event of a rebound (if you think it’s hard to tell investors you are down 40% when the market is down 30%, try telling them you are down 35% when the market is only down 15% two months later) and will deploy cash quickly if they feel the bottom is behind them. In the event of a rebound, we will probably shift back to a more defensive posture, but right now we stand at 100% long and 20% short (the low end of our historical 20%-40% short range). However, volatility, deleveraging, and redemptions remain the big “X” factors in the market. While we believe that the deleveraging of equity investments is more or less complete, the redemption cycle is likely to continue which could lead to continued volatility. At the end of October the market was 15% off its bottom. This means that a further 5% move in November puts us, technically speaking, in a new BULL market. Yes it sounds crazy, but if the market jumps a mere 5% over the next 50 weeks (ending November 1, 2009), the media will be talking about the market being up 20% over the past 52 weeks (mid-October 2008 to mid-October 2009), 15% of which happened in the first two weeks. If there is anything we did correctly, it was sticking to our guns at the bottom, and not making a bad situation worse.

Thank you for your continued support,

Brandon Osten, CFA

President, Venator Capital Management

This is intended for informational purposes and should not be construed as a solicitation for investment in any of Venator’s Funds. The Funds may only be purchased by Accredited investors with a medium-to-high risk tolerance who are seeking long-term capital gains. Read the Offering Memorandum in full before making any investment decisions. Prospective investors should inform themselves as to the legal requirements for the purchase of shares. All stated Venator returns are net of fees. It is important to note that past performance should not be taken as an indicator of future performance.

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WHAT IS AND WHAT WILL NEVER BE

Getting to the point, the Funds had a tough time in the latter half of the month.  Venator’s results,
contrasted with the market, are noted in the chart below.

?* The performance of the Venator Investment Trust approximates the performance of the Venator Founders Fund

As some of our longer term investors are aware (and have previously experienced) the Founders Fund

has a particularly difficult time when the market suffers severe short-term downturns. This is a function of our long-biased strategy and our small cap focus. Months such as September are particularly difficult for us because of the lack of news-flow in our companies (we only had one company release material news in the month). This puts the Fund at the whim of the market, as companies have a difficult time differentiating themselves without news. Compounding the Fund’s difficulty in the month were signs of capitulation of the retail and small cap investor in Canada. We saw many names post high-percentage declines on very light volumes as investors were willing to reach down for any liquidity they could find; we have seen this before and it has usually marked a bottoming process in these less liquid stocks.

I think it’s fair to say at this point that the last 18 months of the recent 8 year run in commodities may have in fact been a “bubble” (probably 50/50 odds at this point), rather than a new super cycle based on a 20-year high growth cycle in emerging markets that is expected to continue regardless of the state of the economy in North America sending oil through $200, copper through $4.00, potash prices up 20% a year forever, etc. (once again the market is shocked that: IT’S NOT DIFFERENT THIS TIME). The idea of investing blindly in commodity stocks based on the “Keep It Simple Stupid” thesis of “Why do we like commodities? – China and India” was as risky as betting on these countries themselves. Now down 50% from their highs (or headed there) investors need to make a 100% return on their China, India, Agriculture, Energy and Metal commodity investments just to get back to where they were a few months ago:

• Oil, the granddaddy of all commodities, is going lower. It really is amazing to see how history repeats itself in the commodity cycles with regard to resource production cycles. Spare capacity, the primary determinant of the oil price boom given the perception of a lack of it, has been increasing through new development in OPEC nations and Canada, just as demand is peaking. If OPEC does cut, the world will see even more of a spare capacity buffer while demand is held in check from a slower economy and energy conservation. Wars are bullish for oil, spare capacity is bearish, and everything else is just a subset of these two factors or just noise. Could oil eventually hit $200? Eventually sure! But it may drop to $60.00 first which would be a normal percentage drop from past cyclical peaks (sending investments down 80% from their highs, and leaving investors needing a 400% gain to get back to where they were!). We also remain bearishon Natural Gas, but concede that most of the downside move there is behind us.
• Copper is finally showing off that PH.D. in economics it’s always bragging about. Yes, inventories remain tight, but demand is slowing and planned expansion of existing mines is already committed to, as evidenced by three year hard backlogs at equipment suppliers. To be sure, the majors (95% of production) are happy to sell copper at anything above $1.50 given their less than $1.00 cost bases. So we think that’s probably where copper goes (take a look at nickel and zinc charts if you think we are out of line).
• Agriculture stocks have fallen 50% in six weeks. While we take some pride in having seen this coming, as evidenced by past monthly reviews, we have not been able to make money off the call as the volatility in these stocks triggered stop-losses in our positions before the quick collapse of last week (sometimes a capital preservation strategy doesn’t work out); but at least we weren’t long. What triggered the collapse was a surprising 20% weekly drop in urea prices, followed by some negative market commentary out of Mosaic. As much as market experts want to think Potash of Saskatchewan is going to make over $13.00 in EPS next year, they forget that they made less than $4.00 per share last year, and that they are only one negotiated price contract away from going back to $5.00 in EPS, or $40.00 per share.

In terms of the stock market in general, pessimism is at an all-time high in the US. Things may get worse before they better, but we think they will get better. Yes, unemployment is high at 6%, but employment is at 94% (there’s a statistic you never hear!). Yes, people are losing “their” houses; but if you never had any equity in either your house or furnishings, did you really lose anything? Hopefully the “bailout” works, with the government looking to buy mortgages freeing up the financial system to lend to corporations. Yes, the US economy stinks, but we believe the dollar will strengthen as the rest of the world (i.e. Europe) is only in the proverbial second inning of fixing problems that the US is in the eighth inning of solving. By the end of this year, all the financial institutions that are going to disappear will have disappeared (FYI, JP Morgan recently hit a 52-week high). We have to believe that house prices will hit bottom at some point next year if not sooner (this doesn’t mean they bounce back, just that they find a bottom; FYI housing stocks are up this year). A stronger dollar (we are short the Euro big time and its working) and lower commodity prices will help the US consumer stabilize (again not grow, just stabilize). If this thesis plays out, the market should start rallying in the next eight weeks (since the market usually turns six months early). Yes we will have a tough earnings season to get through as companies digest a bad domestic economy and subdued international growth due to the stronger dollar, but stocks are cheap, and many balance sheets are rich.

A word of caution: Remember that we are contrarians. We will often be wrong before we are right. Our letters from June of 2007 through June 2008 spoke consistently of why we were concerned about the economy, commodity stocks and the market in general. The volatility prevented us from capitalizing on some of these views (we didn’t want to be short Potash while it rallied 70%+ from $125 to $230 in hopes of it eventually dropping to $105, which is what would have happened; wrong for a year in order to be right for October 2nd and 3rd). However our cautious stance has left the Founders Fund relatively flat on the year, despite average market exposure of 70% through the year, and has allowed us to sidestep some previously very popular investment themes that may be proving incorrect given recent market events.

In terms of investing your money, we are getting more aggressive with our asset allocation in preparation for a market rally (getting more long and less short), while getting more conservative with the underlying investments. Remember that we are looking for a forward view of stabilization to spark a market rally, not a return to high growth. Yes, there are some true growth companies out there like portfolio holdings Zynex and Digital Ally and recent addition Research in Motion, whereby growth is neither debt, nor acquisition reliant. But where we are really focused is on lower growth (5%-15%), solid balance sheet, free cash flow positive, non-economically sensitive companies with good visibility into the next several quarters of business such as portfolio holdings Pet Valu, Allion Healthcare, New Flyer Industries, Futuremed Healthcare, Glentel and Hammond Power Solutions which all trade at valuations around or below 10x earnings. That being said, there are a lot of cheap stocks out there, so you really want to avoid high debt and high valuations (why pay 20x earnings for anything when you can buy Research in Motion’s 50%+ growth rate for 15x earnings? Why buy an over-levered company at 10x earnings when you can buy a stronger balance sheet at the same valuation?).

We are not trying to time the markets here. If US markets were to rally 10% over the next twelve months, I can almost guarantee that the first week of that rally is going to see a move of 7%. If you miss that week, you will miss most of the year.  That being said, we urge our investors to be careful out there. If we are right about commodity markets, Canadian markets can fall while the US rises. While we have half our money in Canada, it is not in resources, and we hope that investment dollars start finding their way into Canada’s non-resource stocks, which would be a huge boost to the portfolio.

Yours Truly,

Brandon Osten

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BULLS, BEARS and … ANTELOPES?

Venator’s funds managed to keep pace with a surprisingly flat market in the month of August. Although we should no longer be surprised by these trading patterns, the general markets continued to post consistent 1%+ intraday moves en route to flattish monthly results, a hallmark of the markets since February. Venator’s results, contrasted with the market, are noted in the chart below.

? The performance of the Venator Investment Trust approximates the performance of the Venator Founders Fund

At this point we are losing sight of whether we are in fact in a bear market anymore, and it is difficult to see where the next move is from a macro standpoint (good thing we are bottom-up stock pickers, rather than top-down money managers). The truth is that markets have been in a volatile holding pattern since February, despite rumours to the contrary. Since a rough start to the year, what were perceived to be market recoveries never turned into more than fizzled rallies, indicating good support for markets but lacking the capitulation necessary to mark a true bottom or new bull market. The US economy looks weak, but stock valuations appear reasonable (excluding over-levered companies that may have trouble rolling their debt). China and India are down 50% this year (for reference, it look the NASDAQ 8 months to drop 50% too, before it dropped another 50% over the next 18 months). Canadian markets’ reliance on resources and financials have given it a flat year, but the excessive weighting towards the former in the small cap arena has caused the TSX small cap index to unravel. Agricultural commodities appear to be blowing off a short-term rally, as is natural gas. While the market celebrates $120 oil, with daily $6.00 moves becoming a regular occurrence, we are merely a week away from $150, or $100. What we are trying to illustrate here is that there is plenty of room for both bears and bulls to get excited on a daily basis, with daily 1%-2% moves making each party think they are right every other day:

• Oil bulls can say that supply/demand remains tight and nothing has changed in the outlook since oil hit $140, the bears can say that the US dollar is rising and Europe and China are headed towards a US-caused slowdown, and that nothing has changed since oil was at $60.
• Copper bulls can say that copper supply/demand fundamentals remain the same and the stocks look cheap, bears look at nickel and zinc price collapses and wonder what makes copper so special that it won’t suffer the same fate.
• US market bears point to the ongoing credit crisis, the weakening consumer, and that stocks will get more expensive as earnings continue to fall, the bulls say that stocks are cheap (many great companies trade at 10-12x earnings) and that we are near the bottom.
• Emerging market bulls take a 10-year view on nearly guaranteed economic expansion in these markets, while the bears have shifted their concerns from valuation (good call) to whether or not they can maintain above 5% growth rates without a strong US export market.

Frankly, we think all of these views make sense. The problem is that the fundamental differences are what make this market uninvestable from a macro standpoint. It’s far easier to ride an obvious economic expansion and simply argue about valuation (yes, we miss the 1990’s, too). We will have to live in this antelope market, hopping noticeably up and down on a daily basis, without gaining speed in either direction, until the bear or the bull slays it. Investors need to stay focused, pick their spots and try to ignore the daily volatility. If you think a lot of US financials are going to zero, then you need to ignore the 50% short covering rallies. If you think oil is going back to $150, hold onto those stocks. If you think retailers look cheap at 10x earnings, go get’em.

At Venator, we have become infatuated with the medical services and devices markets. Our three largest positions in the Founders Fund are in the healthcare markets. In fact, at this point over 35% of the Fund is leveraged to healthcare.  We have found that there are still a few out there that trade at very reasonable valuation with some big upside “kickers”, because in this market, they are not getting a lot of value for the “kickers”. Outside of that, we think we are very well positioned in terms of defensive businesses trading at low valuations and we continue to see a lot of upside in these names. We appreciate your continued faith in our stewardship of your money.

Thank you for your support,

Brandon Osten, CFA
President, Venator Capital Management

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VENATOR CAPITAL MANAGEMENT: Keeping You in the Game

Getting to the point, the Founders Fund dropped 2.7% in July, better than Canadian markets, which were off over 6%, but lagging the US half of our benchmarks, where the Russell 2000 gained 3.6%. As the Bear gathers steam it’s worth noting that all four of our benchmarks are now negative on the year while we hold onto our 8.4% gain. Clearly, a weaker global economy is getting to the commodity bulls, and unfortunately the US has spent their rebate checks and China is effectively shut down for a month, leading us to believe that Q3 numbers will be uninspiring and that we could see continued weakness in the markets until Q4s are reported in January.

It’s August 4th and I am sitting in the office on this beautiful Monday catching up on a few things and thinking if the Toronto Stock Exchange were open today, it would be down about 5%.  We find it ironic that the market would choose a Canadian holiday to absolutely decimate oil and gas stocks (down about 7%), agriculture stocks (down 7%), gold stocks (down 5%), copper stocks (down 9%), and the once mighty Loonie (below $0.965).  Of course last month we saw broken and more-or-less insolvent US financial institutions jump over 50% in a week (Bank of America added over $50 Billion to its market value that week). The volatility is shocking. At end of the day you can sit on the sidelines, try to trade it, try to hedge it, or simply
“ride it out”.

We are not advocates of the first two strategies. We have never been big advocates of holding cash. Inflation is just eating away at your purchasing power (as is a now declining Canadian dollar) and it’s difficult to “time the turn”. Generally speaking, the first move up tends to be big and those sitting on the sidelines usually don’t know it has happened until it’s too late. Markets can move 8-12% a week in this market; in other words, you can miss the whole year in one week. Trading this volatility could drive you insane. This market has no qualms about 2% intraday moves with several changes in direction. If you don’t mind staring at a computer all day and flinching every 15 minutes, this might be the guessing game for you. But it’s worth noting that with the market moving 1% intraday on a daily basis (that’s 20% a month in aggregate), US markets finished relatively flat. Volatility can be fun to trade if you have some direction but it can be a fast money losing exercise without direction.

We are advocates of the last two strategies mentioned above. If you have a good degree of conviction towards your investments, and are willing to give yourself a few years for an extended bear market to pass, then by all means go long. However, if you like to sleep better at night, it might be worthwhile to hedge your bets, which is what we do here at Venator.  It has allowed us to be patient with the names we like, while riding out the volatility shorting names we don’t. The key is to make sure you are still in the game when things do eventually go our way. Numbers work in funny ways: if you lose 20%, you need to make 25% to get back to even, if you lose 50%, you need to double your money to come back. In other words, once you have lost money, it becomes proportionately harder to get it back. This is where not hedging can really hurt you, while instruments such as leverage can really kill your financial aspirations. The goal behind capital preservation (the first and most important investment goal here at Venator) is to keep you in the investment game while things are going in the wrong direction. We are not trying to time the markets, but we hedge our market risks so that when our investee companies fulfill our hopes and dreams for them, it will result in profits for our unitholders, and not just a recovery of losses.

Thank you for your support,

Brandon Osten, CFA
President, Venator Capital Management

This is intended for informational purposes and should not be construed as a solicitation for investment in any of Venator’s Funds.  The Funds may only be purchased by Accredited investors with a medium-to-high risk tolerance who are seeking long-term capital gains.  Read the Offering Memorandum in full before making any investment decisions. Prospective investors should inform themselves as to the legal requirements for the purchase of shares.  It is important to note that past performance should not be taken as an indicator of future performance.

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ANYWHERE TO HIDE?

The Founders Fund experienced a good uptick of 2.4% in June, not bad considering that markets were generally down in the month (TSX down 1.7%, TSX Small Cap down 1.6%, S&P 500 down 8.6% and the Russell 2000 down 7.8%). This puts the Fund up 11.5% over the first six months of the year, which compares favorably to our benchmarks:

While we have managed to escape what has been an incredibly tough market for small caps for the better part of three years, it’s getting increasingly difficult to work against a backdrop that has become common knowledge: THIS MARKET SUCKS. Steve and I are working harder than ever to uncover the hidden gems in the market than can give us positive performance in difficult markets, with good success. Even our multitude of screens are pulling up fewer intriguing companies, as fundamentals have deteriorated for growth companies, leading us to believe that a renewed shift to value companies could be in the offing as people gravitate to safety over risk. The bottom line is that we see risk everywhere, and we have summarized some of our recent thoughts, below.

OIL: Demand is starting to push back. We are no longer talking about driving less, we are closing SUV and Truck plants (not just lines). We are not just seeing lower flight demand, we are cancelling service to towns. China is refusing to subsidize further hikes in prices which will probably curtail demand for that slowing growth, and still largely poor citizenry. Furthermore, it now appears that if oil prices stay up here, US politicians will have to allow drilling off the coast of America. A few statistics released by several sources
(which may or may not be true, but still worth noting): the outer continental shelf is thought to contain a minimum of 18 billion barrels of oil (roughly 10 years of current US oil output). US oil shale and tar sands are believed to have between 800 billion (US government estimate) and 1.8 trillion barrels (Rand Corp. estimate) in Colorado, Utah and Wyoming (equal to 100 years worth of imports). There are another 10 billion barrels in the Arctic Wildlife Reserve. All of these estimates are for recoverable oil (even though some of these projects need $100 oil to get started, they could subsequently be sustained at oil prices above $60).

Inflation Rates: The Fed has finally woken up to the fact that oil and food inflation hurts the American consumer more than stagnant wages do (after all, wages aren’t about to go up 50% in six months). The problem is that the rest of the world is figuring out this as well, as inflation in Asia is through the roof (over 20% by some measures). In other words, they will have to strengthen their currencies, too. We are not sure how you increase interest rates when no one seems willing to lend at low rates, but the world seems to need to find a way.

Bonds: We are quite concerned that rising inflation could result in rising rates across the globe. If everyone starts raising in tandem, then commodity prices can drop without countries worrying about the relative values of their currencies. Could interest rates go back to 10%? We think it’s possible; although we are not yet sure it’s probable. This would severely impact the values of securities like bonds and preferred shares. Regardless of the magnitude of the move one thing is clear: the next big move for interest rates is up, which means the next move for bonds is likely down, possibly for stocks as well.  Just remember: don’t count your coupons before your capital is cashed.

D-Emerging Markets: If you think U.S. markets dropping 13% is bad for headlines, try Shanghai dropping 47% and Bombay Sensex Index dropping 32% over the same time period. Fortunately Latin American strength has resulted in the popular iShares Emerging Market ETF only dropping 11% this year. This is why taking advice on foreign trends from local money managers talking on the television is often not a good idea. Markets down 40%+ and inflation up 20% in Asia doesn’t quite jive with the more popular views of these markets, but it’s happening.

Cash is Crap: As tempting as it may seem for us to lock in our 10% YTD returns and go all cash for the balance of the year, inflation is killing your purchasing power and we would be doing you a great disservice by “playing it safe”. You need to be invested to keep up, and we need to work hard to find the few stocks that can go up sustainably in such a tough economic environment.

DOES ALL THIS MEAN IT’S TIME TO BUY? Tough to say as I don’t think we are being pessimistic, only realistic. Pessimistic would be calling for a big downturn in corporate profits, whereas we are only looking for a low-to-no growth scenario. Stability isn’t the end of the world, but it’s not enough to get us to “pay-up” to high multiples. This is why we are still out there looking for defensive, inexpensive companies, rather than chasing high-growth/high value or cyclical companies. Our motto at Venator is Preservation, Appreciation, Performance and while a 10% gain over six months would normally have us shifting into Appreciation mode, we are staying in Preservation mode until things settle down, and we can get a better sense of direction in the market (or at least a little less volatility).

THE VENATOR INCOME FUND: A GOOD PLACE TO HIDE?

Markets are tough, and finding a safe place to hide is proving difficult for many (and remember what we said above: Cash is Crap in the current inflation environment). We have therefore decided to open a new Fund designed to provide more predictable returns through investing in higher yield instruments such as income trusts, bonds and preferred shares. This Fund is not designed to provide the superior returns we target in the Founders Fund; rather, it will target 8%-12% returns with safer, and hopefully less volatile underlying investments. The Fund will initially target the Canadian Income Trust market as yields are high and we can still find some non-cyclical companies carrying very low valuations in this sector. Given our above concerns about interest rates and the capital risk inherent in bonds and preferreds, we will not be investing in these instruments at the outset. Since this investment vehicle is designed to provide lower returns, albeit with a safer strategy, fees and terms will be reflective of these criteria. The Income Fund will carry a 1% management fee and a 10% performance fee over a 5% threshold. Investors will be required to invest for a minimum term of six months. If you are interested in knowing more about this investment vehicle please contact JoAnne at 416-934-7994.

A FUND BY ANY OTHER NAME…

On June 16th, the name of the Venator RSP Trust was changed to the Venator Investment Trust.  All other aspects of the Trust remain the same – it is still structured as a Fund of Funds that currently invests 100% in the Venator Founders Fund, and it is still available on FundServ on code VCM100/101.  The Investment Trust can accept both RSP and non-RSP money – and we believe the new name makes it clearer to all that it is not exclusively an RSP-only vehicle.

Yours Truly

Brandon Osten
President, Venator Capital Management

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BACK IN BLACK

May was another strong month for the Fund, which again managed to move ahead with the markets. Positive performance was broadly based within the portfolio, though we note that performance was exceptionally strong for several of our top investments. We gained 9.7% on the month vs. a blended benchmark gain of 3.5%. The really good news is that the strong month puts the Fund in positive territory year-to-date to the tune of 8.8%, despite three of our four benchmark indices still being down on the year (the TSX being the lone outlier with a gain of 6.4%). Furthermore, the Fund’s net asset value per unit stands at a new high $16.64, meaning that every one of our investors has made money, which is the whole point of the exercise.

We really don’t have any new macro opinions to ruminate on this month. We are fortunate to have not acted on several of our contrarian views yet (i.e. shorting oil, agriculture) while some that we have acted on are starting to pay off (i.e. shorting gold). Often, momentum can carry on for a long time before the market realizes the thesis is flawed; lots of money was made on uranium and zinc on a flawed theory that there was a shortage coming before the market figured out this wasn’t going to be the case. Here are some recent thoughts we have been tossing around the office:

• Oil: Unfortunately, we just find ourselves unable to jump on this bandwagon. The argument for peak oil (the theory that we have seen peak oil production and that annual supply will fall from here, causing significant shortages in supply) continues to gather steam. However, we are also concerned about our own version of peak oil, whereby US oil imports peaked three years ago, and demand is expected to decline for the foreseeable future. While emerging markets are more than picking up the demand slack, a US-spawned global recession could end that temporarily, while energy efficiency is likely to continue unabated. Already we see SUV sales in free fall and Hybrids in take-off mode.  If oil remains high after Hybrids become dominant you could see a further shift from Hybrid-Electrics to All-Electrics (and don’t worry about the power grid, you will only be charging twice a week for three hours at a time, and overnight when grid demand is at its lowest). That being said, we have to admit that we were embarrassingly wrong when two years ago we stated that we believed that oil was now in a cyclical range of $30.00-$90.00 (oil was at $70.00 at the time), we now believe that range to be $60.00-$180.00 (the marginal cost of production at current exchange rates to the historical top of 3x that amount).
• Natural Gas: We have never really had very strong views on this commodity, which has been on fire this year. However, having owned a few junior natural gas names, we are getting more familiar with oil’s poor cousin. While the market seems to have reason to take oil higher, we can’t see any reason for gas to follow suit. Natural gas storage numbers are nearing all-time highs, and supply growth is as high as it has been in recent history as new technology is opening up huge shale gas fields. Meanwhile, in response to last year’s weaker prices, the big boys such as Encana have been holding production back. Finally, gas surpluses overseas are encouraging exports of liquefied natural gas to North America where prices are high despite over-supply. In other words, we are awash in natural gas, with seniors holding back production and juniors filling the non-existent supply-demand gap. There are a few contrarians out there talking about this while the macro guys are blindingly calling this year the year Natural Gas plays catch-up to oil. That being said, North America finds its Natural Gas supply-demand/storage-production growth factors as bearish as they have been this decade. Natural Gas could realistically fall from a current level of over $11.00 to $5.00– seriously.
• Fertilizer: Depending on who you talk to, known reserves of the various nutrients range from 600 years to 3000 years. This is not oil.
• Gold: The problem with gold is that it is the “buggy whip” of the commodity markets. Marginal cost of production for what mankind actually wants (jewelry) would argue for $300. With financial, futures, currency and ETF markets opened up to the retail investors, there are better ways to hedge inflation/play a falling U.S. dollar than gold. Gold as an inflation hedge has outlived its usefulness now that those inflating commodities/currencies are so easily investable.
• US Consumer: Retail stocks are cheap (we are avoiding the sector while revenue growth rates turn negative), restaurant stocks are expensive (we are shorting these), gas prices are up (see above), while home prices are collapsing. As we are fond of saying: there are other/easier places to make money.
• The Fed: At a 2% rate, is another 1/4 point going to make a difference? If this isn’t the bottom, its close. The Fed won’t be able to spur the economy, but maybe it can ease inflation through a stronger dollar.

The Fund has performed well, but it has come from a dark place (like the rest of the market). Therefore, the near 20% move we have had in the past two months has still left plenty of upside in our existing portfolio. We have recently completed a due diligence “sweep” of the portfolio and believe that our companies’ business prospects are good, and that their shares remain undervalued. While we continue to ferret out new opportunities, it will be difficult to find room for them in our fully invested portfolio. We are also maintaining our close to 35% short position largely because we think those securities will decline in value, rather than out of concern for the markets in general.

Yours Truly

Brandon Osten
President, Venator Capital Management

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ONE AND DONE AND DONE AND DONE

April was a very strong month for the Fund, which managed to move ahead with the markets on the heels of big moves in a few select portfolio stocks. We gained 9.6% on the month vs. a blended benchmark gain of 3.8%. Rest assured, with the Fund still down 0.8% this year, we are working hard to find the right balance between risk, reward and hedging to ensure that we can take advantage of some of the compelling values we are seeing out there, without exposing the Fund to excessive market risk.

The Fed has finally come near full circle and dropped rates back down to 2%, about the same level that Greenspan saw fit the post-tech bubble but before the knee-jerk 9/11 rate cut. Without another geopolitical disaster, this is probably as low as we go. Accordingly, we have likely hit a near-term low in the US Dollar. Dollar-bashing has been a popular and justified trade over the past several years, but it has gotten rather crowded and we believe the dollar is poised for a short-term reversal against the Euro, which has yet to reduce interest rates to account for their slowing economy (they have been more concerned with fighting inflation). We also think that this reversal could knock a lot of steam out of commodity prices which, as far as market sentiment is concerned, are priced in US dollars, making the ensuing drop likely headline fodder in North America for the balance of the year.

We do not believe that there is any point to cutting interest rates further (if there was even a point in cutting them this far in the first place). Let’s look at some of the main influences behind the rate cuts and why we think they aren’t having any effect on these sickly facets of the US economy:

Housing: The only way the housing market is coming back is if banks start offering 110% mortgages again. Yes, people were buying $1MM dollar houses when lenders were offering $1.1MM of financing, but this practice is dead for now. Now that Americans are actually faced with the prospect of putting $100K down for a $500K house, the affordability factor has dropped considerably, which has nothing to do with interest rates or house prices. That you can’t find anyone to back the mortgages is almost a red herring when compared to the sales pitch of “I will lend to an extra $100K to move in” vs. “you have to come up
with $100K to move in”.

Manufacturing: It’s time to accept that America is done as a manufacturing economy. Only the most automated of manufacturers will survive which won’t do much for jobs. Focus on making the non-exportable industries stronger such as trucking, retailing, restaurants, printing, infrastructure and healthcare. You will never see the dollar at the point where labour is competitive with the Rimini, Rupee, Peso or whatever Eastern European country you choose.

Lending: The problem isn’t the cost of the product, it’s the perceived quality. The only thing rate cuts are accomplishing is bringing treasuries to a yield of near-zero, while lesser quality corporate yields remain quite high. Investors are not going to buy what they perceive as cubic zirconia over diamond rings just because they’re cheaper. So as long as non-government debt is perceived as high-risk, people will stay away. These markets need time to heal and for investors to appreciate the underlying cash flows of corporate America; rate cuts are not making the difference.

We do like the more creative levers the Fed is pulling to deal with specific pain points in the economy. Having JP Morgan buy Bear Stearns was a great transaction in that Bear’s shareholders got the shaft, but Joe Lunchbox, with money deposited in the once-formidable institution, was spared. Protect Ma and Pa’s life savings, forget the shareholders, forget the debt holders; I have no problem with this.

The real problem with the US, which the rate cuts and the ensuing falling dollar have exacerbated, is that inflation has gotten out of control. We do not believe the Fed is only concerned with the popular “ex-food and energy” numbers; we believe they are very concerned about those two categories. Once they give up on the hopeless factors mentioned above, they will realize that food and energy represents a greater threat to cost of living than does the interest portion of a mortgage payment. We listen to a lot of conference calls. Menu prices are going up at restaurants while apparel prices are going up at retailers. Inflation is everywhere and needs to slow down. Letting the dollar float a bit without aggravating its fall with rate cuts is the fastest and best way to do this once you accept that a low interest environment won’t fix housing, manufacturing or lending for any extended period of time.

We fully believe that this is it for rate cuts, and fully expect the Greenback to move closer to par with the Euro vs. the latter’s current 50% premium. This could cause as much as a 20% near term rise in the battered currency, which could cause a similar 20% drop in commodity prices (as quoted in US dollars) over a very short period of time. Commodities have moved too far too

fast recently due largely to American speculation, leverage and fast money looking for the next commodity trade (energy to base metals to precious metals to agricultural commodities). That commodity trades have kept creeping into more esoteric assets, the whole “own real assets” thing has gone too far in our opinion. To the naysayers may we note that an ounce of gold doesn’t grow into two ounces, acquire other ounces, or pay dividends. Two commodities we think are particularly susceptible to drops include:

Gold: We think gold is the most susceptible commodity to a dollar rally, largely because it’s the primary commodity to be pegged to the dollar without any real fundamental supply-demand underpinning to support it; but also because it’s a market where high leverage is commonly employed. Fundamental (non-financial) demand for gold is well below supply. While people believe that demand out of China and India will be strong, we believe those countries would rather build tanks to store oil, than vaults to store gold. As gold falls, we do not believe that American speculators, who have bid it up to hedge inflation, will think to hold their gold and short the Euro; they will just sell their gold.

Agricultural Commodities: This has definitely been a too far too fast story in our opinion. The agriculture bull market has moved from a story on page 7 of the business section, to page one of the business section, to the front page of the paper in less than a year (there are about two front page articles a week). That is a very crowded trade for what’s historically a very cyclical and weather-sensitive market. While the world wants more meat, the cattle herd surplus is as high as it’s been in years. Yes, high food prices are causing shortages amongst the world’s poor, but that is a pricing function, and government regulation/restriction function, more than it is a supply/demand function. Amazingly overlooked in the whole agriculture mania are several crucial fundamental factors: food is a renewable resource (crops have seeds, animals reproduce), there is no current or future shortage in fertilizer reserves (and production can be brought on quite quickly by the current manufacturers), and the crop season is highly weather dependant (try arguing it’s different this time against that factor); actual food demand only goes up by less than 5% annually. The agricultural move has been spurred largely by artificial factors that have affected pricing more than fundamental factors that have affected supply and demand. Some of these factors include government suppression of exports, pointless bio-fuels and the allowance of speculators into a market that was designed to keep them out (Barron’s had a great article on this subject in early April, warning that regulators are looking at closing those loopholes).

Oil and copper, to name two other commodities, have weekly inventories, political, and shortage vs. substitution factors leading us to believe they will only drop to the extent that the dollar trade would dictate (all else being equal). But valuations can drop if investors increase their required rate of return on a company-specific finite resource pools. Unlike the technology boom, the commodity boom is more price-related than volume/demand related. These prices can drop dramatically (probably about 30%) without any disruption to expected supply in gold, copper, food, uranium, coal, or oil.

These are fairly contrarian calls, and we will always reserve the right to change our minds, but we have been hedging our few resource positions to carry a market neutral weight in energy and a net short position in gold. We believe that we are likely past the turmoil phase experienced in the beginning of the year. While the economy may stay weak for some time, good companies can now rise on their own merits instead of being dragged down on macro-economic concerns as was the case earlier in the year. This is a period where individual stock selection can be crucial, as rising/lowering tides aren’t going lift/sink all boats anymore, although certain sectors are still likely to move in tandem. The Fund is currently fully invested on the long side, with a 50/50 split between Canadian and US companies. We are over 45% short right now as well, with nearly all short positions in the US.

Yours Truly,

Brandon Osten
President, Venator Capital Management

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March saw a retracement of our February gains, with the fund losing 5.6% in a market where Canadian small caps continued their recent trend of abandonment, while US stocks ended flat in an otherwise volatile month. For the first quarter the fund dropped 9.5% vs. a 10.2% drop in the Russell 2000 and a 5% drop in the TSX Small Cap Index. Given the difficult market performance (or to put it more bluntly, given that the Fund is down 10% this year) we thought we would focus our letter a little more on the Fund itself, and why we are optimistic on the Fund’s prospects.

The first quarter of the year saw a disparity between our success rate in predicting our companies’ financial results and the performance of their stocks. Out of over 30 positions in the fund (long and short) we had less than five go against us. Usually 25 “beats” would be able to greatly offset 5 “misses”. That just hasn’t been the case this year. Generally, good earnings expectations have allowed stocks to hold their ground, while missing causes the normal punishment. In one particular case, that of our Pet Valu holding, the company managed to top our revenue expectation by 10% and our earnings expectation by 30%, and we were rewarded with a 15% subsequent drop in the stock (the company does not provide guidance so we couldn’t blame any forward-looking statements on the stock’s decline).

As we have stated in the past, short term market volatility is generally bad for the Fund, and the market has been setting new records for volatility. Most of our companies tend to be poorly followed by the investment community, which gives rise to both the low valuations as well as low liquidity. These types of stocks tend to move well on news, but poorly during volatile periods in the market. When the market goes down, they sometimes lag, but eventually capitulate; often on very low volume. During subsequent rallies they will lag as well, as the lack of liquidity offers a poor way for people to get their money back into the market (but our more liquid shorts do rally, which hurts the Fund). As a result we would expect the Fund to perform better in a more muted market environment than the one we are seeing today. We expect the Fund to appreciate in all markets, but volatile markets require more breathing room than our monthly reporting affords us.

Canada has been a particularly challenging place to invest this year. We have found that liquidity has completely dried up in our sandbox of small caps (under $200MM in market cap). This has, in turn, scared away any buying, with complete disregard for valuations, growth rates and visibility. We have actually been shifting our assets more to the United States, where we are finding that good earnings can get attention even with a poor economic backdrop. Things can change very quickly in the markets. When you own a growing company, with limited cyclical vulnerability, and trading at 8x, money can be made fairly quickly on a move to a still inexpensive 10x earnings. We believe that a move to 10x EPS by Hammond Power could add 5% to the fund on its own (a realistic target given that we expect it to grow by over 35% this year).

To be completely fair, there have been places to make money (i.e. agriculture, solar) but we tend to shy away from highly cyclical names (unless we believe the cycle is early, and the stocks are cheap) or expensively valued high growth stocks as slight disappointments can cause crushing losses. We also shy away from “blind momentum” as it can turn against you quickly even if fundamentals haven’t changed (The iShares China ETF was down 40% between late October and mid-March). We are trying foremost to Preserve Capital, and we believe that the Fund’s positions are set up for that goal.

We appreciate your continued support of Venator Capital and believe your patience will be rewarded with the continued profitable outperformance that you have grown accustomed to in our short history. To this end, Steve and I have both recently made substantial investments in the Fund. The expected return on the portfolio’s long positions is as high as it has ever been. If we can get one-third of this potential return this year it will be a very profitable one, despite the slow start.

Yours Truly

Brandon Osten
President, Venator Capital Management

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POLARIZED WITH FEAR

February was much kinder to the Fund than January, as earnings season propelled the Fund to a 6% gain. This may not look so stellar in light of Canadian markets being up 5% for the month, but it’s worth noting that we estimate that our Canadian holdings were quite flat during the month, as we received only one earnings report, and we are not invested in the resource plays that drove the Canadian markets higher. On the other hand, we estimate that our US holdings, many of which have reported earnings at this point, gained over 10% in what was another down month stateside for the markets. We can only hope that the Canadian earnings season is as kind to us in March as the US earnings season was to us in February. Rest assured, with the Fund still down 4% this year, we are working harder than ever to find the right balance between risk, reward and hedging to ensure that we can take advantage of some of the compelling values we are seeing out there, without exposing the Fund to excessive market risk.

We have talked about the “polarized” nature of today’s market briefly before. In reviewing the 2007 markets there was clearly a sense of “haves” (represented by agriculture and certain other commodities, large cap technology, and infrastructure) and “have nots” (such as apparel retailing, financials, small caps and anything real estate related). Lots of “year in review” articles would typically say that the exclusion of one or two stocks/sectors would have had dramatic effects on the year end performance of certain indices. Without getting into statistics, it has been widely publicized that the TSX Index, which showed a healthy return of 7%, would have been flat without Research in Motion, Potash of Saskatchewan and Alcan. The meager performance of the S&P500 would have been close to +10% excluding the financials, while the strong performing NASDAQ would have looked fairly mediocre without Amazon, Apple, Google and the aforementioned RIM.

We believe that the markets views are currently getting even more extreme, and consequently more volatile, in the current environment. The bottom line is that right now an investment theme appears to be either incredibly bullish, or incredibly bearish. It’s not like the technology bubble, where other sectors would suffer from neglect as all the money went to technology stocks. Right now it’s not neglect but sheer negativity that is leaving the have-nots (financials, real estate, retailers) behind. Even small caps in general fall into this category of negativity as people are afraid of illiquidity.

The commodity boom is a large one that continues to have legs. Unlike the technology bubble, which saw investors hopping between variations on a theme, the commodity bull has multiple disparate themes to play on. Investors can hop from commodity to commodity (i.e. wheat to gold), or from stock to stock (i.e. Barrick to Deere). What is increasingly fascinating is the move out of stocks and into the commodities themselves. For those of you that haven’t noticed this, it actually makes tremendous sense. Now that all commodity producers are effectively above their cost of production, the leverage to increasing commodity prices is not what it was, and with much of the rise attributable to the deteriorating dollar, foreign producers whose costs are in their local currencies aren’t getting the full benefit of these commodity price increases (Canadians know this all too well). Furthermore, companies leveraged to the commodity boom (i.e. mining companies) are still companies with all the associated risks that came with them; the potential returns are not what they once were but the risks are pretty much the same. We think this direct play on commodities can continue for a while as there are so many that can be rotated in and out of (oil, gas, copper, wheat, corn, cattle, etc.), while equities may continue to lag as a way to play commodities.