Quarterly Letters

Roumell

Quarterly Update

October 31, 2007

Performance Summary

  Annualized as of 9/30/07
  3Q 2007 YTD 2007 1 Year 3 Year 5 Year Since
Inception
(1/1/99)
Roumell Equity -5.76% -0.98% 6.91% 12.81% 18.50% 14.82%
S&P 500 1.56% 8.78% 16.07% 13.02% 15.38% 4.12%
Russell 2000 -3.09% 3.17% 12.35% 13.36% 18.75% 9.04%
Roumell Balanced -6.40% -1.73% 4.70% 9.68% 14.67% 10.66%
Thomson US Balanced Index 1.94% 7.10% 12.19% 9.42% 10.49% 4.57%
Please refer to performance disclosures at end of document.

Roumell Asset Management, LLC is in compliance on a firm-wide basis with the requirements of the Global Investment Performance Standards (GIPS®) as adopted by the CFA Institute. Ashland Partners & Co. LLP completed its examination of the firm's performance returns for the period of 1999 (inception) through June 30, 2007. Please refer to the annual disclosure presentations at the end of this document.


Challenging Year

After several years of growing account values with little disruption, the tables were turned on us in the third quarter. The third quarter was marked by exceptional volatility as investors reacted to rising credit concerns, the deflating housing bubble and an expected economic slowdown. Essentially, risk taking itself came under severe scrutiny and it was discovered that many investors hadn't been properly assigning risk to their investments. Included were all those holding some piece of the sub-prime mortgage tail (banks and investors), particularly hedge funds that bought these securities on margin, as well as those who held securities on the basis that cheap credit would create a steady private equity appetite to take companies private. We are not exempt from this group in that we too held securities without full recognition of the underlying risk. Below is a description of the issues affecting our accounts this year.

  • Small company shares - and value ones in particular - are out of favor. The bifurcation of the market this year is wide. Year-to-date as of September 30th, the S&P 500 is up 8.8%, but the Russell 2000 Value is down 2.7%. We are all cap deep value investors with a strong historical bias toward smaller companies given their value proposition; i.e., they're more often inefficiently priced. This segment of the market is simply out of favor - at this moment - and it has consequently affected our portfolio values. We believe we hold strongly financed companies that will prevail. We remain focused on company fundamentals, not on "stock market" risk resulting from day-to-day fluctuation of prices. Many of these companies simply do not possess much liquidity (not many shares are available for trading) and, therefore, can be very volatile. In instances where we have reassessed business value, we have acted accordingly.
  • Micro capitalization companies - market capitalization of $500 million and less - have always made up a component of our portfolios. Perhaps the single largest impact on account performance this year is a result of our basket of micro cap companies. Our strategy is to hold a basket of typically extremely well financed companies led by management teams with significant equity interests in which a company buy-out is deemed likely in the absence of going-concern success. First, the aforementioned liquidity issue is compounded. Second, this is a riskier set of companies in which strike-outs seem to be an unavoidable aspect to the strategy. Nonetheless, we analyzed the total micro cap investments we've made over the past five years and confirmed that the net results are quite favorable. The foregoing notwithstanding, the results of this aspect of our portfolio this year are quite poor. By our estimate, a large part of our underperformance is attributed to the following four securities: Entertainment Distribution Company, Inc. (EDCI), Infocus Corp. (INFS), ICT Group Inc. (ICTG) and ValueVision Media, Inc. (VVTV). The decline in the share prices of these micro cap securities has occurred over roughly the same period of time. In retrospect, while these firms were certainly statistically cheap on several fronts, the specific company and industry challenges they faced were greater than we anticipated at the time of our analyses. They had net cash on their balance sheets, possessed assets to monetize, and had valuable net operating losses that would be attractive to an acquirer. That said, they were distressed or structurally disadvantaged businesses and in the absence of a take-out, value has eroded. We will remain focused on our assessment of intrinsic value in light of each security's current price.
  • Financials are out of favor. We went into the third quarter with roughly 12% of the portfolio dedicated to financial related companies. These included two mortgage insurers purchased at book (having never really traded at a discount to such values), three regional banks and a financial guarantor. We sold all but one regional bank, added to the guarantor, and sold the insurers. In aggregate, we realized modest losses. The securities sold were reassessed in light of new and material information (all have dropped significantly since our sales). These were disappointing investments given that we decided earlier this year to stay clear of homebuilding companies only to be caught holding companies participating in some manner in the mortgage machine.

Going forward - opportunities and pitfalls. The world is growing and that's a very good thing. Astute writer Fareed Zakaria recently noted in a Newsweek article, "The End of Exceptionalism," "Large majorities across countries and cultures are in favor of democracy, free markets, trade and cultural exchange." In fact, eight of the wealthiest ten individuals in the world are now non-American (and each one is an entrepreneur). Multinationals are gaining ground by entering new markets and taking advantage of the increasing game changing nature of investment opportunities abroad.

On the other hand, the pitfalls posed to our domestic economy as a result of the housing bubble bursting are real, and moreover, the full consequences are really not known. One can only speculate on the extent to which steadily dropping home values will have an impact on American consumers. We believe this reverse wealth effect is quite real and as a result we are cautious in selecting new investments. However, the market appears not to be overly concerned: total domestic market capitalization as a percentage of GDP is currently about 130%. This total market cap to sales ratio has averaged roughly 60% over the past 75 years and peaked at about 170% at the height of the internet bubble (and stood at roughly 100% at the last low reached in 2002). Further, profit margins over time have stayed within a fairly predictable band: over the last 50 years net profit margins have ranged from 4% to 7% (the consensus expectation for next years' S&P 500 earnings assumes a roughly 9% net margin). Perhaps this overall valuation helps explain why Warren Buffett's Berkshire Hathaway remains roughly 25% in cash and fixed income. Cash and fixed income at the end of the third quarter was about 37% for Equity Accounts and about 48% for Balanced Accounts.

Notwithstanding the above concerns, as fundamentally oriented bottom up deep value investors, we strive to take advantage of opportunities that present themselves because at day's end, it is our belief that investment results will be tied to the particulars of a given company (based on the price paid) and not to general markets.

Finally, it is important for our clients to understand what we are striving to accomplish - respectable risk-adjusted returns. We have never hesitated to hold significant cash balances. We have often been heavily invested in deeply discounted closed-end bond funds in both our balanced and equity accounts. In short, we pursue an eclectic opportunistic investment approach that spans across asset classes: small cap (micro cap), mid cap, large cap, international companies, closed-end bond funds, individual bonds and cash as well. While it has been rewarding to beat the S&P 500 for the past eight years because of its popularity, it appears likely that we will not do so this year. However, it should be clearly understood that we are not seeking to beat the S&P or the Russell per se; rather, we are seeking to judiciously grow our accounts while utilizing all available asset classes, cash and bonds included. To pursue such indices would entail fully participating in speculative periods, since to mirror such an index in a frothy period would, by definition, likely involve participation. Our discipline will not change and, as a result, we will continue to pursue individual opportunities that we believe carry great investment merit like the ones discussed below.

Our Three Top Purchases

Legg Mason Inc., LM. Legg Mason is a pure asset management firm having exchanged its retail brokerage operations two years ago for Citigroup's asset management business. The collection of brand managers in its portfolio include: Royce & Associates, Brandywine Global, Western Asset, Permal Group and, of course, its own Legg Mason branded funds. Roughly 48% of its assets are in fixed income funds, 36% are in equity funds and the remaining 16% are in money market funds. The mix of assets among the various asset groups provides stability to its overall business; i.e., while equity funds may be seeing outflows in a given quarter, bond funds are likely to be witnessing inflows.

The asset management business is long known for its steady stream of income generated from management fees. Asset retention can be a challenge to smaller firms lacking diversity of product offerings and distribution scale. Legg Mason scores well on both fronts. In particular, the firm has a distribution agreement tapping into Citigroup's large network of retail brokers. Product depth is underscored by a steady rise in total AUM (assets under management). The particular funds managed by Bill Miller (roughly 6% of Legg's AUM) appear to be weighing on the stock.

Most compelling about Legg Mason, however, is the price we paid: roughly 11x cash earnings, about 8.5x enterprise value to EBITDA, or about 1.1% of its roughly $1 trillion in AUM. To wit, Putnam Investments, LLC - an asset management firm under a three year compliance cloud with its AUM in decline - was purchased earlier this year by Great-West Lifeco Inc. for about 11x EBITDA, or about 2% of its AUM. Nuveen Investments was purchased by a consortium of private equity firms for about 17x EBITDA, or about 4% of its AUM. In Legg Mason, we own a company with a steady recurring income stream buttressed by a strong balance sheet (cash exceeds debt), scale and diversification of product offerings.

LandAmerica Financial Group, Inc., LFG. LandAmerica Financial Group is primarily engaged in the domestic real estate title insurance business. Historically, LandAmerica has generated roughly 90% of its total revenue from the sale of title insurance mostly to residential home buyers and existing homeowners in refinance transactions. In recent years, the company's commercial segment of the title business has experienced significant growth. In 2007, commercial is expected to constitute roughly 20% of total revenue.

At first glance, our investment in LandAmerica begs the basic question, "Why invest in a company levered to housing activity?" First, we purchased LandAmerica at an average price of roughly 50% of book value. The share price was 60% lower than highs reached in June 2007. Since LFG's IPO in late 1993, the stock has dropped to a trough price/book valuation of about 0.4x on two separate occasions. Second, LFG is not really in the insurance business given that its loss ratio hovers around 6%. More accurately, it's in the real estate closing business or perhaps the warranty business. Finally, LandAmerica's investment portfolio of high quality fixed income securities alone is capable of generating about $4.50/share of after tax earnings to offset weakness from residential real estate transaction earnings. In LandAmerica, we believe that we have acquired a "toll bridge" on the real estate transaction and refinance market. We fully expect that traffic crossing this toll bridge will slow over the next year or two. That said, we believe that we have aligned ourselves with a highly capable management team that has successfully led LandAmerica through multiple real estate cycles and is focused on improving shareholder return.

Citigroup Inc., C. Citigroup is a diversified financial services company with operations in consumer and corporate banking, insurance, investment banking, and retail brokerage. The stock price has largely been flat over the past five years. Investors have been frustrated by what they believe to be lack of execution by Charles Prince, CEO, and the rest of his management team since taking over for Sanford Weill in October 2003. Some have been calling for a break-up of this global financial supermarket and the resignation of Prince. Thus far, management and the board of directors (which includes Robert Rubin, former U.S. Secretary of the Treasury) have rejected these calls and instead continue to press ahead with Citigroup's strategic plan to grow domestically and internationally while reducing operating costs.

Citigroup's stock price pulled back from its recent highs along with the rest of the stock market due to the deterioration in the credit markets. The financial sector was hit hard in particular and Citigroup was no exception. Citigroup is certainly exposed to credit risk, interest rate risk and operational execution risk. It has exposure to mortgage related securities and loan commitments to leveraged buyouts that will have to be written down. Additionally, there is a fear over potential losses related to structured investment vehicles. In spite of these near term challenges, we believe this mega-cap offers a compelling investment opportunity. We paid about 10x earnings for the shares and we're receiving a dividend yield of about 4.75%. There are various levers to pull to improve the results of the diverse lines of business (or perhaps jettison some) and opportunities to expand around the globe. In our opinion, short-term concerns have provided us with an investment opportunity in a multi-cylinder operation with a true global financial footprint, trading near its historical low P/E, providing us with a free option on execution of its strategic plan.

Once again, we want to thank you for the trust and confidence you have placed in us. We invest alongside our clients in order to insure that our interests are aligned with yours. Further, we preclude ourselves from buying any public securities not also being purchased for our clients. We eat our own cooking (and no one else's in fact).

Disclosure: The specific securities identified and described do not represent all of the securities purchased, sold, or recommended for advisory clients and the reader should not assume that investments in the securities identified and discussed were or will be profitable. The top three securities purchased in the quarter are based on the largest absolute dollar purchases made in the quarter.

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ROUMELL ASSET MANAGEMENT, LLC
EQUITY COMPOSITE
ANNUAL DISCLOSURE PRESENTATION

  Total Firm Composite Assets Annual Performance Results
Year Assets USD Number of Composite S&P Russell Composite
End (millions) (millions) Accounts Net 500 2000 Dispersion
2006 280 176 458 16.89% 15.79% 18.37% 2.18%
2005 199 111 312 12.38% 4.91% 4.55% 2.59%
2004 123 47 125 20.18% 10.88% 18.33% 2.69%
2003 66 15 46 32.13% 28.69% 47.25% 4.04%
2002 41 8 44 -10.15% -22.10% -20.48% 4.33%
2001 31 5 30 32.76% -11.89% 2.49% 6.33%
2000 19 2 12 7.97% -9.10% -3.02% 4.05%
1999 16 2 9 26.02% 21.04% 21.26% 3.92%

 

Equity Composite contains fully discretionary equity accounts and for comparison purposes is measured against the S&P 500 and Russell 2000 Indices. The S&P 500 Index is used for comparative purposes only and is not meant to be indicative of the Equity Composite performance. In presentations shown prior to March 31, 2005, the composite was also compared against the Nasdaq Index. The benchmark was eliminated since it did not represent the strategy of the composite.

Roumell Asset Management, LLC has prepared and presented this report in compliance with the Global Investment Performance Standards (GIPS®).

Roumell Asset Management, LLC is an independent registered investment adviser. The firm maintains a complete list and description of composites, which is available upon request.

Results are based on fully discretionary accounts under management, including those accounts no longer with the firm. Past performance is not indicative of future results.

The U.S. Dollar is the currency used to express performance. Returns are presented net of management fees and include the reinvestment of all income. Net of fee performance was calculated using actual management fees. Net returns are reduced by all fees and transaction costs incurred. Wrap fee accounts pay a fee based on a percentage of assets under management. Other than brokerage commissions, this fee includes investment management, portfolio monitoring, consulting services, and in some cases, custodial services. As of December 31, 2006, wrap fee accounts made up 33% of the composite. Wrap fee schedules are provided by independent wrap sponsors and are available upon request from the respective wrap sponsor. Returns include the effect of foreign currency exchange rates. Exchange rate source utilized by the portfolios within the composite may vary. Composite performance is presented net of foreign withholding taxes. Withholding taxes may vary according to the investor's domicile.

The annual composite dispersion presented is an asset-weighted standard deviation calculated for the accounts in the composite the entire year. Dispersion calculations are greater as a result of managing accounts on a client relationship basis. Securities are bought based on the combined value of all portfolios of a client relationship and then allocated to one account within a client relationship. Therefore, accounts within a client relationship will hold different securities. The result is greater dispersion amongst accounts. Additional information regarding the policies for calculating and reporting returns is available upon request.

The investment management fee schedule for the composite is as follows: For Direct Portfolio Management Services: 1.75% on the first $200,000, 1.50% on the next $300,000, and 1.00% on assets over $500,000; For Sub-Adviser Services: determined by adviser; For Wrap Fee Services: determined by sponsor. Actual investment advisory fees incurred by clients may vary.

The Equity Composite was created January 1, 1999. Roumell Asset Management, LLC's compliance with the GIPS standards has been verified for the period of January 1, 1999 through June 30, 2007 by Ashland Partners & Company LLP. In addition, a performance examination was conducted on the Equity Composite beginning January 1, 1999. A copy of the verification report is available upon request.






ROUMELL ASSET MANAGEMENT, LLC
BALANCED COMPOSITE
ANNUAL DISCLOSURE PRESENTATION

  Total Firm Composite Assets Annual Performance Results
Year Assets USD Number of Composite Thomson US Balanced Composite
End (millions) (millions) Accounts Net Mutual Fund Dispersion
2006 280 87 158 14.00% 10.47% 3.69%
2005 199 73 142 8.56% 4.22% 2.67%
2004 123 66 119 16.48% 7.79% 3.82%
2003 66 42 100 28.26% 18.60% 3.94%
2002 41 27 79 -9.70% -11.36% 3.77%
2001 31 17 39 21.18% -4.19% 4.75%
2000 19 10 23 8.47% 1.95% 4.53%
1999 16 9 22 12.53% 8.35% 2.63%

Balanced Composite contains fully discretionary balanced accounts (comprised of equity, fixed income and cash investments) and for comparison purposes is measured against the Thomson US Balanced Mutual Fund Index. In presentations shown prior to March 31, 2006, the composite was also compared against the Lipper Balanced Index. Additionally, in presentations prior to December 2006, the composite was measured against the Vanguard Balanced Index Fund. The Thomson US Balanced Mutual Fund Index is a blend of over 500 balanced mutual funds and is therefore deemed to more accurately reflect the strategy of the composite.

Roumell Asset Management, LLC has prepared and presented this report in compliance with the Global Investment Performance Standards (GIPS®).

Roumell Asset Management, LLC is an independent registered investment adviser. The firm maintains a complete list and description of composites, which is available upon request.

Results are based on fully discretionary accounts under management, including those accounts no longer with the firm. Past performance is not indicative of future results.

The U.S. Dollar is the currency used to express performance. Returns are presented net of management fees and include the reinvestment of all income. Net of fee performance was calculated using actual management fees. Net returns are reduced by all fees and transaction costs incurred. Wrap fee accounts pay a fee based on a percentage of assets under management. Other than brokerage commissions, this fee includes investment management, portfolio monitoring, consulting services, and in some cases, custodial services. As of December 31, 2006, wrap fee accounts made up less than 1% of the composite. Wrap fee schedules are provided by independent wrap sponsors and are available upon request from the respective wrap sponsor. Returns include the effect of foreign currency exchange rates. Exchange rate source utilized by the portfolios within the composite may vary. Composite performance is presented net of foreign withholding taxes. Withholding taxes may vary according to the investor's domicile.

The annual composite dispersion presented is an asset-weighted standard deviation calculated for the accounts in the composite the entire year. Dispersion calculations are greater as a result of managing accounts on a client relationship basis. Securities are bought based on the combined value of all portfolios of a client relationship and then allocated to one account within a client relationship. Therefore, accounts within a client relationship will hold different securities. The result is greater dispersion amongst accounts. Additional information regarding the policies for calculating and reporting returns is available upon request.

The investment management fee schedule for the composite is as follows: For Direct Portfolio Management Services: 1.75% on the first $200,000, 1.50% on the next $300,000, and 1.00% on assets over $500,000; For Sub-Adviser Services: determined by adviser; For Wrap Fee Services: determined by sponsor. Actual investment advisory fees incurred by clients may vary.

The Balanced Composite was created January 1, 1999. Roumell Asset Management, LLC's compliance with the GIPS standards has been verified for the period of January 1, 1999 through June 30, 2007 by Ashland Partners & Company LLP. In addition, a performance examination was conducted on the Balanced Composite beginning January 1, 1999. A copy of the verification report is available upon request.

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