2011 value investing congress notes

Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/

2011 Value Investing Congress Notes

Speaker #1:

Seeing Value Through the Cloud

Kian Ghazi- Hawkshaw Capital Management

- Background (from Whitney Tilson)

o Kian has been running this company for 10 years.

o Worked at Lehman brothers and is a Wharton MBA

o Firm does some of the most extensive scuttlebutt research of anyone in this business

- Understanding how a manger thinks through his ideas is the most valuable part of attending the

conference

o As such, he is going to go really deep into a single idea

- Concentrated value portfolio with a focus on in-depth research

- Long short portfolio

o Extensive primary research: calling customers and former employees to get insights into

the industry

o Trying to confirm or refute their variant view

o They do not use paid networks

o The majority of what they do is cold calls to proprietary contacts who are unpaid

- How do they invest?

o They are value investors but their style goes beyond cheap business—

Look for high quality, one of a kind business.

Does the business have a dominant market share, barriers to entry?

Shown by return on capital (ROC)

Rock solid balance sheet with excess cash and monetizable assets

o Do a deep dive to try to see land mines before they step on them

o Perform a pre-mortem on an investment

If there is a permanent impairment to the earnings power, what might cause that?

If they can think of a lot of these they will avoid investing

o Invest in a business and not a stock

- Best Idea: Ingram Micro Inc. (NYSE: IM)

o Have talked to 25-30 industry

contacts—employees, customers,

competitors

o World’s largest IT distributor—

1500 vendors and 180K value added

resellers

o $3B market cap, $35B in sales,

trading .9x TBV and 10x EPS

o Number one share worldwide

Number 1 in the US and

number 2 in Europe


o Bear case:

Commoditized service in a highly competitive, low margin business

Mediocre returns on capital and thus the stock should trade at book value

Shift to the cloud is a major headwind

If Microsoft, Cisco and HP are trading at 10x earnings, then the middle man

should trade at a lower multiple than those companies

o Subtle industry tailwinds that the market does not understand

Offers a cost effective sales channel to small to medium sized businesses

(SMBs)

Industry competitive dynamic is shifting toward a better environment

Cloud fears are overblown

Oligopoly is developing

o Valuation

Book value is a floor to the value

Appraised the business at 100% upside over 2 years

- Why does this opportunity exist?

o Threat of the cloud

Uncertainty leads to an opportunity

o Large cap tech is out of favor

o Margins are at peak levels

o Change in the industry is subtle

- What is the value of 2 tier distribution

o Exists because they are the primary sales channel for selling tech into SMBs

8M SMBs

These firms purchase 40% of all tech products sold

o 30% are sold through 2 tier distribution

Other 70% is sold direct or through the 1st tier

o Cost effective sales channel

o What is the value to the distributor?

Cost effective sales channel—outsourced sales

Don’t need a large sales force—cost effective

Choose to use this to reach SMB than direct

Outsourced credit department

o All outside billing and collections

o One credit worthy company

Outsourced training

Distributor trains the value added reseller

Help with troubleshooting

o Industry Quotes

Comes down to efficiency, logistics and scale—many companies don’t want

to manage sales

o What is the value to the reseller?

One stop shop: one place and one bill


This very important and some customers are willing to pay more for

it

Source of financing—need credit extended by the distributor

Outsourced logistics and fulfillment

Resellers do not have to hold any inventory—no warehouses

If an order is placed by 5pm then the product is received the next day

with labeling that says it comes from the reseller

Support and expertise

Conferences to help them understand trends

o Realize that price is not everything—service is very important

- Why is a rational oligopoly in the making?

o 4 changes in the industry

Key geographies have consolidated—less competition

US: top 5 players have a 75% share

o Top 3 do the same thing

Mainly sell PCs, printers, and other computer

peripherals

o Next 2 are slightly different

High touch, low velocity

Ship to products directly to the data center

o Servers

Europe

o Top 5 have 62% share

o #2 and #4 in Germany have merged (# 1 market in Europe)

Synnex is no longer a price spoiler

No longer have to build share fast to achieve the scale they need to

compete

The CEO was the CEO at Ingram

He is focused on return on tangible capital (ROTC) and profits now

o Margins are trending up

Lifting the weight off of the shoulders of the industry

o This reduces pricing competition

Focus on ROC in the entire industry

Was previously focused on growth

Didn’t talk about ROC at all

o Synnex is now talking about ROC

o Same is true of Tech Data now

Company wants to achieve a ROC 500bps above the

cost of capital

o Ingram has a chart dedicated to ROC now

Targeting ROC 300-400bps above the cost of capital

Each company is pursuing growth adjacencies with little overlap

Better growth opportunities and better margins


Ingram

o Data capture and point of sale—bar code scanners

Synnex and Tech Data are not in this market

o Logistics

3rd

party logistics

Have inventory but don’t own it—get a fee

for service

50% of all items distributed from Wal-

Mart.com come from an Ingram warehouse

o Apple and Amazon as well

Tech Data

o Mobility

Synnex

o Outsourcing

Call centers

The overlap between the 3 is in the data center market

o Higher margin business

o Really going after other firms’ markets

o These 4 changes can drive mid-teens returns on capital give the changes in the

industry

- Fears of the cloud

o A major headwind to this business in general is customers moving to the cloud

o Cloud computing- distribution of software applications over the internet

Characteristics

Shared servers rather than in-house servers

o Servers are in 3rd

party data centers

Virtualization

Cheaper and broader broadband pipes make the move easier

o Big growth expected

35% CAGR through 2013

o 2 impacts on the 2 tier distribution

Software—some companies will shift to the cloud

Others will leverage two tier distribution

Hardware

With the server not on premises anymore, they will not need certain

hardware

There will absolutely be an impact if companies to go to the cloud and

circumvent two tier distribution

However, just like not all IT services got offshored to India

o Not all software/hardware is going to be going to the cloud:

Bandwidth constraints

Mission critical apps

Service disruptions

Legal/compliance


Customized software

o 68% of their sales will not be impacted by the cloud

Peripherals—monitors, printers

PCs

o At risk at to competition from the cloud is the remaining 32%

Mainly software

- Worst case

o 50% shift to the cloud n 5 years

Very draconian downside scenario

16% of revenue could go away if half of the 32% exposed goes away

Lose $1.1B in revenue

But the other 68% of the business will still grow

If it can still grow at historical growth levels, that would be $1.2B

annually

o Revenue would be about flat

o Company is priced for an Armageddon scenario

- Base Case

o 30% shift to the cloud in 5 years

$3.3B headwind over 5 years

Offsets

Cloud is going to need 2 tier distribution as well

o Value of 2 tier is not eliminated

o Cloud-based service providers will need to be able to tap the

SMB market

They will not build out their sales forces

There will be a land grab

First to market will be important

o The reseller will need 2 tier distribution

Will aggregate a 1 stop suite for cloud customers

o 50% of lost sales to the cloud could be offset

Higher end data center products—higher margins

POS bar codes and scanners

Base case is 3% growth per year

- Upside case- 10% shift to the cloud (20% is his actual guess)

o 5% growth projected by IDC for non-cloud IT spending

- None of the range of outcomes is horrible

o 0-5% annual growth even if 50% goes to the cloud

- Valuation

o Significant downside protection and 100% upside

o During a 5 month period in 2008 and 2009 the company traded below tangible book

value (TBV)

Is credit exposure an issue?

Write offs are 1% of gross profits over time

Only a small uptick in 2008 and 2009


Concerns were unfounded

Is there inventory write down risk?

80-90% has contractual rights of returns or price protection

o Very little inventory risk

Gross margins actually improved during the downturn

Profitable every quarter during the downturn

$0 inventory write downs

Managed the downturn really well

o Trading at .9x TBV

Synnex (SNX): 1.5x TBV

Tech Data (TECD): 1.3x TBV

o Base case

3% revenue growth, some reasonable SG&A leverage

8% EPS growth

13% return on invested capital (ROIC)

o Apply a 12x forward multiple and add back cash they will

use for a sizable buyback and some tuck-in valuations

$35 price

Upside is 90%

o Thinks that ROIC will be better than before and the multiple

could expand to 13-14x

- Risks

o Severe downturn in global IT spending

But the stock only trades at .9x TBV

o Company is implementing an ERP system for the next 3 years

There Inevitably will be some hiccups

o HP is a huge customers and losing HP would really hurt

o Ingram straying from its ROIC focus

- Summary

o Had a bias at first and changed his mind after looking at it closer

o Book value sets a floor for the valuation

- Q&A

o How long do they propose to own Ingram?

3-5 years

Appraise intrinsic value over a pretty long time frame

2 year out price target

o What would inspire the company to sell?

He likes that it is not a play on one company’s technology

They are going to take part in the cloud boom

IM is an arms dealer to all vendors

What would cause him to sell

ROIC focus went away

HP changed how it was going for its distribution


Not worried about a downturn in tech spending

o Why do the US-based companies in this sector not pay dividends? Why are the

models rated differently outside of the US? Does this make a case for the electronics

manufacturing services (EMS) industry as well?

Can’t comment on EMS—does not know that sector

Doesn’t know why Ingram trades at a discount to Synnex and Tech Data

He does not want to see them pay a dividend

Thinks they should buy back shares instead

o The best return on allocated capital is from share buybacks

Not going to get any value from paying a dividend

Tax inefficient

o How do they narrow down the investing field enough to do so much research on a

single name?

They used to pass on a company after 2-3 weeks of research

Implemented screening technology to find a more fertile hunting

ground

Narrow the universe to the cheapest stocks

Companies like Ingram Micro had been on his screen for a long time but he

liked a lot the more he dug in

o Did they analyze what TBV consists of?

Inventory is the biggest chunk

But, you could not get that carrying value if you were liquidating that

business

Price protection and ability to return reduce write down risk but you

can’t liquidate at the value on the balance sheet

Excess cash

Net PP&E—world-class distribution facilities

Accounts receivable

o Question from Whitney Tilson of T2 Partners: Is this like Costco (COST)—high

velocity but low margin business that actually is great?

Sales are a pass through and gross profits are like true revenue

Is more like a 25% margin business if you look at it this way

o 22% in 2008 and 2009

o Jumped back to 25% in 2010

Suggests a better business than it would at first glance

o Is there a franchise value to this business? Brand value?

Hard to argue for some enduring value for the brand

Don’t think much about the intangibles in this case

o Thinks about who will miss the company if they it is gone

o Companies only want to deal with 3-5 vendors

New company would find it hard to enter

Need customers to attract products and vice

versa

No good answer to what the price they would not buy more stock back


If it were trading a little above TBV he would still buy it

10% downside and 100% upside is a good tradeoff

o If .8x TBV is the floor

Speaker #2

The Human Side of Investing, or the Difference Between Theory and Practice

Howard Marks- Oaktree Capital Management

- Great quote from Yogi Berra

o ―In theory there is no difference between theory and practice. In practice there is.‖

This applies to investing

- It is important to realize that there is another side of investing not taught in schools and textbooks

o Professors provide a simple roadmap to investment success

There is no simple formula and it is the human side that screws it up

o Markets are objective, efficient and clinical and thus assets are priced accurately

But markets are made up of people who have emotions and swing between

extremes

o Riskier assets must provide higher returns to attract capital

If they could always be expected to produce higher returns then they wouldn’t be

riskier

o Appropriate risk premium is incorporated into returns

Sometimes the premium is appropriate

Other times it is inadequate or excessive

o Q3 2007 and Q4 2008 were on different extremes

o Since markets price asset fairly, if you buy at the market price you can expect fair returns

Buying at the market price cannot be counted on to produce a fair return

o People want more of something at a lower price and less as a higher price

Normal demand curve taught in Economics 101

Unfortunately, investors warm to investments when they rise and shun them

when they fall

Demand curve is actually the opposite in investing

- The swing of the pendulum

o Constantly going between greed and fear, risk tolerance and risk aversion, and optimism

and pessimism

o In theory, the pendulum should be at the happy medium

On average it is in the middle

But it spends little time there

Excesses constitute the errors of herd behavior

3 stages of a bull market

Few people feel things are getting better

Most people realize improvement is taking place

Everyone thinks things will get better forever

―What the wise man does in the beginning, the fool does in the end‖

o The last buyer pays the price

3 stages of a bear market


Few people realize that things are overpriced and dangerous

Most people see the decline is underway

Everyone believes that things will get worse forever

o Great opportunity to buy if we can behave counter-cyclically

- Importance of being a contrarian

o Quote from Mark Twain:

―Whenever you find yourself on the side of the majority, is it time to reform.‖

o A market top is coincident with extreme bullishness

How do we avoid getting caught up in the mania?

Approach has to be value-based and objective and we must be steadfast

in our attention to the swings in the pendulum

o What most people believe to be true in the investment world is often not true

It is very lonely being a contrarian and as value investors we have to be fine

straying from the herd

- Investor memory has to fail us for extremes to be reached

o According to John Kenneth Galbraith one of the main factors that contributes to euphoria

is the extreme brevity of the financial memory

We are less likely to repeat the past and go to extremes if we can bear these past

events in mind

1929 repeated in 2008—had to have been born in 1908 to have experienced both

events

o A man is willing to believe things that will make him rich if they are true

Greed can overwhelm caution

- Pro-cyclical behavior

o One of the most frequent mistakes investors make

o We were told to buy low and sell high

Instead we do the opposite

When the cycle is going well, media is positive, financing is available

o Coincident with rising cycles

o We need to be anti-cyclical when others are acting pro-cyclically

- Overstate knowledge of the future

o Value and growth investors are different

Value investors focus on the value here and now

Current assets, current cash, current cash flow

Growth investors are buying a piece of the dream

o But these are not that different

We need to understand the future in either case

At the same time, we should be cautious in what we expect of our prescience

o Another quote from Galbraith: ―There are two kinds of forecasters: those who don’t

know, and those who don’t know they don’t know.‖

o Amos Tversky said that it is frightening to realize that you might not know something

By in large the world is run by people who have faith that they know exactly

what is going on

Very dangerous to act as if you know the future


o Quote from Mark Twain

―It ain't what you don't know that gets you into trouble. ... It's what you know for

sure that just ain't so.‖

o 2 schools of investing

The I know school

The I don’t know school

The I know school is the most prevalent school

o These people tell others what will happen in the future to

markets and economies

o Tend to invest based on the assumption that they are right

When they are proven wrong they try to invest again on

their predictions

o Make one outcome bets

o Have concentrated portfolios

o Target only maximum price gains

o Lever heavily

The best investors are in the I don’t know school when it comes to the macro

environment

o So, what do they do to limit risk?

Diversify

No leverage

Avoid losses

Is as important as generating gains

Hedge their bets

o Most people think in terms of norms and ignore outliers

The I know school thinks in terms of the average

Never forget about the 6 foot man who drowned in a lake that was 5 feet

deep on average

These people got into trouble in 2008

Leverage is what hurt people and didn’t let them survive the outlier

events

Single scenario investors cannot account for Black Swans

Believe that the event they see as most likely is the one that will happen

o There are still many other events that could happen that have a

higher cumulative probability

Quote from Elroy Dimson

―Risk means more things can happen than will happen‖

o It is important to recognize the twin imposters

Short term outperformance and underperformance

Neither says anything about skill

Events collide with an existing portfolio

Events can be unforeseeable and hurt a thoughtful portfolio

o Doesn’t not say anything about investment ability

Remember the lessons of Nassim Taleb’s Fooled by Randomness


o Investors are right and wrong for all kinds of reasons

o Good decisions fail all the time; bad decisions work sometimes

o Randomness can produce just about any outcome in the short run

o Alternative histories

The other things that could have happened

Events are part of a range of probabilities

If we understand that then we reduce the

significance of what actually happened

Long term performance is what we should focus on

o If we think of the past as being as variable as the unknown future, it is very difficult to

get investment timing right

What should happen and what will happen are very different

Folly to bet your chips on what should happen

If you expect too much you get into trouble

o Hard to do the right thing in the investing business

Impossible to do the right thing at the right time

We are all going to be wrong

Being too far ahead is indistinguishable from being wrong

o We must avoid the pitfalls of investment bureaucracy

David Swenson of the Yale endowment says that ―active management strategies

demand uninstitutional behavior from institutions, creating a paradox that few

can unravel.‖

Over-diversification

Fear of embarrassment

It is better to fail conventionally than to fail unconventionally

Ultimate conundrum

o We must take the chance of doing a lot of something that fails

o Take the chance of being too early if we are going to be great

investors

o Investing in things with obvious appeal and that can be understood

Implies elevated prices and substantial risk

Real bargains come from areas in which the herd shuns

Focus on buying assets well as rather than buying good assets

Inefficiencies are the superior investor’s reason for being

Mistakes of others lead smart investors to make vast sums

o Oaktree’s philosophy and approach

Understanding and controlling risk

Involved in less efficient markets

High degree of investment specialization—leads to expertise

Does not raise and lower cash levels to try to time the market market

No reliance on economic projects

- Q&A

o How much are they holding in cash for future opportunities given the frothy markets?

Oaktree has lots of different kinds of funds


Some are 90%+ invested

Some distressed debt and real estate funds are invested based on their

vintage

In most areas cash is high relative to normal times

o Challenging today to find exceptional bargains

Risk tolerance is too high

Time for great selectivity, caution and discipline

o Question from Guy Spier of Aquamarine Funds: Why does Oaktree still run institutional

money if it is so hard and the investors are so biased?

Swenson has worked it out how to handle institutional investors better than most

of his peers

He has outperformed his peers by about 3%a year for 25 years

In Oaktree’s case, some of it is an historic accident

Howard has been in the institutional business since he was 21

Believes Oaktree has added value to the institutional world

o Not many people bring this message to the institutional world

o Which area(s) are they finding the most interesting?

Does not know of any areas in which dollars are going for 50 cents

Very hard to answer that question

Oaktree is raising funds which keeps him from marketing outside the

institutional meetings

o Can’t say exactly where but they are raising money in some

areas

o How do you build the right temperament? How has he done it?

It helps a lot to be born with a reserved and steady temperament

Aloof, removed, analytical, skeptical

He didn’t do exercises to develop the right mentality

Reading is the most important thing

Read about the excesses of the market

o It should strike a chord with you

o If you read it and it you think it doesn’t apply to you—you are in

the wrong business

Galbraith book –A Short History of Financial Euphoria

o If you get this book then this business is right for you

The best investors are not artists

They are analytical, introspective and not emotional

Emotional investors may not be able to become value investors

Need serenity, consistency and stability

Many forces bear on us- envy, greed, benchmarking, fear

o Forces that cause bubbles, crises, and bear markets

Value investors see them for what they are and rise to

the occasion rather than succumb


Hard to teach yourself how to do that

consciously

o People who read his new book and don’t get should probably be

in another business

o Question from VIC organizer John Schwartz- Does it help to be well self-analyzed in

order to counteract certain human emotions?

He once wrote that the most important science is not economics or financial

analyses or accounting

It is psychology

o People who have their psyches in control are in the best shape to

be great investors

A portfolio manager came to him in 1998 after LTCM crisis and was

worried that the world was going to end

o Howard said he understood why he was scared but told him to go

back to his desk and manage his portfolio

A battlefield hero is one who is afraid and does it

anyway

In 2008 they were impressed with the fact that they could be wrong

o Were not sure if they were going to fast or two slow

It was that tension that told them that they were doing

the right thing

But it was really hard to do at that time

o Were shown by the fact that very few

people didn’t jump back into the

markets that they were right

o If you couldn’t deploy money back then,

you were not alone

o It is often hard to buy something when prices are falling if you don’t own it. How do they

think about position sizing and how do they scale positions?

Within the areas they work, they are toward the more diversified end of the

spectrum

Have never had a position over 2%

o When things go right, they never have enough

o When you don’t have big positions, you can’t have big mistakes

o Graham and Dodd described fixed income as a negative art

What you don’t own is what is most important

Position sizing is forced upon them

When there aren’t attractive new investments available they may buy

more of things they already own

Will take large positions of 5-6% in certain distressed situations

Oaktree I still around after 30+ years because the focus has been on protecting

capital and managing risk

Many competitors are not around anymore


o There are old investors and bold investors. But there are not that

many old and bold investors

o Question from Marcelo Lima- If he likes inefficient markets, then why he is Oaktree not

more involved in the equity markets

They are not active in mainstream equity markets

But they do have funds for emerging market equities and Japanese

equities

Just don’t invest in developed world equities

o How does he think about dollar depreciation risk in the long term, especially when it

comes to illiquid investments?

Clients are looking to Oaktree for dollar-based returns

Don’t have superior knowledge about dollar depreciation

So, the best thing to do is try to generate high returns

Clients are fully equipped to do their own hedging

Oaktree offers dollar returns and they can hedge if they want

o Question from Ryan Morris of Meson Capital- Does he ever pay attention to external

issues that are not intrinsic to the market but can still affect the market?

The answer is no

His son is investing now

For years the 1st thing Howard says to him when he brings up an

investment idea is who doesn’t already know that?

o Meaning, why is this not priced into the market already?

For example, trade barriers are likely to go up around the world

But who doesn’t know that?

Is that priced in or not?

He doesn’t know anything about the future or exogenous events that

nobody else knows

o Can’t add value there

In high yield, the formula is simple:

o Buy ones that will not default and avoid those that will

o Will look at macro factors on individual investments when

assessing the level of risk but does not go beyond that

o He says Oaktree does not raise or lower cash based on market timing but has more cash

now? Is there a contradiction there?

Likes people to point out his contradictions

They never say: we are worried about the market and we are adding 10% cash

What they say is that there is a lot to sell and to little buy so cash levels

float up

o Their actions are the result of active portfolio management

Not a conscious decision to hold cash


Speaker #3

Prospecting for Compounding Machines in a Minefield of Value Traps

Rahul Saraogi- Atyant Capital (from Chennai India)

- Has been investing in India for 11 years

o Long only, concentrated strategy

No shorting or leverage

$15M under management

- Ben Graham said that one of the mysteries of the business is how the price of a stock converges

to intrinsic value

o How do we deal with this mystery?

This is something that value investors are always trying to do

- Munger says, always invert

o So he thinks about what prevents a stock price from converging to intrinsic value

- Background on India

o India has been discovered by value investors

Some people have had good experiences and others have had bad experiences

o Tailwinds

Demographics

1.3B people- 3.5x the size of the US

600M people under the age of 25

85% of the people are under the age of 45

By 2020, 50% of the population will be in urban centers

o This is driving significant demand

14% nominal GDP growth

o 8% real growth

o This is in spite of the government

The government has done just about everything wrong

Demand is growing 25% each year for certain products

Has very deep markets

o T+2 settlement

o 6000 listed companies

o Every sector is represented

o Cost of going public is low

o Developed investor base

o Founded in 1875—one of the oldest exchanges in the world

Paradise for value investors

o Very short term and top down focused

Money waxes and wanes with risk on and risk off trade

80% of the total market cap of the index is made up of

15 companies

Market cap weighted indices

o Liquidity advantage


People often choose to invest or not invest based on

volume

ECN based market

Liquidity is very volatile

Risk off: $2B market cap company can trade

20K shares

Risk on: Same company then trades 2M shares

Investors refrain from trading in illiquid stocks

Because they can’t get out in 10 days

Very happy as value investors to be in these markets

o Information advantage

Useful universe is top 1500-1700 companies

$50M to $100B in market cap

o Not much research coverage outside of

the top-tier companies

If you can put your feet to the ground you can

have a huge advantage

- What prevents a stock from converging to intrinsic value?

o Hurdles

Eliminate companies that will never converge

Corporate governance

o Not just fraud and embezzlement

o Many companies have dominant shareholders

How do they treat minority shareholders?

Violations

o Not securities fraud necessarily

o Related party transactions

Buying and selling to

companies related to the

dominant shareholders

Investments/loans to related

companies

Exposed to risks without upside

o Skimming cash from the company

o 100% leverage in CAPEX

How do you identify it?

Related parties—past track record of

management

Fraud/syphoning

o Looking at the financials

Interest higher than net profits

Extremely low ROE

Are they paying taxes?

Stewardship of capital


o ExxonMobile (XOM)- has consistently managed to keep ROE

high and returns cash when there are no opportunities

o Can they generate $1 in PV for $1 in retained earnings

o Most companies see declines in ROE because the opportunities

disappear

Are they returning capital to shareholders

o Empire building or vanity?

Private jets, cricket teams, stadiums?

o Frequent equity dilutions?

o Are they raising money every opportunity they get in a bull

market?

Business fundamentals

o Domestic demand driven?

o Competition from imports?

o Pricing power?

o Distribution strength?

o Cost competitiveness

o Moats

o Great brands are overpriced in India

Can’t have an edge in franchise businesses

o Commodity businesses often have moats, but not in a way that

developed market investors usually think of them

Distribution

Entrenched position in a market for years

Financial strength

Relative opportunity

o Price history

o Major holders

o Insider transactions

o Valuation relative to market

o Valuation relative to industry and peers

Most people focus on the last 3 aspects

o 2 most important in India are the first 2

o They look for catalysts

Best catalyst is if the intrinsic value is compounding continuously

Framework helps them categorize firms as compounding machines

Not a lot of value in net-nets in India

- Case Studies

o Videocon Industries Ltd. (Bombay Exchange: VEDI.BO)

Well-recognized brand

30% compounded growth

Consumer durables

Washing machines, dishwashers, and other home appliances

Can compete with multinational brands


Understands Indian consumer’s mindset

Rural Indians have different needs

Strong financial

position

Valuation

P/B: .74x

P/E: 7.4x

Bad corporate

governance and

stewardship of capital

Relative

valuation is not

attractive

Don’t get caught up in the brand of Videocon

o Just because the business fundamentals look good does not mean

that it is a good company

o Gujarat State Fertilizer and Chemicals (GSFC for short; Bombay Exchange:

GSFC.NS)

Large producer of complex fertilizers

Lowest cost producer

Advantageous port position

Entrenched distribution

Debt free

Most fertilizer

companies have a

lot of debt

Most of the market

cap is in cash

State-owned company

But has great

corporate

governance

Great steward of capital, fundamentals, financial strength and relative valuation

Looks like a commodity company but it is a great business

Earnings have tripled from 2007 to 2011

No earnings smoothing

Do not care about pleasing the street

Cash has grown substantially from $48M to $370M (2007-2011)

Why do they have so much cash?

o Really have a bazooka in a gun fight

Competitors don’t have the financial strength to compete

o Reinvestment opportunities have been and will be fantastic

Indian crop yields need to go up


Complex fertilizers is a growth business in India

How much can they make?

Think that earnings can double in 3 years

o If that happens and the P/E ratio re-rates to an 8x, that would

lead the price being 4.4x times higher in 3 years

- Summary

o India has a lot of value traps so you have to be careful what you are invest in

o Sufficient universe of qualifying stocks

Market is infested but their idea pipeline is full

- Q&A

o How do they know earnings will double at GSFC?

The markets that the company are in are huge agrarian markets

Fertilizer growth is faster in their markets than in the rest of the country

Yields really need to go up so their suite of products will do very well

Natural growth and cost reductions will lead to a lot of earnings growth

o What is it that allows some companies to fly straighter than other? How are they

insulated from government and business?

The universe of those companies is very few

Not even they do it 100% straight

Lots of low level corruption

Public servants are not paid well

o Big companies are even involved in paying charges that are not

necessarily legitimate

Used the example of Hyundai

See this as a cost of doing business

o Who is corrupt?

The management – red flag

The company has to do things on the ground to run their

business—just the law of the land

o What returns are you expecting going forward?

Returns have been about 10% compounded

He hopes to be a better investor in 5 years

The last 5 years has been very interesting in India

Since 2006 the Sensex has outperformed everything else in India

o The gap between the largest and most visible companies

exploded when hot money flowed into India

As a result of this money going into the largest

companies, small companies did not outperform the

index

o How do they measure their alpha? What about India’s returns given inflation and interest

rates? What is his outlook for India?

Alpha: Manages money with a focus on low downside and high upside

opportunities

Opportunities that are growing- growing capital, moats and franchises


Buy companies when they do not see permanent loss of capital, a margin

of safety and a potential upside greater than 0%

Inflation and interest rates.- Thinks that rates have overshot on the upside

Inflation is not driven by rapid growth of money or the general price

level

Change in relative prices is happening

o Food prices are going up—Indians are getting wealthy at a

phenomenal rate

Eating more meat and thus more grains

Increase in food prices is structural

Supply infrastructure is exploding due to the price

increases

A supply boom is 3 years away

Federal government is using a loose fiscal policy

o Due to democratic set up, reforms have been slow

Only thing that the bank can do is reign in demand

because supply response is slow

India will grow 7-8% in the next decade

o 13% nominal growth if there is 5-6% inflation

o Things are good in India and the outlook is good

o Tight money is not a bad thing

Prevents capital misallocations

Doesn’t want the Indian banking system to

become insolvent in a few years due to too loose

monetary policy

- Does GSFC export its fertilizer?

o Not, it does not export but they do import some goods

Speaker #4

Using Discipline, Patience and Cash to Realize Long-term Value

Steve Leonard- Pacifica Capital Investments

- Founded his fund in 1998

o 2 phases of his life

Commercial real estate (CRE) and then public equities

CRE

o Moved from LA to Denver and back to Southern California to

take advantage of distressed real estate properties

Moved along as the recovery became self-sufficient

Provided substantial returns to investors

Started his equity fund in 1998 after making money from his real estate

investments

o $250M in AUM now


- It’s not about beating the market every time

o Don’t actively trade

o Don’t short

o Don’t use leverage

- Decision making process

o Is the industry/business the type they have a chance of knowing deeply?

Can/will they know it better than the competition?

Is it the best company in the industry?

Does it have global growth opportunities?

Are there competitive advantages and are the advantages sustainable?

o Does the management generate a high return?

How do they allocate excess cash?

o Is the price attractive?

Is there a margin of safety?

Is there the possibility of strong returns over time?

- 3 mantras

o Discipline

o Patience

o Concentration

When you find the right company you need to invest heavily

- Often have large cash balances

o Had 50% cash in their accounts in 2007

2 years later when the market was soft, cash was very low

Cash levels are building now

o Do best when the market is weakest

IRR since inception of about 12%

- Focus on the companies they own

o Don’t worry about the macro environment

Although they do pay attention to unsustainable trends

o Prefer to own American-based companies

But they want favorable growth opportunities as well

Developed world policies are not designed for growth

India, China, Brazil exposure

o Are careful regarding debt levels

Don’t like companies with large pension obligations

Entitlements and pension funds are a disaster than will occur down the

road

- Stocks/holdings

o Fairfax Financial (Toronto Stock Exchange: FFH)

Is their largest holding

Really likes the management team

Thought their experience with CRE helped them understand the P&C insurance

business

o Berkshire Hathaway (BRK)


Is their 2nd

largest holding

Allows them to sleep well at night

o Starbuck’s (SBUX)

When the company was just becoming popular, they saw long lines for expensive

coffee

Could see that the returns they were making on each new store were high

Saw that the culture could translate well to other countries as well

Liked that the company did not have any debt

Was 15% of their portfolio for a time

Generated high return on new stores and the stock price went up

But then they started doing things he was not comfortable with

Lower returns on stores

Aggressive stock options

Bought back their own shares using all their free cash flow (FCF) and

debt

o At too high a price

Sold out by 2006

Still liked the characteristics on the company

But, results suffered from misallocation of capital

Price dropped a lot during 2008-2009 and they bought back in

Now the 3rd

largest position

o Now more focused on returns

o Now paying a dividend

Less cash lying around

o RG Barry (DFX)

Sells slippers that are sold at Macy’s and other retailers

Sold a low price item but had a manufacturing platform that was based on high

cost labor

Outsourced to China to cut costs

Are the largest shareholder of this company

o Goldman Sachs (GS)

Have always admired the culture

Were concerned about the aggressive culture

But crisis came and the competitors went away

This is a business they want to own, despite concerns over future returns as a

result of regulations

o American Express (AXP)

Great global brand with loyal customers

o Wells Fargo (WFC)

WFC came through the crisis better than ever

Best management team

o US Bank (USB)

#1 in the west

o Stacked (Private)


Take a store that would akin to the size of a California Pizza Kitchen (CPKI)

Menu that specializes in burgers, salads and pizzas

Get seated by the hostess and there is an iPad on the table that allows you to

customize your order

Hostess brings the food when it is done

Swipe credit card on iPad when you are done

Raised $10M to open 4 stores

LA, San Diego and Orange County

o All mall locations so far

Looking for a non-mall stores as

Looking to franchise it around the country

o FFH+ BRK+ SBUX+ Cash represents about 50% of the portfolio

- Q&A

o Given his real estate background, does he have plans to invest in CMBS? Can they take

advantage of future dislocations in that market?

Would not invest in companies that manage real estate

They can do that themselves

Saw how REITs managed their properties and do not want to run their

company that way

Thought that the financial crisis would create opportunities

o But it didn’t happen- too much capital and cap rates are too low

o Leverage is so prevalent these days

You need leverage to make great returns

o Can he give some examples of companies they invest in with exposure to Brazil?

Don’t invest in companies in Brazil

Most obvious company is Coca Cola (KO)

They wouldn’t look at KO because you can see a Coke sign everywhere

when you travel the world

But, AXP is a good example

Emerging countries will use more credit cards in the future

Do not do much in commodities

o Does he have opinions on the housing market?

Housing market—they were careful not to be anywhere near it in 2006 and 2007

Liked what Prem Watsa said would happen with housing

Liked what he did with CDS

Housing will bottom at some point

Then there will be the need to build some new houses

On his street all of his neighbors owned 5 houses

That was unsustainable

Not an industry that they are going to mess with

Like less cyclical and commodity-like opportunities


His friend who is a CEO of a homebuilder is not optimistic—although he was at

first more optimistic after the crash

There are too many houses in foreclosure

o They like companies that they are comfortable with. How can they invest in banks given

that? How can they trust management teams?

Tougher to know what is going on in insurance policies or bank loans

You can get to know management

When you listen to WFC talk, it is totally different from other banks

Knowing that these industries were not going away, they believed that

the ones who were not doing foolish things would come out ahead and

with a stronger market position

We’re willing to own Fairfax going into the crisis

Bought WFC too early

Think the management team is good—want the team to be their partner

o What was is about the valuation of SBUX in the 1990s that attracted them? Didn’t it have

a really high multiple?

SBUX sold at a large P/E but there was a lot of demand and room to grow

Almost didn’t care about the multiple they paid

Now they have 15,000 stores and the price really makes a difference

Have to think about international growth now

o How many stores can there be in China?

No brainer in 1998—could have paid 10% more or 10% less and it

would have not mattered

o What attracts them about preferreds during the crisis?

Have a lot of cash and wanted to park their cash somewhere that generated

returns

Look at preferreds with variable rate features from banks like GS

Not a buyer today because the 20% discount to par has closed

Looking for a future opportunities to buy more

o Don’t pay much attention to the macro data, but they have made good calls. What other

info or data do they look at?

They look at the market prices and valuations of the stocks in the same sector as

companies that they own

Are they higher or lower than the companies they own?

o Try to assess the state of the market with that framework

Don’t try to guess when the market is going to peak

o When they were buying SBUX during the lows, how did they size it?

The second time they he was thinking of buying SBUX, he remembered that he

had said he would never buy until they had a SSS decline

But he bought when it went below $20.

Bought under $20 and bought more around $10

o Knew the business was not going to go away

o The accounts owned about 10% SBUX


Today they are thinking about trimming their position and would not be a

buyer today

o What about the overlap between their holdings and those of BRK? Are they ever

concerned that the overlap makes them too concentrated since they own BRK as well?

Are other segments of the markets not represented?

When he was buying CRE in Denver, he put all of his net worth in there

He knew Denver real estate and knew he couldn’t lose

Would rather own more of what they are most comfortable with

Do not want to spread their risks into things they don’t understand

When you have good management, they are likely to not make mistakes

When they see that a market was going to change, they chose to get out—like in

the real estate markets

But good managers have the ability to avoid bad markets

Even if a company has a great brand, you have to pay attention to

management too

Speaker #5

Opportunities in a Complacent World

Steve Romick- First Pacific Advisors

- Now he has all of the time in the world after not having to present in years before

- He has no idea what the future holds and the present lacks clarity

o Looks to find something in the rubble that looks attractive

o Looking for cheap stocks is like trying to ski down Aspen in the summer

- We blew it after the crisis

o People are complacent

o People claim to look for safety but they are seeking risk

o People believe in the government to stop bubbles

Romick does not believe that people who didn’t see bubbles in the past will be

able to stop them this time

- Hard to have confidence in the US governments numbers

o GAO report said that the government’s financial statements have material weaknesses

If they say there isn’t inflation, that is only because they don’t eat or drive

Government is talking its book

Believe there is much more inflation than is being reported

o Government is increasingly hiring more people though

- We have a debt problem

o Mandatory spending keeps on increasing relative to GDP

o Only 16% of the budget was on the table to cut in the newest Obama budget

If we were really serious about cutting expenses, everything would be on the

table

Social security is morphing from benefit to an entitlement


Great deal for people as the collection age has not gone up with life

expectancy

Not saying that we should get rid of social security

o We just shouldn’t add to the obligations

o How does the government keep spending money when consumer cannot?

Successively diminishing return on productivity of debt in the US

Government is supplementing Treasury demand by borrowing short

40% of debt maturing in the next 2 years

Have to convince lenders that we can pay off our debt and that the dollars will

be still be worth something then

Given that, he doesn’t know who is buying our debt

CBO has sanguine estimates—CPI inflation projected to average just 2% until

2021

These unrealistic numbers keep politicians complacent

Even so, they have interest expense getting so high in the future that it is

more than defense spending

5% increase in interest rates would cause interest expense as a percentage of

revenues to go from 6% to 21%

o Government spending spigot continues to be open

We are confusing medicine for narcotics

We haven’t taken the pain

We need assets to fall in value and prices to clear

We are in a recovery is between 2 crises

Children will pay for the sins of their fathers

o The New Monopoly game

Eliminated paper money—creating electronic money

o One path leads to inflation and that can be seen in commodity prices

It is hard to imagine that the increase in monetary base will not end up in

inflation down the road

o FPA’s returns will come from what they don’t own rather than what they own

Anxious about the returns on the US dollar

Cash is building in the portfolio

Looking for large business with foreign revenue sources

Not many opportunities

Margins are near all-time highs for US companies

o Wall Street said that there is always an opportunity

Analysts have a terrible track record

o Using a cyclically adjusted Shiller P/E, the S&P 500 trades as 23x

Small caps trade a 20% premium to large caps

Fewer analysts—less efficiently priced?

Easier to understand?

Grow faster?

o This is a myth based on Russell 1000 and 2000 data

Large caps stocks have grown faster since 1995


Large caps have more exposure to foreign

revenue

More likely to be bought?

o FPA is basically short M&A

o FPA is positioned for inflation

Largest sector is energy

Have a big position in an insurance broker

Subprime whole loans at $.45 on the dollar

Private REIT in farmland

- CVS Caremark (CVS)

o Likes the trends in pharmacies

o Lots of growth in the old age population

o Pharmacy utilization should be up

o Medicare market is growing fast

32M people will get coverage in 2014 – if it happens

Free option—could be a 20% bump to the number of prescriptions that

CVS already writes

o Drugs are 10% of health care spending

Patient adherence to prescription regimens saves money

o CVS and Walgreens (WAG) are both best positioned

7100+ stores

Great footprint and opportunity to gain shares from independents

Independent share is down to 20% and has halved in the last decade

o Is mail order a real threat?

Small affect over time—only 19% of the market consistently

o Lots of drugs coming off of patents

Generics come on and it is beneficial to CVS

Better margins—peak in 2012 since they make better margins on

generics

Now self-distribute generics and can capture the margin there

o People care about private label versus branded when you can taste the product

But people don’t care as much when you can’t taste them

Production problems and JNJ recalls are helping private label sales

Higher gross margins but lower price on these products

Could increase operating income by 3.5%

Tesco has 50% private label products

CVS has a lot on runway on this front

o PBM

Almost 50% of CVS’s sales and 1/3 of the profits

PBMs aggregate buying power to get lower prices

Induce pharmacists to switch from branded to generic

PBM and retail business allows them to offer mail order business as well

15% of Caremark’s customers use maintenance choice

o Could grow even more


Challenges

Lower future rebates

Legally mandated transparency of drug purchase costs

Decided to hedge out some of the PBM risk

o Management

Skilled operators and capital allocators

Retiring CEO has $300M in share exposure

CVS has been returning capital to shareholders

$3-4B in buybacks per year

Added to a dividend the yield jumps a lot

o CVS has the opportunity to reduce inventory

By 2013 their goal is to be on one platform

CVS estimate of $2B in inventory savings by yearend 2013

o Trading at 6.6x 2011 EV/EBITDA

Caremark can outperform its peers but they have still hedged out the PBM

exposure by shorting other PBM companies

o Could they spinoff Caremark?

Want to let the company execute on its plans regarding

Express Scripts and Medco could be likely buyers if CVS cannot improve the

PBM’s operations

o The stock is not a homerun and is not as cheap as it was when he started writing the

presentation

- Goldlion Holdings Limited (Hong Kong: 0533)

o Hong Kong based company that is a wholesale clothing and apparel brand

o The company has $400M market cap; flout is about 1/3rd

of that

o It is like the Polo of HK but is not as nice as Gucci

o Maintains quality about all else

Do not want cutthroat prices

o Market share slide shows 6% market share in the fragmented Chinese apparel market

Ranked 6 in a Credit Suisse brand survey in Chin

o Positives

Rapid growth

ROC: 49%

High margins

Optionality

Real estate assets

6.3% divvy yield

Public since 1992—name brand auditor

Lots of cash

Investment properties

Have not de-worsified in recent years

o Current market cap is HKD 3.26B

Effective multiple of 2.6x trailing EBIIT

Upside of 50-100% , supported by the dividend


- Value investing is the best means to preserve capital and provide adequate growth over the long

term

o Let thoughtfulness and patience be the driving philosophy

- Q&A

o CVS- What is the appraisal of the current management?

Acquisitions are not likely because they have already bought what they could buy

Systems are going to help the, drive inventory out

You see out of stock positions at CVS and not at WAG

Very high marks regarding

o Goldlion- corporate governance?

China is the wild west

Never has been insider dealings

Public for 20 years

Paper trail and history give you comfort

o Inflation—calculations have changed over time. What does P/E 100 years ago have to do

with today’s?

There are appropriate changes to CPI that should be made

The data on the CAPE might not be great going way back

o Goldlion—have they been leasing a lot over the last few years?

They are not a retailer

Even if you adjust ROC for leases, it is still very high

50% is ridiculous

o Very large ROC even if you incorporate leases

Own it only in small funds due to the small float and the ability to accumulate

shares

If you want to invest in China, there are no guarantees

But there is a margin of safety

Trying to swing for a bigger hit; not just looking for a compounder

If you can buy the asset at a large enough discount, you can make money

o CVS PBM, are there other headwinds?

Drug prices are going to be transparent

Corporate customers will see the price of drugs

o May demand lower prices

o No idea how to handicap that

Caremark had been losing share but the new management team looks set

up for success

o Hedging out industry risk

Thinks they are going to stabilize and gain market share

o Winning lower margin but large accounts

Insurers will be getting into the business

Especially on the specialty pharmacy side

o Rising interest rates—what would be the catalyst?

2 catalysts


If we get that inflation—could be hard to see with high unemployment

and low capacity utilization

o We could also import inflation in commodities

o Bernanke mentioned inflation 86 times in his most recent

presentation and deflation only twice

o One day the inflation will be here without much warning

Lender goes on a buyer’s strike

o Will lenders want to get paid in the same dollars they are lending

money in?

o Lenders will want a higher rate of interest, even without inflation

Hockey, Snow and Value: Uncovering Bargains North of the Border

Guy Gottfried- Rational Investment Group

- He is 29 years old

- Fund launched during 2009—40% returns per annum

o Average cash of 27% since inception

o Have not realized a loss yet on any investments

- Americans are concerned with US monetary and fiscal policy

o Canadian market offers an opportunity

Economy has been strong

11 years of budget surpluses before the recession

4th lower corporate tax rate in OECD

Lowest debt to GDP of G7

Strongest banking system in the world for 3 straight years

No crazy mortgage products

No bailouts and not one bank even cut its dividend during the crisis

This is an inefficient market

Very few value investors

People are obsessed with Canadian resource stocks

o Mining and oil comprised about 33% of all of the listed

companies in the TSX

o Entire economy that is overlooked

Small markets

- Idea

o Morguard Corp (TSE: MRC)

Market cap: $780

Great business and are dirt cheap

Originally a distributor of auto parts

Controlling shareholder turned around the operations, sold them and had

cash

Real estate stocks had a slump in the 1990s in Canada


o Bought stakes in 5 large real estate firms at this time

4 parts of the company

Wholly owned properties

Other investors

Investment in Mortgage REIT

Management and advisory business

Extremely cheap

4.8x FCF, net of Morguard REIT investment

Implied CAP rate of 13% on its portfolio

Valuing its portfolio below $0

o Getting paid to own them

High quality assets

Outstanding assets and capital allocation

Several catalysts possible that can unlock shareholder value

o Why is it so cheap?

Most R/E stocks are REITs and pay dividends

Pays out less than 10% of FCF

o Likes to retain capital rather than pay it out

Illiquid due to CEO large ownership

Not big enough for large institutions

No sell side coverage

Not promotional

o Owned portfolio

Assortment of apartments, industrial, retail and office properties

Trailing NOI of $152M

10.3K apartments

Most stable, lower cap rate real estate asset class

97.5% occupied apartments located in Toronto, Canada’s

o Morguard REIT

Owns 8.3M square feet of real estate

Morguard owns 45%

$35M in management fees and dividends each year

Dividend is sustainable

0 risk of losing MRT as client

Steady stream of growing fees

Capital source, exit strategy for dully valued properties

o Advisory- Property Management Segment

Real estate management services to Morguard and other firms

Wholly owned sub that provided $20M in NOI

One of largest property managers in Canada

Smaller numbers than generated by owned portfolio

Low CAPEX business

30% pretax margins

Grew even during the recession


Stable cash flows and revenues

Want to grow this business and they have been successful

o Capital allocation and management

Great capital allocator in a capital intensive industry is really important

Strong b/s and discipline can create opportunities by buying during the

panic

Owner operator who owns 50% of the company

Has aggressively bought back the stock

Have not issued an option in a decade

Strong B/S- 50-55% LTV on the owned portfolio

Low, given that a lot of the properties are apartments, which are

leverageable

Conservative account

FFO includes PPE deprecation on non-building items

o Peers inflate FFO by adding back all depreciation

Very conservative company

Has bought back 38% of its diluted EPS since 1996

The company is buying large blocks of stock

Has continued to buying throughout its history

o 2006-201: 11.8% of shares bought back, all at a great place

This is what we look like as value investors

o Acquisitions

Sahi is a corporate raider and has performed takeovers at fire sale prices

Have done 5 major takeover recently

Goldlist Properties

o 17 multi-unit apartment buildings

o $335M price, including assumed debt

o Busted IPO

o Morguard bought 40% of the IPO at $9

Cut the offer price of the IPO by 10% and reduced the

dividend the owner pulled out of the company

Revenue properties

o Gained control of the company at an average cost of $1.48

o Privatized RPC in 2008 by buying the remaining 27% at $12 per

share

Advisor hired to provide a fairness opinion at 420

o Implied cap rate of 35%

MIL

o Bought from Mutual Life Assurance

o Generates $20M in per tax income now and was bought by

$33M

o Valuation

7.1x FCF (14% FCF yield)

High quality business


If you back out MRT, the core business free cash flow multiple is 4.8X

Owns MRT for strategic reasons; not for operating reasons

o Instructive to see how the market is valuing the rest of the

company, ex-MRT

Cap rate calculation

NOI/Market Cap implies a cap rate of 12.8%

o For the owned portfolio alone

o These are Toronto apartment buildings that have a 5.5% cap rate

Even Commercial and industrial properties in Canadian

command a 6-7.5% cap rate

If you subtract out the value of the other segments, the owned portfolio is

valued at less than $0 (-$79)

o We are being paid to own 10.3K residential units and 6.9M

square feet in commercial space and generating $150M in NOI

o Catalysts

Create a new REIT too hold investment properties

Cap rates on apartments are in the 5.5% to 6.5% range

o Implied cap rate is 13%

New stream of income

o Would become property manager and advisor to those buildings

Could sell properties to MRT

Morguard investors are clamoring for the company to expand

o Analysts want the firm to grow its portfolio

US expansion

Valuations are rich so there is little to do in Canada

o Undervalued acquisitions are likely on the horizon in the US

o Profit from compression of the difference between price and intrinsic value

Also get growth in intrinsic value

o Q&A

Any concern that the supply of apartments is going to increase?

There are a lot of cranes there, but there are 10x as many in Israel

Residential construction in Toronto is on the condo side

o There are few apartments

o Condos are hotter because more can be squeezed out

Cap rates are extremely rich

o Company knows this and hinted that it might try to monetize

some the assets at those rates

Takes a long time to do

o Are the controlling partner’s incentives aligned with shareholders?

He doesn’t think he plans to buy out the company (feel to $13 in the crisis) and

he could have bought it out

Now it is at $60

Meaning that he does not want the price to stay low so that he can buy it


o He could have bought it over the last 20 years are much lower

prices

Thinks he wants to grow the business instead

o But you never know 100%

Even a margin of safety can protect you from something

like that

The market has a mind of its own—the price can go up no matter what

the CEO wants

o How do you differentiate between skill and being in the right place at the right time?

Does the skill move abroad

Already have been active in the US

Great management can create value in any environment

Most companies operate with the herd

o Make acquisitions when times are good and do not buy during

panics

Has been able to maintain its results in good times and bad

o Can operate better in down markets

Cheap price with a management that knows how to deploy capital

o Peter Brotchie- If they do not spin the properties off, is there a lot of maintenance

CAPEX in the pipeline, based on that age?

No, they have a normal CAPEX program and does not expect a large ramp in

CAPEX in the coming years

o How accessible has the management team? Can they be influenced?

Not amenable to activism

Management has been buying back stock at the right times and making deals at

the right price

Has already been selling properties to MRT without pressure

Slowly embarking on this strategy

When you are aligned with good owner-operators, you don’t need to be an

activist

o Alex Rubalcava: How did he value the asset management business? Has the CEO sold or

bought?

No exact science to valuing a business

Pretax income multiplied by 12x

o Did not look that closely at comps because the company is so

cheap

CEO has bought shares in 2008 and 2009 at the $30 range

Has never sold a share

Through buying back shares and buying shares he has taken his stake

from 20% to 50%

o How old is the CEO and does he have kids in the business?

Daughter works for the company in the US

He is in his mid-60s

No kid who is an executive or who is highly paid


No evidence of nepotism

o What is the variant perception here? Why is the stock being ignored?

He is not aware of what he is missing

Market is looking at:

Illiquidity- can buy a few millions of dollars in it

Business is a bit obscure

o Owned portfolio dwarfs the numbers of those of the property

management business

Shares a conference call with the REIT—95% of questions go to the

REIT

o Very low profile company

Does not need to be promotional

Pays a low dividend

Ori Eyal- Global Value Investing: Guildlines Opportunities, Pitfalls and Actionable Ideas

- Has been running emerging value capital since 2008

- Had the opportunity when he was working at Deustche Bank and had the opportunity to

participate in a Russian power plant IPO

o The ultimate decision was based on his meeting with the CEO

The CEO said he was issuing equity and said he was doing so because equity was

free and debt had to be paid back

He didn’t do the deal and he was lucky because it performed very poorly

- Lack of concern for the rights of minority shareholders is prevalent outside of the US

o In the US companies at least pretend to care

o Do not even pretend to care

- Take the principles or value investing and apply them all over the world

o Guidelines

You have to do detailed research on the company and the country you are

investing in

Some countries are more attractive than others and you can’t just invest

in every country

Don’t chase GDP growth

No correlation between GDP growth and stock market returns

Why not?

o Expected GDP is priced into the stocks you are buying

o Benefits of growth may accrue to new firms not in the basket

you purchased

o Benefits of the return could get stolen, inflated away or

expropriated

Why is my cash in US dollars?

o Emergency market and commodity currencies are likely to

appreciate versus the dollar over time

Not going to be a straight line though


o When they can invest in country like these, they can get an

additional tailwind

o They need cash when there is a crisis

Flight to safety occurs are people move from risky assets

to US dollars

Dollars are likely to be up in times of crisis, when they

need their cash

One billion new capitalists

o People moving to the cities and they embrace capitalists

o They become an emerging middle class

o Look for businesses that have good management and trade a t a

reasonable price that are selling more to emerging markets

- Ideas

o PRIS- Share class arbitrage

PRISA is a levered media company

Merged with a US SPAC (Liberty Acquisition) at the end of last year

Created new shares

o PRISA A and PRIS B

B shares are a lot better

Yet, they trade at almost the same price

Short the A shares and go long the B shares

Benefit when the

B shares eventually become A shares

Mandatorily convert in 3 years

o Can convert at any point

A shares cannot trade at a higher price than the B shares

because people would just convert

The spread cannot turn negative

B Shares pay a mandatory dividend while the A shares do not

1.6 euros per share is the NPV of that stream

o This is not the whole story though

B Shares offer downside protection

As long as 8 shares trade above 8 euros, you get a 1 to 1 conversion

But, if they trade below 8 euros, you get extra A shares

o Do not lose money until the A shares fall below 6 euros

B shares look like they are worth 2.8 euros more than the A shares

This is a lot considering that the A shares trade at 8 euros

o Price should be about 4.2 euros

About 50% upside and little downside

Catalysts

Dividend are going to start to be paid

o Hasn’t been paid yet—we don’t know when it is going to be paid

Between now and September

Bad news from PRISA group or macro bad news from Spain


o Highlight the value of the downside protection

Larger funds have not been able to borrow the A shares

If you can’t borrow them (exchange A shares for B shares), just go long

the B shares

o This is a good opportunity even if you can short the A shares

o Research the country: Israel

Often finds very interesting opportunities there

Israel has a well-managed economy and barely felt the economic crisis

Most NASDAQ listed company and start-up companies outside of the

US

Shareholder protection and rule of law are present

Favorable business environment

Highest rates of entrepreneurship among women

Higher life expectancy than UK, Germany and US

Discovered a huge offshore natural gas field

Will wean Israel off of foreign energy sources

Most well regarded research universities in the world

o Willis Food

NASDAQ listed company

One of Israel’s largest food importers

Search the world for successful food products and work with the maker

to create kosher products

o Specialize in Kosher food

o Appeals to Muslims and other non-Jews

Viewed as healthier due to less animal fat

o 80% of sales are into Israel

20% rest of the world- mostly US

o Expanding rapidly internationally

o Growing 15% each year

Divisions

Gold Foods

Shamir Salads

o 51% interest

Financials

$100M in sales

9.5% operating margin in 2010

$8M in net income

$51M in cash and no debt essentially

Market cap is $100M

o EV equals $50

o Should earn $10M in 2011

o Net of cash, the company is trading at 5x this year’s earnings

Looking to acquire a distributor in the US

o They are not going to overpay


o Want to get their food on the shelves of US stores

o If they can’t acquire one, they will pay a dividend

Are in talks with private equity firms

o Only get a onetime bump

o Hopes they don’t get bought out

This is a compounding machine

Well managed, recession resistant business

Literally trade on the NASDAQ—not an ADR

- Q&A

o Regarding PRISA, would you consider writing a covered call on the As if you can’t

borrow the A shares

Don’t think they have listed options

Would love to create a synthetic short or buy a put

o Thoughts on the turmoil in the Middle East. How does it affect this company?

Doesn’t affect Willis Food in any way

In fact it could benefit because other foods get rationed in the event of a

war

The main issue is that Iran is building a nuclear bomb and a mechanism to

deliver it

Egypt and Libya situations are not as important as what is going on in

Iran

o What exactly they hope to achieve with a US distributor? US market is well developed

already

Willis Food already has products on shelves

There is a shortage of strong kosher brands

Third party distributors eat up profit and control of shares

Think they could distribute much better if they owned their own distributor

Are not disclosing any names of who they are interested in

o Can you elaborate on the 2.6 euros and 4.2 euros upside on PRISA group?

Dividend stream+ Downside Protection (3 year at-the-money put option)= 2.8

euros

Extra value comes at the expense of the A shares

o 2 A shares for every B shares

o If the B shares gain 2.8 euros then the A shares lose 1.4 euros

o 1.4 euros + 2.8 euros= 4.2 euros

How did this come about?

Merged with Liberty Acquisition and the merger was complex

Brokers can’t even find the B shares

Market is just not recognizing what is going on

o The company will pay a dividend of close to 8%

o How is Willis Foods position to handle rising food costs?

Rising food costs are a negative for every food produced in the world

They are full aware of it and have hedged in the past

Got It wrong and stooped hedging


They do try to match currencies though

May depress margins in the short run

In the LR the costs have to be passed on

o Michael Kao—Could the company increase the float or add A shares?

It is possible to issue more A shares

May also be able to issue more B shares

The SPAC was mostly cash and the result of the merger was a de-levering

So, the company is not that levered and has little reason to issue equity

David Nierenberg

D3 Funds

Lessons from 15 years in Micro-Cap Land

- D3 Funds

o Concentrate portfolio

o Large block stakes

o Undervalued growth micro caps

o PE like model

o 10% stake

o Busted growth companies

o Not activism—constructive engagement

Want to be partners in unlocking value

o Almost all of it comes from individuals and families

Multiyear lock up and the stick around after it expires

o Avoid leverage

o Most of the net worth is the funds

o 12 years beginning in 1999—compounded after fees at 11.4%

- Macro matters

o Painful lessons learned

o Sailed through the 2000-2002 correction

Actually gained over the 3 year period

o 2008-09 period was payback time

Had to rethink how to preserve capital

Cheap got cheaper

40% of companies were trading at less than net cash/share

Smallest companies were illiquid and the stocks went down more

o Average market cap: $400M

Needed to figure out how to profit from the pain

o Ed Easterling

Market likely remains in a bear market

Multiples may trough at 8-10x P/E multiple

Increasing inflation and slowing growth are likely to compress P/E multiples

Market is likely to remain volatile


Slow growth

Reinhardt and Rogoff’s rule of 90% debt to GDP=> growth starts to slow

Aging population

Need to have a point of view and focus on preservation of capital

Even if they are wrong, their strategy will not hurt them

o Changes

Sell at market valuation as opposed to target valuation

Unless they have proprietary insight that the company could be worth far

more than it is

Cash is not trash

Now know what appropriate purchase levels are for future purchases

Defensive valuations

Started returning to public board service

Shift portfolio to higher growth businesses and higher margin geographies

Emerging markets

Natural resources

Mobile computing

Seek/generate regular and special cash dividends

45% of returns came from dividends in the last century

Shorting

Invest in businesses that benefit from inflation

- Companies: AACC, BABY, ESIO, HDV, HPY, MBAC, MDTH, MOVE, MPLUS, PSA

- Growth investing

o Multiplus

o MBAC

- Activism

o ESIO

o RSYS

If you own more than 10%, make a difference

As tech growth slows, do something smart with the cash

Invited to own on the board in the last year

- Multiplus

o Loyalty program operator

Only 2 publically traded ones in the world

Busted IPO

Spun out of leading Brazilian airline—Tam

Rushed to market because it went to market before it had a CEO or CFO

Revenues generated from the sale of points, breakage and float

Breakage- points expire unused

Float- 18-24 months of float before the points are typically redeemed

Growth in credit card usage: 22% CAGR

Personal consumption expenditures: 11% CAGR

Passenger traffic: 9% CAGR


Wealth distribution now includes a middle class

World cup and Olympics are coming to brazil

No inventory and negative working cap

Float at around 12%

95% of earnings are to be paid as dividends

Yield will be 17% in 2011- special and regular

6% estimate yield in 2012

o MBAC Fertilizer

Building a phosphate mine in Brazil

Low CAPEX, fully funded and permitted construction

Cash flow positive Q4 2012 /2013

Twain: A mine is a hole in a ground with a liar in front of it

CEO and CFO were involved with Yamana Gold—a D3 investment company

Know phosphate mining very well

Economist article on the miracle of the Ceraddo

Brazil has by far the most potentially arable land of any country

Brazil leads the world in a number of different commodities

o But it needs fertilizer—especially in the Ceraddo

7x the amount needed in the US

Landed cost advantage

Cost advantage over imports and domestic competitors

o Exploration and M&A

Expansion into Itafos resources

Number of M&A opportunities

o 3 different outcomes

NAV

Valuation per ton of the resource

EBITDA multiples

Short term 35% upside potential but it could be as much as a 4x

- Generic Observations about boards

o Too much time spent on the wrong things and not on the critical things

Box checking compliance idiocy

Sarbanes Oxley

Fighting the last war

Management dog and pony shows

Solution is part of the problem

o Interpersonal dynamics suppress questions, doubt and consent

Group think happens too frequently

o Compensation is excessively complex and ineffective

Rigged to insiders

o B?S assets are seen as corporate assets and not shareholder’s assets

o Not enough skin in the game

Too many options and RSUs

Not buying stocks with cash


- What does he bring?

o Focus

o Sense of urgency of an owner

o Asking questions with the willingness of child

o Look at cash requests based on other opportunities

- ESIO

o Leading supplier of laser based manufacturing

o Financial fortress

Land at book and Cash came to $7.20

½ the share price

No debt

Positive CFO every year

o What is he doing?

Succession planning—old CEO and Chairman

Capital allocation decisions

Emphasis on imperative for cost reduction

Manufacturing and cost of quality

Linkage between compensation and performance

Performance

- Radisys (RSYS)

o Leading provider of hardware and software embedded computing systems for next

generation IP networks that enable telecom, medical and mil/aero customers

o Game changing acquisition and management change today

Current CEO will become Vice Chairman of combined board

Acquired CEO will be combined CEO

Opportunity to reduce customer concentration and to improve margins as the

acquired company has much higher margins

o Priorities

Succession planning

Rational, analytical and outward looking process for capital allocation

Cost reduction

Focus

- Q&A

o What is the preferred way of aligning management and shareholder interests?

Good idea to ask people what incentives light up the scoreboard for them

No one size fits all

All companies and people are different

Start with the people on the compensation committee to have one-on-one

discussions about how to motivate people

Agnostic about the mix

But it has to be linked to performance

o Growth in EPS and total shareholder return

Not averse to working with consultants to unscramble the mess

Compensation is what a lawyer is a non-delegable duty


Too often people use consultants and lawyers and consultants

o What can be done to reverse the trend of management ripping off shareholders?

Proxy advisory business has mushroomed into a powerful movement

May be faith-based sometimes

These firms are so powerful now

Being on the board is challenging because it requires subjective decisions

Can’t always find a great formula for compensation

There should be more situation in which large block shareholders are asked to

become part of the board

They should be able to rock the boat just enough to create value

Board members should be required to have real skin in the game

Not RSUs and not options

o Aaron Edelheit- Was hurt in 2008 as well. Is there not every 20 or 30 years an event that

causes small cap value to go down a lot? Does what happened in 2008 helps perpetuate

the outperformance because the competitors are gone?

100 year floods hit the financial markets hit a lot

Increasing use of complicity, leverage and electronic trading almost

guarantee that they will happen again

This is why they went through the changes they discussed in the slides

o Tons of corruption in Brazil—lots of payoffs. How does he feel about that?

US-based companies have more trouble getting contracts

MBAC is Headquartered in Toronto but all of the management team live in

Brazil

It is a very tough country to do business in Brazil

They feel really great about the management team

Need to bet on the right people

o Alex Rubalcava: technology transition at RSYS has taken a long time, why? Regarding

MBAC, should they become a producing company?

Should not say much about RSYS’s situation aside from the fact that the

technology transition has taken longer than they had hoped

MBAC- in this case they prefer that they become a producer

But everything has a price and would love to be bought out at a huge

price

If it were more early stage they might want them to prove out and then

sell out

Management team is populated by operators

This things is up and ready to go

Glenn Tongue and Whitney Tilson

T2 Partners

An Update on St Joe and out Analysis of Howard Hughes Corporation

- Largest short: St Joe Company


o Berkowitz responded to Einhorn’s short presentation with a presentation that showed a

lot of beautiful pictures of Windmark, a development in Florida

o Many of the lots in Windmark are in foreclosure

But ST Joe sold all of those off so they have no exposure to what is known as

Phase 1

o Bubble burst before they were able to sell the lots off

Only 42 lots sold and only a few homes built

No beachfront properties in Phase 2 lots

Phase 1 houses are beachfront

o Photos in the Fairholme presentation appear to be staged

No sales are being made

Foreclosed lots from Phase 1 are competing with sales of St Joe’s lots

Shows pictures of stores and restaurants that have actually been shut down—

even before the presentation was released

Many of the pictures have no people in them

The people doing construction may be doing it because they have contractual

obligations

o What’s Windmark worth?

Being carried at $160.9M

But Greenlight valued it at only $17.8M

o But overestimated how much lots were actually selling for

May only be worth $12.25

Don’t think this is a $0 because it has net cash on its B/S

Just overvalued by a multiple of 2x-3x

Incentive not to write down assets because the market will catch on that the stock

is completely overvalued

Delayed their 10-K: took no impairments

o Recoverability test—if undiscounted future cash flows added up

are worth as much as the carrying value, then no impairment is

not necessary

o Management assumed 7% price appreciation for 17 years!

Claiming that the selling period for the residential

properties are 17 years and 35 years for the commercial

real estate

There is no precedent for this

St Joe has a lot of Timberland but that cannot make up much more than $7-$8 of

the stock price

o Berkowitz has said that the current state is depressed but the market will pick up and

people will buy and develop these lots

This is the Redneck Riviera

Poor, high unemployment, poorly developed

Who is going to be buying these properties?

o There is 8 years of condo inventory in nicer areas of Florida

These lots may never be built


- Howard Hughes Company

o HHC owns, manages and develops commercial, residential, and mixed use real estate

o 3 types of properties

Master planned communities

Operating properties

Development opportunities

o Spun out of General Growth Properties

o REIT structure is not ideal for owning development assets, master planned communities

and assets whose cash flows do not reflect future potential

They would have stayed in GGP if the assets had not been very attractive

o They believe that HHAC has undervalued, high quality real estate assets in premier

locations

- Basics

o Price: $65.21

o Warrants: 10.7M

- Spinoff characteristics

o Spun out of a reorg

o No research coverage

o Many GGP investors own REITs so they sold the asset- also couldn’t own this

o The only assets that the management team cares about are in HHC

o Insiders are incentivized

- Very difficult to value the company and have no idea what it is worth

o Limited downside but they think it is worth way more than it is trading

o Insiders own 50% of stock, including warrants

o New CEO purchased $15M in warrants and President purchased $2M

o The plan sponsors (Brookfield, Pershing, Fairholme, etc.) put in 5.25M additional shares

for $250

o Very low leverage

o Great management team

o Major shareholder have very big stakes

Pershing skewed its warrant ownership to HHC as opposed to GGP

o Each asset will be examined to extract maximum value

- Master Planned Communities

o 4 communities

Summerlin- in Las Vegas

60% of the value of this segment

7.5 miles away from Vegas

Real property

o 40K homes here, 100K people, 25 schools

o Assets are being sold every day

Sell land to developers all the time

Sold $20M in 2010 for development

Valuations are the ones he will use to value the

community


Bridgeland

In Houston

11.4K acres

More future based development plan

o Operating assets

South Street Seaport in NYC

Does generate about $5tM in NOI each year

o Held on the books at 1x NOI

5% CAP rate then the value should be $100M

o Poorly run asset that needs attention paid to it

o Redevelopment plan

Hotels, condos

Ward Centers

Waikiki mall

o Strategic development assets

Not generating CF

Land in New Jersey

Air rights above a mall in Hawaii

- How do they value it?

o Chairman said it was hard to value it

o Issues

LT horizon—do not want to flip them

Uncertainty around housing and real state

Difficult to use traditional valuation metrics

NOI producing assets appear to be under-earning

Wide spectrum of possible future outcomes

Try to create a floor and put numbers around optionality

Master plan

Carrying: $1.3B in total

o Portions of Summerlin have been impaired

o Total range: $1.2B to $2.25B

No need to sell these assets all at once

Operating Assets

Very hard to value

Each one has NOI

Certain ones stick out

o Ward Center

Approval for a new, high end mall and residential

development

Has tremendous upside as Hawaii has not seen

the real estate collapse the rest of the country

saw

o South Street Seaport


Arrive at a value of $150-$300M

o Landmark Mall in DC

Arrive at a $200-$400M value

Strategic development assets

o Fashion Show air rights

o Located on the best part of the strip

o Not going to be build tomorrow

o Over 48 acres in the ideal spot to build a new mega-casino

o Hard to value it but

o Conclusion

Get a share price from $77 to $141 per share

Attractive risk-reward

Multiple free options

Downside protection

Premier real estate is a great inflation hedge

Non-recourse leverage

Catalysts

Asset land sales

Development announcements

Hidden assets uncovered

Analyst coverage emerging

Risks

Double dip in housing

Time value of money

Unable to access financing to fund developments

Execution

- Q&A

o Synthetic option for HHC CEO to buy?

Struck in the mid $40s and the CEO put in $15M for that option

They were not granted this option

7 years and are not allowed to hedge it for the first 6 years

They checked out the assets on their own and this was their dream opportunity

Can make a fortune if they can execute and perform

o How would management develop the properties in general?

There are different assets that have different timelines

Ward Center have an approved plan

Each asset will have its own timeline

South Street Seaport will not be built for a number of years because it

takes a long time to build in NYC

Day #2

ValueAct’s Time Horizon Advantage: It’s a Culture Thing


Jeffrey Ubben- ValueAct Capital

- One of the most successful activist out there

- Manages about $5B and has been managing for 11 years or so

- Mission Statement

o Culture is impossible to measure

o Hard to perform due diligence

o Not a more important factor in influencing sustainability of high performance as firm

culture

o A wealth of information creates a poverty of attention

This is why he moved to San Francisco

Wanted to be away from New York City

Too much information can actually impair understanding

o Only wants to invest in good business

Lost money investing in poor businesses before starting ValueAct

Airlines, retail, commodities, consumer discretionary stocks

Has accumulated knowledge through error

AN expert is someone who has made a lot of mistakes in a very narrow

field

o Under that definition. He is an expert in a very narrow field

o He is not going to stray from his area of expertise

o Everybody owns the portfolio investment process

Always a lead partner on an idea but everyone should touch the idea

o Bad decision happen when the mental debate is cut short

o Farm team investments

Kind of like a flight simulator

Real life training ground for investing

150 farm team ideas have not made it into the portfolio

o Made mistakes in 2007

Reaching in terms of valuation

Missed on business quality

Top of the market errors

Hopes that it has made them better

o Money follows passions

Delayed gratification for long term gain

o In tough times, the team performs the best

In 2008, they were at their best in terms of handling challenges

Singularly focused on investing in one of the richest environments in a

generation

Tried to stay calm during the stress test in 2008

o Biggest competitive advantage

The ability to focus on the long term in an industry that has focused on the

opposite

Have to match a culture with the investment philosophy


- ValueAct Businesses

o Profitable, predictable and sustainable

o Observer businesses for a while before they become core positions

o Do not short stocks

o Cash flow in good times and bad

Recurring revenues

Pricing power

Small part of customer cost structure but a huge part of the critical path to

workflow

High barriers to entry

If you buy the number 2 or number 3 player, you want number 1 to have

a high margin and a high PE

o Has to defend the position

Attractive secular growth

2x GDOP

o >10% FCF growth and yield

o Investment Process

Start with business quality

Valuation dislocation

Governance filter

Farm team

Core

o Average holding period is about 3 years

- Consistent themes

o Industries in transition

o Companies in tarnation

Management missteps

Will give on 49poor management because you can change

49management

Misunderstood turnarounds

External dislocations

Conglomerates shrinking to grow

o Getting smaller to get better

o Governance

DO not pick fight

Have only done one proxy in their life

o Was a terrible investment and don’t want to do that again

Not looking for projects

Ends up on the board of many of these companies

Adds value whether they take board positions or not

Isolate execution risk and avoid uncontrollable

Focus on value creating levers

o Hey questions

Do they have the right CEO (18 CEO changes in 60 core investments)


Transparent, measureable strategic goals

Compensation structure reads results

Detailed knowledge of the business

o Board strategy

Keeps strategy target

Fact based decision making process

Doesn’t accept bad financial models

Pays CEO for shareholder value, not growth

Keeps the board honest

Severs on special committee

Speak the truth

Companies get sold when it’s the right thing to do

Sense of urgency

Companies buy smart and at the right time

Companies shrink and then recapitalize

Great sense of the capital markets—don’t listen to bankers

o Track record

16 whole company sales

If they are unwilling to sell, then ValueAct will not go on the board

o Want a upside positions from a takeout premium

8 big breakups

4 acquisition growth strategies

o Be contrarian in the M&A cycle

Buy low and sell high

- Going for the jugular

o When you have a proven CEO

o When nobody else wants to buy

Capital markets are cold

Industry is out of favor

Target company Is mismanaged

Deal is complicated and messy

Deal fatigue is a problem

They embrace complexity

- Case Studies

o Valeant Pharmaceutical

Perfect example of an industry in transition

1990’s: great run with an attractive industry

o Secular growth blockbusters

o High ROIC

o IP: mini monopolies

Early 200’s: hits the wall

o Growth slows

o Blockbusters go off patent

o R&D diminishing returns


Overinvestment in therapeutics

o Safety scares

Mid-Late 2000’s: opportunity created

o ValueAct invested in June 2006

Tackle the whole backfield and look for the one who has the ball

Took an operating approach as opposed to the science

o Wanted a business model with a predictable revenue stream

Long tail generics with 1000+ products

Right company with the wrong CEO

Got lucky and found the most maverick CEO he has ever seen

Took an owner-oriented model to the public markets

Went from 68 countries to 12

2000 SKUs to 1000 SKUs

o Were able to double cash flows

Philosophy

Don’t fall in love with your assets

Don’t bet on science, bet on a management

Speed is incredibly important

Invest ahead of the need

Fact-based decision making

o Willis Holdings

Own 7% and haven’t sold any shares

Low cost

Outperforms in the down cycle

Number 3 player in the big 3

Willis, March and Aon

Have the ability to take share

Industry turn is available to them

Premiums to GDP are at a 40 year low

8 straight years of negative pricing

Highly likely to occur in the 3-5 years they own it

Bought at 9x EPS

Improved leverage from recovering GDPs or a hardening market

Have to be there when the hard market develops

If you wait, you will miss it

Stocks double in 6 months

o Motorola Solutions

Industry overhang

State and local government spending

Fast twitch traders can’t get past this

Critical path

Do not want to lose a policemen die to radio failure

Dominant


6x install base the nearest competitor

o Growth through upgrades

Multiple ways to win

New product cycle

o LTE broadband

o Video

Margin improvements

o Spin off 52opportunity

Industry cycle

Balance sheet as a weapon

o Cash = 40% of B/S

Cash on cash =11%

R&D as a percentage of sales has increased from 8% to 13%

CEO options have been struck

Thinks he gets the problem

Valuation

$15B equity cap

$7.5B in cash

$2B in debt

$1.8B pension

o Included in EV

$1.5-1.6B in EBITDA

o Very conservative

o Add back pension attribution

o If rates go up, some pension liabilities shrink

$200M in CAPEX

- Q&A

o Are they sending pharma companies like Valeant into runoff despite

Don’t give up on R&D

They just partner it off

Have the same products, they just don’t have the same upside

Hesitant to invest in new products at high cost

Can argue that they deserve a low PE

Ability to do accretive deals is crazy

After buying Biovail, EPS went from $2 to $5

o That’s how much cost can bet cut

o Cephalon deal (they got outbid) would have doubled EPS again,

adjusting for the ramp up in shares as a result of the deals

Have to keep doing deals

This is a rape and pillage situation

Don’t usually like these situations

o But they have a rape and pillage CEO


Until management companies become better at allocating cash, there will be a lot

of accretive deal out there

o CEO process and how evaluate CEOs and define if they are doing their job—in terms of

pay

Pay is binary: either you are paying too much or not enough

When they go on a board the CEOs do not say Thank God you are on the board

They are supporting the CEO most time—want him to be successful

They don’t go in with a strategy to blow up the CEO

But the company is underperforming

Get them to understand accountability

If they do well they will get a nice equity package and do really well

But if he doesn’t succeed he is going to be accountable

They don’t pick the fight if they find a CEO and board that are not willing to be

accountable

Don’t think that CEO who left after ValueAct got there would say negative

things about ValueAct

o Whitney Tilson- Is it true that there is widespread complacency and mediocrity on boards

at average companies?

Board meetings are very dry and mechanical

Talking about whether or not the company beat consensus earnings

Mediocrity leads to poor returns for shareholders

o Process of taking costs out of R&D in pharma acquisitions—are these science-based?

There is w Wall Street community that focuses on the pipeline and the CEO

internalizes that

He wants a huge pipeline and doesn’t scrutinize the pipeline decisions

o Wants as many open opportunities as possible

This is what Wall Street wants to talk about

You just have to kill projects

o Leading Wall Street down a new path

6 sells on Valeant because Wall Street hated this strategy

Management teams who have focused on the pipeline are incapable of

making this change

o Need a new generation of managers

o Whitney Tilson- What stock is he really excited about?

Motorola is that company for sure

Does not like to talk about the farm team because he doesn’t know enough about

them to put money it

On Values…

Claude Leveille- Courant Investment Management

- Fundamental principles of investing

o Risk understanding

o Understanding the right incentives


o Having the right partners

o Temperament

- A more rational approach to risk

o When price goes down, risk does not go up—margin of safety goes up

o Risk is the probability of losing one’s capital

o Understanding risk is the first step to becoming a great investor

o Does not short stocks

- Temperament

o Rationality is critical

- Incentives

o Incentives are powerful with a deep psychological impact

o Typical 2/20 fee structure grossly misaligns interests

75bps management fee

15% carry over 5% hurdle for performance fee

97% of wealth is invested alongside

100% of performance fees remain in the fund

No gates or side pockets

30 days to get out, at will

- Partners

o The psychological pressure from having the wrong partners can not only make life

intolerable, but also lead to flawed decision making

o Most of his partners are friends of his

6 of them are guys who have sold businesses to Google

Very rational people

Share the same philosophy

Feels a moral duty to his partners

Thinks about bringing on new partners like Buffett thinks about issuing

Berkshire stock

Better to not dilute quality of the current group

BP was an early test: thought it was a great investment

Worried about the liberal bend of his partners

He then invested 10% of the partnerships in BP stock

People wanted to by BP shares themselves when they found out he was

buying

o Thinking rationally in investing

Favorite biases

Wishful thinking

Confirmation bias

Herd instinct

Self-serving bias

Incentive-cause bias

Over-influence of authority

- Investment process

o Pay a lot of attention to the price paid


o Stay within circle of competence

o Eliminate a lot of stock right off the bat

Business is not understandable

No rule of law in a geography

Economics are driven by commodity prices

Technology area where the rate of change is very high

o Winnow down to about 10-12 stocks

o Analyze the business and not the stock

Doesn’t worry about P/E ratio or 52 week high/low

o Look for critical issues that will drive yes/no for the investment decision

Time is a constraint

o Use a checklist to make sure he doesn’t miss anything

Understand the business?

Solid moat?

Does management control the economics?

How long is the history of the economics and the current ROE?

- Track record

o Compounded by 7.4% since 2001

o Was only down 9% in 2008 when the S&P was down 37%

What was he doing?

Sitting on his hands

o Not acting is acting

o While the real estate bubble was building, he was building cash

Impervious to lagging S&P be several % points

o 2009

In 3-4 months he shifted the entire portfolio

Went from cash and TIPS to stocks and fully invested

o Prologis, White Mountain, and other P&C insurer

o Bought investment grade corporate bonds

70% invested in deeply discounted bonds

o The best investments are the simplest to understand

Prologis bonds

Largest US industrial warehouse REIT

$20B in assets, $12B in debt, $8B in equity

o Debt was trading at 50% of par

Effective valued real estate at less than 35% of cost

Simple tools

No need for advanced formulas, financial projections of anything of the

sort

Spirit Aerosystems

75% of TBV, at 4x earnings, with little debt

Long term exclusive fuselage and wing contract with Boeing

o Monopolistic like contract

Financial crisis would not cause civil aviation to disappear


- Mistakes

o Selling too early

Solid investments are very rare

Best to let them compound at a high rate

o Not concentrating positions even more

o Going outside of the circle of competence

Recent investment in Hong Kong

China and HK require on the ground knowledge

Likes South Korea and Singapore

o Holding too much cash

Macroeconomic noise is almost always a distraction to be ignored

Has 25% in cash right now

- What is he not investing in in now?

o Bonds

Owns no bonds—all his positions have been liquidated because prices are up so

much

o US Treasuries

o Gold

Very weary on inflation but believes it is a red herring

o Euro

People are going for slightly more yield standing in front of the a number of

countries

PPP with the dollar is about 1.10 and

- What is he buying

o South Korean equities

A few sound companies with high ROE, with family as majority and long term

shareholders

1x TBV, 6-7x EPS, 15%+ ROE

Food products and retail

Thinks that the Won is discounted 25% based on PPP

Country is a phenomenal story

15%-20% of his portfolio is in South Korean equities

o Bermuda P&C insures

P&C market is very soft

Buying at $.65 on the dollar

Looks at it like a corporate bond

o US large caps

Healthcare specifically

Companies that are amazing franchises with high ROE selling at 9-11x

earnings

Businesses are not going anywhere

Multiples haven’t been seen 10 or 15+ years

Intends to hold for a long time

o Keeping about 25% in cash


Wants to be able to respond to new opportunities

- Q&A

o Core skill set is protecting capital. Is he overstating how much he is a value investor?

Referring to the BP investment ---which does not look like its fits his investment

strategy—he thought the market had overreacted

It is important to protect capital in bad years

Huge different between multiplying by zero and protecting wealth

Thinks he can protect capital and generate high returns

Higher risk and higher returns approach/concept is insane

Likes defensible businesses that he can get at a great price

o What is he doing to protect against inflation?

It is very difficult to protect against

Buying really good businesses with high ROEs

Even if inflation is high, the companies should be able to raise prices

Companies that will not need to deeply new capital at inflated prices

TIPS have had negative yields so that doesn’t make sense

Cash or defensible businesses are the answer

In general, he doesn’t like resource companies because there is no way to predict

the price of commodities

Weary of investing in business in which the profitability has to do with

the price of the commodity

Will invest in resource companies such as BP opportunistically but not

for the long term

Does not think resource stocks can protect investors against inflation

- What Bermuda reinsurers does he like?

o Aspen and Axis are the ones he likes

- Luis Ahumada- can he balance talk about how he decides how much cash to hold

o Does not pay attention to the macro side

Said we should tune out all of the media focus in the macro-economy

Used an example of all of the useless discussion of whether the US will

experience a double dip recession

Looks at the price of the security far more

- How does he have an edge in SK

o Much better rule of law and property right

o Enforceability of contracts

o Very simple businesses

No debt, no leverage

Long track records of very sound numbers

- How did he determine to deploy cash in 2009?

o Started in late 2008

Thought the times were amazing

o Invested gradually

Knew something great was happening

There was too much to buy


Working 20 hours a day

Going to focus on corporate bonds and few stocks in which nothing could happen

Thought a real collapse was unlikely but possible

It did limit his upside but he was sleeping very well at night

A Treasure Chest Beneath a House of Cards?

Michael Kao- Akanthos Capital Management

- Set up Akanthos in 2002

- Capital structure long/short hedge fund

- Value investor across multiple dimensions

o Equity, credit and volatility

Convertible arbitrage, capital structure arbitrage, event driven strategies

o Seek a margin of safety across the capital structure

- Want to be long optionality as opposed to short optionality

- Layer in a portfolio with a lot of asymmetric payoffs, a lot of good things can happen

- Looks for latent and explicit catalysts

- In between high concentration and a lot of diversified

o Need to be thematically diversified

Trumps all other types of diversification

Perpetuity option

o An opportunity with an asymmetric payoff of a speculation that

can be analyzed like an investment. An option with no imminent

expiration date

Railroad bonds

Nationalization fears and government

intervention produced a generational opportunity

in railroad bonds

2008 produced multiple ―Railroad Bond‖

opportunities in convertibles

- The Ultimate Railroad Bonds

o GSE (Fannie and Freddie) Preferreds

Started off as a short idea—were yielding 7-8% in 2007 and they didn’t think that

yield compensated investors for the risk in the housing markets and economy

Went down to 1.5 cents on a dollar

Now are 6-7 cents

Capital structure was a house of cards

Huge amounts of debt and a thin layer of capitalization

Extra thin layers of subordinated debt and preferreds

There were many factors to blame in the housing crisis, not just the GSEs

GSE’s were placed into conservatorship

Guaranteed the senior debt and subordinated debt

o Wiped out the dividends on the preferreds arbitrarily


Paulson said that everything above the preferred line got

par and everyone else got nothing

US Treasury has put in $155B into the firms and now have a preferred

that pays 10%

Community banks were huge holder of the preferreds

$2.6B of preferreds issued in 2008 did not even pay a dividend before

97% of value was wiped out

Regulators actually encouraged banks to buy these preferreds to protect

against losses

o Were considered part of core capital

The preferred market was the last bastion of capital for banks and after the

conservatorship, the entire preferred market fell apart

o Misconceptions

Mush be abolished

Full nationalization or privatization

They are black holes

They caused the financial crisis

They cannot be fixed

GSEs are generating record net interest margins

10% dividend on government preferred is unduly punitive

o TARP banks only paid 5%

o Think that if the GSEs were 100% privatized, rates would go up so much that the housing

market would be destroyed

o But $6T would be added to national debt if they got 100% nationalized

So, we are basically stuck

o Thesis

Public-private compromise is necessary

The GSEs can recapitalize themselves over time

The third option is the one that Akanthos likes

Privatized structure with a reinsurance program structured behind private

capital

o Treasury is leaning towards a modified status quo

o Treasury

Reduce market share to 40% in 5-7 years

Raising prices on GSE guarantees

If they do not take extreme actions, the optionality in the preferreds remains and

extends out to perpetuity

The government preferred is preventing the company from recapitalization

All are reportable losses are from the government dividend

They are drawing down more money from the Treasury to pay the

dividend on the preferred

o That is just crazy

o Are they well enough reserved?


Net charge offs have been less than their provisions

Total realized losses are less than their reserves

FHFA estimates of how much loss the GSEs would require—how much they

would draw down— have been much higher than actual losses

o Suggested recap #1

Cut senior preferred dividend to 5%

Restore publicly traded prefer dividend

Less than $3B per year combined

Would reopened the doors to letting the public markets back in

Restoring capital in regional banks

Where could they trade?

o If they traded at a 10% yield, the preferreds could trade 80-90

cents

o Suggested recap #2

Equitize the senior preferred and publicly traded preferreds as pari passu

obligations

Where could these trade in this scenario?

Base case 1: all serious delinquencies default

Base case 2: based on cumulative default curves

Bad Case: All high LTV loans default

o Only case in which they are not adequately reserves

What could they make

Assuming 40-50% market share

Not expected to pay net income taxes for a long time

Fannie: about $15B per year

Freddie: about $13B per year

o If you add 8-10x multiples

o 90% to 160% upside

o Risks

Political

Principle reduction

Nationalization

Forced wind down

Market

Decline in housing prices

Interest rate or credit shock

Idiosyncratic risks

Accounting risks

Derivative mis-hedging

o Summary

Extreme solutions of 100% nationalization or privatization are not likely

Modified status quo and a regulated public/private model is the best solution

A recapitalized, tightly run Fannie and Freddie could become very profitable


- Q&A

o What CUSIP are they advocating?

Trade like penny stocks because they are delisted

Even though there was $35B issued, these are incredibly illiquid

Ticker: FNMFO

Trading around $6500 with a par of $100,000

o How are the preferreds represented? Is there a credit committee?

In every large Chap. 11 or reorg there has been heavily organized creditors

Not a large voice in this case

Conspiracy theories

o Buyers were the banks and insurance companies

Banks are now owned by the FDIC so there is no voice

You can wield a lot of power with a small bond ownership stake

o Have been trying to round up other owners of the preferreds

Found only $2B of the $35B being held at hedge funds

Who owns the other $33B?

The community bank lobby has been writing to Congress suggesting a

plan similar to what Akanthos is suggesting

o Different default assumptions for Fannie versus Freddie? Are the portfolios different?

Based on what was available to them from the companies

Took the assumptions from the companies

Freddie may have a better book in the guarantee book

Does not change the thesis

o What size bet would you put on for a position like this?

Will size highest conviction ideas to lose no more than 3% in the worst case

When the price goes up, it becomes a larger % of their capital

To control mark to market risk, try to establish trailing stops on their

positions

Inflated to a 10-12% position after the

o Thesis hasn’t changed as the shares have gone from $.02 to

$.065

o Can you talk about the commitment fee waiver?

So far the commitment fee has been waved and it looks like it was put in there as

a catchall in case the government wanted to

The best case scenario is if the tax payers get their money back and private

capital replaces the government’s capital

Turn it into a regulated utility

o Ryan Morris- Would the government actually allow pari passu securities to be created if

the preferreds were equitized?

The government made decisions to arbitrarily hurt the creditors of Chrysler’s

bonds because the base was made up by hedge fund and TARP banks

Nobody likes TARP bonds and


The government would not and could hurt the mom and pop retail

investors on GM debt

o Can you share other themes?

Inflation issue worries him quite a bit

Thinks in option-like payoffs

o Gold, farmland and real estate have already left the station

He doesn’t even know how to value gold

These assets are already full priced

HK dollar is the only full convertible liquid currency that is hard pegged

to the dollar

o Open up an account at an HSBC bank and buy HK dollars

o Earn zero here or zero there—so you might as well hold HK

dollars

They have major asset inflation and they are letting

Bernanke run their modern

They are likely to de-peg

Very asymmetric bet

o Could the equity sliver be worth anything?

In a rosy scenario is yes

But remember how much capital is on top of that equity

Combined market cap right now is around $8B

Total value of preferred right now are only $2B

o Even though they are higher up in the capital structure

Would be short the equity versus the preferreds

Does not make any sense

Americans Abroad: The Cautious Adventures of US Value Investors

Jonathan Friedland- Portin Orlin

- Stock pickers with $1.3B in management

- Almost everybody in the research department is partner in the firm

- Low correlation with other hedge funds

- Looking for value with optionality

- How did they start investing globally?

o Started investing globally in 2002

o Industry was moving in this direction

o Paired EDS/ Indian Outsources

o Distressed debt opportunities in 2002

o US may not be the most stable, safest market in the world

What do you do when risk free has a negative outlook?

o Development of global effort

Adapted core principles

Found great businesses in highly concentrated industries

Slowly developed competencies, relationship and knowledge


Internal database

Great companies and great managements that many not be appropriate

but they want to keep track of

o When prices fall and valuation become more attractive

Emerging market companies have better balance sheets and less leverage

Think that EM will have better growth going forward

Think portfolio companies can achieve growth better than GDP growth

Dependency ratios are much lower than in developed markets

o Consumers will spend on consumer goods and not medical care

as in the west

Risk

o Portfolio management at the asset class level

Markets move as a class at times

Look at where they are trading relative to their histories,

other countries and developed markets

o Look at the country level

Big domestic population?

Strong balance sheet

Stable and predictable economy

Dependent on global growth or internally driven?

Imports and exports to GDO ratios

o Company level

Great companies

Great franchises

Great management

Optionality in the shares

High barriers to entry

Strong balance sheet

Predictable and recurring revenues

Generally misunderstood assets or prospects

Open ended growth opportunities

o Very active in hedging

Lots of shorting

Tough in emerging markets

Derivatives with defined downside and lots of upside if

we get big hiccups

Not good infrastructure for hedging

Buy the long term investment case and hedge hiccups

that cause speed bumps

- Raia of Brazil

o Drugstore operator in Brazil

o Secular growth and consolidation opportunities

o $1B market cap

o Strong balance sheet- $250M in net cash


o Income growth lead to increased spending on drugs

o Increased sales of HPC and generics

Similar generics cycle to the one in the US

o Pharma and HPC markets are both growing by 10%+ annually

o Confortable with the management team

Company was founded 100 years ago

CEO has been there for 30 years

CFO is former CFO of Natura

Insiders and sponsors own over 50% of the stock

Pragma family owns 10% of stock

Gavea owns 6%

o Nova Mercado Listing

Strong protection of minority shareholder rights on this exchange

o Secular shift to organized drugstore format

Improved tax collections

Tax evasion advantage that moms and pops had is gone

Economies of scale

Removing the cost advantages of informal operators

Chains are about 20-25% of pharma sales in the US and over 50% in the US

o Unit economics of new stores is very attractive

32% ROIC

o Disciplined competitive environment

5 major chains

Expansion looks like it is taking consolidation in mind

Companies are building new stores in different areas

Have 30-40% cost advantage over moms and pops

o 25% CAGR for generics

Gross profit is 2.5-3x branded

o Top line growth of 20%+, SSS growth, 10-15% growth in new stores

Thins

o 8.5x forward EBITDA

Think that CF can grow at 25%

o Think about it like Walgreen’s in its consolidation phase

- Television Broadcasts LTD

o Dominant franchise

Competitor has been through management changes

Market share has been growing

o Strong balance sheet

15% market cap is net cash

o 4% revenue from China

o Important shareholder change

o TV’s share of advertising is growing, despite the internet

o Very popular in Mainland China

Cantonese is spoken in HK and Guan Dong--- the closest province


Have some of the top dramas in China

o Valuation

Not much value to the China opportunity

Pays a 4% dividend yield

About 11x EPS, net of cash on 2011 numbers

o Catalyst

Consortium purchased 30% stake from the 104 year old founder

Providence Equity joins the board

o Jonathan Nelson (the CEO) himself is on this board

Has great experience in China

Big investor in Baidu originally

Co-founder of HTC

Chairman of ITC Corporation

- Coal India

o IPO that came in the last year

o Best characteristics of a growth opportunity and a utility

o $45B market cap

o Largest coal reserves and production on the planet

o India has a huge power shorter

Cannot get enough coal in India

Have to import coal

Most of India’s electricity comes from coal

o Have hit 95% of their production targets for the last 10 years

o 90% owned by the Indian government

Engineers are in control

Have reduced employees by 100K over the past 5 years

Not a government job bank

o Sells coal in the Indian market at about ½ the level of import prices

Has pricing power and ability to raise prices

o They are a low cots producer

Importer cannot have a lower cost base

Open cast mine in India

Coal is sitting on the ground—lucky about that

o New market opportunities

eAuctions

Could get to 20%

Washed coal

Create cleaner, higher quality coal

o The company has to be 25% owned by the market in the next few years

Will have to sell more shares

o Valuation

Expenses are growing less than revenues due to revenue attrition of 4% per year

Trading at about 12x calendar 2012 EPS

Earnings are under-reported


Have excess amortization that is disallowed by IFRS, which is coming to

India

10.4x P/E excluded excess amortization and net cash

Comparable national champions trade around 15x EPS

- Q&A

o Sanofi Aventis, is that really a great company? Headlines say that Coal India is raising

prices to pay higher wages. What do they think of that?

Sanofi is a significant position and think there is a lot of value there

Market is overlooking LT earnings power just because of a few down years

Has more recurring revenue than other pharma companies

Trading at 7-8x earnings even though

o Coal India has had a number of negative headlines

All expansion plans were halted right after the IPO by an environmental regulator

Didn’t think they could stop expansion because India has a power

shortage

If they shut down India Coal’s expansion then India has to import

expensive coal

Big wage hikes come with high price hikes

o Do they look at relative valuations between Brazilian drug store companies?

Think the one they own can grow the store base faster

Don’t look at relative valuations although they thought it was cheaper than the

competitors

o How do they get comfortable investing all over emerging markets, especially off the

beaten path ones?

Some people used to shut down when they heard people wanted to invest in

Vietnam

Were lucky to start investing when valuations were very low

Developed a competence little by little since then

Got comfortable slowly and carefully

2011 value investing congress notes

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