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Graham & Doddsville An investment newsletter from the students of Columbia Business School Issue XVII Winter 2013 Inside this issue: Graham & Dodd Breakfast P. 3 JANA Partners — JANA Partners P. 4 Collaboratively Frank Martin Unlocking Value — Daniel Krueger P. 14 Winning by Not Losing Frank Martin P. 28 Frank Martin Russell Glass P. 42 Frank Martin is the founder and owner of Martin Capital Management, an investment partnership based out of Elkhart, Jon Friedland P. 50 Indiana. He is the author of two books on investing, Speculative Contagion (2005) and A Decade of Delusions (2011). (Continued on page 28) Barry Rosenstein Scott Ostfeld Founded in 2001, JANA Part- ners is a value-oriented in- Editors vestment advisor specializing Russell Glass Jay Hedstrom, CFA in event-driven investing. G&D sat down with two of — MBA 2013 the firm’s partners, Barry Rosenstein and Scott Ostfeld Arbitrageur of Jake Lubel MBA 2013 ’02. Barry Rosenstein is the Value founder and Managing Part- ner of JANA Partners. Prior Russell Glass Sachee Trivedi (Continued on page 4) Russell Glass is founder and managing partner of RDG Capital MBA 2013 Management, a New York-based investment management firm that specializes in activist investing. Prior to RDG Richard Hunt Capital, Mr. Glass served as President of Icahn Associates, the MBA 2014 Daniel Krueger investment firm of Carl Icahn. A passionate sports fan, Mr. (Continued on page 42) Stephen Lieu — “Uncertainty MBA 2014 is our friend” Visit us at: Jon Friedland — www.grahamanddodd.com Searching for www.csima.org International Battleships Jon Friedland Daniel Krueger Jon Friedland ’97 is the Director of International Research at Daniel Krueger ’02 is a Man- Amici Capital (formerly named Porter Orlin). He is aging Director and Partner responsible for sourcing and analyzing the firm’s international at Owl Creek Asset Manage- long and short ideas. Prior to joining Amici in 2001, he ment, a hedge fund in New worked at Zweig-Dimenna Associates, a New York-based (Continued on page 14) (Continued on page 50) Page 2 Welcome to Graham & Doddsville We are proud to bring you the very attractive risk-return sce- the coming years. latest installment of Graham & narios, as well as how he en- Doddsville. This is the 17th edi- courages his team, in their Jon Friedland ’97 from tion of Columbia Business early work on a company, to Amici Capital shared with us School’s student-led investment zero in on the key questions the factors that make a com- newsletter, co-sponsored by the that need to be answered. pany a ‘battleship’ company. Heilbrunn Center for Graham & He then conveyed the attrac- Dodd Investing and the Colum- Frank Martin from Martin tiveness of searching for these Pictured: Professor Bruce bia Student Investment Manage- Capital Management de- companies in emerging mar- Greenwald. The Heilbrunn ment Association. scribed how he picks compa- kets. Center sponsors the Ap- nies on a bottom-up basis, yet plied Value Investing pro- We were very fortunate to sit spends much of his time thor- This issue also contains pic- gram, a rigorous academic down with six well-respected oughly studying the macroeco- tures from the 22nd Annual curriculum for particularly and successful investors that nomic environment. He also Graham & Dodd Breakfast, committed students that is span the value investing spec- explained his reasoning for which took place on October 5 taught by some of the in- having a conservatively posi- at the Pierre Hotel in New trum – they prove the old ad- dustry’s best practitioners. tioned portfolio today. Mr. York. Investing luminaries age, ‘there is more than one way to skin a cat.’ Martin goes into detail about Tom Russo, Bill Ackman, Mario the behavioral aspects of in- Gabelli, William von Mueffling, Barry Rosenstein and Scott vesting and what he does to and others were on hand to Ostfeld ’02 from JANA Part- avoid traps to which many mingle and listen to keynote ners explained their process for investors fall prey. speaker Meryl Witmer from constructively engaging manage- Eagle Capital Partners. ment in activist situations. They Activist Russell Glass from also talked about how their RDG Capital made us very We thank our featured inves- entrepreneurial backgrounds envious when he shared his tors for sharing their time and have helped shape their careers unique business school and insights with our readers. and the way they look at compa- early career experiences. Mr. Please feel free to contact us if nies. Glass thoroughly shared how you have comments or ideas his firm has been able to profit about the newsletter as we Distressed expert Dan handsomely by actively advo- continue to refine this publica- Pictured: Heilbrunn Center Krueger ’02 from Owl Creek cating for the sale of underval- tion for future editions. We Director Louisa Serene Asset Management shared ued companies. He also illumi- hope you enjoy reading this Schneider. Louisa skillfully the intricacies of distressed debt nated for us how the large issue of Graham & Doddsville leads the Heilbrunn Center, investing that make it his favor- amounts of cash in private and find the interviews as infor- cultivating strong relation- ite hunting ground for ideas. He equity and corporate hands mative and thought-provoking ships with some of the also explained how the econom- could lead to a robust mergers in written form as we found world’s most experienced ics of averaging down create and acquisitions environment in them to be in person. value investors and creating numerous learning oppor- tunities for students inter- ested in value investing. CSIMA Scholarship The classes sponsored by the Heilbrunn Center are among the most heavily The Columbia Student Investment Management Association (CSIMA) will be demanded and highly rated awarding its inaugural scholarship this spring with the proceeds from today’s classes at Columbia Busi- conference. Through this program, we will award a $10,000 scholarship to ness School. an incoming Columbia Business School student that exhibits an outstanding aptitude and commitment to investment management. All incoming MBA students in the Class of 2015 are eligible to apply and the recipient will be chosen by a panel of CSIMA students. We are excited to initiate this scholarship and look forward to making this an annual tradition. Volume I, Issue XVII Issue 2 Page 3 22nd Annual Graham & Dodd Breakfast, Oct 5, 2012 at Pierre Hotel Keynote Speaker – Meryl Witmer Bill Ackman Mario Gabelli with William von Mueffling Tom Russo in deep conversation with Sid and Helaine Lerner Dean Hubbard thanks Ms. Witmer Prof. Greenwald makes a point Engaged audience “Bring a sharp pencil and leave your emotions at home!” – Meryl Witmer Page 4 JANA Partners (Continued from page 1) out of business school. The answered the phone. I to founding JANA Part- interviews didn't go that started talking as fast as I ners, Mr. Rosenstein was the founder and Managing well for me, and there could and he finally said, Partner of Sagaponack weren't big banking pro- "Well, come on in." This Partners, a private equity grams like there are today. led to me becoming Edel- fund. Mr. Rosenstein re- What did lead to a job was man’s co-head of takeovers, ceived his MBA from cold-calling. The trick I a job for which I really was- Wharton and his B.S. from used to get jobs coming out n’t qualified. Lehigh University. Scott of business school was to Ostfeld is a partner of call people after 5:00 p.m., G&D: Can you tell us the JANA Partners and is re- when their secretaries had story of how you actually sponsible for special situa- tions investments, includ- left, so that the person I got the job offer from Asher ing active shareholder en- really wanted to speak to Edelman? gagement. Prior to joining would likely pick up the Barry Rosenstein JANA Partners, Mr. Ostfeld phone themselves. In the BR: Asher was the corpo- was with GSC Partners in case of my first job oppor- rate raider back then, and I its distressed debt private tunity, I cold-called a Whar- was a nobody associate at equity group. Mr. Ostfeld ton alumnus at a boutique Merrill Lynch; no one there received his MBA from firm called Warburg, even knew who I was. He Columbia Business School, Becker, Paribas. Unfortu- started by telling me that his J.D. from Columbia Law School, and a B.A. from nately, the first week on the he'd been talking to the Columbia University. job, the firm was sold to heads of the M&A depart- Merrill Lynch and I was ments at various investment G&D: Can you tell us again without a job. That banks about coming to about your background and was the start of my career. work for him to co-head his how you became interested Fortunately, Merrill called takeover business. I didn’t in investing? me about a week later and understand why he was tell- told me I could interview ing me this as it had nothing Barry Rosenstein (BR): I for a job with them and, to do with me. After about wasn't one of these people apparently, they needed 15 minutes, he turned to me who invested when I was bodies so they hired me. I and said, "I think you and I nine years old. I was good worked in banking for about are going to do a deal here." at math and I was interested two and a half years but I I had no idea what he in business. Frankly, I didn't frankly didn't like it that meant. Then he asked, really know much about much. "What's it going to take to Wall Street at all but as I get you to take this job?" read more about the busi- Back in the mid-80s, corpo- At the time, I was making a ness world when I was in rate raiders were beginning salary of $40,000 and hoping college, it became clear to to make themselves known, for a $30,000 bonus, but my me that I should go back to and I would excitedly read reviews were not strong so Scott Ostfeld business school. I did so at about their exploits at the I didn't have high hopes. I Wharton. There seems to time. That was an interest- had heard that the top mer- be a hot industry anytime ing world to me, so the chant acquisition bankers that you are in graduate question was how to get made $1 million, which was school. When I graduated into that field? I once again more money than I had ever from Wharton in 1984, in- tried the cold-call technique heard of in my life. So I said vestment banking was the (I don’t remember how I to him, “one million dol- hot field, so that's where I found his number) to speak lars." He stared at me for focused my efforts. to one of the main raiders 30 or 45 seconds, which is a of the time – a guy named long time when you're com- I actually didn't have a lot of Asher Edelman – and pletely full of crap. Then he luck getting a job coming wouldn't you know it, he (Continued on page 5) Volume I, Issue XVII Issue 2 Page 5 JANA Partners (Continued from page 4) jaw hit the floor. Asher. I learned technical said, "Alright, done. You G&D: Clearly you had a balance sheet analysis and just have to start tomor- lot to learn essentially start- business analysis more row," to which I responded, ing from scratch. What are through working on situa- "I'll start right now. I'll sleep some of the things that tions, talking to bankers, here tonight if you want." stand out in your mind that and talking to some of the That's how I became co- you learned during that pe- other people who were head of takeovers for Asher riod working for Asher that working at the firm. But Edelman. I wasn’t prepared shaped the way you run the from Asher, I probably for the position when I learned more important started, so I had to figure skills. These had more to out the responsibilities of do with taking risks while the role as I went along. not blinking and remaining This made for a uniquely fearless. I give him a lot of amazing experience. “But from Asher credit. He wasn't the most technically savvy guy, but he G&D: How old were you [Edelman], I had great instincts and he then? never showed fear, even if probably learned he felt it at times. That was BR: I was 27. an important lesson. more important G&D: That was quite a skills. These had G&D: Mr. Ostfeld, can you career advancement at that walk our readers through age! more to do with your unique background? How has this background BR: I'll add a funny post- taking risks while impacted your investment script to it, as well. The style? very first deal I was working not blinking and on, we were trying to take Scott Ostfeld (SO): I was over a supermarket chain remaining fearless. an Art History major when I called Lucky Stores and sure I give him a lot of was in undergraduate school enough, Edelman had ap- at Columbia, so that didn’t proached Merrill Lynch for credit… he had necessarily portend a career the takeover financing. in finance. I started two About a week into my job great instincts and businesses in college. I as co-head of takeovers, started a menu business Merrill’s senior M&A team he never showed where the restaurants came in to our office to talk around Columbia paid me to us about the financing. I fear, even if he felt to put their menus into a noticed the Merrill people it at times. That menu book that I distrib- looking at me as they were uted to students for free. probably thinking, “What's was an important This was just before the he doing here? I didn’t know Internet had taken off, he was assigned to the lesson.” which certainly would have deal.” I was so insignificant put me out of business. I at Merrill Lynch that nobody also started an event plan- even knew I had left. So ning business. One of the Asher gave his 30-second problems back then as a introduction and then said, firm today? Columbia undergraduate "My co-head of takeovers, student was that there was Barry here, is going to take BR: I didn't really learn no central place to congre- you through the financing anything technical from (Continued on page 6) we're looking for." Every Page 6 JANA Partners (Continued from page 5) During my time in business tender offer to try and buy gate at night – you may have school and law school, I a public company called seen somebody on campus, spent a summer at Wachtell Justin Industries, which was but you never saw them at Lipton, which today happens the largest manufacturer of night. So I started initiating to be on the other side of cowboy boots and bricks in events at different venues our firm in activist situa- the country. I never ac- for Columbia students, tions. That was an interest- quired control of the com- where I was paid to bring ing experience that helped pany, however. [Editor’s students. It grew to the frame the debate on share- Note: This Company was later point where I was organiz- holder versus board and acquired by Berkshire Hatha- ing events for Tahari and management power. After way in 2000.] It was an in- Lacoste in New York and graduation, I went into in- teresting experience being even Miami. Toward the vestment banking, where I the person on the firing line, end of my time as an under- focused on helping compa- as opposed to somebody's graduate, I applied to the nies unlock value. From right-hand man. It was also law school thinking I wanted there, I moved into dis- interesting trying to go after to be a lawyer, though not tressed private equity. That the oldest company in the necessarily understanding was basically investing in the state of Texas. what that meant. I also had context of a legal process to an entrepreneurial orienta- gain control of a company I also became involved in tion, so on a whim I said, and improve value as an the cellular industry. I was “Maybe I should go to busi- equity owner, which was invited by a group of gentle- ness school as well.” I was again leveraging many of my men to form a partnership lucky because the business skills and experiences. I then that submitted applications school typically doesn’t ad- moved to activism when I for all of the remaining rural mit candidates with no real joined JANA Partners about cellular licenses in the U.S. work experience. seven years ago, which puts that had not yet been all of my experiences to awarded. The FCC didn't The foundation of entrepre- work evaluating companies hold auctions at that time – neurial experience, law with an owner orientation they just held a lottery – so school, and business school to figure out how to unlock all one had to do was apply. has helped me as an activist value. We invested a relatively investor. Entrepreneurial small amount of capital to experience gave me an G&D: Mr. Rosenstein, you meet the legal fees associ- ‘owner orientation’ that is were involved in many en- ated with applying and we very helpful in thinking trepreneurial situations be- then applied to every loca- about how to create value fore you founded JANA – tion in the country. We at companies. Business will you talk about a few of figured we had a one in school and law school gave them? three chance of winning one me many of the foundational of them. It was like playing tools to be a competent BR: My career is not very the lottery but with much analyst. Believe it or not, I conventional. I didn't grow better odds. In fact, we had never even used Excel up in the hedge fund busi- won Mississippi and the before I attended business ness and work for a bunch Poconos and, after building school. Courses like Ad- of people and then decide the necessary systems, sold vanced Corporate Finance, to start my own firm. I was them for a terrific return. Corporate Restructuring kind of a serial entrepre- and Corporate Tax gave me neur. Some things worked I then moved to San Fran- a great foundation for ana- and some things didn't cisco at the end of 1991. lyzing companies and think- work. When I left Asher, I Remember that this was ing about ways to unlock did two things. First, I went back when New York was value. off on my own and I made a (Continued on page 7) Volume I, Issue XVII Issue 2 Page 7 JANA Partners (Continued from page 6) and use them again and was an incentive to get bet- going through extremely other people buy them for ter pricing. He had all kinds difficult times – the home- the parts. of ideas that no one in his less problem was out of industry had done to date. I control, Wall Street was I became curious about auto returned to my office in the completely dead, and there salvage after someone had city and tried to scrape to- was nothing to do. In the mentioned that it could be gether the $7 million to meantime, I met some peo- attractive. So I started call- back him. I remember eve- Pictured: Mario Gabelli at ple in San Francisco who ing one participant in the rybody telling me that I was Omaha Dinner in May 2012. asked me if I wanted to join industry after another, each crazy being in this industry them to start a new invest- more unsavory than the last. and backing this person. ment and merchant banking I finally met a guy named But I just saw something in business. Not having any- Willis Johnson who had a him. I was able to back him thing else to do, I decided little company called Co- and he turned out to be one to give it a try for a year or part. At the time, Copart in a million. He bought a two and then return to had one location in Califor- number of companies, inte- New York. I ultimately nia, generated $8 million in grated them very well, and stayed in San Francisco for revenue, and offered neither started to build a real com- 16 years! After about five audited financials nor GAAP pany. Copart went public a years of helping build that accounting. Copart was little over a year after my successful little boutique basically a dirt lot with a investment. Today, it's a $4 business, I left to start my barbwire fence and dogs billion market cap company own firm. running around. The head- and it has hundreds of loca- quarters building was a tem- tions all around the world. G&D: Towards the end of porary corrugated metal Their business has shifted to your time in San Francisco, building, and Johnson frac- the internet now, of course, you made an investment in tured the English language and today it's the biggest Copart, the salvage vehicle regularly. The only thing online seller of automobiles auction company. Could that I could think of, as I in the world. you tell us about this busi- was trudging around in the ness and your thesis at the mud with the CEO, was G&D: What inspired you time? that I can't believe my ca- to found JANA Partners and reer has fallen this far, this to include a distinct activist BR: That’s right. Near the rapidly. Nevertheless, I investing approach within end of my time on the west probably spent four hours part of your business? coast, I did a deal which was with Johnson. I remember something of a life changer calling my wife on the phone BR: So I made some for me in certain ways. Yet on the way back to San money on my various ven- again, I cold-called someone Francisco and saying, "You tures and that provided a – this time it was a partici- know, I think I just met the springboard for me to start pant in the auto salvage in- smartest guy I have ever my own private equity firm dustry. Auto salvage is a met in business." in 1997. I ran that for about fragmented industry that three years and produced runs an auction on behalf of Willis Johnson was a self- very average results for my insurance companies for taught, self-made business- investors. It was a very permanently damaged vehi- man. He had a vision for difficult time for the private cles. This is the company creating a national company equity market and I was just that the insurance company and signing national con- happy that the investors calls and says, "Go pick up tracts. He also believed he were returned their princi- the car for us, turn it into a had a way of sharing the pal plus a small return. But I salvage vehicle, run an auc- proceeds with the insurance really didn't like the busi- tion, and sell it." Some peo- companies so that there (Continued on page 8) ple buy the cars to fix them Page 8 JANA Partners (Continued from page 7) through 2008 and a big ness. I felt like I couldn't be downturn, with assets under G&D: Does your activist entrepreneurial – if we won management falling a lot. I approach stem from the fact a deal, it was because we restructured the whole firm that you have a sense of had offered to pay more over the last couple of years what good businesses are than everybody else. It was and how a business should right around 2000 when I be managed to get to the Pictured: Louisa Schneider decided to not raise another “I think we’re ‘right- private market value? Is and Glenn Hubbard at Gra- fund. that how you convince the ham & Dodd Breakfast in term’ because we management to unlock the October 2012. I instead saw an opportunity try to consider all value? in the public markets to close what I saw as a gap available BR: Right. Nobody was between the price at which really doing that when we public companies were trad- information and started. There were a lot of ing and what I felt their ulti- companies that were value mate private market values construct the traps. They either needed were worth. So not know- to restructure, sell off ing anything about how a optimal plan for the money-losing businesses, hedge fund works, I set up a spin off an unrelated busi- company under the hedge fund. ness, or they just didn't be- circumstances that long independent and I remember when I was needed to be sold. My ini- trying to raise money, trav- are known or tial impetus was to try and eling to various institutions force that kind of change. and talking about being an knowable and activist. People would say, G&D: Many value inves- “That's not a strategy; you'll predictable over a tors talk about having a long never raise money; nobody -term approach, but at reasonable period does that; forget it.” Things JANA you have a medium- have really changed. My of time to best term time frame. Why is very first investor was Lee this the right time frame? Cooperman [Editor’s Note: position the Cooperman was featured in SO: I wouldn’t even call it Issue 13 of Graham & company for medium-term; I’d call it Doddsville], who had been a ‘right-term’. I think we’re close friend for many, many success. I think ‘right-term’ because we try years and someone I viewed to consider all available in- that’s the right time as a mentor. He largely formation and construct the understood the idea and frame, frankly, for a optimal plan for the com- believed in what I was trying pany under the circum- to do. He backed me when board to be stances that are known or nobody else really would. knowable and predictable evaluating the over a reasonable period of I started with $17 million time to best position the and no expectations beyond opportunity set for company for success. I that. Before I knew it, the think that’s the right time the company.” business grew and by 2007, frame, frankly, for a board we had over $8 billion un- and we are back flying again. to be evaluating the oppor- der management. We gen- Other than probably 2008 tunity set for the company. erated a pretty strong track and a year or two after that, So I think our horizon maps record over this period of it's actually been a lot of fun. (Continued on page 9) time, as well. Then I lived Volume I, Issue XVII Issue 2 Page 9 JANA Partners (Continued from page 8) the last 10 years, but it's you'll be pushed as far as appropriately with the never come down to a you're willing to go and then board’s horizon. proxy vote and you’ve you have nothing. Nobody G&D: How much overlap never been very vocal about ever questions whether is there between JANA’s your position. How do you we're prepared to go all the passive efforts (that is, non- way. We are very careful activist ideas in this context) about how we prosecute versus its activist efforts? “Basically, we have to activism. We've never had be comfortable buying one actually go to a final SO: We are one team, one vote because management portfolio, all on one floor, in at a valuation that comes to the realization all interacting on a regular provides us with a that there's no point going basis. So there is a constant to a final vote because flow of ideas from passive margin of safety, they're going to lose. to active, and frankly, many irrespective of any of us can’t separate our The reasons are twofold: brain and say, “This one’s activism we will one is our approach and the clearly active, this one’s attempt to initiate and other is our structure. In passive.” Frequently posi- our approach, we're ex- tions fall in the middle. But that may be tremely disciplined. I don't my primary focus is on the unsuccessful. We have want to be only an activist activist side, and that’s what because then you force I’m paying attention to 90% to be comfortable that things and the quality of of the time. if it really came down your ideas is diluted. We don't ever have to be an G&D: Does your activist to a vote that we would activist here. We can just style impact your portfolio have shareholder invest in event-driven situa- construction – meaning, tions. For something to be does the fact that you are support. And variety of an activist play, all of the often the catalyst enable ways to win – you want criteria have to be present you to be more concen- for us. We came up with trated than you would oth- to make sure that this rubric we call V-cubed, erwise feel comfortable there's more than one which is Value, Votes, and being? Variety of ways to win. lever you can pull in Basically, we have to be SO: Yes. Our highest con- case circumstances comfortable buying in at a viction ideas are the ideas valuation that provides us where we have the most change. In my with a margin of safety, irre- impact on the outcome. experience, if you have spective of any activism we Those are our activist ideas will attempt to initiate and which tend to be our largest all three of those that may be unsuccessful. and highest returning posi- checked off, you're We have to be comfortable tions in the portfolio. that if it really came down You’re also, frankly, doing a guaranteed victory.” to a vote that we would lot of work on these posi- have shareholder support. tions, so you want to bene- engage management? What And variety of ways to win fit from that work by mak- makes the strategy possible? – you want to make sure ing it a large position. So that there's more than one our portfolio can be a bit BR: Well for the first part lever you can pull in case more concentrated. of that, I would say you have circumstances change. In to be prepared to go all the my experience, if you have G&D: You've been an ac- way because if you're not, (Continued on page 10) tivist in many companies in Page 10 JANA Partners (Continued from page 9) are. reputation we are able to all three of those checked attract very accomplished, off, you're guaranteed vic- SO: When we become experienced, and successful tory. If you're missing one involved in situations, we value creators who get a of them, there's a good typically are working with very good reception when chance you're going to lose. industry operators who are we do bring them to com- We're extremely judicious. helping us carefully analyze panies or run them for the situation and are on slates. For example, when In terms of our approach, I we were involved in CNET have no ego with respect to in 2008, we ran a slate of these activist pursuits. I directors to help turn the don't need to claim victory company around. We had or get credit. I try to work very qualified people like behind the scenes. I tell John Miller, who had run every one of these CEOs AOL, and Julius Gena- that they can be the hero, “In terms of our chowski, who only months and we'll be their biggest after being on our slate was approach, I have no advocate, if they do what nominated by President we want them to do. In- ego with respect to Obama to be chairman of stead of going on TV and the FCC. As with CNET, forcing people or embar- these activist when we do run a slate, it’s rassing people, I find it much designed and tailored to more effective when I give pursuits. I don't address the very specific them a chance and I treat need at the company. them with respect. We can need to claim go hard at somebody if we G&D: How do you go victory or get credit. have to, but in my experi- about finding your activist ence you convince people I try to work behind targets? Do you screen for to go along with you a lot companies through valua- more successfully if you the scenes. I tell tion screens or do you gen- treat them the right way. erally find your ideas every one of these through other means? G&D: How is JANA Part- ners structured to conduct CEOs that they can SO: A friend who works at activist investing? another activist firm aptly be the hero, and described it: it’s a bit like BR: We run our activism we'll be their panning for gold. You need activities like a machine. It's a lot of throughput to find what these guys do every biggest advocate, if that gold nugget. I can’t say day, all day long. We also we ever know where our bring in industry partners in they do what we next idea is going to come all of these situations; so from, but looking for activist we're not just financial guys. want them to do.” ideas is very similar to how We bring in industry opera- you would look for tradi- tors who have greater ex- tional investment opportuni- pertise and track records ties in public equities. than existing management There’s screening, reading teams, so it's very hard for research reports, talking to the management teams to standby to become board industry operators, talking argue against us when members if necessary. to companies about their they're arguing against peo- Given our successful track competitors, and bench- ple who are better thought record and collaborative (Continued on page 11) of in the industry than they Volume I, Issue XVII Issue 2 Page 11 JANA Partners (Continued from page 10) sue us or put a poison pill in marking peers. Ideas can place. We don't get any of G&D: What, in your opin- come from other sharehold- that anymore, because the ion, is a driving motivation ers calling and from follow- companies have come to behind the subset of corpo- ing events that create op- realize that all they're doing rate America management portunities such as an an- is alienating their own teams that have a penchant nounced acquisition that shareholder base and it's for limiting or destroying doesn’t make sense for counterproductive. We value for shareholders? Is it “...we don't face the shareholders. hire the same bankers and related to self-preservation? kind of fights that lawyers all the time and we Empire building? Disen- G&D: Mr. Rosenstein, you know what they tell man- gaged boards? said that last year was the we used to face. agement teams, at least in strongest environment for our case. They tell them, SO: It’s very difficult to Ten years ago, I'd activist investors that you “You can't ignore JANA. answer because it runs the had seen in your career. They do their homework, spectrum. You sometimes show up in front of Do you think that's still the they come up with good have companies with good case, and why is this? ideas, they're really tough, operators who think they’re a company and they're not going to go doing things that make BR: I do. I think there are they would sue us away, and you're better off sense for shareholders, but a couple of reasons for this. just trying to work things they may not be as experi- or put a poison pill In terms of opportunity set, out with them.” I think enced navigating the capital there are a lot of companies those two broad dynamics markets or as thoughtful in place. We don't that are undervalued. I find continue to create a great about ways to increase the stocks at very reasonable environment for what we value of a stock. You also get any of that prices. I think that you still do. have situations where CEOs have a dynamic today that or boards are not prioritiz- anymore, because exists where a lot of compa- G&D: Has the recent in- ing the right things. Some nies are worth a lot more the companies have crease in funds with activist may be interested in grow- than where they’re trading strategies made it any ing at the expense of come to realize that and where they would trade tougher for you to find your unlocking value. Other as private companies. I also ideas? times you get people in all they're doing is think balance sheets are situations that are not com- very healthy with lots of SO: There really aren’t petent enough to execute alienating their own cash. You have financing that many activists, and the appropriate strategy to rates that are very low. there certainly aren’t that maximize value. shareholder base You also have the dynamic many activists with a 12- where companies and man- and it's year track record of col- BR: A big part of the prob- agements are having diffi- laboratively unlocking value lem is that the incentives culty generating internal counterproductive.” the way that we have. are all wrong. If these were growth and so they're as There are also not that family businesses and they open to value creating ideas many activists that focus on owned all the stock, they as they have ever been. the market cap size that we probably wouldn't be mak- That's from an opportunity have participated in ($10- ing a lot of the decisions set standpoint. $20 billion), particularly in that they're making. But the past two years. It is they own very little stock Then, if you think about the actually much less competi- and most of the stock they environment for activism tive today than it was prior own has been given to them and the market's perception to the financial crisis when or is in the form of options. of activism, we don't face everybody was an activist Their current compensation the kind of fights that we investor. Yet the opportu- is probably more valuable used to face. Ten years ago, nity set today is very attrac- and important to them. As I'd show up in front of a tive for activism. (Continued on page 12) company and they would Page 12 JANA Partners (Continued from page 11) tions where assets are held back stock ahead of all that. a result, the incentive is to in inefficient structures, ei- If an activist is pillaging a run a bigger and bigger ther because there is a business for some kind of company. The bigger the more appropriate structure short-term gain, then that’s “If you went back company you run, the more to own it in like an MLP, or problematic, but if they are and looked at the you can justify higher com- you’re combining assets that advocating steps that make pensation levels and it don’t make sense together. the stock more valuable, activist situations makes you feel like a big I think it’s actually a coinci- then they are doing exactly shot in town. The incen- dence that we’ve had a few what the board and manage- we’ve been involved tives are all perverse. I in a row that have been ment are supposed to do. If in, and you were to think ultimately when you more spin-off focused. If an activist were harming a start to point out irrefutable you went back and looked company’s future prospects categorize them, they facts and you get share- at the activist situations every time they showed up holder support they see we’ve been involved in, and at a company, they would are actually fairly your point. I would say in you were to categorize not be successful winning balanced among most cases, management is them, they are actually fairly over shareholders who may trying to do the right thing, balanced among capital allo- end up owning the stock capital allocation, but they're either blinded or cation, capital return, block- after the activist has sold they are not necessarily ing M&A deals, separations and moved on. capital return, always looking to maximize or divestitures, buybacks, blocking M&A deals, value. They're just going sales of companies, and op- G&D: Is there any mistake about their business every erational turnarounds. The from your career that might separations or day and they're lost in the common thread is that we stand out or something that divestitures, forest a little bit. But you advocated steps that best you really learned from also have some people who positioned the companies to them that sticks with you buybacks, sales of are just not thinking about create value. today? things the right way and are companies, and thinking about themselves G&D: One oft-heard criti- BR: I’ve made so many operational and not the shareholders. cism of activist investors is mistakes I can't even think They may protest and say that you are simply ‘pulling about it. I'll give you one turnarounds. The that's not the case but it is. value forward’ and harming thing that's not an investing It's not until someone like a company’s future pros- concept, but something that common thread is us shows up and they feel pects. How would you re- I've come to realize that that we advocated threatened that they actually spond to this characteriza- might be helpful. Being po- move. The proof is in the tion? lite to people and treating steps that best returns we generate. In people with respect is good virtually every situation, the SO: As long as you’re do- business. It's not just a positioned the stocks have reacted ex- ing something that doesn’t good thing to do, it actually companies to create tremely positively and not harm the value of the com- inures to your benefit as just short-term bumps, but pany, accelerating the bene- well. If you're a jerk to value.” companies have been fits to shareholders is ex- somebody, they remember. rerated. All of a sudden actly what creating value is They may never get the companies go from being all about. The best exam- opportunity to pay you value destroyers to value ple, of course, is buying back back, but if they do, they creators. stock. If you have a great surely will. I've had more long-term story and a value- instances where I've inter- G&D: Recently, JANA has creating plan ahead of you, acted with somebody I don't pushed for spin-offs in sev- why would you wait and buy even remember, perhaps 10 eral companies. Is that sim- back stock after the market years prior and this person ply a coincidence, or do you fully reflects the value? shows up working for a prefer to deal in spin-offs? From a capital allocation potential investor or is in- standpoint, you want to buy (Continued on page 13) SO: We like to find situa- Volume I, Issue XVII Issue 2 Page 13 JANA Partners (Continued from page 12) hire people unless they have some of these things. Just volved with the company significant work experience. take chances, go for it, and and they say, "You were I don't necessarily care that don't look down. really good to me. You they went to business were really nice to me. I school, but they've got to SO: Investing is a lot didn't forget that." And have significant work ex- harder than Columbia Busi- they've invested with us or perience at an investment ness School. A hypothetical they've helped us get a com- bank and another hedge 'A' in the investing world, Pictured: Bill Miller at CSIMA pany to do something. To the point at which you are Conference in February 2012. me there's no upside to performing at the highest treating people badly. level, only requires being right more than half the SO: When I was working time. The truth is investing in investment banking, I had “Being polite to can be very frustrating, diffi- this naïve and mistaken view people and treating cult, unpredictable, and gru- that if you have a good idea eling. So you should only that a company should pur- people with respect pursue the career if you sue, it will automatically be have the passion, if you’re adopted and pursued. is good business. intellectually curious, and if Changing the status quo at a you’re committed to it, be- company isn’t easy and It's not just a good cause at every turn, you can sometimes requires more be very quickly humbled. than just logic. thing to do, it That’s the nature of the actually inures to business. G&D: Do you have any advice for the readers who your benefit as well. G&D: Mr. Ostfeld, you are keen to get into invest- started with an entrepre- ing or activist investing? If you're a jerk to neurial background and ended up in a career in in- BR: Go to places where somebody, they vesting. What advice would you can learn. You can you give students who are learn from every experi- remember. … To interested in both investing ence, but just provide your- and being involved in an me there's no self with the best opportuni- operating business? ties to work with people upside to treating who you think are smart SO: If you learn how to and who you respect. people badly.” invest and manage money Maybe the world's changed that’s portable to anything and you can go right into you want to do. the hedge fund space today, but I still think there's fund or private equity fund, G&D: Mr. Rosenstein and something to be said for and probably five plus years Mr. Ostfeld, it’s been a having more of a fundamen- of experience before we'll pleasure speaking with you. tal background, getting bring them in as an analyst training at an investment here. Don't be afraid to bank or private equity firm, make changes and jump. If I and then moving into the thought about the down- principal side and the public side, I wouldn't have done markets. I think that's a half the things that I did. good way to access it. But And after the fact, as I sit again, maybe hedge funds here, I think I must have are hiring directly out of been out of my mind to do business school. We don't Page 14 Daniel Krueger (Continued from page 1) the debt was worth less distressed. I really enjoyed York that manages over $3 than face value and the eq- the complexity, the way that billion. He is Co-Portfolio Manager of Owl Creek’s uity was trading at option different people had differ- Flagship Funds and is the value. I noticed that some ent motivations, and that firm’s Global Head of representatives of a dis- the power shifted from eq- Credit. Prior to Owl tressed hedge fund that uity holders to creditors in Creek, Mr. Krueger owned the bank debt of one such situations. worked in distressed debt of the companies were sit- at Chase Securities and ting silently in the back of I eventually progressed to a Angelo Gordon. Mr. the room at every meeting distressed analyst position Krueger earned his A.B. on the loan desk and then, from Harvard College and his MBA from Columbia against the advice of my Daniel Krueger Business School. colleagues, decided to go to business school. I went to “It was very clear Columbia Business School in G&D: What was your in- troduction to investing? that the math had 2000. Right around that time, the default rate had DK: When I was graduat- broken down, and it started to ramp up. Every- ing from college, I had no body told me, “Krueger idea what investment bank- was because these you're being an idiot. Why ing was, but I knew that all are you going back to busi- of the smart kids were going were distressed ness school? You're picking to New York to do it, so I the exact wrong time to go. companies where the You're going to miss the figured I would join them. I came to New York and debt was worth less entire cycle.” I figured they worked for five years at may be right about that, but Chase in investment banking than face value and I planned to be doing dis- and private equity, as well as tressed for a really long on the distressed loan desk. the equity was time, not just for the next As a junior analyst in the few years. I thought the healthcare group, I vividly trading at option tools I could gain in business remember my boss and me school outweighed not be- value...it was very ing able to work on a few working on a proposed M&A deal between two clear that [the distressed credits over the companies that had stock next couple of years. Luck- prices that were trading creditors] were in ily for me, they turned out pretty close to zero. What to be only partially right – I had learned in analyst charge, not the although the default rate training, and what had been had moved materially higher reinforced through that stockholders.” while I was in business point in my career, was that school, there was still a lot the total enterprise value of to work on when I got out, a company is the sum of its including Enron, Adelphia, debt, plus the number of and, even though they were WorldCom, and others. I shares times the market creditors, it was very clear started working at Owl price of the shares, minus that they were in charge, Creek part-time during the cash. But that math didn't not the stockholders. As a second semester of my sec- really work in this situation. junior analyst, a year out of ond year at Columbia Busi- It was very clear that the college, I found that dynamic ness School and stayed on math had broken down, and very interesting and very full-time after graduating. it was because these were intellectually stimulating. So I've been here for almost distressed companies where That gave me a taste for (Continued on page 15) Volume I, Issue XVII Issue 2 Page 15 Daniel Krueger (Continued from page 14) ple of major distressed cy- next 12 months – Greece 11 years. cles. I've certainly learned a may do this, the Japanese lot from Jeff since I joined Yen will do that, China may G&D: How did you make him and I've learned a lot have a hard landing or a soft the decision to join Owl from being in this position. landing – the liquidity of the Creek, a start-up fund at the I’m now a Co-PM of Owl issuer, which we spent ex- time? Creek’s Flagship and Credit tensive time analyzing, is strategies and Global Head almost entirely independent DK: During the summer of Credit. of those things. I know that between my first and sec- I don't need other investors ond years of business “We take risk for a G&D: Could you share in the market to pat me on school, I worked at Angelo some of the unique aspects the back and say, "Good living, all investors Gordon, which was a leader of distressed credit investing job. That’s a smart invest- in distressed debt investing. that you particularly appre- ment and now I want to do, and we are I really liked my experience ciate? make it too." The treasurer at Angelo Gordon. Those of that company will either comfortable with guys have mostly moved to DK: I feel very fortunate to wire us the money at ma- different places now, but Jeff that. What I like work in distressed debt, turity or not. If they do, Aronson and the other especially in schizophrenic then we know exactly what members of the team are about the distressed markets like these where our return profile will be – some of the smartest guys there is massive volatility all the 20 points from 80 to asset class, though, I've ever been around. They around the world. This is 100 plus the coupons. weren't hiring full-time ana- an event-driven investor’s That's a huge asset to have is that the risks we lysts at the time, so they did dream, and no style of value in investing – these defined, me a big service by intro- investing is more event- built-in events. are taking are ducing me to other people driven than distressed, in like Jeff Altman, who is the concentrated my opinion. I always ap- We take risk for a living, all Managing Partner of Owl proach things with the same investors do, and we are Creek. When Jeff gave me around the things mindset asking myself: comfortable with that. an offer, it was really a no- “What is it that I don't What I like about the dis- we are analyzing, brainer because I was join- know, and do I really know tressed asset class, though, ing somebody who already any better than the next is that the risks we are tak- leaving fewer had a tremendous pedigree guy?” What I love about ing are concentrated around and background (from his credit, and distressed in the things we are analyzing, unanalyzable risks time at Franklin Mutual particular, is that you have leaving fewer unanalyzable working with Michael Price), to worry about.” built-in events that you can risks to worry about. Your who was a known money- analyze. For example, here results should, over time, maker, and somebody from at Owl Creek, most of our more accurately reflect the whom I would learn a lot. I best investments are ones quality of the work that you was getting in at the ground that we never need to sell. do and the soundness of the floor, so I looked at it and We’ll buy loans or bonds investment thesis, as op- thought, “This is great, if it and then get taken out for posed to other big-picture works it's going to really, cash at maturity, or there things that can make valua- really work and I would will be a liquidation. tions move up and down have been the first analyst There’s an element of sepa- every day. that he hires. If it doesn't ration from macro events. work – I'm twenty some- We may buy a bond at 80 G&D: Are you involved at thing years old and single. (meaning that the market all in the equity side of I'll go find another job.” price equals 80% of the face things? Luckily for me, it did work amount) that matures in a and it's been a great ride year, knowing that while the DK: I will occasionally over the past 11 years, dur- market may move over the (Continued on page 16) ing which we've seen a cou- Page 16 Daniel Krueger (Continued from page 15) for a security, which scenar- well if they stick to their work on equities. I head up ios are more or less likely discipline and don’t get car- the credit side of the port- to occur, and how much ried away with the sea of folio and my colleague, Jeff money you can make or noise that exists in the fi- Lee, heads up the equity lose in the different scenar- nancial media. side and we both report to ios. Once you’ve estab- Jeff Altman. But there have lished a proper framework, G&D: Could you talk a bit been periods of time over the answer jumps off the about idea generation at the past 11 years where page, and it’s a matter of Owl Creek? “If you use there has been less to do in deciding if the opportunity is credit. Distressed is a cycli- attractive enough to go into DK: Ideas are generated by intellectual honesty cal business and you need to the portfolio or not. everyone, from Jeff Altman know when to really press at the top to the summer to ascribe your bets and you need to G&D: Do your analysts analyst. We don't take a probabilities to know when to walk away. focus on specific sectors or whole lot of pride in idea The trick is that in those are they generalists? ownership here. We're different sets of times when you are sup- trying to make money with posed to be loading the DK: Most people here the capital that we invest. If events, over time boat, it usually makes you start off as a generalist but an analyst comes up with an sick to your stomach to add over time develop expertise idea, they'll bounce it smart investors risk, so it’s easier said than in certain industries. In around with the PMs and done. But in those periods terms of division of labor, it other analysts, getting differ- should do well if of time when we are doing makes sense to have some- ent people’s perspectives. they stick to their less in credit, I might work body who's already looked As an example, one of our on equities. at five media companies analysts was a bankruptcy discipline and don’t look at the next one, if they lawyer for a number of The analyst team here is can. On the other hand, years before going to the get carried away pretty fluid between credit some of the most interest- buy-side and his niche at and equities. You don't ing conversations we'll have Owl Creek is to evaluate with the sea of really notice a difference in around here are the ones the legal component of our terms of the conversations where we get a fresh set of ideas – mostly on the credit noise that exists in around here, whether eyes looking at an industry side but occasionally on the the financial you're talking about a credit or company, which I think is equity side as well. So you’ll or a stock. It's all about: what really separates good usually have multiple people media.” “What is causing the mis- investors from average chiming in on an idea. Our pricing in the market price? ones. We don't think that belief is that the more peo- What advantage do we we're the smartest people ple you have taking a look at think we have in terms of that work at hedge funds. If something, the higher the our view? How high is our we’ve added a secret sauce probability that you either conviction level? What is to our portfolio construc- eliminate what is only a me- our margin of safety for tion, it has come through diocre idea or recognize being wrong?” The answers our group dynamic, con- when you’ve got something to those questions help us stantly reminding ourselves pretty special. To us, that’s decide whether an idea will that we can be shocked by just simple math. I hear go into the portfolio or not, things that were previously some people at other places and, if it does, what size it unknown, and reminding argue that if you open up should be. The framework each other to remain intel- the discussion to too large for analyzing risk/reward is, lectually honest. If you use of a group, then you make it to us, identical no matter intellectual honesty to as- too hard to get ideas into what type of security you’re cribe probabilities to differ- the portfolio, because it’s looking at. Namely, you ent sets of events, over time easy for one or two people need to understand the smart investors should do (Continued on page 17) range of possible outcomes Volume I, Issue XVII Issue 2 Page 17 Daniel Krueger (Continued from page 16) if the price moves against thought “Why did I buy in to torpedo the sentiment. us. If you think about it the 30s?” Then it was in the But I think that’s exactly the mathematically, in a perfect low teens and they thought, point. There are thousands world, if you're looking at a “Wait a minute, what am I of securities out there that bond that's trading at 50 missing? I must not be get- we can invest in today that cents on the dollar and you ting something.” Then the are “pretty good,” but if pass on it, if it moves to 49, CDS [credit default swap] that’s the burden required Pictured: Michael Karsch of it should be slightly more auction (which occurs a Karsch Capital Management to get into your portfolio, attractive now, assuming all month after a default) at CSIMA Conference in then what are you really else is equal. And then at priced the bonds around February 2012. doing to differentiate your- 48 it's even slightly more nine. Granted, Lehman's a self? You know when you attractive, etc., etc. Eventu- very bizarre animal because have something special ally it could get to a point that was of course the big- when four, five, or ten where you think it's attrac- gest bankruptcy of all time. smart people can sit in a tive enough to go into your A huge amount of debt all of room and agree that the portfolio, and let's say that's a sudden went from invest- risk/reward is uniquely at 43. Now, you couldn't ment grade hands to looking good, and I’m fortunate at possibly want to make it a for a home in the distressed Owl Creek to be sur- giant position at 43, other- market, which was not rounded by such people. wise you should have nearly large enough to ab- “...a good investor bought some at 44 because sorb that amount of paper. G&D: When you’ve fully the risk/reward isn't that But that’s the point: a good needs to analyzed something and dramatically different. So investor needs to under- you’re comfortable that it’s we'll usually dip our toe in stand that the value of a understand that the still attractive, do you to start and let the risk/ security is built from the gradually build a position in reward come to us. bottom up, using good value of a security the name or do you estab- analysis, and that markets lish the full position immedi- Our best investments are follow valuation. Not vice is built from the ately? ones where we dip our toe versa. bottom up, using in at, to take the prior ex- DK: As you can imagine, ample, 43 cents on the dol- G&D: Since it's more likely good analysis, and we pass on more than 90% lar and a few days or weeks that a judge or some other of the things that we look or months later it's trading third party will get involved that markets follow at. If it does pass the initial at 31. In distressed, that in the distressed space rela- smell test, analysts will happens all the time. Bonds tive to non-distressed credit valuation. Not vice come into my office if it’s on can move up and down by or equity investing, how do the credit side or Jeff's office 10 points on headlines like you get comfortable with versa.” if it's on the equity side, and litigation outcomes, a the risk/reward of your in- we'll bounce the idea busted financial covenant, vestment ideas given this around a little bit. If it con- the sale of a business, or additional layer of uncer- tinues to look interesting, something else significant, tainty? we'll usually get the whole but sometimes the price can investment team together swing around on no news at DK: That's a great ques- to talk about it. The last all. If the latter happens, tion. You're teeing up an component is to decide that then you can load up the answer that is very impor- we’re ready to dip our toe boat at the lower prices. tant to get across in order in. We very rarely will Lehman Brothers is a great to properly describe the make something a full posi- example of irrational price opportunities in distressed tion right off the bat. Usu- moves – that bond started investing. First of all, uncer- ally what we prefer to do is trading in the 30s the week tainty, to us as distressed make it a small- to medium- that it filed, and then it was investors, is our friend, be- sized position but leave in the 20s and people (Continued on page 18) plenty of room to add to it Page 18 Daniel Krueger (Continued from page 17) man entities, you knew that that a judge's decision on cause uncertainty is some- the numerator in a recovery litigation is an unanalyzable thing investors will pay to calculation was going to be a blue cell. We talk about avoid – sometimes pay a giant number. such things every day here large amount. We love at Owl Creek. We also situations like Lehman which At that point the analysis hire outside counsel to we call “high uncertainty, turns to the denominator – chime in on these issues, low risk.” In those few the other unsecured claims. which is money very well weeks after Lehman filed, In that regard, some people spent when considering we any person's analysis of were talking about these manage a few billion dollars “...uncertainty, to what the ultimate recovery really scary things, swap of credit investments on the would be on those bonds contracts, guarantee claims, long and short side. We us as distressed had enormous holes in it. customer losses, etc., and it run a pretty concentrated Every good analyst who was sounded really bad. But book. We're not the sort investors, is our looking at that situation had what you were supposed to of investors that want to friend, because dozens or possibly hundreds be doing is building your sprinkle our assets across of unanswered questions. waterfall model, under- 100 different ideas. Our 10 uncertainty is But we knew these would standing all of the different biggest positions represent eventually get answered variables, and coming up the vast majority of the something investors over the coming months, with a realistic range of out- credit portfolio, so we quarters, or years. comes from bad to good. If know those 10 positions will pay to avoid – you had done this, you extremely well and we have What's interesting about the would have realized that very high conviction in sometimes pay a process, and about the dis- even in the worst possible them. I can assure you that large amount. We tressed asset class, is that scenario, you still got an as they're trading lower, occasionally you'll be given answer where you're not with very few exceptions, love situations like an opportunity to buy going to lose a lot of money we're not selling them and something at a price where from nine cents on the dol- running for the exits, we're Lehman which we even though you have a lar because you were essen- buying more. And when hundred unanswered ques- tially the most senior part of they trade higher we try and call ‘high tions, you realize that re- the waterfall, and where remind ourselves of the gardless of what the an- across most of the range of need to have the discipline uncertainty, low swers are, you probably outcomes you would be to start to sell things as the risk.’” can't lose a lot of money, making very good risk- risk/reward becomes less and most of the time you adjusted returns. To put favorable because of price will make a little or a lot. numbers around this, if your moves. This buy and sell This obviously assumes that base case showed a recov- discipline sounds pretty you correctly understand ery of 30 cents on the dol- simple, yet all of us know the capital structure, which lar, your estimated claims, that it’s a lot easier said is key in distressed invest- the denominator, could be than done. We try to use ing. Some people looked at twice as bad as in your base the group dynamic to re- a Lehman Brothers holding case and you’d still get a mind ourselves of that on- company bond trading at recovery of 15 cents on the going challenge and to make nine cents on the dollar and dollar and earn a double- sure that we don't get thought about the fact that digit IRR over five years. caught in a trap where we if you deconsolidated the That’s a pretty massive mar- fall in love with our own balance sheet and calculated gin of safety. So high uncer- positions. what the assets of the hold- tainty, low risk is a subcate- ing company were, which gory within distressed that G&D: You mentioned at included individual assets, as we love. the CSIMA Conference last well as tens of billions of year that it's very important dollars of intercompany Secondly, we don't think (Continued on page 19) receivables from other Leh- Volume I, Issue XVII Issue 2 Page 19 Daniel Krueger (Continued from page 18) and build the model very there is to know about eve- to stick to your investment early in the process. If I ask rything else in the universe, process. Could you de- you to analyze a bond that's and these were the last few scribe Owl Creek’s invest- trading at 52 cents on the things you didn’t know. But ment process and how you dollar, and let's say it's a most of the time there's built it over the years? company that makes TVs, two or three big things that your first inclination is to really matter and it makes DK: Generally speaking, read a hundred things about sense to focus the research we're big believers in the the company and go talk to effort there. “This buy and sell notion that you need to them and do a bunch of calls focus early on in the analysis and other stuff. That's all In distressed, specifically, discipline sounds on the major drivers of important work to do, of sometimes you can have a what's going to make or course, but I might suggest situation where the out- pretty simple, yet lose you money in the in- to you that you should do a come is dependent on a vestment, and avoid the all of us know that little bit of work first, and single variable. For exam- temptation to simply go out then you should start to ple, does the intercompany it’s a lot easier said and gather a lot of data. think about what's going to loan exist between Subsidi- The reason I say that is not make that price look cheap ary A and Subsidiary B? It's than done. We try only because it’s a waste of or expensive. Think about either there or it's not, and time to do the latter, but in the variables that go into if it's there your bonds are to use the group the worst examples, extra- the analysis: sales growth, worth par, and if it's not neous data are a red herring margins, capex, whether your bonds are worth zero. dynamic to remind that can cause a person to they win or lose a contract, In that scenario, does it draw an incorrect conclu- ourselves of that things like that, and then really make sense to ask sion. There’s an interesting build your valuation model why ARPU at the holding ongoing challenge book written by the CIA for in Excel, and think about company was down 2% in their internal use that talks what the blue assumption the third quarter? That’s an and to make sure about this concept. The cells are. Without doing a exaggeration, of course, but book can actually be read lot of hard work, you won’t the point remains the same. that we don't get online for free on the CIA’s yet have good views about website – just Google “CIA what the right numbers are We also do a lot of primary caught in a trap intelligence analysis book” to plug into your blue as- research. It's a cliché obvi- and you should be able to where we fall in sumption cells, but you'll ously, but then again there find it. In it, it describes then go out and talk to the are a lot of things in invest- love with our own how the human mind can company and be able to ask ing that people can agree keep very few concepts in targeted questions that spe- are important but which positions.” mind at any one time. As an cifically address the blue they don't actually do. It's example, the book asks the cells. Over time the model not enough to just hear reader to try to multiply any will evolve and become from the sell-side that a pair of two-digit numbers in more refined, and you’ll be certain contract has very one’s head, say 47 X 63. building on earlier work and loose language surrounding This is a task that is easy to making improvements, not the termination rights of a do with a pen and paper but just gathering more facts. large customer. You need is tricky to do in one’s head What I found in my time to go find that contract, if because it’s hard to keep all doing this and going to con- it's in the public domain, and the pieces of the puzzle at ferences or sitting in small you need to read it. Maybe the forefront of one’s mind group meetings, is that a lot you need to ask a lawyer together at the same time. of people will have an hour who's an expert in contract with the CEO and ask about law to read it as well and In that regard, what I say to a lot of industry jargon that give you his or her opinion, the students in my class as a could only possibly matter if especially if that's a big part tip, and something that we you knew absolutely all (Continued on page 20) do around here, is to try Page 20 Daniel Krueger (Continued from page 19) etc. – these are things for mediocre to bad economy, of the risk/reward. which you need a special because it has a lot of catch- The process for analysis in toolkit to analyze. You ing up to do. distressed is very tedious, need to be willing to invest very labor intensive, and the time to look through all Another thing we do as part “I think a lot of very boring. Sure, parts of of the documents and, let's of our investment process is it can be action-packed, like not forget, this is all on top remind each other to tune people mistakenly when you're sitting in court of the valuation work that out the market noise that a and the judge walks out to every analyst would need to lot of us have been tacitly think the task in give you the answer to the do to analyze an equity. So trained to tune in. I think a investing is to try to key question on your invest- you need to be skilled at lot of people mistakenly ment, and you know the valuation, but you also need think the task in investing is predict in which bonds will move 20 points to be strong in your under- to try to predict in which in a few minutes, you’re just standing of all of the struc- direction market prices will direction market not sure if it will be up or tural aspects of distressed go next. It’s a subtle differ- down. But to get to that investing. Then, if that ence, but I think it’s a mis- prices will go next. place you need to have read weren't complicated take from the start to think two credit agreements, 16 enough, you need to under- about it that way, as op- It’s a subtle indentures, understood the stand the motivations of posed to thinking about difference, but I financial covenants back- different people: What potential outcomes and the wards and forwards, mod- does the LBO sponsor want payoff structure across that think it’s a mistake eled out the company's op- to do? Do they want to range of outcomes. What erations quarter-by-quarter extend their option on their the great investors that I from the start to for the next eight quarters out-of-the-money equity or respect most recognize is to understand exactly when file the company tomorrow? that the market is not some think about it that they'll run out of cash, What currency might they wild beast in need of being looked through 8-Ks, pro- have with which to get a tamed, but that mispricings way, as opposed to spectuses, regulatory filings deal done with creditors? in the market are what cre- thinking about to look for intercompany What does management ate the opportunities. And loans or special dividends want? What do employees if your analysis causes you potential outcomes that could have been paid want? What do competi- to have a certain view, long up or down in the struc- tors want? How are com- or short, you cannot expect and the payoff ture, etc. We're generally petitors going to react if this that every day, or every looking at big organizational company goes into bank- week, or even every year structure across structures that have a lot of ruptcy? For example, one you will be rewarded for different pieces, which in- of our current investments your view. We try to use that range of creases the complexity and is in an industrial company. our team environment to outcomes.” workload, but also maxi- A few years ago when the remind ourselves of that, mizes the chances of finding company was distressed and and it’s easier to stick with mispriced securities. their EBITDA was negative, one’s conviction when you their competitors went out have a lot of smart people Take a company like TXU. of their way to lower prices around you also buy into This was the largest LBO of to make it that much worse the investment thesis, as all time, has a huge amount and try and force the com- opposed to being alone in of debt, multiple layers of pany to liquidate. The your view. the capital structure whole industry got screwed (subordinated, senior, and up because of these pricing G&D: Can you talk about a secured) at multiple differ- actions. That didn’t work current investment idea that ent subsidiaries with cross- and the company is still in you like? guaranties, funds flows in business today. Pricing is many different directions, now going through the roof DK: There's a company tax issues that arise from in that industry, even in a (Continued on page 21) the corporate structure, Volume I, Issue XVII Issue 2 Page 21 Daniel Krueger (Continued from page 20) the company, and we cer- would sue these companies called Aiful where we own a tainly didn’t believe that that and drain out cash, and, lot of debt. It's a Japanese liability was fictitious or that indeed, you could see in company that does con- it should be ignored. But their historical financial sumer finance. They pro- what we did recognize was statements the cash coming vide consumers with small out of these companies. micro-loans, generally What we liked about this equivalent to a few thou- dynamic and the risk/reward Pictured: Bruce Greenwald sand dollars. This business of the position at the time is at Graham & Dodd Breakfast doesn't exist in the U.S., that their assets were in October 2012. where credit cards serve “You need to be willing largely unencumbered, this purpose. The back- to invest the time to meaning they had not been ground here is important, pledged as collateral to so let me spend a couple look through all of the other lenders, and, thus, the minutes on that. The rea- documents and, let's company was free to use son this company was inter- these assets however it esting to us initially was be- not forget, this is all on wanted. We reasoned that cause they got into trouble top of the valuation one option for the company a number of years ago when was to sell those assets and the Supreme Court in Japan work that every analyst use the proceeds to pay our ruled that Aiful and certain would need to do to bonds as they came due. competitors had been Another option was to get charging an interest rate analyze an equity. You us to voluntarily extend our above the legal limit. You need to be skilled at bond maturities into the might ask yourself why they future if they granted us the would do something that's valuation but you also assets as collateral. The illegal. In Japan, there are need to be strong in latter was a deal we would different interest rate caps have done because we based on different types of your understanding of would have gone from own- businesses and these com- all of the structural ing unsecured bonds with a panies always pushed the lot of downside in the event envelope in terms of what aspects of the distressed of a default to being secured category they fell into. The asset class. Then, if and very well protected. Supreme Court came back Ultimately, the path chosen and said, "You're wrong and that weren't by the company was one you've been acting too ag- complicated enough, where the assets were gressively all these years." pledged to the banks to get Overnight, giant contingent you need to understand them to extend their ma- liabilities popped up for the motivations of turities a number of years. these companies because As soon as that was done it their former customers different people...” cleared a pathway for our would now be able to sue bonds to get repaid at par them to recover damages upon maturity. for this excess interest. The size of this new liability Fast forward to today – caused Aiful’s bonds to that the liability was not what we own now is that eventually trade down as going to “mature” and be- bank debt which got ex- low as the 30s around the come payable anytime soon. tended, which is a different summer of 2009, for bonds In that respect, we viewed bet. The original idea was a that were maturing in a year our near-dated bonds as liquidity bet where if we got or two. quasi-senior to these liabili- it wrong we were going to ties. Over time, people (Continued on page 22) We didn't necessarily love Page 22 Daniel Krueger (Continued from page 21) capped at par plus interest; proved from 2-to-1 to 5-to- get creamed in terms of our i.e. the shareholders are 1. However much you liked recovery, but where we getting that 67% upside. it at 50, you should really thought our probability of love it at 40. I think a lot of getting paid off at par was Lately, in this environment, people miss this relationship good enough to warrant the we love buying 1st lien bank because they are overly downside risk. Today it's debt. It's very comforting focused on their base case Pictured: Whitney Tilson the opposite – it's a valua- of T2 Partners LLC at to know that when you're a outcome and the return tion bet, not a liquidity bet, secured creditor, you are that one scenario would CSIMA Conference in Feb- where we think our down- first in line and that, almost generate rather than think- ruary 2012. side is limited even in the always, you will get some ing about the range of possi- worst case outcome. We recovery on your paper ble outcomes. If you're not think that the assets of this because it's highly unlikely thinking about how much company, in our base case, that the residual recovery capital you have at risk, i.e. should create enough value value on the assets after the downside, then I think for this bank debt to get bankruptcy fees and liquida- you're leaving out a very back par. In addition to tion fees would be zero. So important part of the equa- that, the fundamentals of if you’re comfortable that tion. the company have been you’ll have some recovery in improving because the cash a worst-case scenario, then G&D: What is another outflows from the excess the upside/downside analysis investment that you like interest liabilities have been becomes really important. currently? coming down recently. We What we say to each other think that the market has around here is that it's only DK: Sometimes distressed “...it's only with the been overly cynical about with the benefit of under- opportunities come in the the ability of this company standing your downside that form of equities, and we’ve benefit of to dig itself out of its hole you can start to dream played a lot of distressed operationally. There’s a about the upside. For ex- equities over the years. We understanding your maturity date in the summer ample, if you have 1st lien like buying out of the money downside that you of 2014, so you’ll eventually bank debt at 50 cents on options at a cheap price, get an answer to the ques- the dollar, and you think the and that’s what you get to- can start to dream tion. In our view, it has ultimate recovery can be day owning Leap Wireless very good downside protec- somewhere from 30 to 90, equity. In fact we would about the upside.” tion because it is secured you would probably buy it argue it’s not even “out” of debt, and you've already because your upside is 40 the money. Leap is a wire- built in a large margin of points and your downside is less company that trades at safety just in the discounted 20 points, so you have a 2- a little over $6 a share. The price from par down to 60, to-1 upside/downside ratio. market value of equity is where it trades today. The Your expected return, as- around $500 million, but upside/downside is very suming a normal distribu- that represents only a sliver compelling, meaning you can tion, is +20% (from 50 to of the total enterprise value. make enough money on the 60). Now imagine that, on What we love about this upside owning it at 60 – i.e. no fundamental news, the idea, and the reason we +67% on your money – to bank debt trades down 20% bucket this as a credit idea, justify the downside risk. to 40 – your upside/ is that you need to under- That's very distinct from downside is now dramati- stand the capital structure buying a bond at 100 cents cally different, even though and the liquidity of this com- on the dollar, where your the price is down “only” pany in order to understand valuation work may indicate 20%. Think about it, from the risk/reward. We think that you’re “covered” on 40, you've got upside of 50 the liquidity profile is decent valuation by 67%, but you and downside of 10, so your enough that it doesn’t need don’t keep that upside be- upside/downside has im- (Continued on page 23) cause a bond is always Volume I, Issue XVII Issue 2 Page 23 Daniel Krueger (Continued from page 22) So we’ve got a highly vola- ton of spectrum that it is to file for bankruptcy any- tile asset where we’ve made not using and it seems sur- time soon, and you’ve got a a bet in a small part of the prising that the management very large shareholder as capital structure and we team has not tried to Chairman of the Board, so have a long period of time monetize it sooner given its you shouldn’t see manage- to find out how things end leverage profile. ment proactively filing the up. So, figuratively speaking, company to the detriment if we roll the “spectrum DK: Actually, my under- of shareholders. So our valuation” die and it hits on standing is that over the starting point is that we’ve one of the upside cases, we past couple of years the got an option that will sur- should make multiples of company has sold a signifi- vive for at least a few years. our money owning this eq- cant chunk of out-of- uity. You can do this math footprint spectrum to raise Then we think about what for yourself and you'll see liquidity, so I don’t immedi- “[With Leap our asset is and what it pretty clearly that you can ately agree with the premise could be worth in different make two, three, four, five, of the question. And as I Wireless equity], scenarios. A lot of people six times your money in said, we think the company like to look at EBITDA mul- scenarios that are not pie in has a decent liquidity run- you can do this tiples for this company, but I the sky. Plus, we get to roll way. Let's say we’re wrong, think that’s really missing math for yourself that die multiple times, given though. The other possible the point, because Leap’s the company’s liquidity. If path for this company is that and you'll see most important asset can- we’re wrong, the stock may they go into bankruptcy. As not be discerned on the go to zero, but we believe I say to my students on the pretty clearly that income statement, but even that is questionable first day of class every year, rather on the balance sheet. given management’s expec- bankruptcy has a negative you can make two, It’s not how much EBITDA tations of turning the corner connotation in society, but they generated over the and getting to positive free bankruptcy and Chapter 11 three, four, five, six past 12 months, it's the cash flow. The debt trades exist for a reason. It exists spectrum that they own, as times your money in around par, at least for now, to allow a company to tran- well as the subscriber base so raising some money in a sition out of its old, bad scenarios that are that they have and all the debt financing is another capital structure into a new, plant and equipment that option for the company if more manageable capital not pie in the sky.” they've accumulated over they choose it. We would structure as smoothly as time. If you think about it never make this a giant posi- possible, as well as restruc- that way and then you rea- tion in our funds given the ture operations via renego- son that other people are downside risk. Rather, we tiation of leases, supply con- buying and selling the stock would size it so we can live tracts, union agreements, based on EBITDA multiples, to fight another day if we etc. So if Leap went into it strikes you that you may roll snake eyes. The point bankruptcy, theory tells you have something interesting of portfolio construction is that creditors will get into a to look at here. We’re not to have enough of a mix of room and negotiate a plan the world's leading experts these in your portfolio of reorganization, vote it on spectrum and we’re not where over time you should through, and then come out going to pretend to be, but do pretty well if you’ve of bankruptcy and continue we know enough about it to properly analyzed the prob- along its path of operations. know that most people are abilities of various outcomes But another thing that fre- in the same camp as we are and how much you make or quently happens in bank- in, even if they don’t admit lose in each scenario. ruptcy is that the assets get it to themselves. The sold to the highest bidder. traded values of spectrum G&D: What do you think If that happens, and if you over time have been all over about the management team go back to that bottom-up the map. there? The company has a (Continued on page 24) Page 24 Daniel Krueger (Continued from page 23) nize that no amount of including a lot of other good valuation work around the work can make an opportu- short ideas, especially when spectrum and other assets, nity appear in front of you. you think about the fact that you can certainly build a The best one can hope for we're a global investor that case for why this stock as the reward for a lot of can invest in any part of the might be worth a lot of hard work is to uncover world. Today, we’ve got money in a bankruptcy. opportunities that already roughly 40% of our credit Pictured: Daniel Krueger GGP is an example of a at CSIMA Conference in exist, but that is not a given portfolio invested in situa- stock that came out of upfront. The reason I men- tions outside the U.S. on February 2012. bankruptcy with substantial tion this is that we try not the long side. value. So it wouldn’t be the to get too wrapped up in worst thing if this company trying to predict what the G&D: Do you utilize credit was on the cusp of bank- future opportunity set will default swaps (CDS) and, if ruptcy and the market in- look like. We find that do- so, how? correctly traded the stock ing so can sometimes cause at pennies on the dollar additional, unnecessary DK: We tend to use CDS because it equated bank- pressure to trade. a lot on the short side. Oc- ruptcy with a worthless casionally we use it on the stock. Clearly, you should The measure of how attrac- long side as well. And be adding a lot more stock tive the opportunity set is at sometimes we do both, on in that scenario if the analy- any given point in time is the same company, by using “We don't play sis hasn’t changed much and how much stuff is getting what's called the “CDS if you thought the risk/ into the portfolio. Right curve” to make very precise very much at all in reward was good at $6 per now we’ve got over 60% of credit bets at some precise share. our assets invested on the point in the future. The on- the new issuance long side in credit, and the-run CDS contract that G&D: As a guest lecturer we’ve also got a lot of expo- most people quote is the market. We view in Columbia Business sure on the short side, so five-year contract. This School’s Special Situations clearly we are finding plenty represents how much you that as our future class recently, Howard to do. Remember that even have to pay per year to buy Marks showed several when the default rate is low, protection against the de- supply of distressed charts of how surprisingly as it has been recently, you fault of a company for five credits.” consistent the high-yield can still have situations years. You pay the same market cycles are. We've where companies are get- amount each year for five been in a period of a lot of ting into trouble but not years, and if a default occurs high-yield issuance and rich defaulting, which creates within the five-year period, valuations for a while now. opportunities for very high then the owner of protec- How are you positioned or returns within a defined tion gets the benefit of get- thinking about taking advan- period of time – i.e. owning ting 100 cents on the dollar tage of the eventual oppor- stressed bonds to maturity. for the notional amount, tunities in that market? and the protection holder Like I said before, we run a returns the post-default DK: We don't play very very concentrated credit value of the bond to the much at all in the new issu- book. You don’t make party who sold the protec- ance market. We view that more money by owning tion. But think about it: as our future supply of dis- more names, you make why five years? It’s a totally tressed credits. We've seen more money by owning arbitrary number. If you this movie before and How- better names. So I don't were properly analyzing the ard Marks is telling you a worry that we're not going credit risk of a company, story of how it ends – it to be able to find 10 to 20 you should be able to form usually doesn't end pretty. high-conviction ideas to a view of the credit profile We don't disagree with that, own at any one time, not (Continued on page 25) but it’s important to recog- Volume I, Issue XVII Issue 2 Page 25 Daniel Krueger (Continued from page 24) September 20th of 2013 for they bust covenants due to within discrete buckets of which we paid 87 cents on financial performance before time. the dollar. the end of the third quarter. Nowadays, a lot of traders In that case, the company will trade CDS contracts So why did we do that? We would survive past the expi- that are four, three, two, did that because this is a ration of the CDS that we and one years out, and distressed company with sold in September, so we sometimes even shorter, in bank debt trading at dis- would again keep the 13 addition to the more cus- tressed levels, and we think points, as both the contract tomary five-year contract. that there's a reasonable we bought and the contract That's very interesting to us probability that in the next we sold would have expired because in very complex few months, the auditors worthless. So we're fine situations you could form will go in to do their review with the company defaulting “So we've the view, for example, that a and they will look at the before June, defaulting after company’s credit risk is company's liquidity profile September, or never de- essentially largely in the twelve months and projections and say “no faulting. If the company between three and four clean opinion.” If that hap- defaults in July, of course, constructed [using years from now, but not pens and they don't get a we have a problem. But before or after that. This CDS contracts] a clean opinion in their 10-K, that's a calculated risk we sort of unnatural credit that would be an event of are taking, and we've sized three-month bond curve could exist for a lot of default under the bank the position accordingly. I reasons, such as how much agreement. We find it very wouldn't advise you to put that is issued on cash the company has on its unlikely that lenders would your entire 401K into this books versus the cash burn, not use that as an opportu- one trade, but within a June 21st of 2013 whether it has an unfunded nity to push the company portfolio of a bunch of dif- revolver, when it might vio- into bankruptcy – and for ferent event-driven ideas, and matures on late the financial covenants good reason – because this it's a good one to have be- in the credit agreement, September 20th of company pays out an enor- cause we think the ability to whether it has a big subordi- mous amount of money in earn the equivalent of 15% 2013 for which we nated bond maturity in a coupons to junior creditors for three months of risk, or few years, whether it has a every year. And every time the equivalent of 75% on an paid 87 cents on big customer contract that a dollar goes to a junior annualized basis, is a mis- might roll off, etc. creditor, that's a dollar less priced opportunity given the the dollar.” that the first-lien secured facts here. As we say I won't mention the name, creditors get to keep upon around the office when try- but right now we have a a bankruptcy filing. So we ing to illustrate the risk/ position in our books where think they would love to use reward of a binary-outcome we own protection through that as a lever to push the idea, if we put this same June 20th of 2013 that we company in. trade on a hundred times bought for 18 points up- over our careers, we will front, but we simultaneously The timeframe for that de- have done very well, even sold protection through fault exists before the expi- though not every time will September 20th of 2013 at ration of our June protec- we have made money. 31 points upfront. We’re tion, and if there is a default, long the credit risk of this our short and long positions G&D: Could you describe company for only three cancel each other out and your strategy on the short months, but we got paid 13 we keep our 13 points. On side and how it’s different points (the delta between the other hand, if the com- from your strategy on the 31 and 18) to take that risk. pany gets a clean opinion, long side, if at all? So we've essentially con- then it will keep chugging structed a three-month along – we don't think DK: In terms of doing the bond that is issued on June there's any material risk that (Continued on page 26) 21st of 2013 and matures on Page 26 Daniel Krueger (Continued from page 25) if something bad happens – tion per year for a couple of analysis on the short side, maybe supply and demand in years, and we'll take the it's the same as it is on the the steel market gets out of position off and move on long side. As you might whack because of all the with life. But if any of these “Let's remember that guess, we tend to short new supply in China, or positions end up working, companies that aren't yet maybe there is a bad global we'll make many multiples in credit – to perceived as stressed or slowdown – we would be of what we're investing in distressed. Occasionally paid handsomely. We don't this trade per year to keep oversimplify it – you we'll press a short when the pretend like we can predict it on. On the short side the are analyzing only company has already bro- with certainty what's going analysis is the same but usu- ken, but most of the time to happen, but we own an ally the attraction is that two questions: First, we will simply buy CDS on option on something hap- we're looking for problems companies where we fore- pening in a realm where that the market doesn't give what is the see some higher probability there's a lot of inherent much weight to today that probability of a that things will get really volatility due to operating we think should have a messy than what is reflected leverage, financial leverage, higher weight. default, and second, in current credit spreads. and cyclicality. Let's remember that in G&D: You’ve been teach- if there is a default, credit – to oversimplify it – The one pushback we al- ing at Columbia Business what will the recovery you are analyzing only two ways get on this idea is that School since 2006. Could questions: First, what is the in Japan, whenever compa- you describe the genesis of on the debt be? probability of a default, and nies get into trouble, the your class and whether Clearly the answers second, if there is a default, banks just come in and bail you’ve seen any change in what will the recovery on them out. They say that the the students since you be- to those two the debt be? Clearly the banks don't really do any gan teaching it? answers to those two ques- credit analysis, it doesn't questions depend on tions depend on a thousand matter what a company’s DK: When they first asked a thousand other other questions being an- leverage is, what its cash me to teach the class, I said, swered, but if you're not flow is – if it’s a big indus- "No thanks. I think that's a questions being thinking about it that way trial company, it asks for the poor idea for a class be- then you're not really doing money and gets it. First, we cause distressed investing is answered, but if credit analysis in my view. disagree that this is always really the intersection of you're not thinking So as credit investors, and true, as we've seen some value investing (I'm not go- especially as distressed in- Japanese companies go into ing to compete with Bruce about it that way vestors, we're built to ana- insolvency proceedings. Greenwald and all these lyze and opine on tail out- Japan Airlines and Elpida are other fabulous professors then you're not really comes. examples. I also feel like in on value investing), bank- doing credit analysis an environment where ruptcy law (no one can Japanese steel companies, there's already a tough eco- compare to Harvey Miller, in my view.” on which we own a lot of nomic landscape, to think who teaches that at the Law CDS, are extremely lever- that the system needs to School), and turnaround aged, and bankruptcies in continue to exist to subsi- management (again, some- Japan tend to produce hor- dize the highest-cost pro- thing that is already taught rible outcomes. I think the ducer of steel in the world very well).” They asked me average historical recovery doesn't ring true when again a year later, and I rea- over a long period of time viewed through an eco- soned that rather than try has been roughly 13 cents nomic lens. and teach those things, I on the dollar, much worse would just be the professor than in the U.S. where it's in We may get this wrong, and who gathers it together and the 40s. The steel industry if we do we will have lost a puts it in a package that as we all know is a very couple of hundred basis involves making money – cyclical industry. By owning points on the notional posi- (Continued on page 27) CDS we own an option that Volume I, Issue XVII Issue 2 Page 27 Daniel Krueger (Continued from page 26) think it will be almost im- bor. It was just the three of making good risk/reward possible to teach these 40 us on the investing side and decisions. to 45 students about dis- we were trying to make a I tell my students that, first tressed investing because go of it. In that sort of sce- of all, I truly believe the it’s a very daunting topic and nario, the world is your class and the skill set of dis- something that, in a lot of oyster. tressed investing is some- ways, you really can't teach. “In a Warren thing that doesn't only apply You learn it on the job over In distressed specifically, like to distressed investors. I Buffett-style of a number of years. I still I said before, you learn on think it's a very useful class learn something new every the job. A lot of people in to have taken if you're going value investing, if day, which is why I like my distressed have a broad to work in private equity or job so much. array of different back- your most if you're going to work in grounds: turnaround advi- equities. How many times G&D: Do you have any sors, lawyers, bankers, sell- important asset is have we seen equity inves- advice that you would give side analysts, private equity tors and equity sell-side to students interested in investors, etc. So if you're a your human capital analysts get caught in a trap distressed investing? second-year student at Co- because they didn’t look at a you need to set it lumbia Business School to- company's capital structure DK: My advice for business day and you think you defi- or think about its liquidity? on a growth school students generally is nitely want to go into dis- If you're just looking at a P/E that the most important tressed, don't think that if trajectory with multiple, you're not captur- asset you have at this stage it's not your first job out of ing a lot of other things that in your career is your hu- business school that you double digit CAGR are important to your stock. man capital, not your finan- can't find your way in even- Areas such as advisory and cial capital. Occasionally I tually. When we hire peo- for a number of consulting at some time or see people worrying about ple to come in at the analyst another also touch the dis- years. In a number who's going to pay them the level here at Owl Creek, we tressed landscape. Even if most or which firm has the expect them to have a pas- you're the CEO of a com- of years that will most glamour attached to it, sion for investing and a lot pany and your company which I think is a mistake. of raw horsepower, but have grown into never goes into bankruptcy, In a Warren Buffett-style of they don't need to be Seth your competitor might. If value investing, if your most Klarman their first day on something that's this happens, what is the important asset is your hu- the job. They need to be competitor going to do? man capital, then you need people who are smart, who powerful and useful Who's going to buy them? to try to set it on a growth have the right skill set, and Are they going to shut all of and something that trajectory with a double- who we think can develop their plants? Are they going digit CAGR for a number of into good investors over to slash their labor costs will be even more years. After a while, that time. and use that to under-price will grow into something important to you.” you? There are a lot of powerful, and then you’ll G&D: Thank you very different things that could have many more options. much for your time, Mr. happen. So these are all The way you do that is to, Krueger. things that pop up in dis- first of all, find a job working tressed and pop up in my with people who you like class. and in an environment where you can do meaning- I've always been very im- ful work and learn a lot. pressed by the students in Certainly that's what I got my class. I'm always very when I joined Jeff here at excited to see the progres- Owl Creek. It was Jeff, me, sion from the first day of and one of my classmates class to the last day. At the from Columbia, Shai Tam- start of every semester, I Page 28 Frank Martin (Continued from page 1) a fighter or attack aircraft primarily comes in print After graduating from off carriers. I defaulted into form. I also watch Bruce Northwestern University in 1964, Mr. Martin served as my investment management Greenwald, your professor an officer in the Navy for career because I flunked the at Columbia Business two years. He is an avid flight physical three times School, from time to time reader, writer, and due to an astigmatism, on video, along with other philanthropist. He is which is a minor eye investors I respect such as Frank Martin founder and chairman of disorder. So I didn’t lend Kyle Bass and David DreamsWork, a mentoring Coke machines or conduct Einhorn. and scholarship program other for-profit endeavors for inner-city children. He as the child prodigy, Warren Another positive is that my “We call Elkhart received his MBA with honors from Indiana Buffett, did. commute is 10 minutes. ‘Omaha University South Bend in Compare that to how long 1978. Finally, perhaps as a means the average New Yorker East’ [laughs]. I of compensation, a latent spends getting to and from G&D: Can you tell us and almost insatiable desire work, and you get an idea of can’t think of a for knowledge and wisdom the competitive advantage I about your background and better place to be how you became interested emerged and I became an have. But I also have in investing? avid reader. I suspect I read another edge. I get up than in Elkhart, or a at least 30 hours each week, seven days a week at 4:30 in FM: As an investment between books, periodicals, the morning. The first four better place not to and the current news. I hours are the most management major, I took a be than in New course during my senior avoid all the social media productive in my day. year at Northwestern on sites but am fastidious about There’s an old adage that York. I don’t get the security analysis. The emails. says, “An hour in the teacher was an adjunct morning is worth two any typical distractions G&D: Your firm is located other time of the day.” In faculty member, Corliss in Elkhart. … I think Anderson, who was one of in Elkhart, Indiana, far away terms of staying current, at the founders of Duff, from New York City, the 4:30 I begin with the it’s a lot easier to be Anderson & Clark, which hub of the investing world. internet versions of the was a Chicago-based In what ways has this been a Financial Times and The New independent without municipal bond firm that has positive for you? York Times. I then read The the herd pushing since been broken into Wall Street Journal and sign pieces. Anderson was the We call Elkhart ‘Omaha onto Bloomberg early to you toward the perfect mix between the East’ [laughs]. I can’t think read the news and check theoretical and the practical. of a better place to be than the global markets. I usually mediocre middle. I He had been in the field, in Elkhart, or a better place get this done before 5:30 in know for sure it’s and he used Graham’s not to be than in New York. the morning. The Economist Security Analysis as his I don’t get the typical is on my list, but not as a much easier to think textbook. It was a distractions in Elkhart. We daily read. Given the independently.” watershed event for me. have no watering holes, at abundance of information, least so far as I am aware. I the biggest challenge for all But I have to tell you, unlike haven’t been to a bar in my of us is to separate the a lot of the investors you’ve life for after-work drinks. I wheat from the chaff. By featured in Graham & think it’s a lot easier to be limiting myself to an hour Doddsville, if I had any independent without the for current news at the epiphany, it really occurred herd pushing you toward beginning of each day, I in slow motion. I went to the mediocre middle. I effectively impose a time Northwestern primarily to know for sure it’s much filter that forces me to seek become a Navy pilot, so I easier to think out the meaningful over the was a naval ROTC student. independently. I control trivial. My dream as a kid was to fly most of my input because it (Continued on page 29) Volume I, Issue XVII Issue 2 Page 29 Frank Martin (Continued from page 28) CDs yielding 14%, why came down those high G&D: What led you to the would I lock myself into a coupons kept looking better founding of Martin Capital 20% tax-exempt bond?” As and better. So I was kind of Management? we know, one of the great a local hero there for a challenges in our profession while. Then, when the FM: It took me 20 years to is to see beyond the municipal yields fell, the get there! I started in 1966 moment, even though most spreads narrowed. The on the sell side with people live in that space. M&A world came alive. So Walston and Company. My since I was used to doing mandate was to go out and these kinds of long-tailed sell. The product de jure transactions, it was an easy was, believe it or not, transition to M&A. When Hedge Fund of America. I Walston failed, I sold our was told as a rookie that “At one point in the office to McDonald and Hedge Fund of America was Company in 1974, which designed to make money on early 1980s, the had a strong presence in the the long and the short side. lowest-yielding tax- municipal market, and were But I learned in 1969 that guys who I greatly admired you could actually lose exempt bond I had who were very skilled in the people money, even with M&A arena. They were hedge funds, which left a in my own portfolio great teachers. One of really bad taste in my those teachers, Mark mouth. was 14%. That was Filippell, eventually co- back with 50% tax founded Western Reserve I didn’t like this idea of being Partners and I sit on the in a position where you rates. So gross that M&A firm’s board. could actually lose people money as a fiduciary. So I up, and that’s a I cut my investment teeth in spent the next 10 years on the early 1980s; I had to the municipal finance side of 28% equivalent, make one correct decision the business. As interest at that time – I had to rates rose through the which is three times believe that interest rates 1970s, it was a very fun would come down. That business for me. At one the Ibbotson return was an easy call, I felt, point in the early 1980s, the since 1926. That’s because the U.S. Dollar was lowest-yielding tax-exempt clearly the world’s reserve bond I had in my own a no-brainer type of currency, and in that role, portfolio was 14%. That we simply couldn’t be was back with 50% tax investment.” running a double-digit rates. So gross that up, and inflation number indefinitely that’s a 28% equivalent, or we’d lose our credibility which is three times the completely. If interest rates Ibbotson return since 1926. came down, then P/E’s That’s a no-brainer type of Through sheer persistence would come up, and stocks investment. and force of will, I managed would be an excellent play. to convince some people. If interest rates came down, Since I originated these The nice thing about selling bonds would be an even financings and had some people 20-year tax-exempts, better play. I put my entire access to investors in the which were all callable in 10 retirement plan in 13.5% 20- area, I asked them if they years, is that they think year zero-coupon bonds. wanted to participate. Of you’re a genius for the next That was an automatic 12- course, most of them said in 10 years because as rates (Continued on page 30) the early 1980s, “Jeez, with Page 30 Frank Martin (Continued from page 29) U.S. treasuries when fascinating and equally bagger without any credit or October 19th hit. I had been perilous time because the duration risk – all in U.S. writing for a long time public, which had long been treasuries, which then about the dangers that I had absent from the market as allowed me to do a lot of seen. So even though I was measured by the ICI fund other things. In the 1980s I a startup and didn’t have flows, came back in spades. had more ideas than I had that many clients, I was able I think there were 5 million money. Three clients and I to call all of them that night families that were in funds bought a 25% stake in a and say, “Your portfolios at the beginning of the bank at 50% of book value are actually up for the day decade and nearly 50 million that was well capitalized and because of the flight to at the end. So it became an returning 15% on equity. safety.” I got off on a good increasingly retail-oriented Once again, the math is foot with my new clients in market. The 1990s were pretty simple – 15% on 1987. capped off with the dot com stated equity is 30% on my bubble and the insane cost. I bought a lot of it, valuations, so during that and it was ultimately a 10- time I was mostly playing bagger. We had a few “When it comes to defense. Of course, I was other ideas like that and I still collecting good coupons thought it was prudent to compounding, I’m from the tax-exempt bonds. make big bets because The year 2000 was a not sure everyone investors were generally watershed year for me. I over consumed with understands that thought anything technology avoiding risk. In other -related or dot com-related words, the antithesis of percentage losses was insanely expensive. But today. The 1980s were just the bifurcation of the an incredible time to be an and gains are not market was clear. I could investor. And I hope – and buy mundane manufacturing expect – that someday we equal. I’ve always companies – the ‘main may find ourselves in an street’ companies, if you will managed to avoid environment where risk is – on the cheap. So if you overvalued and return is the large losses. look at our investment underpriced! And this time, results from early 2000 to double-digit interest rates Imagine something 2001, we were up sharply may not be the cause. while the market was down. as simple as that As you can imagine, we fell When I was 36 (1978), I was behind the markets in the diagnosed with multiple being one of your late 1990s. There was no sclerosis (MS). I knew that way you could keep up with secret sauces!” the life of a mergers and the near doubling of some acquisitions banker, which is of the technology-related all travel and pure madness, indices during the height of would not be the career for G&D: Given that the the bubble. But we made it me in the later stages of my macro environment plays an up by going up when the life. So I went back to important role in your market went down in the school at night and had a investment style, can you early part of the next wonderful time earning my talk about how you’ve decade. When it comes to MBA and the CFA charter. thought through some of compounding, I’m not sure Just before the market crash the significant events of the everyone understands that in 1987, I hung out my past 25 years? percentage losses and gains shingle. 1987 was beautiful are not equal. I’ve always because I was fully invested The 1990s were a (Continued on page 31) in tax-exempt bonds and Volume I, Issue XVII Issue 2 Page 31 Frank Martin (Continued from page 30) you hope to achieve well. It was a simple call. managed to avoid the large competitive long term Deep out-of-the-money losses. Imagine something compounding. Although puts were exceptionally as simple as that being one most of the time I am a long cheap, unlike today. You of your secret sauces! -only investor, the financial almost couldn’t afford not system had become so to do it. Kyle Bass calls The same thing really untethered from reality that such situations “asymmetric happened later on as we I wound up doing what bets,” where the payoff is approached the financial Michael Burry later many times the risk crisis. It was pretty easy to described as “going long the incurred. They are as rare see that what I called “the short side.” I tried to sell as they are profitable. easy money fool’s rally” of everybody in the firm on [*Editor’s note: all of the 2003-2007 was going to end the idea of buying puts on opinions/events/decisions and badly. You couldn’t the investment banks. As so on referred to in the describe it exactly. Ben was thoroughly documented interview were chronicled real- Graham said, “You don’t in Chapter 10 of Decade of time in Martin Capital have to know a man’s exact Delusions*, it was Management’s annual reports weight to know if he’s understandably a tough sell. – several reaching 100 pages obese.” Like in the early So I went through the – that became the grist of two 1980s when buying long- investment banking section books, Speculative term bonds, I only had to be in Value Line and picked Contagion (2006) and A generally right. Anecdotally four or five companies that I Decade of Delusions you could look at things, thought were candidates. (2011).] such as house prices, the Bear Stearns had won the impending end-game of Investment Bank of the Year Let’s go back to the year Hyman Minsky’s financial award for three years 2000. I looked at valuations innovation hypothesis, a running, so I figured that using a crude approximation shamefully lax financial they had lots of hubris. Like of what Bob Shiller turned regulatory environment, and a superficial Michael Burry, I into something incredibly the perverse incentives up read a couple of their high- helpful. The Shiller P/E ratio and down the food chain, yield money market fund uses inflation-adjusted data which included the rating prospectuses from cover to and 10-year moving agencies that became cover, which was quite a averages of earnings. complicit by abdicating their job. I thought, “Oh my Valuations were in the role as watchdogs. And the goodness, these guys are insane area – they were list goes on. I looked at smoking dope!” So Bear much higher than where structured finance deals, and Stearns was an easy they were in the late 1920s. the whole idea of candidate. Of course, I looked at the broad-based overcollateralization or Lehman was always playing inclination to take redundancies, to the extent it a bit fast and loose and unrewarded risks – the they had any, and the idea of too close to the edge in speculative contagion, which layering risk in tranches to terms of leverage, so it was had permeated Wall Street get higher ratings struck me another easy candidate. and particularly the retail as insanity. I didn’t know it Merrill Lynch was our investor. We hadn’t gotten would end as badly as it did, custodian before we moved into the huge leverage however. to Fidelity, so I had some problem yet. I believed personal experience in then as I believe now that I came back from the dealing with the chaos at we were at a secular market Berkshire meeting in May Merrill. Call it envy, but I, top. If you look at the 2007 thinking that Charlie like Michael Lewis, always Shiller data, these markets Munger was right – you felt that Goldman Sachs was typically don’t clear until the must avoid catastrophic pushing the envelope as (Continued on page 32) losses in your portfolio if Page 32 Frank Martin (Continued from page 31) the downside. If our FM: I would like to think Shiller P/E gets below 10 competitors behave that that being defensive is an times, and sometimes way and we understand the educated conclusion. The materially below. difference between time- first book, Speculative weighted and dollar- Contagion, came out in 2006. Buffett at the same time was weighted returns, the At the time people said to writing about 17-year “edge” of our sword cuts me, “Gee, I like your book, cycles, which I had thought two ways! but I have no idea how to a lot about, and I agreed pronounce the title.” I with. Around 2000, I wrote would say to them, “You that I wouldn’t be surprised wait, in a few years, the if a 6% coupon U.S. treasury word ‘contagion’ will be would outperform the part of the common equity markets through the vernacular of the trade.” next cycle. Once again, the This is, of course, what has beauty is in its simplicity. “The problem with happened. So the title was Let's say in 2000 you bought ahead of its time, but I’m a 6% 20-year zero-coupon [investing in not sure the book was. A treasury. Today, it’s got Decade of Delusions was sort seven years to run. It government bonds] of a capstone in 2011 for would have cost you 33 the preceding decade, which cents on the dollar. I think is the institutional was a decade that I have felt because of the low five-year had been way too risky for rates, it would be selling at imperative. People two reasons. First, 96 cents on the dollar. don’t pay us to valuations had been That's an internal rate of stretched, certainly if you return of just under 9%, think, they pay us used the aforementioned versus a sub-2% return, Shiller P/E. Second, because including dividends, for the to act. They don’t of increased financial S&P 500. The S&P 500 leverage throughout the would have to be at 3,500 pay you for playing world, tail risks had to match the zero. increased greatly. With that good defense; they overhang throughout the The problem with that is pay you for playing decade, I was thinking to the institutional imperative. myself, “Wow, what I don’t People don’t pay us to think, good offense.” need to do is get blindsided they pay us to act. They because we are paid on don’t pay you for playing performance. I don’t want good defense; they pay you to get underwater.” You for playing good offense. can’t afford to get deep One would think that underwater if you really everybody understands expect to achieve good long Einstein’s great insight – that G&D: Much like in the late -term compounding. I’m compound interest is the 1990s, your defensive invariably defensive too most powerful force in the nature served you well early as I was then. And I universe. We all are aware during the market run-up justified that because of the of the simple example that a and collapse following the optionality of cash, the 50% loss requires a 100% financial crisis. Could you aforementioned gain to equal things out. Be describe your defensive overvaluation, and the tail that as it may, people would nature and this latter period risks that I think people had rather play offense and then a bit? not priced in. I hope that lick their wounds after they (Continued on page 33) have a bad experience on Volume I, Issue XVII Issue 2 Page 33 Frank Martin (Continued from page 32) I also think people’s be on the global stage. I sometime in the not too expectations related to jobs could see a renaissance in distant future, the markets have been greatly manufacturing in America will complete what I downsized. People are because of the traumatizing consider the ultimate end thinking much more events through which labor phase of a secular bear rationally. A job is no has gone. Workers have market that really began longer an entitlement, it is a reordered their with the peak in 2000. This expectations – we’re not Pictured: Mario Gabelli and is clearly a minority view. going to have folks at GM David Winters at Omaha “I would ask the making, with benefits, Dinner in May 2012. G&D: In your opinion, are anything comparable to the market and the question, can the what they made in the American economy on their heydays. I think we’re going way to being mended and excesses built up to spend a lot of time attractive or does it remain focusing on those areas as “deluded” as it was from the success where manufacturing can during the last decade? enjoy a renaissance and generated by a long where labor inputs will be I would ask the question, period of conserva- reasonable on the world can the excesses built up stage. I think that’s really from the success generated tive economics and exciting. Matt Ridley’s, The by a long period of Rational Optimist, helps one conservative economics and deregulation be understand where the deregulation be cleansed in opportunities just might a matter of six months from cleansed in a mat- arise. September 2008 to March of 2009? I don’t think ter of six months On the other hand, profit human behavior works that from September margins are peaking. Top- way. Most of us need to line growth hasn’t been have a trip to a woodshed 2008 to March of there. You can’t cut costs before we begin to mend to prosperity. You our ways. There’s a good 2009? I don’t think eventually have to have top- analogy with the labor line growth. The economy market. Labor has been human behavior continues to struggle. I’m bludgeoned in part because worried about the fact that of the excesses in the works that way. tax revenues have averaged financial sector. And many 18% of GDP – true over the Most of us need to homeowners, who are part long-term, with a low of the labor pool, have also have a trip to a standard deviation, and been suffering greatly. I seemingly impervious to think this will be resolved woodshed before how high the top marginal through a significant tax rate is – and we’re behavioral change. People we begin to mend spending at a rate of more will not use their home as than 24%. It’s that issue an ATM. They will not use our ways.” that I think we have to homes as a way of making a privilege. What’s going to address at the legislative quick profit. Throughout happen, I think, is that the level, which I don’t think has my investment life, people longer this goes on, the much of a chance of used their home as a way to better our workforce’s occurring for some time to build up equity by paying attitude toward laboring is come. down their mortgage, not as going to be, and the more a speculative vehicle. competitive we’re going to (Continued on page 34) Page 34 Frank Martin (Continued from page 33) today. That’s why I think down, especially over the Additionally, I do think that Dodd-Frank is the toothless last decade, that I’ve missed the capital markets have not tiger. All this leads me to a lot of layups that I could gone through any kind of believe that we’re just have had if I had been just a catharsis of the sort that playing games with little more open-minded and labor has. Labor no longer ourselves. The bell curve is shorter-term oriented. I’m has a powerful lobby but a joke, and value at risk is a like Bob Rodriguez in that capital does. I recently read concept that is a really lousy I’ve been very defensive that $3.6 trillion of measure of true risk. I think since the summer of 2010, corporate bonds were sold you’ve got to gross up risk and that has not paid me by mid-December 2012 – at the big banks, derivatives very well because the who’s buying those? Well, risk in particular. If you do default asset class, for a guy it’s in part the small investor that today you’ve got who’s looking for some who’s disaffected with yourself a crisis. So the place other than the market equities and bound and world’s financial system to put his money, doesn’t determined to get some remains in a critical state. yield anything. So for the yield out of something, so Basel II allowed the first time in my investment he’s stretching out the risk European banks to go to a life, there is not an curve and scrambling for 2% capital ratio. Is that not alternative that actually pays some sort of return. a prescription for disaster? me something. I just don’t think we’ve The shadow banking system written the final chapter in But believe it or not, when in the United States is $25 this. We are at a critical it comes to individual trillion, I believe, and $65 state, but I have no idea security selection, we are a trillion globally. Neither what the catalyst is. bottom-up firm. We’re not domestically nor globally interested in cigar butts; have the numbers changed G&D: Can you talk about we’re a classic Buffett-type much since 2007. In the the investment strategy at investor. We want United States, total assets in Martin Capital Management? companies that we don’t our banking system are $13 have to sell unless the trillion. So the shadow FM: I would like to say that market bids them up to banking system, which is we’re a situationally- uneconomic prices. For mostly asset-backed lending, sensitive value investor. example, Gentex is one of is double the size of the Everything is situation- our current holdings. regulated lending market. specific. The situation I’ve We’ve actually bought Ben Bernanke really doesn’t just described is one that Gentex twice. I love buying have as much control over suggests that tomorrow’s the same company twice the financial mechanism as opportunity set may be because you’ve already done most of us would like to better than today’s. So your work. It’s very think. You would have sometimes you have to play efficient. I bought it the first thought that the whole defense. You’re always time in late 2008 and again shadow system – the arms- trying to find fish that swim recently. The business length securitization system against the stream, but performed beautifully during – would have collapsed, but shopping in a crowded big- the recession, but the stock the numbers suggest box store shortly before became too expensive. otherwise. This all tells me Christmas is really Then they had some news that 2008-2009 wasn’t problematic. What’s your regarding their rear camera cathartic, and that we’re edge if you’re piling in there display option, which was kind of back to the old with everybody else? This is negatively received. The games. often a significant failing on cameras were going to be my part – I think I’ve been placed on the dash instead The banking lobby is just so preoccupied with top- (Continued on page 35) incredibly strong, even Volume I, Issue XVII Issue 2 Page 35 Frank Martin (Continued from page 34) G&D: Many value both human and institutional of in the mirrors on a investors tend to avoid behavior are vital to long- couple of their big macroeconomic thinking in term investment success. customers’ cars. But I their individual stock I’ve seen a lot of very smart didn’t think that this selection. Why is it so people who have lacked development was that important to understand the these virtues.” material, and I love the top-down perspective along demonstrated productivity with bottom-up analysis? I was reading this and of their research process. thinking, “Where’s the The stock tanked a number FM: Because I think this is bottom-up stuff in this?” of months ago, so we took a really a fascinating subject, Was this kind of a quiet big position in it again. I and I notice that most value warning to the world that “But I think also really admire the CEO. investors are primarily things were crazy? Based bottom-up. I took you on his subsequent behavior, [Warren Buffett] The first document I read through the decade of I don’t think it was. But I on any company is the delusions, but let’s go back think he hit the nail hit the nail proxy statement because I to 2006. The 2006 absolutely on the head. want to know where the Berkshire Hathaway annual There are times where absolutely on the incentives and rewards are. report came out in March of you’ve got to think top- Obviously I like owner- head. There are 2007, and the meeting was down when the risks I operators, but you don’t May 5th of 2007. So I’m mentioned earlier are times where you’ve find those in the big-cap reading the annual report present, perhaps in spades. companies. Then you’ve got about what Buffett was That’s why I think as I do, got to think top- to read the 10-K to find out looking for in a successor. and that’s why I hope that what the real story is, Let me read you these two my job will become down when the because the 10-K is the short paragraphs: immediately redundant annual report without the when we experience the [macroeconomic] adjectives. If you strip out “Over time, markets will do downside of the cycle. This the adjectives in an annual risks I mentioned extraordinary, even bizarre, is really critical to how this report, it looks pretty bland. things. A single, big mistake might differentiate me. As I earlier are present, Of course the 10-K requires could wipe out a long string say, it’s situational. When disclosures like risk factors of successes. We therefore stocks are cheap, and tail perhaps in that you would never put in need someone genetically risks are priced in, or we’ve an annual report. If you’re programmed to recognize gotten rid of some of the spades.” comfortable with a company and avoid serious risks, tail risks by addressing some after you get through those including those never before of the still excessive two documents, then it’s encountered. Certain perils leverage throughout the time to see if management that lurk in investment entire system, then you squares up with what the 10 strategies cannot be spotted really won’t have to worry. -K says. I also always read by use of the models The biggest tail risk, five years’ worth of glossy commonly employed today obviously, is still financial, annual reports, and I always by financial institutions.” unless you listen to Leon read them in one sitting. Panetta saying that we might It’s a great exercise. You Now I would say that have a cyber Pearl Harbor. would not believe how there’s nothing micro about But that’s so abstract that I many companies’ reports that, nothing bottom-up. can’t price it in. But the are so different year-to-year And then he goes on to say: “gray” swan risk of another that you don’t even leg in the financial crisis is recognize them as the same “Temperament is also real. While we can’t assign company. I want to make important. Independent a probability to it, it’s sure that one year is not thinking, emotional stability, nonetheless real. inconsistent with the year and a keen understanding of (Continued on page 36) preceding. Page 36 Frank Martin (Continued from page 35) The Crowd, written in 1895 that we’ve barely begun a G&D: Could you describe by Gustave Le Bon, is deleveraging cycle that will the interaction between you probably the most impact growth for a long and your team? instrumental book in time, that’s not a bet I’m framing my ability to go willing to make. FM: The dynamic tension against the grain of that exists between my conventional thought and At Northwestern I took a Pictured: Bruce Greenwald team and me is a good thing not feel insecure. Le Bon survey course in religion in and David Einhorn at because the guys force me CSIMA Conference in Feb- basically said that when one which I read the great to keep my bottom-up eyes joins a crowd – when one theologian Reinhold ruary 2012. open, and I force them to becomes part of the herd – Niebuhr’s Moral Man and keep their top-down eyes he tends to function at a Immoral Society and was open. So I like that tension. much lower level. In the enamored with it. It was We all get along. This is a capital markets – because of my first introduction to group that appreciates my the Bloomberg terminal, crowd behavior. When perspective, and I appreciate because of instantaneous Extraordinary Popular theirs. We have an open communications, because Delusions and The Madness of forum – everybody can say everything is live and online Crowds came along, I what’s on his mind. – we can create devoured that. The title is Ultimately, I make the final instantaneous synthetic so descriptive and so decision, but I respect these crowds. This whole timeless; think of how well guys, so I listen to them. business with ‘the Fed has it describes the mood of our back, that as long as the today. Bob Shiller is a G&D: You said in your Fed is going to keep the leading light among a book, A Decade of Delusions, spigots open, you’re not growing group of behavioral that you attempt to going to get a bear market,’ economists, and his Irrational continually understand the is a simple suggestion – Exuberance, published in psychology of the according to Le Bon, the early 2000, revealed his marketplace to gain a crowd loves simple multidisciplinary capacity. I competitive edge. What is suggestions. almost didn’t read the the genesis of your interest Understandably, it is second edition that came in, and commitment to, incapable of complex out in 2005, because it was understanding the reasoning. Imagine the edge essentially a reprint… psychology of groups? one has if one simply except for a rather disassociates himself from fascinating discussion on the I think this is something that the crowd. emerging real estate bubble! I hope you will put in your What he said in a practical mental hard drive, because For example, I think many sense resonated so well it’s been a great asset to me investors are misreading with all the social science over the years. Again, I live what the Fed is doing today. theory I had read. I’m in Elkhart, IN. It can be Once they submit to the deeply in his debt. I just very intimidating reading the will of the crowd they are read Daniel Kahneman’s guys interviewed in Graham almost Pavlovian in Thinking, Fast and Slow, and I & Doddsville, or, if I’m responding to the simplicity think that he and the late inclined – which I’m typically of the “Bernanke put” and Amos Tversky are some of not – to watch CNBC and are thus oblivious to the the great behavioral the talking heads. There are long-term consequences. scientists. Since nobody in some guys in this industry Somehow this has to be our industry thinks about who are really smart. So I unwound. Everybody this very much, I think about may ask myself, what edge thinks, “Well we’ll just grow it a lot. do I possibly have with this our way out of it.” Well, crowd? perhaps we will, but given (Continued on page 37) Volume I, Issue XVII Issue 2 Page 37 Frank Martin (Continued from page 36) there’s a chance the future that cash is a good hedge G&D: Even Kahneman will prove that I’m wrong against deflation and a admits that knowing about about a decision that I’m respectable hedge against the failings of human considering, whether I’m inflation, and offers huge psychology and decision- wrong because of biases or optionality, is that I’m going making doesn’t mean you I’m wrong because I to let an opportunity slip by. won’t still fall prey to them. incorrectly assessed the The beauty in this business Are there specific steps in situation, if the downside is is that there are just hordes your investment process permanent loss of capital, I of future opportunities that ensure you won’t fall waiting and some of them prey to these biases and may be huge if you’re heuristics? “If there’s a patient. And I think Ben Franklin summed it up well: FM: That’s a problem chance the future “He who has patience can everybody has to have what he will.” acknowledge that they have. will prove that I’m It’s painful to read a book For those who are long with wrong about a like his because you wonder the throng, they’re going to just how much of your decision that I’m have to explain, if I’m right, subconscious biases are why they’re down, say, 50%. ruling your decision-making. considering, I’ve never been in that I try to benchmark my position; our clients have thinking, and thus try to whether I’m wrong never suffered a bear override my biases, by market. In bull markets, frequently looking at a host because of biases you underperform. Being of charts I’d made using Bob down under 7% in 2008 and or I’m wrong Shiller’s 10-year moving being up so nicely in 2009 average data. I’m aware because I probably put us in the top that biases exist. What I 5% of our class. But we don’t know is to what incorrectly trailed pretty significantly extent they invade my from 2003 to 2007. And otherwise rational mind. assessed the I’m trailing now again. So Clearly they do but I am I’m a classic ‘win by not utterly uncertain as to how situation, if the losing’ guy, at least for the much. I find some solace in time being – at least in this downside is the Bertrand Russell quote: high-tail risk, overvalued “The trouble with the world permanent loss of market. But I will welcome is that the stupid are when “this too will pass” cocksure and the intelligent capital, I can’t go because this is no way to are full of doubt.” live. I’d rather be totally forward with that focused on individual I agree with Nassim Taleb – companies, fully invested, whose work I find incredibly decision.” and sticking the ones I really stimulating although he can like in a lockbox – like be an offensive writer – that can’t go forward with that Gentex – not even thinking everything has to go decision. If the downside is about it for five or ten through the Pascal’s Wager the loss of an opportunity, years. filter (he couldn’t even then I’m okay. By playing resist taking issue with the defense like I’m playing right G&D: Your firm’s annual great French now, the worst that will report shows that since mathematician’s and happen to those for whom 2000, you’ve never been probability theorist’s use of I’m a fiduciary, if you believe (Continued on page 38) the spiritual metaphor!). If Page 38 Frank Martin (Continued from page 37) nets around 5.6%. That’s your hedge fund valuable more than 70% invested. just awful. So I thought, enough?” And I reply, “I Were there times in the let’s come out with a pricing don’t know. Look at our late 1980s or during the structure that I would want track record for yourself.” 1990s where you were fully when my estate comes to And they say, “Well, your invested? be managed by my firm after track record is pretty my death. So I came up good.” And I say, “Why FM: I started managing with a 90 basis points should I charge 2 and 20?” money for others in 1987 maintenance fee for most And they say, “Well, if you and for myself for many accounts, or – ‘or’ is the don’t, you give the years before. I was always critical word – 10% of the impression that your service 100% invested. That could gains above a high water isn’t as valuable.” The “you be long tax-exempt bonds mark. Granted, this is pay for what you get” belief at 14%. It might have been Elkhart, but this money is so well entrenched – with owning a bank in the early management business, if you substantial justification in 1980s. In fact, the 1980s actually make money for most cases – that the were a most atypical period clients, is nicely profitable, weaker players among the for me. I actually borrowed even at 90 basis points or hedge funds have been able money for a while. I’m a 10% of gains above a high to thrive unexposed under guy who doesn’t like to use water mark. that perceptual umbrella. I leverage. I haven’t suspect that 2 and 20 will borrowed money for the If you look at this in the have changed dramatically last 30 years of my life for context of the grand sweep by 2020 because it simply anything – I pay cash for of history, we are living in a cannot survive forever in a everything, because I think if most unusual time that is low-return environment. an investment doesn’t work surely getting long in the Maybe we’ll be seen as without leverage, it’s not an tooth. In finance everything leading the charge. investment you should do. is cyclical whereas in, say, Admittedly, I think it’s hard But the 1980s were a time technology, today’s ideas for a value investor to where I had many more are built on the shoulders of understand the appeal of ideas than I had money. I yesterday’s. Think iPod, Veblen goods – like the high can envision a period in the iPhone, and iPad. You can -end German cars or Rolex future where this could make incredible fortunes in watches – or even most happen again. It’s easy to this business, and you don’t hedge funds. imagine a number of have to overcharge to do it. scenarios that could cause You get to build equity, G&D: What was the prices to sell as dramatically which means you never impetus for launching your below what they’re worth have to worry about your first mutual fund in May of as they have been selling finances, unless you’re a bad 2012? dramatically above what investor. If anything, our they’re worth. industry has become an FM: We never had a embarrassment of riches. In marketing person until two G&D: Your separately the aggregate, after fees we years ago. We brought on a managed accounts don't are a negative value-added fellow who I believe is a have a traditional fee proposition. great marketing thinker and structure. Can you talk strategist. He asked me about your fee structure People say to me at parties, when he came aboard, and why you feel it’s a “How come you’re not ‘Why don’t you have a better alternative to the charging regular hedge fund product for the retail traditional 2 and 20? fees?” (People mistake us investor?’ for a hedge fund because of FM: Obviously a 10% gross our investment style.) “Isn’t (Continued on page 39) return with a 2 and 20 fee Volume I, Issue XVII Issue 2 Page 39 Frank Martin (Continued from page 38) If you can reach those kinds 1989, ultimately getting as Sometimes you need a of people, you’ll have the low as 7500 and currently catalyst to overcome inertia. kind of investors you want trading around 10,800, it’s First of all, it takes you and deserve. We take the been a trader’s or about a year, if you are relatively unusual tact of contrarian investor’s methodical, to get the posting commentaries to market. I hope that we concept from inception to the fund’s website [Martin don’t go into a Japan-style, market. Then we went out Focused Value Fund] to lethargic period, but unlike and talked to some people Pictured: Bill Ackman of Per- keep investors regularly the post-2009 episode, I that we like as long-term shing Square Capital Manage- apprised of our thinking. don’t think we’re going to ment at Pershing Square Chal- investors. We said to them, The most recent was “Why go back to the races lenge in April 2012. “Are there buyers for a fund Would an Enterprising following the next down leg. that is basically a call option Investor Hold Cash Today?” If it’s more like the post-‘74 on financial assets becoming With our fund, like our experience in the U.S., more rationally priced, separately managed sentiment will be negative maybe even cheap?” Bob accounts, we depart from and prices will remain cheap Rodriguez, who’s been as the mainstream: we control and investors will stay risk- risk-averse as I have, says the critical asset allocation averse for a much longer that in expensive markets, decision like the FPA funds time. Stocks will be he'd try to get people to do. Done right, it has a unpopular and the whole buy his fund. He'd say, very salutary effect on dollar process will be anything but “We’ve got a lot of dry -weighted returns. Most glamorous. In that powder take advantage of investors chase environment, I think the opportunities as they performance while we are fund could do well because appear” (Of course they looking for value. I doubt then we could strictly focus think 30% cash is that we will ever have a on stock-picking and grow extravagant. I think 30% problem of too much slowly, while attracting the cash is straddling the money coming in over the kind of clients who just fence!). What Rodriguez transom. But still, biggest is might stay the course. I found is that they’ll say, “I not always best. openly admit that trying to don’t want to put my find permanent capital in the money with you now, and If I can read the tea leaves mutual fund space pay fees, because you’re not and we do go through this admittedly may be insanity earning anything. Call me cathartic process, it’s by another name. I think when things get cheap.” probably going to be like Chuck Royce talked about post-1974. Buffett knocked that in his Graham & But, most investors are the ball out of the park from Doddsville interview (Fall afraid to buy when 1974 to the early 1980s in a 2012 issue). everything’s cheap. Even if bumpy, flattish market. The they know things are cheap, public was exiting the G&D: Can you walk us they worry that they will markets, particularly through your process for become cheaper and they through funds. But what he finding new ideas? find it difficult to pull the found was lots of individual trigger. So the trick for us values. If I could paint a FM: Obviously one thing is to see if we can get picture of the future, I’d say we don’t have, which people into the fund it’d be something like that, Warren Buffett and Seth without any assurance other or maybe something like Klarman do have, is than that we have the Japan. There have been incredible sourcing courage of their convictions great opportunities in Japan. opportunities for – when prices were higher! But ever since the Nikkei investment ideas. We have We’ve been good at 225 began its long about 40 names that we’ve stepping up when times are meltdown from 39,000 in (Continued on page 40) tough and stocks are cheap. Page 40 Frank Martin (Continued from page 39) G&D: What advice do you managements and looking identified as businesses we’d have for students interested for little clues about like to own at a price. The in the investment whether their behaviors cost structure of building management industry? reconcile with their talk. and maintaining an inventory When I see a value investor of “ideas” is quite different FM: As soon as you can who lives really big, it from manufacturing. In our disabuse yourself of the strikes me as a fixed-cost business, we importance of money, it will contradiction in terms. I “People don’t talk analysts think of ourselves help you immensely. All the know there are many as Santa’s elves, working day stuff that’s important in life, exceptions and there are about this very of- in and day out to build you get for free. All the dangers in stereotyping – inventory for Christmas. stuff that’s unimportant, you but when you see such ten, but it’s clear in Our job is to build an buy with money. When I lifestyles, it makes you want inventory of investable first started, I said to myself, to dig a little deeper. John Templeton ideas, so that when prices ‘Boy, as soon as I make a come to us, we’ll get to pick million dollars, I will be G&D: It’s obvious from and certainly in maybe 15 or 20 names. secure.’ Now that shows this interview that you are a Buffett, that the We’d like to get it up to you how misguided I was. voracious reader. Keeping about 50, and then we’d like But as a starving student, the list pretty short, what great value inves- to do what Gerald Loeb, you’re really low on books would you from E.F. Hutton, Maslow’s hierarchy. It’s not recommend that students tors have a lifestyle recommended years ago – unnatural to think, ‘money read? every time you add one, you will fix my problems.’ But if that’s earmarked by take one away. you can disabuse the notion Toward disabusing money frugality. … In fact, that money is a measure of as a measure of success, I We obviously won’t know success, it will really help recommend two books. I’ve never really un- in advance which you. One is Viktor Frankl’s Man’s companies, out of these 50, Search for Meaning. In that derstood how a guy we’ll buy, but we’ll follow Money is very corruptive. book, he says that success, them closely and add them Obviously it’s not been the money, and all the can claim to be a individually to the portfolio case with Buffett. You’ll accouterments of the so- when they get down to a notice the way he lives. called “good life” should fully committed price that is likely to People don’t talk about this never be sought for their produce an expected very often, but it’s clear in own sake, but should be the value investor and return of, say, at least 15%, John Templeton and unintended side effect of live big.” properly risk-adjusted. So it certainly in Buffett, that the devoting yourself to a cause won’t be top-down at all. great value investors have a greater than yourself, or It’ll just be when individual lifestyle that’s earmarked by loving a person more than names like Gentex fall to a frugality. There is no doubt you love yourself. If you price range where I can say, in my mind that Buffett can identify what you’re this thing’s going to double discovered early on that doing as a cause, and it in five years or less. We’ll redundant personal assets happens to be remunerative, default into being fully are really liabilities in it can be a good thing. One invested. Obviously, disguise – that you can easily of the things I decided when exogenous forces like bear lose your personal freedom I made my career choice is markets produce a plethora by becoming slave to your that if I’m going to be good of buying opportunities. possessions. In fact, I’ve at what I did, I’d like to be One must be more never really understood paid for it. This profession circumspect when the how a guy can claim to be a does that. It’s what you do precipitating forces that lead fully committed value with your largess that to lower prices are investor and live big. You defines you. “The measure endogenous. talk about going to see (Continued on page 41) Volume I, Issue XVII Issue 2 Page 41 Frank Martin (Continued from page 40) Adam Smith is famous for exploiting the asymmetry of of a man is not what he Wealth of Nations. But my information between agent gets, but what he gives.” favorite book of Adam and principal in increasingly Smith’s is The Theory of complex systems, capitalism I’d also have people pick up Moral Sentiments. Smith broke down. It’s because Kahlil Gibran’s The Prophet. basically says, if you take everybody forgot the He writes about work, and care of your customers’ second of Adam Smith’s he writes about giving. interest, you’ll take care of two great books. It’s a Those are two chapters that your own. So if you sell the great system, but only if the I would highly recommend best good and if you meet players live by the Golden to young people. I think the customers’ needs better Rule. that will help shape who you than your competitors, become. you’ll always do well. The Lastly, some of the most important of life’s lessons I’m 70 years old and I’m in a are not taught in books. By wheelchair. Even though I all means, find mentors who no longer play golf, I’m like you think are really worthy the golfer who shoots of respect, people who have (works) his age [laughs]. It “If you want to, lived their lives in ways that isn’t work at all. I love it. I you admire. You can’t don’t want to acquire you can make all imitate Buffett, but you can knowledge for knowledge emulate him. I have a sake, rather for wisdom’s the mistakes by try- mentor wall that is the first sake. When I read that thing you see in my small Todd Combs researches an ing to learn every- office. By identifying men idea for 500 hours before who you really admire, you thing yourself, or he buys it, that’s kind of can shortcut your learning impressive. That’s what all you can sit at the curve tremendously. You of our analysts and I should learn ethics by example. aspire to. If you’ve read feet of the masters, Jack Bogle and Warren Outliers, you’ll understand Buffett, in terms of shaping that you’ve got to do the which I have chosen my values, have really had a 10,000 hours. There are no huge impact. And I shortcuts. Too much IQ to do, and shortcut probably have another 10 or can actually be an 15 people on the list of that.” impediment. When I read people to whom I am in the stories of the great debt in perpetuity. If you achievers in our industry, want to, you can make all most of them appeared to the mistakes by trying to have ample intelligence. learn everything yourself, or What seems to differentiate theme of Smith’s second you can sit at the feet of the them is that they appear to book explains why the masters, which I have have overcome the system broke down in the chosen to do, and shortcut limitation embedded in the last 15 years. The Theory of that. idea that “because I’m so Moral Sentiments spoke smart I don’t have to work about the importance of G&D: Mr. Martin, it’s been very hard.” ethical behavior throughout a pleasure speaking with the system. So when you. Don’t limit yourself to just people – and this is Charlie reading business and Munger’s big criticism which economics. Read he calls “moral drift” – philosophy and read the started cutting corners and great economic thinkers. Page 42 Russell Glass (Continued from page 1) construction figuring they afternoon. Glass is co-owner of the do a great deal of future New York Mets and is a director of the San Diego traffic pattern analysis and After graduation from Chargers. He also advised demographic research to Stanford Business School, I Jerry Jones on the $140 determine attractive set up Premier Partners, a million acquisition of the locations. A few years later, merchant bank in Dallas Dallas Cowboys when he in high school, I used to with a close friend and Russell Glass was 26 years old. Mr. Glass read Value Line investment classmate of mine from earned his B.A. in research reports and was Princeton. Our first economics from Princeton fortunate to get a summer transaction was advising University and his MBA internship at LF Rothschild Jerry Jones on the $140 from Stanford Business School. Unterberg Towbin where I million acquisition of the worked in the risk arbitrage NFL Dallas Cowboys when I G&D: What was your department. It was a great was 26 years old. Although introduction to investing? learning experience to many who did not know analyze companies involved him at the time thought “My schedule at in M&A activity. I then went Jerry may have overpaid RG: Growing up, my main Stanford was interests were investing and to Princeton and majored in because the highest price sports, though I found I was economics. After for an NFL franchise until unique in that I more successful with graduation, I started my then was only $100 million, investing. I have been career at Kidder Peabody & the investment has yielded would go to class in fortunate to pursue both Co., where I worked in greater than an estimated these interests throughout corporate finance advising 20x return, or $3.5 billion in the mornings, then companies on their defense value, as the team is my career. On the investment side I have of hostile takeovers, which currently appraised for frequently take the put me at the forefront of approximately $2 billion and served as the President of Spanos corporate Icahn Associates, the the 1980s hostile takeover has probably generated investment firm of Carl wave. Afterwards, I decided cumulative operating profits jet to attend Icahn, and later as the to go to Stanford Business in excess of $1.5 billion. founder of RDG Capital School where I had a The Cowboys went 1-15 business meetings Management. On the roommate who happened during Jerry’s first year of sports side I recently to be the nephew of Alex owning the team but ended during the day, and Spanos, the owner of the up winning the Super Bowl a became a co-owner of the New York Mets and, for a NFL’s San Diego Chargers few years later. The fact later fly back in and founder of the A.G. that Jerry was able to sell number of years, I have also time to attend class been a director of the Spanos Companies, one of luxury suites in a very weak Spanos-family-owned San the top real estate economy at the time and in the afternoon.” Diego Chargers. My developers in the country. turn around an interest in investing started Eventually, I started working uncompetitive team early in at an early age. I made my as a financial advisor for the his ownership tenure first investment at age 13 privately held Spanos demonstrates what a when I bought some organization on a part-time consummate marketing California real estate in basis while in graduate expert and extraordinary northern Los Angeles school. My schedule at entrepreneur he is. County prior to the Stanford was unique in that I construction of a new would go to class in the G&D: How did your highway that would reduce mornings, then frequently career progress from commute time from the take the Spanos corporate advisory into investing? property to downtown by jet to attend business half. I purposely selected meetings during the day, and RG: My focus has always land close to a new later fly back in time to been on investing in McDonald’s that was under attend class in the (Continued on page 43) Volume I, Issue XVII Issue 2 Page 43 Russell Glass (Continued from page 42) as well as investor Carl whom you’ve worked with companies that are Icahn. After some time or have come in contact undervalued – I’m a value though, I realized that being with throughout your “The idea of the investor. After advising a principal had a number of career? Jerry Jones on the Dallas advantages over being a fund was to use Cowboys purchase, I set up research analyst. RG: In my opinion, Carl an independent investment has been the pioneer of corporate research firm called Premier I decided to partner with a catalyst-driven, activist Investment Research and governance as a group of former executives investing. He is both a pure served as an investment and associates of T. Boone value investor and tactician means to hold advisor to a select group of Pickens forming Relational who has produced investors including the Hunt Investors, an activist fund investment success with a management family, owner of the NFL based in California. The multitude of companies, Kansas City Chiefs, led by idea of the fund was to use both on the long and short accountable to Lamar Hunt, who was both corporate governance as a sides. Carl’s returns have a sports visionary and means to hold management been excellent and he is an shareholders. I saw successful businessman. accountable to impressive short seller, Our investment research the efficacy of shareholders. I saw the which most people don’t firm provided investors with efficacy of being a proactive know or pay attention to. being a proactive in-depth, fundamental, 100- investor in companies years His investments have page research reports. We earlier, after seeing Boone compelling risk-adjusted investor in were hired on an annual Pickens’ success with Gulf return profiles. When you retainer basis – so it was Oil, which when he invested look at other investors or companies years truly an independent in it, was trading at a steep hedge funds, you cannot just research service with no discount to the intrinsic look at the headline return. earlier, after seeing conflicts of interests. We value of its reserves because You need to know how were not paid on our ability Boone Pickens’ it was so poorly managed. much leverage was used and to trade or set up After a couple of years at what other types of risks success with Gulf management meetings, but Relational, Carl Icahn were taken to generate rather on our ability to help recruited me to become those returns. Carl’s Oil, which when he our clients find profitable President of Icahn portfolios are prudently ideas. Back then, 99% of Associates. Carl was a hedged, so I would say that invested in it, was Wall Street research had a great mentor. He is a self- his risk-adjusted returns are ‘Buy’ recommendation, but made professional with even more impressive than trading at a steep our research was 1/3 ‘Buy’, great intelligence and most realize. 1/3 ‘Sell’, and 1/3 ‘Fair discount to the strategic acumen – he went Value’. to Princeton from a public G&D: Can you talk about intrinsic value of its high school that had your current firm, RDG We took the approach of probably never sent a Capital? reserves because it looking at public companies student to Princeton before. from the perspective of a Carl was one of the first and RG: At RDG, I have was so poorly private equity owner. Our most prominent investors essentially replicated the research consisted of who believed in taking a staffing and structure at managed.” thorough due diligence as proactive approach to Icahn Associates. We have opposed to just predicting investing in public four investment next quarter’s earnings. companies. When I joined professionals, all of whom This thoroughness caught his firm he had already have M&A backgrounds. the attention of a number of established himself as a Our investment style is mutual funds, hedge funds, legendary investor. private equity oriented – we and investment managers employ a hybrid private such as Fidelity Investments, G&D: How does Carl equity / public investment Wellington Management, compare to other investors (Continued on page 44) and Neuberger & Berman, Page 44 Russell Glass (Continued from page 43) if we believe an opportunity opening expenses, growth- strategy. We look for is compelling, not just oriented R&D and capital undervalued public because we have to put expenditures, or other companies that can benefit money to work. As a result costs associated with from a catalyst to both our investment process investing for the future. If enhance and unlock value. yields a high rate of you find cheap companies We focus on U.S. equities, profitable investments that are unfairly penalized consider ourselves to be because we have such a high for making long-term “I have always industry agnostic, and invest threshold for value – we investments in the business, across the market typically require at least a those investments can believed some of capitalization spectrum, 50% “margin of safety” as become very productive and although most of our Seth Klarman from Baupost yield significant returns for the best investment historical investments have would say. the business and its generally been in small and investors. We also favor decisions are those midsize companies. Among G&D: Can you give us a companies which trade at you choose not to the catalyst events we little detail on your research low valuations relative to generally focus on are their make. Our special private equity sustainable and strategic free cash situations buyouts, flow that corporate have investment spinoffs and operating divestitures, margin approach allows us monetization improvement to invest if we transactions of potential and non-core which often believe an assets, share have a sum buybacks, of the parts opportunity is special value in dividend excess of compelling, not just distributions their trading and other price. because we have to RDG Capital team put money to Once having recapitalization events, and process? identified interesting work.” improvements in operating undervalued companies, we management and corporate RG: We first conduct a then conduct extensive due governance. statistical valuation screen diligence with management, to generate ideas, and if industry analysts, customers, Historically we have they pass our screen, we competitors, bankers, and structured special purpose perform a more detailed often private equity firms investment partnerships quantitative assessment and who have relevant sector with co-investors who we analyze companies on a expertise. I have also been believe bring strategic value qualitative basis. While our on the board of several or industry experience to systematic screen finds companies in an array of each investment public companies that trade industries, including real opportunity. I have always at a significant discount to estate, energy, biotech, believed some of the best peers, we also look at things manufacturing, and business investment decisions are others often do not focus services. These those you choose not to on or issues for which the directorships give our team make. Our special market unjustly penalizes insights into many types of situations investment companies, such as pre- (Continued on page 45) approach allows us to invest Volume I, Issue XVII Issue 2 Page 45 Russell Glass (Continued from page 44) million, despite the fact that independently), improving businesses and provide the company had only staff scheduling, increasing valuable operating executive recently invested $150 higher-margin beverage relationships. We have a million in cumulative capital revenue mix, and licensing great pool of industry expenditures over the prior the Benihana brand to contacts that we can call on few years. The market was selected grocery products. “As industry- when we need to do a deep discounting the recent Finally, we were also dive to learn about an capital improvements by attracted to the fact that in agnostic investors, investment opportunity. If 50% and assigning zero value addition to owning its we still find the opportunity we look for public to the existing restaurant flagship restaurant chain, attractive after such an chain generating $25 million Benihana also owned two evaluation process, we then companies that in recession-level EBITDA other restaurant concepts, consider what catalyst which you were essentially New York-based Haru and would be better off events may enhance and getting for free. Mid-Atlantic-based RA unlock shareholder value. Sushi. These restaurant being private Finally, we consider the At the time, the company chain subsidiaries separately corporate governance was trading at less than 3x were worth nearly the entities. If you look structure and shareholder EBITDA and, moreover, entire market value of the composition of a company at a typical industry owned about $50 million parent company. to determine the feasibility worth of real estate of implementing the desired -focused fund, the underlying several of its We decided to team up catalyst initiatives. restaurant locations which with a restaurant-focused sector that it Ultimately, we seek to could be monetized via a private equity firm and invest in those companies sale/leaseback transaction. made a buyout offer to the focuses on would which meet all our If you took the near $75 company. Though our offer investment criteria. It is a million enterprise value and was rejected, the company likely be compelling very time- and labor- subtracted the approximate subsequently hired Jefferies intensive process, as we as an undervalued $50 million in real estate to explore strategic want to understand the value, the company was alternatives and eventually business and not just the opportunity only really trading at just 1x sold itself to Angelo security. That process EBITDA adjusted for the Gordon. The stock went 5% of the time, and usually takes about three to modest incremental rent from $4 to $16 per share in six months before we make expense. Furthermore, at less than two and a half it would be each investment. By the time of our initial years. maintaining these investment, the economy reasonably valued investment disciplines and was just starting to come As industry-agnostic acting like private equity or overvalued the out of the recession, and we investors, we look for public investors in publicly traded believed that the company companies that would be companies, we have other 95% of the could increase EBITDA better off being private historically generated from $25 million to $40+ entities. If you look at a time.” unlevered IRR in excess of million just based on a typical industry-focused 30%. recovery in same store sales fund, the sector that it growth and without any focuses on would likely be G&D: Can you provide an operational improvements. compelling as an example of this strategy as it Yet, we were also able to undervalued opportunity applied to a past identify a number of only 5% of the time, and it investment? operational improvements would be reasonably valued that could be made, or overvalued the other RG: A couple of years ago, including centralization of 95% of the time. This is the we invested in Benihana, the purchasing (many of the nature of a reasonably Japanese steak house chain. restaurants at the time had efficient capital market – At the time, the enterprise been buying supplies (Continued on page 46) value was less than $75 Page 46 Russell Glass (Continued from page 45) professionals have M&A retail and manufacturing much of what is out there is backgrounds, which we find industries. For large fairly priced at any given helpful to navigate these retailers and manufacturers, point in time. We try to corporate governance this is mission critical focus on the 5% of matters. software – approximately companies that are valuation 75% of the top retailers and outliers, regardless of the G&D: Can you talk about a manufacturers use JDA’s Pictured: Tom Russo industries that they’re in, speaks at the Omaha Din- recent investment? software. The supply chain and because of this, we will management software ner in May 2012. typically only invest in half a industry has been dozen to a dozen companies undergoing significant on an annual basis. consolidation. G&D: What is your When we started looking at targeted time horizon for a the company, we were able typical investment? to identify a high quality company trading at a low RG: We’d ideally like to valuation relative to its “We’d ideally like see value created within a sustainable free cash flow year’s time, if not sooner, to see value created with significant costs that but we are not short-term could be cut out by a opportunists. As within a year’s time, strategic acquirer. Trading arbitrageurs of value we are around $27 per share, the content to invest in longer- if not sooner, but company had an term opportunities. Our approximate $1 billion investments have generally we are not short- enterprise value and, ranged from six months to term opportunists. generating nearly $200 two years. The longer million in EBITDA, was you’re in an investment, the As arbitrageurs of trading at only 5x EBITDA, longer you’re subject to or an approximate 20% free exogenous risks. If you can value we are cash flow yield given the low influence change sooner, it capital-intensive nature of increases your IRR and content to invest in the business, with reduces macroeconomic substantial recurring risk. We aim to generate longer-term revenue from long-term the highest return with the software maintenance opportunities.” least amount of risk, so the contracts. Based on our faster we can help push analysis, we believed a along the value-unlocking strategic buyer could moves that need to be extract as much as $125 made, the better. million in synergies so, in reality, the company could We also view a company’s generate more than $300 annual meeting as a way to million in adjusted EBITDA, enact change and gain RG: Several months ago, implying an approximate 3x support from other we became involved with an pro forma EBITDA multiple, shareholders. Every public enterprise software an especially attractive company is required to hold company called JDA discount to the 10-12x an annual meeting, and Software. JDA is primarily average EBITDA multiple of some companies allow for known as a best-in-class its enterprise software the calling of a special supply chain management industry peers. meeting. As I mentioned software vendor for the (Continued on page 47) earlier, all of our investment Volume I, Issue XVII Issue 2 Page 47 Russell Glass (Continued from page 46) recently completed spent in the next 24 months At the time, the company acquisition and the pending before LP capital was under investigation for introduction of new commitments expire. accounting irregularities by products. JDA also had an Private equity firms are “We figure the Securities and Exchange M&A value according to our eager to put this capital to Commission. We looked analysis that indicated a work. We figure altogether altogether there is into the accounting issue private equity or strategic there is $300+ billion in and determined that it was $300+ billion in acquirer could justify paying private equity “dry powder” not fraudulent in nature, but $45+ per share or a 50%+ plus $750 billion in readily rather a minor issue private equity “dry premium and still expect to available low-interest debt regarding the historical generate an attractive 25%+ financing in a robust credit powder” plus $750 timing of revenue equity IRR and an active market (in which leveraged recognition. JDA was also shareholder base with buyout debt/EBITDA billion in readily in the process of completing customary corporate multiples have increased to the integration of an governance policies. In fact, near historic levels); this available low- acquisition and preparing to we believed the private translates into $1+ trillion in introduce a promising new interest debt market value was double private equity-sponsored multi-channel software the public market value. acquisitions in the next 24- product, so we expected financing in a 36 months. Additionally, better results going We liked the investment there is $1.7+ trillion in robust credit forward. because there were multiple cash on the balance sheets ways to win, either through of non-financial market (in which Based on the steady nature an accretive share buyback corporations, nearly one of its business – high-margin or a sale of the company at third of which is higher than leveraged buyout long-term contracts, sticky a substantial premium. In amounts typically held under customer relationships, and debt/EBITDA the end, the company normal economic low churn – we thought the recently received a $45 per conditions. We believe a company could easily do a multiples have share buyout offer from Red reasonable portion of this highly accretive leveraged Prairie, an enterprise capital (together with new increased to near recapitalization share software company owned public equity issuance and buyback which would result by private equity firm New additional debt financing) historic levels); this in stock appreciation from Mountain Capital. It was a will be directed toward $27 to $40 per share. One good outcome for public company M&A translates into $1+ of the two largest management, private equity activity. shareholders had already trillion in private investors, and shareholders. achieved board Our thesis is that in the last representation and was equity-sponsored G&D: In a recent guest few years, most companies advocating for a sale of the lecture at Columbia have grown earnings by acquisitions in the company. The company’s Business School you cutting costs. By now, most valuation metrics and mentioned that you believe companies cannot cut costs next 24-36 fundamentals were there will be a tsunami of much more because there is compelling. It had a low EV/ buyouts in the next couple no room. Economic growth months.” EBITDA multiple on both an of years. Could you expand is going to be slow for the absolute and relative basis on that? foreseeable future, which compared to its peers, was means that for most trading at a 20% free cash RG: We estimate there is companies, top-line revenue flow yield, was growing approximately $150 billion growth will be sluggish. revenue and earnings at high in private equity capital that Therefore, in order for single digits on an organic was raised a few years ago companies to grow bottom- basis, and had operating in vintage 2007-2008 buyout line earnings there is strong margin improvement in funds that has yet to be motivation to acquire process from the cost deployed and needs to be (Continued on page 48) savings implemented in a Page 48 Russell Glass (Continued from page 47) RG: Working with Carl at companies through the industry competitors and (Icahn) helped me see the lens of a private equity eliminate duplicative costs. merits of being a proactive investor. We like a hybrid This scenario should result investor in companies. Just approach – being a public in an increase in both as Steve Schwarzman and shareholder but thinking and friendly and hostile M&A Henry Kravis find attractive acting like a private equity activity in the next few fractional business owner. years. In fact, this Although we lack the expectation is supported by absolute control of a private a relatively recent Ernst & equity owner, in cases Young survey which where we garner the “It’s important to look indicated that 36% of U.S. support of a majority of corporations intend to at companies through shareholders, we become engage in M&A activity the informal voice of the the lens of a private within the next year or so. majority and thereby have equity investor. We like influence on management. G&D: It sounds like some In the past we have hosted a hybrid approach – of those supportive informal shareholder forums dynamics have been in place being a public to discuss the management for a while. Why do you and future direction of shareholder but think the buyout activity companies in which we are hasn’t ramped up this year? thinking and acting like a stakeholder. The benefit a private equity of being a public investor is RG: The election certainly that you can typically played a part – corporate fractional business acquire equity at a executives don’t like to significant discount to its owner. Although we make important M&A intrinsic private market decisions in an uncertain lack the absolute value (rather than a buyout environment. They want to premium), employ no control of a private know what the tax, leverage (rather than 4x or healthcare, and regulatory equity owner, in cases often greater debt/EBITDA environment is going to in an LBO), and still have an where we garner the look like. With the election element of constructive over, there is more clarity. support of a majority of influence on the company. Companies have reached shareholders, we the end of their cost-cutting There’s been a positive ability, as well. To put this become the informal change towards shareholder in a sports analogy, we activism in the past 10 voice of the majority believe that we’re in the 7th years. The rise of proxy or 8th inning of companies and thereby have advisory firms has provided reducing internal costs and a level playing field. After influence on will now begin to see a shift recognizing years of to acquiring businesses. management.” corporate mismanagement and malfeasance, G&D: Do you think activist institutional investors have investors are still viewed become justifiably more with a stigma? It seems like active and now have a it is now more socially businesses and enhance greater willingness to acceptable, if you will, to those businesses, we believe support dissident engage management and professional public market shareholder initiatives. advocate for change than it shareholders can do the Unlike in the past when was 10 or 15 years ago. same. It’s important to look (Continued on page 49) Volume I, Issue XVII Issue 2 Page 49 Russell Glass (Continued from page 48) management does not have 10-15 years ago? institutional investors their personal interests almost always sided with properly aligned to RG: While the number of incumbent management maximize shareholder value. activists has grown modestly against activist shareholders, In these cases, we organize in recent years I believe the in recent years dissident shareholder forums, engage opportunity set has grown shareholders have actually in proxy contests, and more and that we are still at more often than not won exercise other corporate the early stage of public the majority of proxy governance measures to shareholders taking more contests or reached “In a study hold management initiative in the governance favorable settlements, such accountable to serve the of the companies they own. conducted by as board representation, to best interest of avert a proxy contest. shareholders. G&D: Can you talk about a researchers at Although there is still the few mistakes you've made in classic management / agency G&D: You’ve done your career? Wharton and dilemma in corporate academic research around America, the board and Columbia Business activist investing and how I should have bought more management of more once an activist becomes land in southern California companies, recognizing their School, companies involved, a company’s stock when I was 13 years old. fiduciary duties to price outperforms the which had been the shareholders, have become market. Can you talk a little G&D: What’s the best appropriately more about your research? advice you’ve ever received? subject of 13D responsive to activist investors. We think activist RG: As an undergraduate RG: Working with Alex filings indicating the investing is still in its early majoring in economics at Spanos taught me to have a stages here, and presence of an Princeton I wrote an “can-do” attitude. From a international markets are 10 academic research report man who overcame to 20 years behind the U.S. activist shareholder on the efficiency of capital adversity early in his life to with regard to corporate markets and the economic become one of America’s generally governance and activism. benefits of shareholder true Horatio Alger success activism and hostile stories, Alex advised me to outperformed the G&D: In terms of the takeovers. Since then, there set achievable goals in life range of activists, from have been numerous and, when confronted by S&P 500 by friendly activists such as academic studies highlighting challenge, to act with Relational at one end to the approximately 5%- the efficacy of shareholder integrity and dedication to more antagonist activists on activism on investor returns. “just make it happen.” the other end of the 7% per annum.” In a study conducted by spectrum, where do you researchers at Wharton and G&D: Thank you very stand? Why is this Columbia Business School, much for your time, Mr. approach best for you? companies which had been Glass. the subject of 13D filings RG: We are in the middle indicating the presence of an of the activism spectrum activist shareholder with flexibility to work on a generally outperformed the constructive, collegial basis S&P 500 by approximately with incumbent 5%-7% per annum. management to the extent they are legitimately willing G&D: Do you feel that the to explore ways to enhance activist investor field is shareholder value, but also getting crowded? Are there to work as a staunch still the same opportunities defender of shareholder for you that were available rights in cases where Page 50 Jon Friedland (Continued from page 1) the stock was widely owned backpacked around Asia. hedge fund, where he was by many hedge funds. After This was perhaps my first responsible for media, entertainment, and leisure a few years at that fund, Pat explosive learning ideas for the firm. Mr. Duff, a fellow CBS Alum experience. I traveled by Friedland received his B.A. who had been one of my boat, bus, train, and plane all in Political Science from visiting Security Analysis over China, Tibet, Thailand, Vassar College in 1991 and professors, introduced me Vietnam, and Nepal. For his MBA from Columbia to Paul Orlin and Alex someone that grew up in Business School in 1997. Porter of Amici Capital. Ohio, this was really an eye- We hit it off very well in opening trip. I fell in love G&D: How did you first terms of investment with learning about different Jon Friedland become interested in philosophy and approach. cultures, which led me to a investing and what brought That was over 10 years ago five-year career in foreign you to Amici? and I still come to work aid prior to attending CBS. happy every day. JF: At Columbia Business The great thing about the School, I took a number of G&D: What is the meaning investment business is that classes that had a profound behind the name of your there are investment impact on the course of my firm, Amici Capital? opportunities to suit career. Bruce Greenwald’s anyone’s background, “The great thing Value Investing class was JF: As of January we interest, and creativity. one. The creativity and changed the name of the When I came to Amici in about the clarity with which he management company from 2001, there was little analyzed businesses was Porter Orlin to Amici international investment. investment business fascinating. Second was Capital to align it with the Then in 2002 we saw a Security Analysis with Jim name of our funds. ‘Amici’ number of restructurings of is that there are Rogers. He put students in in Latin means ‘friends’. The international companies in the role of a real time capital that was initially industries that I had studied investment company analyst. New raised was from friends, so carefully in the U.S. – opportunities to York-based investment from the beginning Amici specifically the managers with expertise on was used in our funds’ telecommunications and suit anyone’s our companies would come names. Since the firm’s cable television industries. to Jim’s class to grill us. It establishment in 1976, we Companies like NTL background, was great. It gave me a have maintained the Incorporated in the UK and sense of how much you philosophy that our pan-emerging market cell interest, and should know before making investors and partners phone operator Millicom an investment. And I fell in should be treated as friends. International were trading at creativity.” love with the explosive Amici is also reflective of distressed levels because of learning process that the cooperative culture forced sales and complexity. accompanies primary within the firm. The comfort that I had from research on an industry or my foreign aid work in company. G&D: What drew your Africa, Asia, and Latin initial interest to investing America was important. It I was hired out of CBS by a primarily outside of the helped us to become more large hedge fund because I U.S.? What are some of the comfortable applying the had done some original advantages and Amici investment process of primary research on an disadvantages with an deep fundamental business, ultrasound system international focus? industry, and valuation manufacturer for that analysis to recognize that Security Analysis class. My JF: Halfway through my these companies were research suggested the college career at Vassar, I trading at a significant company’s stock was highly took a semester off and (Continued on page 51) overvalued, at a time when Volume I, Issue XVII Issue 2 Page 51 Jon Friedland (Continued from page 50) How do you narrow down inwardly driven. Imports to discount to intrinsic value. your hunting ground to a GDP plus exports to GDP manageable level from sum to a mid-30% of GDP Around this time we were which to sort through to in both, which is quite low also short automotive find new ideas? by comparative standards. manufacturers in the U.S. in We like internally-driven large part because JF: We try to invest in the economies because they are competitors in Japan and same way and in the same less subject to global elsewhere were gaining types of companies no economic winds. market share and operated matter where we invest. Increasingly we have also with structural advantages. We are looking for great developed contacts and Additionally, we were short franchises trading at experience in these some IT consulting substantial discounts to countries, which has companies in the U.S. as intrinsic value. increased our comfort level their most profitable further. business lines were facing We invest in emerging stiff and increasing markets because our view is Secondly, we invest in global competition from Indian IT that consumers, corporates, companies that do business outsourcing companies. and sovereigns in emerging in a portfolio of emerging markets have far better markets countries, many of I think at that time, and balance sheets than they do which we would not invest increasingly since then, the in the developed world. As in directly. We are able, ability to apply our a result, we believe that through a portfolio investment process to an economic growth in approach, to take advantage expanded universe of emerging markets is going of positive trends in investment candidates to be far greater than it will countries in which we improves the likelihood of be in the developed world. would not take a our success. I think this is a The World Bank just concentrated position. big advantage for us. published a study projecting Brazil and India have that GDP growth in predictable government G&D: Are international / developed countries in 2013 policies and a rule of law domestic pair trades, such will be 1.2% and in that we understand. We as the aforementioned ones developing markets it will be cannot say this about many from a decade ago, a big 5.5%, which is a huge other countries. part of what you look for? differential. G&D: How do you go JF: We do not seek out Within that context we take about looking for new ideas? pair trades. We are quite a multi-pronged approach. active in our industry First, we invest in JF: As our team travels, analysis in trying to identify companies doing business in reads, and speaks to people, both winners and losers. specific emerging market we are always looking for Sometimes this will result in countries, India and Brazil great companies that we a short or hedge from the being primary examples, would love to own at the same industry, but each where we have a high right price. investment, long or short in degree of confidence in the our portfolio, goes through long-term macro outlook. We enter these companies the same investment Both countries have large into a database and refer to scrutiny and must stand on populations and diversified these companies as our its own. economies that are capable ‘Battleships’. These are of supporting world-class large, highly profitable, and G&D: There is an companies. Second, both of well-capitalized companies extensive universe of those countries are fairly (Continued on page 52) international companies. Page 52 Jon Friedland (Continued from page 51) opportunities presented to list, the 101st company? that have demonstrated them. We have met and pricing power in studied management at JF: It comes slowly. We consolidated industries with most of these companies, may add two to five low competitive intensity. and have done extensive companies a year, while at They are run by the same time a few management teams that companies will come off of have established a record of “We believe that the list if some missteps intelligent capital allocation have happened or the story and have made strategic investing in has changed. We do a lot decisions we understand. of traveling to Latin We believe that investing in ‘Battleship’ America, Asia, and Europe ‘Battleship’ companies, as companies, as distinct looking for new ideas and distinct from very small we like to meet with new upstart companies with from very small companies. We are always Pictured: Jon Friedland speaking at the Moon Lee illiquid stock, gives us an looking for new candidates. added margin of safety upstart companies Prize Competition in Janu- ary 2012. because these companies with illiquid stock, G&D: How important is are less likely to be blown meeting with a management around by economic gives us an added team face to face? volatility. We believe this is margin of safety an important risk JF: It is very important. management component because these We believe that strong when investing in emerging management teams play a markets, where both companies are less critical role in the ultimate operating performance and success of an investment. likely to be blown stock price performance can We need to know that be more volatile. around by economic management teams are thinking like owners and we G&D: It sounds like you volatility. We believe have to understand their are looking for ‘Warren long-term outlook for their this is an important Buffett-like’ companies and company and their industry. have a longer-term time risk management We need to understand horizon than the typical what is important to them, hedge fund. component when how they incentivize their investing in emerging employees, and what their JF: In a way that is right. company culture is like. For Our Battleships list contains markets, where both us, this interaction is roughly 100 international important and can be telling. companies that we would operating I can recall one otherwise like to own at the right performance and promising investment that price. We may own only a we passed on after meeting certain number of these stock price the CEO who was very companies at any given time, crude, which we feared was but pick our entry and exit performance can be an indication of poor points based on current more volatile.” judgment in other areas. valuations. They may not all be attractive investments in work on them over the G&D: How do you manage any particular year, but the years. your long and short common thread is our high exposure? Is there any degree of confidence in G&D: How do you find mathematical component to their long-term ability to the next name to add to this (Continued on page 53) capitalize on the Volume I, Issue XVII Issue 2 Page 53 Jon Friedland (Continued from page 52) that the much faster growth RFPs for $65 billion worth it, or is it more based on rates of the developing of infrastructure products. the quality of long and short “Sometimes you world economies described ideas at a point in time? in the World Bank report A lot of emerging markets have to go outside we discussed, coupled with are turning the global JF: The Amici Global Fund a valuation discount to liquidity surge from the U.S. to find a that I manage is somewhat developed market stocks, developed market central different than our core creates a rich opportunity banks into their advantage, ‘grand bargain’. We funds. It offers set in emerging countries. trying to steer capital concentrated exposure to believe that the toward foreign direct the international positions Now is an interesting time investments as opposed to within our core Amici funds much faster growth to invest in emerging portfolio flows. We look at managed by Paul Orlin. The markets because emerging this as a third, and smarter, rates of the Amici Global Fund was market governments are stimulus tool in addition to established to take increasingly making positive the more conventional fiscal developing world advantage of the attractive long-term policy decisions, and monetary tools. emerging market dynamics having exhausted most economies we discussed before. It other options. This is in G&D: Can you talk about generally has a larger net described in the part because many an idea that you like right long exposure and accepts countries are bumping up now? World Bank report more volatility on the against more governors on assumption of a highly their growth rates than they JF: Our compliance we discussed [1.2% attractive long-term have in the past decade. department will not allow opportunity. At any given Inflation recently has been me to mention specific growth in time, our exposure is a stubbornly high and a lot of names, but I can speak more function of the risk/reward labor has already come into broadly. Real estate in India developed countries opportunities we are seeing the labor pool. More is currently an area that is with individual stocks. We vs. 5.5% growth in fundamental changes and ripe for investment. There are not macro investors. action from governments is are a few ‘Battleship’ emerging markets], required than has been companies that have We also pay close attention necessary over the past managed to come through coupled with a to valuations across the decade. What gives us the latest down-cycle intact emerging market asset class comfort is that we are and are in a good position. valuation discount on an absolute basis and on starting to see that happen. We have a position in a a relative basis compared to company that owns a land to developed developed markets. This For example, in India since parcel outside of a major analysis goes back 20 years market stocks, September we have seen Indian city, in an area akin to to give us a sense of liberalization relating to Greenwich, Connecticut whether the odds are creates a rich foreign direct investment in outside of New York, which stacked in our favor. retail and aerospace, a it is developing into opportunity set in Emerging market stocks are reduction in subsidies for residential and commercial volatile and correlated, so diesel and natural gas prices, space. We believe it has an emerging we think it is important to and the first hike in asset value substantially be conscious of this data. government-run railroad greater than its current countries.” fares in a decade. Real market value. The question G&D: Where are we interest rates in Brazil have is whether this asset value today in terms of emerging plummeted from over 10% will ever be realized for the market attractiveness versus to less than 2% in the past benefit of minority developed markets? eight years, much of this investors. reduction in the last year JF: Sometimes you have to and a half. The government We are seeing signs of go outside the U.S. to find a in Brazil has recently issued (Continued on page 54) ‘grand bargain’. We believe Page 54 Jon Friedland (Continued from page 53) Brazil. But to support catalysts to help get the positive strategic changes in growth, Brazilian Brazilian government to operating practices that homebuilders began to take some positive actions suggest the asset value may outsource oversight of as discussed earlier. become visible and we are construction to such an hopeful that it will extent that they lost G&D: It seems that you appreciate in the next year. complete control of the are primarily focused on Pictured: Paul Orlin of We have seen developers process. The cost and time hard asset plays in emerging Amici Capital speaking at the sell down crown-jewel overruns were enormous markets. Do you spend Moon Lee Prize Competi- assets and non-core assets and destroyed profitability. much time looking at other tion in January 2012. to shore up their balance Because of the way things types of businesses in these sheets. We see a are accounted for, the markets? willingness to re-focus entire hit to profitability business models on core comes at the end of a JF: Absolutely. There are competencies. The roots of project – you can’t go back such powerful tailwinds these management teams and restate prior periods. behind consumers, such as are as buyers, developers, Financial results look rapidly rising wages and and marketers of land. terrible now but new standards of living. They have now outsourced construction launches have Consumer-focused construction and project declined substantially from a companies are among our management to best-in-class few years ago. We think favorite investment themes companies and substantially that profitability of these in developing markets, as reduced the volume of companies may very well long as we can purchase product they seek to bring return to high levels. These them at reasonable to market annually. This companies are currently valuations. We have will improve quality, pricing trading at or below invested in drugstore and integrity, and ultimately cash liquidation value, with no mall companies in Brazil. flows. value ascribed to the There is a big secular shift ongoing value of the from informal to formalized Furthermore, in India we business. retail in the country. Some think there is a good chance of these companies that that interest rates come G&D: We remember the have scale, buying power, down in the next year, impact that the Beijing and systems are benefitting which will increase Olympics in 2008 had on tremendously. In India we valuations and will increase the level of investment have invested in beverage the availability of mortgages spending in China. How companies. Last year we from extremely low levels. much do the impending invested in a company that Mortgages are below 5% of 2014 World Cup and 2016 had substantial share in the GDP in India, well below Olympics impact the way beverage industry. It ran the global average. you look at construction in into some distribution Brazil? issues that had impaired We see a similar situation profitability in the short with Brazilian homebuilders. JF: I look at these events as term. We studied how Over the last residential real helping force good similar disruptions had estate cycle, all of the decisions. Airports, rail impacted profitability at the developers raised money at lines, and roads around the company over medium-term the same time and began to country are going to have to periods, and realized that grow launches at multiples see some investment. Brazil the company was likely to of prior 5- and 10-year has among the worst recover and pass through rates. Unlike in India, infrastructure in the world. incremental costs that it project oversight and I am hopeful that these faced. In fact, it was one of management was a core events are serving as (Continued on page 55) competence historically in Volume I, Issue XVII Issue 2 Page 55 Jon Friedland (Continued from page 54) Your Core funds were ultimately becomes a long- the largest contributors to down less than 6% versus a term proposition, but once last year’s profitability. 37% decline for the S&P you are seasoned and have 500. How were you able to some maturity allowing you “We have an G&D: What is Amici’s achieve such a great year to understand yourself “secret sauce?” What has investment process when many other hedge better, you might discover led to you outperformance funds and the broader that you should be that has been refined over the long term? market struggled? elsewhere instead. Find a place that you are since 1976 and we JF: We have an investment JF: We have a culture of comfortable with. I was at a process that has been seek constant risk management at Amici growth-oriented hedge fund refined since 1976 and we Capital. It is always primary prior to coming to Amici improvement in that seek constant improvement in our minds. We are never and found myself as the ‘low in that process. We know going to chase performance -beta’ guy there, whereas at process. We know how to identify great if we don’t think the Amici Capital I tend to be businesses and broken how to identify great opportunity set looks more comfortable as the businesses. We have the attractive. We are heavily ‘high-beta’ guy. Find a place businesses and broken ability to judge management short single names – this is a where you can bring your teams by meeting with them core part of what we do. In interests, your passions, and businesses. We have and by analyzing quantitative the process of turning up your experience and try to changes that occur in a the ability to judge great businesses you are differentiate yourself. business while a specific always going to turn up management teams team is in charge. We also some losers. It is important G&D: Thank you for constantly assess risk/ to hedge the portfolio with sharing your thoughts with by meeting with them reward in our individual a set of companies that are us, Mr. Friedland. and by analyzing positions and pockets of misunderstood from a risk in the portfolio. perspective that is too quantitative changes optimistic. Our Over the past eight years, performance in 2008 was a that occur in a we have developed a wide function of sensing the risks business while a array of contacts across the in the global globe. There are not many macroeconomic specific team is in funds that are U.S.-based environment and reducing value investors that have the charge. We also exposure slightly, and, most ability or the inclination to importantly, having a set of constantly assess risk/ look intensively for single shorts that were oriented names in many foreign toward the leverage that reward in our countries. We’ve found had built up in the system. ourselves increasingly individual positions capable of monitoring many G&D: Do you have any and pockets of risk in different situations via our parting words of wisdom list of ‘Battleship’ for our readers? the portfolio.” companies. When a disruption takes place with a JF: As you come out of company on this list, due to business school it is our team-oriented nature, important to take the best we are capable of collapsing opportunity you can find a lot of resources on an idea where you can get the best and quickly coming to a exposure to a variety of conclusion. situations so you can see what you like and what you G&D: Amici had great firm are good at. Ideally that job -wide performance in 2008. Get Involved: To hire a Columbia MBA for an internship or full-time position, contact Bruce Lloyd, Director, Employer Relations, in the Office of MBA Career Services at (212) 854-8687 or email@example.com. Available positions also may be posted directly on the Columbia website at www.gsb.columbia.edu/jobpost. The Heilbrunn Center for Alumni Graham & Dodd Investing Alumni should sign up via the Alumni website. Click here to log in, Columbia Business School (www6.gsb.columbia.edu/alumni/emailList/showCategories.do), then go to the Uris Hall, Centers’ Suite 2M 3022 Broadway Centers and Institutes category on the E-mail Lists page. New York, NY 10027 212.854.1933 To be added to our newsletter mailing list, receive updates and news about events, or firstname.lastname@example.org volunteer for one of the many opportunities to help and advise current students, please fill out the form below and send it in an e-mail to email@example.com. Name: _____________________________ Visit us on the Web Company: _____________________________ The Heilbrunn Center for Graham & Dodd Investing Address: _____________________________ www.grahamanddodd.com Columbia Student Investment City: _____________ State: ________ Zip: ________ Management Association (CSIMA) http://www.csima.org/ E-mail Address: _____________________________ Business Phone: _____________________________ Would you like to be added to the newsletter mail list? __ Yes __ No Contact us at: Would you like to receive e-mail updates from the Heilbrunn Center? __ Yes __ No firstname.lastname@example.org email@example.com Please also share with us any suggestions for future issues of Graham and Doddsville: firstname.lastname@example.org Graham & Doddsville 2012 / 2013 Editors Jay Hedstrom is a second-year MBA student and a member of the Heilbrunn Center’s Value Investing Program. During the summer Jay worked for T. Rowe Price as a Fixed Income Analyst. Prior to Columbia Business School, Jay worked in investment grade fixed income research for Fidelity Investments. He can be reached at jhed- email@example.com. Jake Lubel is a second-year MBA student and a member of the Heilbrunn Center’s Value Investing Program. During the summer he interned at GMT Capital, a long-short value fund. Prior to Columbia Business school he worked under Preston Athey on the small-cap value team at T. Rowe Price. He received a BA in Economics from Guilford College. He can be reached at firstname.lastname@example.org. Sachee Trivedi is a second-year MBA student. Over the summer this year, she in- terned at Evercore Partners in their Institutional Equities division as a sell-side research analyst. Prior to Columbia Business School, Sachee worked as a consultant in KPMG’s Risk Advisory business and at Royal Bank of Scotland in London. She can be reached at email@example.com.
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